CHAPTER 7

Inventory
 Learning Objective 1

Identify what
items and costs
should be
included in
inventory and
cost of goods
sold.
 Define Inventory and COGS. What
are some of their characteristics?
 Inventory is reported
Goods either on balance sheet as
manufactured or an asset.
purchased for  When sold, inventory
resale. is reported on income
statement as an
expense (cost of
goods sold).
 COGS: the cost of
inventory sold during
the period.
 Describe the Time Line of
Business.

BUY SELL
raw materials or ADD finished
goods for resale value inventory

COMPUTE

ending inventory cost of goods sold

 What is Inventory?
Defined according to type
and nature of the company.

Merchandising: Manufacturing:
Items to be resold. • raw materials
For a supermarket, food is • work in process
inventory, the shopping cart • finished goods
is not.
Define Each Manufacturing
Inventory
 Raw materials
 Goods acquired in a relatively
undeveloped state.
 Eventually will compose a major
part of the finished product.
 Work in process
 Partly finished products.
 Manufacturing plant contains work-
in-process inventory.
 Finished goods
 Completed products waiting for sale.
 What Costs are Included in
Inventory?
$ Costs incurred in buying
inventory and preparing it for
sale.
$ Cost of raw materials.
$ Cost of work-in-process
inventory. Costs NOT included
$ Cost of finished goods.
in inventory costs:
 sales effort
 general non-factory
administrative costs
 Who Owns the Inventory?
When goods are in transit?
Q: Who owns the inventory on a truck or railroad
car?
A: The party who is paying the shipping costs.
When goods are on consignment?
Q: Who owns inventory stocked in a warehouse?
A: The supplier until the inventory is sold. The
warehouse owner stocks and sells the inventory
and receives a commission on sales as payment
for services rendered.
 Ending Inventory & COGS
Cost of goods = Beginning Net
available for sale inventory +
purchases

The question is where is the inventory

that could have been sold this period?
Only two choices:
At period’s end, is allocated between
 inventory still remaining (an asset), and
 inventory sold during the period (an
expense, Cost of Goods Sold).
 Learning Objective 2

Account for
inventory
purchases and
sales using both a
perpetual and a
periodic inventory
system.
 What are the Two Methods for
Accounting for Inventory?
Perpetual Periodic
 Records are updated  Records are not
when a purchase or sale updated when a
is made. purchase or a sale is
 Records reflect total made.
items in inventory or  Only the dollar amount
sold at any given time. of the sale is recorded.
 Most often used when  Used when
 each item has a  inventory is
relatively high composed of a
value, or large number of
 the cost of running diverse items,
out of or  each with a
overstocking an relatively low value.
item is expensive.
 Example: Accounting for
Inventory Purchases and Sales
Harper’s Hats recorded the following
transactions for 2001:

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 hats @ $15 each = $ 45
May 2 Purchase 10 hats @ $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats (10 @ $10, 10 @ $15)
July 3 Sales return 1 hat @ $15 = $ 15
Ending inventory 13 hats
 Example: 2001 Inventory
Purchase Sale Balance `
Date Units Total Units Total Units Cost Total
Jan. 1 10 $10 $100
Mar. 1 15 $225 10 $10 $100
15 $15 $225
(3) ($45) 12 $15 $180
May 2 10 $200 10 $10 $100
12 $15 $180
10 $20 $200
June 30 10 $100
10 $150
2 $15 $ 30
10 $20 $200
July 3 (1) ($15) 3 $15 $ 45
10 $20 $200
 Perpetual & Periodic
Journal Entries
 Purchases Perpetual Periodic
 Transportation All purchases At end of period,
costs are added
 Purchase returns  Inventory
directly to the balance is
 Purchase discounts inventory updated using
 Sales account. inventory count.
 Sales returns
 Closing entries for  Temporary
COGS purchases
account balance
is closed
to Inventory to
compute COGS.
 Example: Journal Entries
for Purchases
Harper purchased 10 hats at $10 each
on January 1. Record the entries for
both the perpetual and the periodic
systems.
Jan. 1 Inventory . . . . . . . . . . . . . . . . 100
Accounts Payable. . . . . . . 100
Purchased 10 hats @ $10.
PERPETUAL

Jan. 1 Purchases . . . . . . . . . . . . . . . 100

Accounts Payable. . . . . . . 100
PERIODIC
Purchased 10 hats @ $10.
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation All costs At end of
costs are added period,
 Purchase returns directly to temporary
 Purchase the freight in
discounts inventory account balance
 Sales balance. is closed to
 Sales returns Inventory to
 Closing entries for compute COGS.
COGS
 Example: Journal Entries
for Transportation Cost
Harper hired a trucking company to deliver
its March 1 purchase of 15 hats. The trucking
company charged $10. Record the entries for
both the perpetual and the periodic systems.

