Inventories

Chapter 7
Inventories
© 2021 Cengage Learning, Inc. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Learning Objectives (1 of 2)
• LO1: Describe the importance of control over inventory.

• LO2: Describe three inventory cost flow assumptions and explain how they
impact the income statement and balance sheet.
• LO3: Determine the cost of inventory under the perpetual inventory system,
using the FIFO, LIFO, and weighted average cost methods.
• LO4: Determine the cost of inventory under the periodic inventory system,
using the FIFO, LIFO, and weighted average cost methods.
• LO5: Compare and contrast the use of the three inventory costing methods.
Learning Objectives (2 of 2)
• LO6: Describe and illustrate the reporting of merchandise inventory in the

financial statements.
• LO7: Describe and illustrate the inventory turnover and the days’ sales in
inventory in analyzing the efficiency and effectiveness of inventory
management.
• App: Describe and illustrate the retail method and the gross profit method of
estimating inventory.
Control of Inventory
Primary objectives of control over inventory
• Safeguarding the inventory from damage or theft
• Reporting inventory in the financial statements
Safeguarding Inventory
(1 of 3)
• The purchase order authorizes the purchase of the inventory from an

approved vendor.
• The receiving report establishes an initial record of the receipt of the
inventory.
• The price, quantity, and description of the item on the purchase order and
receiving report are compared to the vendor’s invoice before the inventory is
recorded in the accounting records.
(2 of 3)
• Recording inventory using a perpetual inventory system is also an effective

means of control. The amount of inventory is always available in the
subsidiary inventory ledger.
• Controls for safeguarding inventory should include security measures to
prevent damage and customer or employee theft.
(3 of 3)
Examples of security measures
• Storing inventory in areas that are restricted to only authorized employees

• Locking high-priced inventory in cabinets
• Using two-way mirrors, cameras, security tags, and guards
Reporting Inventory
• A physical inventory or count of inventory should be taken near year-end to

make sure that the quantity of inventory reported in the financial statements
is accurate.
• Then, the cost of the inventory is assigned for reporting in the financial statements.
Inventory Cost Flow Assumptions
(1 of 4)
• Assume that three identical units of merchandise are purchased during May,
as follows:
(2 of 4)
• Assume that one unit is sold on May 30 for $20. Depending upon which unit
was sold, the gross profit varies from $11 to $6 and the ending inventory
value varies from $27 to $22, as shown below:
(3 of 4)
• Under the specific identification inventory cost flow method, the unit
sold is identified with a specific purchase.
• The ending inventory is made up of the remaining units on hand.
• The specific identification method is not practical unless each inventory unit can be
identified separately.
• An automobile dealer may use the specific identification method because each
automobile has a unique serial number.
Cost Flow Assumptions
(4 of 4)of 4)
First-in, First-Out (FIFO) Method
• The first units purchased are assumed to be sold

• The ending inventory is made up of the most recent purchases
Last-in, First Out (LIFO) Method
• The last units purchased are assumed to be sold

• The ending inventory is made up of the first purchases
Weighted Average Cost Method
• The cost of the units sold and in ending inventory is a weighted average of the
purchase costs
Inventory Costing Methods
Example Exercise: Cost Flow Methods
(1 of 2)
• The following three identical units of Item QBM are purchased during
February:
• Assume that one unit is sold on February 27 for $70.
Example Exercise: Cost Flow Methods
(2 of 2)
• Determine the gross profit for February and ending inventory on February 28
using the (a) first-in, first-out (FIFO); (b) last-in, first-out (LIFO); and (c)
weighted average cost methods.
Inventory Costing Methods Under a
Perpetual Inventory System
• For purposes of illustration, the data for Item 127B are used, as shown
below. We will examine the perpetual inventory system first.
First-In, First-Out Method
• When the FIFO method is used in a perpetual inventory system, costs are
included in the cost of merchandise sold in the order in which they were
purchased.
• This is often the same as the physical flow of the merchandise.
• For example, grocery stores shelve milk and other perishable products by expiration
dates. Products with early expiration dates are stocked in front. In this way, the oldest
products (earliest purchases) are sold first.
Entries and Perpetual Inventory Account
(FIFO)
Example Exercise: Perpetual Inventory Using FIFO
• Beginning inventory, purchases, and sales for Item ER27 are as follows:
• Assuming a perpetual inventory system and using the first-in, first-out (FIFO)
method, determine (a) the cost of merchandise sold on November 21 and (b)
the inventory on November 30.
Last-In, First-Out Method
• When the LIFO method is used in a perpetual inventory system, the cost of
the units sold is the cost of the most recent purchases.
• The LIFO method was originally used in those rare cases where the units
sold were taken from the most recently purchased units. However, for tax
purposes, LIFO is now widely used even when it does not represent the
physical flow of units.
(LIFO)
Example Exercise: Perpetual Inventory Using LIFO
• Assuming a perpetual inventory system and using the last-in, first-out (LIFO)
method, determine (a) the cost of the merchandise sold on November 21
and (b) the inventory on November 30.
• When the weighted average cost method is used in a perpetual inventory