Mar. 1 Inventory . . . . . . . . . . . . . . . . 10
Cash. . . . . . . . . . . . . . . . . . 10
PERPETUAL
Delivery charge on 15 hats.

Mar. 1 Freight In. . . . . . . . . . . . . . . . 10

Cash. . . . . . . . . . . . . . . . . . 10
PERIODIC
Delivery charge on 15 hats.
 Perpetual & Periodic
Journal Entries
Perpetual Periodic
 Purchases Inventory is If merchandise has
 Transportation decreased. been paid for, the
costs supplier will
Accounts
 Purchase Payable is reimburse (debit
returns decreased Cash).
 Purchase by same At end of period,
discounts amount. temporary
 Sales purchase returns
 Sales returns account balance is
 Closing entries for closed to
COGS Inventory to
compute COGS.
 Example: Journal Entries
for Purchase Returns
Of the 15 hats delivered on March 1, three
were defective and Harper returned them the
same day. Record the entries for both the
perpetual and the periodic inventory systems.

Mar. 1 Accounts Payable (or Cash) 45

Inventory . . . . . . . . . . . . . . 45
PERPETUAL
Returned 3 hats @ $15.

Mar. 1 Accounts Payable (or Cash) 45

Purchase Returns. . . . . . . 45
PERIODIC
Returned 3 hats @ $15.
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation
Subtract the At end of period,
costs
discount temporary
 Purchase returns
amount from purchase
 Purchase the inventory discounts account
discounts account. balance is closed
 Sales to Inventory to
 Sales returns compute COGS.
 Closing entries for
COGS
 Example: Journal Entries
for Purchase Discounts
On May 2, Harper purchased 10 hats at $20
each. The supplier offered terms of 2/10, n/30.
Record the entries for both the perpetual and
the periodic inventory systems.

May 2 Accounts Payable (or Cash) 200

Inventory . . . . . . . . . . . . . . 4
Cash . . . . . . . . . . . . . . . . . . 196
Purchase discount on 10 hats.
PERPETUAL

May 2 Accounts Payable (or Cash) 200

Purchase Discounts . . . . . 4
Cash . . . . . . . . . . . . . . . . . . 196
PERIODIC Purchase discount on 10 hats.
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation
All All adjustments are
costs
adjustments accumulated in an
 Purchase returns
are entered array of temporary
 Purchase directly in the holding accounts:
discounts
Inventory Purchases
account.
The difference Freight In

in terms of Purchase Returns

journal entries: Purchase Discounts
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation
Recognize Only total sales
costs
sales and are known.
 Purchase returns
COGS on a
 Purchase transaction-
discounts by-transaction
 Sales basis.
 Sales returns
 Closing entries for
COGS
 Example: Journal Entries
for Sales
In June, Harper’s Hats sold 20 hats for $25
each (selling the old ones first). Record the
entries for both the perpetual and the periodic
systems.
Jun. 30 Accounts Receivable (or Cash) 500
Sales . . . . . . . . . . . . . . . . . . . . 500
Sold 20 hats @ $25.
Jun. 30 Cost of Goods Sold . . . . . . . . . . 250
Inventory (10 @ $10; 10 @ $15) 250
PERPETUAL Record cost of goods sold.

Jun. 30 Accounts Receivable (or Cash) 500

Sales . . . . . . . . . . . . . . . . . . . . 500
Sold 20 hats @ $25.
No entry.
PERIODIC
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation
Sales for Sales for returned
costs
returned items items are
 Purchase returns
are canceled. canceled.
 Purchase
discounts Cost of returned
 Sales inventory is No entry is made
removed from to adjust COGS.
 Sales returns COGS and
 Closing entries restored to the
for COGS inventory
account.
 Example: Journal Entries
for Sales Returns
On July 3, one hat was returned from a late
June purchase. Record the entries for both
the perpetual and the periodic inventory
systems.
Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25
Accounts Receivable. . . . . . . 25
1 hat returned from June purchase.
Jul. 3 Inventory. . . . . . . . . . . . . . . . . . . 15
Cost of Goods sold . . . . . . . . 15
PERPETUAL Placed returned hat back into inventory.

Jul. 3 Sales Returns. . . . . . . . . . . . . . . 25

Accounts Receivable. . . . . . . 25
1 hat returned from June purchase.
No entry.
PERIODIC
 Perpetual & Periodic
Journal Entries

 Purchases Perpetual Periodic

 Transportation
All journal entries Temporary holding
costs
are posted to the accounts are
 Purchase returns
ledger. accumulated and
 Purchase added to
discounts Results in new
Inventory.
 Sales balances for
 Sales returns Inventory and Inventory account
COGS. balance is reduced
 Closing entries by the amount of
for COGS Numbers are
verified by COGS.
physical count.
 Example: Accounting for
Inventory Purchases and Sales
Harper’s Hats recorded the
following transactions for 2001:

Beginning inventory 10 hats @ $10 each = $100

March 1 Purchase 15 hats @ $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 hats @ $15 each = $ 45
May 2 Purchase 10 hats @ $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats (10 @ $10, 10 @ $15)
July 3 Sales return 1 hat @ $15 = $ 15
Ending inventory 13 hats
 Example: Closing Entries for
Cost of Goods Sold
Perpetual: the inventory account will have
an ending balance of $255.
Inventory COGS
1/1 100 6/30 250
3/1 225 3/1 45 7/3 15
3/1 10
5/2 200 Bal. 235
6/30 250
7/3 15
Bal. 255
 Example: Closing Entries for
Cost of Goods Sold
Periodic: the inventory account will be debited
by $386, which represents the net
purchases for the year.

Jul. 31 Inventory. . . . . . . . . . . . . . . . . . . 386

Purchase Returns. . . . . . . . . . . . 45
Purchase Discounts. . . . . . . . . . 4
Freight In. . . . . . . . . . . . . . . . . 10
Purchases. . . . . . . . . . . . . . . . 425
 Periodic Inventory
With a periodic system, a physical
count is the only way to get the
information necessary to compute
COGS:

Beginning Inventory, January 1, 2001

+ Purchases for the year
= Cost of goods available for sale during 2001
– Ending Inventory, December 31, 2001
= Cost of Goods Sold for 2001
 Learning Objective 3

Calculate cost of goods

sold using the results of
an inventory count and
understand the impact of
errors in ending inventory
on reported cost of goods
sold.
 Physical Count of Inventory

Essential to maintaining reliable

inventory accounting records.

Perpetual Periodic
Physical count The only way to get information
either confirms necessary to compute COGS:
records are accurate  Quantity count.
or highlights  Inventory costing (assigning a
shortages and unit cost to each type of
clerical errors. merchandise).
 Ending inventory = quantity of
each type x its unit cost.
 COGS Computation

Perpetual Periodic
 The accounting Company does not
records yield the COGS know what ending
for the period as well inventory should be.
as the amount of Assumes physical
inventory that should
be found with a count is the difference
physical count. between cost of goods
available for sale and
 The difference between
the records and actual ending inventory.
count = inventory lost, Cannot tell whether
stolen, or spoiled. goods were sold, lost,
stolen, or spoiled.
 What is the Income Effect of
an Error in Ending Inventory?

An error in
inventory results in
COGS being
overstated or
understated. Any uncorrected
The inventory error error will affect the
financial
has the opposite statements for two
effect on gross years.
margin and net
income.
 Effects of Inventory Errors
Understate
Understate Beginning Understate
Purchases Inventory Sales

OK OK LOW
Understate
Ending Inventory OK LOW OK
LOW OK OK
LOW LOW OK
Sales OK OK OK OK
LOW LOW OK
Beginning inventory OK
Net purchases OK HIGH HIGH LOW
Goods available OK OK OK OK
Ending inventory LOW HIGH HIGH LOW
Cost of goods sold HIGH
 Learning Objective 4

Apply the four inventory

cost flow alternatives:
specific identification,
FIFO, LIFO, and average
cost.
 Inventory Cost Flow
 Kernel King buys and sells corn and had the
following transactions for 2002:
 June 10 Purchased 10 tons at $6 per ton.
 July 28 Purchased 10 tons at $9 per ton.
 October 10 Sold 10 tons at $11 per ton.
 How much did Kernel King make in 2002?
Case #1 Case #2 Case #3
Sold Sold Sold
Old Corn New Corn Mixed Corn
Sales ($11 x 10 tons) $110 $110 $110
COGS (10 tons) 60 90 75
Gross margin $ 50 $ 20 $ 35
Specific Identification
Cost Flow
 Specifically identify the
cost of each unit sold.
 The individual cost of
each unit is charged
against revenue as
COGS.
 To compute COGS and
ending inventory, a firm
must know each unit sold
and its cost.
 Inventory Cost Flow Methods

FIFO LIFO Average Cost

 The oldest units  The newest  An average cost is
are sold and the units are sold computed for all
newest units and the oldest inventory available
remain in units remain in for sale during the
inventory. inventory. period.
 The cost of the  The cost of the  COGS is computed
oldest units most recent by multiplying the
purchased is units number of units
transferred to purchased is sold by the average
COGS. transferred to cost per unit.
COGS.
 Comparison of
Inventory Methods