system, a weighted average unit cost for each item is computed each time a
purchase is made.
• This unit cost is used to determine the cost of each sale until another purchase is made
and a new average is computed. This technique is called a moving average.
(Weighted Average)
Example Exercise: Perpetual Inventory Using
Weighted Average (1 of 2)
• Assuming a perpetual inventory system using the weighted average method,

determine (a) the weighted average unit cost after the November 11
purchase, (b) the cost of the merchandise sold on November 21, and (c) the
inventory on November 30.
Example Exercise: Perpetual Inventory Using
Weighted Average (2 of 2)
Inventory Costing Methods Under a
Periodic Inventory System
• When the periodic inventory system is used, only revenue is recorded each
time a sale is made.
• No entry is made at the time of sale to record the cost of the merchandise
sold.
• At the end of the accounting period, a physical inventory is taken to
determine the cost of the inventory and the cost of the merchandise sold.
• Like the perpetual inventory system, a cost flow assumption must be made
when identical units are acquired at different unit costs during a period.
(1 of 3)
• The beginning inventory and purchases of Item 127B in January are as

follows:
(2 of 3)
• The physical count on January 31 shows that 800 units are on hand.
• The cost of the 800 units in the ending inventory on January 31 is
determined as follows:
(3 of 3)
• Now, we can calculate the cost of merchandise sold, as follows:
• The $18,460 cost of the ending merchandise inventory on January 31 is

made up of the most recent costs.
• The $26,720 cost of merchandise sold is made up of the beginning inventory
and the earliest costs.
First-In, First-Out Flow of Costs
(1 of 2)
• Assume again that the physical count on January 31 shows that 800 units
are on hand.
• The cost of the 800 units in ending inventory on January 31 is $16,000,
which consists of 800 units from the beginning inventory at a cost of $20.00
per unit.
(2 of 2)
• The cost of merchandise sold is computed as follows:
• The $16,000 cost of the ending merchandise inventory on January 31 is

made up of the earliest costs.
• The $29,180 cost of merchandise sold is made up of the most recent costs.
Last-In, First-Out Flow of Costs
(1 of 2)
• What is the average cost per unit and the ending inventory?
(2 of 2)
• The cost of merchandise sold is computed as follows:
Example Exercise: Periodic Inventory Using FIFO, LIFO, and
Weighted Average Cost Methods
• The units of an item available for sale during the year were as follows:
• There are 16 units of the item in the physical inventory at December 31. The
periodic inventory system is used. Determine the inventory cost using (a) the
first-in, first-out (FIFO) method; (b) the last-in, first-out (LIFO) method; and
(c) the weighted average cost method.
Comparing Inventory Costing Methods
• A different cost flow is assumed for the FIFO, LIFO, and weighted average
inventory cost flow methods.
Different inventory costing methods normally yield different amounts for the
following:
 Cost of merchandise sold
 Gross profit
 Net income
 Ending merchandise inventory
• Note that if costs (prices) remain the same, all three methods would yield the
same results. However, costs (prices) normally do change.
Partial Income Statements: (FIFO, Weighted
Average Cost, LIFO)
• Using the perpetual inventory system illustration with sales of $39,000 (1,300
units × $30), the differences in cost of merchandise sold, gross profit, and
ending merchandise inventory are illustrated below.
Effects of Changing Costs (Prices):
FIFO and LIFO Cost Methods
Comparing Inventory Costing Methods:
FIFO
• The FIFO method reports higher gross profit and net income than the LIFO
method when costs (prices) are increasing.
• However, in periods of rapidly rising costs, the inventory that is sold must be
replaced at increasingly higher costs. In this case, the larger FIFO gross
profit and net income are sometimes called inventory profits or illusory
profits.
LIFO
• During a period of increasing costs, LIFO matches more recent costs against
sales on the income statement.
• LIFO also offers an income tax savings during periods of increasing costs.
This is because LIFO reports the lowest amount of gross profit and, thus,
taxable net income.
• On the balance sheet, however, the ending inventory may be quite different
from its current replacement cost.
Weighted Average
• The weighted average cost method is a compromise between FIFO and
LIFO.
• The effect of cost (price) trends is averaged in determining the cost of
merchandise sold and the ending inventory.
Reporting Merchandise Inventory
in the Financial Statements
• Cost is the primary basis for valuing and reporting inventories in the financial
statements. However, inventory may be valued at other than cost in the
following cases:
• The cost of replacing items in inventory is below the recorded cost.
• The inventory cannot be sold at normal prices due to imperfections, style changes,
spoilage, damage, obsolescence, or other causes.
Valuation at Lower of Cost or Market
(1 of 3)
• If the market is lower than the purchase cost, the lower-of-cost-or-market

(LCM) method is used to value the inventory.
• Market, as used in lower of cost or market, is the net realizable value of the
merchandise. Net realizable value is determined as follows:
• Direct costs of disposal include selling expenses such as special advertising

or sales commissions.
(2 of 3)
• Assume the following data about an item of damaged merchandise:
• In applying LCM, the market value of the merchandise is $650, computed as

follows:
• Thus, the merchandise would be valued at $650, which is the lower of its
cost of $1,000 and its market value of $650.
(3 of 3)
• The lower-of-cost-or-market method can be applied in one of three ways.

The cost, market price, and any declines could be determined for the
following:
• Each item in the inventory
• Each major class or category of inventory
• Total inventory as a whole
Determining Inventory at
Lower of Cost or Market (LCM)
Example Exercise: Lower-of-Cost-or-Market
Method
• On the basis of the following data, determine the value of the inventory at the
lower of cost or market. Apply lower of cost or market to each inventory item.
Merchandise Inventory on the Balance Sheet
(1 of 2)
• Merchandise inventory is usually presented in the Current Assets section of

the balance sheet.
• In addition to this amount, the following are reported:
• The method of determining the cost of the inventory (FIFO, LIFO, or weighted average)
• The method of valuing the inventory (cost or the lower of cost or market)
Merchandise Inventory on the Balance Sheet
(2 of 2)
Effect of Inventory Errors
on the Financial Statements (1 of 3)
• Any errors in merchandise inventory will affect the balance sheet and income
statement.
Reasons for the occurrence of inventory errors
 Physical inventory on hand was miscounted

 Costs were incorrectly assigned to inventory
 Inventory in transit was incorrectly included or excluded from inventory
 Consigned inventory was incorrectly included or excluded from inventory
• Inventory errors often arise from merchandise that is in transit at year-end.
• Shipping terms determine when the title to merchandise passes.
• When goods are purchased or sold FOB shipping point, title passes to the buyer when
the goods are shipped.
• When the terms are FOB destination, title passes to the buyer when the goods are
received.
• Inventory errors often arise from consigned inventory. Manufacturers
sometimes ship merchandise to retailers who act as the manufacturer’s
agent.
• The manufacturer, called the consignor, retains title until the goods are
sold. Such merchandise is said to be shipped on consignment to the retailer,
called the consignee.
• Any unsold merchandise at year-end is part of the manufacturer’s
(consignor’s) inventory, even though the merchandise is in the hands of the
retailer (consignee).
Effect of Inventory Errors on
Current Period’s Income Statement
Two Years’ Income Statements
Current Period’s Balance Sheet
on the Financial Statements
Example Exercise: Effect of Inventory Errors
• Zula Repair Shop incorrectly counted its December 31, 20Y8, inventory as
$250,000 instead of the correct amount of $220,000. Indicate the effect of
the misstatement on Zula’s December 31, 20Y8, balance sheet and income
statement for the year ended December 31, 20Y8.
Financial Analysis and Interpretation: Inventory
Turnover (1 of 2)
• Inventory turnover measures the relationship between cost of merchandise
sold and the amount of inventory carried during the period. It is calculated as
follows:
Financial Analysis and Interpretation: Inventory
Turnover (2 of 2)
• To illustrate, inventory turnover for Best Buy is shown below (in millions).
Financial Analysis and Interpretation:
Days’ Sales in Inventory (1 of 2)
• The days’ sales in inventory measures the length of time it takes to acquire,
sell, and replace the inventory. It is computed as follows:
• The average daily cost of merchandise sold is determined by dividing the cost of
merchandise sold by 365.
Financial Analysis and Interpretation:
Days’ Sales in Inventory (2 of 2)
• To illustrate, the days’ sales in inventory for Best Buy is computed below (in
millions).
Example Exercise: Inventory Turnover and Days’
Sales in Inventory (1 of 2)
• Financial statement data for years ending December 31 for Beadle Company
follows:
a. Determine the inventory turnover for 20Y4 and 20Y3.