 LIFO gives a  FIFO gives a

better reflection of better measure
COGS in the
income statement.
of inventory on
the balance
sheet.
 Therefore, LIFO is
a better measure  Therefore, FIFO
of income. is a better
measure of
inventory value.
 Learning Objective 5

Use financial
ratios to evaluate

%
a company’s
inventory level.
 Why Use JIT Inventory
Management?
 Money tied up in inventory
cannot be used for other
purposes.
 JIT attempts to have exactly
enough inventory arrive
“just in time” for sale.
 Its purpose is to minimize
investment in inventories while
at the same time having enough inventory
on hand to meet customer demand.
 Evaluating Inventory Levels
Cost of goods sold
Inventory Turnover
• Measures how many times Average inventory
a company turns over (or
replenishes) its inventory.

• Average inventory =
average of the beginning
and ending inventory
balances.
365 days
Number of Days’ Sales in
Inventory Inventory turnover
 Example: Evaluating
Inventory Management
Buster Boots had cost of goods sold of
$60,000 during 2002. The inventory account
decreased by $1,000 to $4,000 during the
same time. Calculate the inventory turnover
ratio and number of days’ sales in inventory.

Inventory Cost of goods sold $60,000

turnover
ratio Average inventory = $4,500 = 13.33

Number of
days’ sales 365 days 365
in Inventory turnover = 13.33 = 27.38
inventory
 Expanded Material
Learning Objective 6

Analyze the impact of

inventory errors on
reported cost of
goods sold.

!
What Is the Effect of These
Inventory Errors?
If a sale is recorded but the merchandise
remains in inventory and is counted in
ending inventory,
> COGS  understated
> gross margin  overstated
> net income  overstated

If a sale is not recorded, but inventory is

shipped and not counted in ending
inventory,
> COGS  overstated
> gross margin  understated
> net income  understated
 Expanded Material
Learning Objective 7

Describe the complications

that arise when LIFO or
average cost is used with a
perpetual inventory system.
 Using Average Cost or LIFO
with a Perpetual System
 Using average cost or LIFO with perpetual
leads to complications.
 The average cost of units available for sale
changes every time a purchase is made.
 The identification of the “last in” units also
changes with every purchase.
 With periodic,
 One overall average cost is used for all
goods available for sale during the period.
 The “last in” units are identified at the
end of the period.
 Describe the Similarities of
Using FIFO for Perpetual and
Periodic Systems.
 No complications arise as
no matter when sales
occur, the “first in” units
are always the same in
both systems.
 FIFO periodic and FIFO
perpetual yield the same
numbers for COGS and
ending inventory.
 Expanded Material
Learning Objective 8

Apply the lower-of-

cost-or-market method
of accounting for
inventory.
 When Do You Report
Inventory Below Cost?
 All inventory costing alternatives
report inventory at cost.
 Inventory is reported at less than
cost when:
 the future value of the inventory
is in doubt (damaged, used, or
obsolete), or
 it can be replaced new at a price
less than the original cost.
 When Do You Report Inventory at
Net Realizable Value (NRV)?
 When inventory is damaged, used, or
obsolete, it should be reported at no more
than its net realizable value (the amount it can
be sold for, less any selling costs).
 NRV should be recognized as soon as a firm
determines that an economic loss has
occurred.
 Loss is recognized when inventory is written
down, not when inventory is finally sold.
 Therefore, assets are not being reported at
more than their future economic benefit.
 Lower of Cost or Market
(LCM)
Ceiling: the maximum market amount at which
inventory can be carried on the books; equal to net
realizable value (selling price less estimated selling
costs).

LCM: A basis for

valuing inventory at the
lower of original cost or
current market value.

Floor: the minimum market amount at which inventory

can be carried on the books; equal to net realizable
value less a normal profit.
 Example: LCM
Market
Inventory Replacement NRV
Item Cost Floor Cost Ceiling
A 34 20 32 30
B 42 32 36 46
C 52 44 42 62
D 38 50 32 68
Define market value as:
 replacement cost, if it falls between the ceiling and the floor.
 the floor, if the replacement cost is less than the floor.
 the ceiling, if the replacement cost is higher than the ceiling.
 When replacement cost, ceiling, and floor are compared,
market is always the middle value.
Compare the defined market value with the
original cost and choose the lower amount.
 Expanded Material
Learning Objective 9

Explain the gross

margin method of
estimating
inventories.
?
 Gross Margin Method
 There are times when a physical count of
inventory is either impossible or impractical.
 If perpetual is used, the inventory account
balance is assumed to be correct.
 If periodic is used, an estimate of the inventory
balance must be made.
 Gross margin method.
 COGS and ending inventory are
estimated using available information:
 beginning inventory
 purchases
 historical gross margin percentage