b. Determine the days’ sales in inventory for 20Y4 and 20Y3, using 365 days.
c. Does the change in the inventory turnover and the days’ sales in inventory
from 20Y3 to 20Y4 indicate a favorable or an unfavorable trend?
Example Exercise: Inventory Turnover and Days’
Sales in Inventory (2 of 2)
Appendix: Estimating Inventory Cost
• A business may need to estimate the amount of inventory for the following
reasons:
• Perpetual inventory records are not maintained.
• A fire or flood has destroyed inventory.
• A computer security breach has destroyed inventory records.
• Monthly or quarterly financial statements are needed, but a physical inventory is taken
only once a year.
• Two widely used methods of estimating inventory cost are the retail inventory
method and gross profit method.
Appendix: Retail Method of Inventory Costing
• The retail inventory method of estimating inventory cost requires costs and
retail prices to be maintained for the merchandise available for sale.
• A ratio of cost to retail price is then used to convert ending inventory at retail
to estimate the ending inventory cost.
Determining Inventory by the Retail Method
Appendix: Gross Profit Method
of Inventory Costing
• The gross profit method uses the estimated gross profit for the period to
estimate the inventory at the end of the period.
• The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices.
Estimating Inventory by Gross Profit Method

Inventories

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Inventories

Uploaded by

Copyright:

Available Formats

Chapter 7

• LO1: Describe the importance of control over inventory.

• LO6: Describe and illustrate the reporting of merchandise inventory in the

Primary objectives of control over inventory

• Safeguarding the inventory from damage or theft

• Reporting inventory in the financial statements

• The purchase order authorizes the purchase of the inventory from an

• Recording inventory using a perpetual inventory system is also an effective

Examples of security measures

• Storing inventory in areas that are restricted to only authorized employees

• A physical inventory or count of inventory should be taken near year-end to

First-in, First-Out (FIFO) Method

• The first units purchased are assumed to be sold

Last-in, First Out (LIFO) Method

• The last units purchased are assumed to be sold

Weighted Average Cost Method

• Assume that one unit is sold on February 27 for $70.

• When the weighted average cost method is used in a perpetual inventory

• Assuming a perpetual inventory system using the weighted average method,

• The beginning inventory and purchases of Item 127B in January are as

• Now, we can calculate the cost of merchandise sold, as follows:

• The $18,460 cost of the ending merchandise inventory on January 31 is

• The cost of merchandise sold is computed as follows:

• The $16,000 cost of the ending merchandise inventory on January 31 is

• The cost of merchandise sold is computed as follows:

• If the market is lower than the purchase cost, the lower-of-cost-or-market

• Direct costs of disposal include selling expenses such as special advertising

• Assume the following data about an item of damaged merchandise:

• In applying LCM, the market value of the merchandise is $650, computed as

• The lower-of-cost-or-market method can be applied in one of three ways.

• Merchandise inventory is usually presented in the Current Assets section of

Reasons for the occurrence of inventory errors

 Physical inventory on hand was miscounted

a. Determine the inventory turnover for 20Y4 and 20Y3.

You might also like