Chapter 6

Inventory and
Merchandising
Operations
Understand the nature of inventory and
retailing operations

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Accounting For Inventory
Balance Sheet (partial)
Current assets:
Cash $$$$
Accounts receivable $$$$
Inventory (1 shirts @ cost of $300) $30

Income Statement (partial)

Sales (2 chairs @ $500 selling price) $100
Cost of goods sold (2 shirts @ $30 cost) 60
Gross profit $40

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 The cost of
The cost of
inventory that’s
inventory on
been sold =
hand =
Cost of Goods
Inventory
Sold

Asset on the Expense on the

Balance Sheet Income Statement

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Number of units
• Determined from accounting records
• Evidenced by physical count at year end
• Consigned goods:
▫ Does not include those held for another company
▫ Does include those out on consignment
• In transit goods
▫ Depends on shipping terms

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Shipping terms
FOB Shipping Point FOB Destination
• Legal title passes to • Legal title passes to
purchaser when items purchaser when items
leave seller’s place of arrive at purchaser’s
business place of business
• Purchaser owns good • Seller owns goods while
while in transit in transit
▫ Included in purchaser’s ▫ Included in seller’s
inventory count inventory count
• Purchaser pays • Seller pays transportation
transportation costs costs
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Recording inventory-related transactions

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Inventory Systems
Perpetual Periodic
Used for all types of goods Used for inexpensive goods
Keeps a running total of all Does not keep a running
goods bought, sold and on total of all goods bought,
hand sold and on hand
Inventory counted at least Inventory counted at least
once a year once a year

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Perpetual Inventory
• Bar codes on products provide information to
record
▫ Sale of item
▫ Update of inventory record
• Two entries needed for each sale
▫ Record revenue and asset received (cash or
receivables)
▫ Record cost of sale and reduction of inventory

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Recording Inventory (Amounts Assumed)
JOURNAL
Date Accounts and explanation Debit Credit
Inventory 560,000
Accounts payable 560,000
Purchased inventory on account
Accounts receivable 900,000
Sales 900,000
Sold inventory on account
Cost of goods sold 540,000
Inventory 540,000
Recorded cost of goods sold

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 Recording Inventory (Amounts Assumed)
Inventory
Beginning balance $100,000 $540,000 Cost of goods sold
Purchases $560,000
Ending balance $120,000

Cost of Goods Sold

Cost of goods sold $540,000

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Reporting in the Financial
Statements
Balance Sheet (partial)
Current assets:
Cash $$$$
Accounts receivable $$$$
Inventory $70,000

Income Statement (partial)

Sales $900,000
Cost of goods sold 540,000
Gross profit $360,000

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Cost of Net Purchases

Purchase price
+ Freight-in
- Purchase returns
- Purchase allowances
- Purchase discounts
= Net purchases

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Net Sales

Sales revenue
- Sales returns and allowance
- Sales discounts
= Net sales

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Determine inventory and cost of sales based on
various inventory cash flow assumptions.

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Inventory Costing
• Manager decides which accounting method to use,
which affects:
• Profits
• Income tax
• Ratios
• Cost of inventories comprises of:
• Cost of purchase
• Cost of conversion
• Cost of bringing in the inventories

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Inventory Methods

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Specific Unit
• Used for businesses with unique inventory items
▫ Automobiles, fine jewelry, real estate
• Inventory costed at specific price of the
particular unit
• Too expensive for inventories with common
characteristics

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 First-in, First-out (FIFO)
• Oldest items assumed to be sold first
• Ending inventory consists of most recent
purchase costs
Inventory (at FIFO Cost)

Beg bal $100

Purchases: Cost of goods sold (40 units):
No. 1 (25 units @ $14) 350 (10 units @ $10) 100
No. 2 (25 units @ $18) 450 (25 units @ $14) 350
(5 units @ $18) 90
Ending (20 units @ $18) 360
Balance
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 Last-in, First-out (LIFO)
• Most recent items purchased are assumed to be
sold first
• Oldest costs in ending inventory
Inventory (at FIFO Cost)

Beg bal $100

Purchases: Cost of goods sold (40 units):
No. 1 (25 units @ $14) 350 (25 units @ $18) 450
No. 2 (25 units @ $18) 450 (15 units @ $14) 210

Ending (10 units @ $10) 240

Balance (10 units @ $14)
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Average Cost
Average cost Cost of goods available *
per unit
Number of units available*

*Goods available = Beginning inventory + Purchases

Cost of Number of Average cost
goods sold units sold per unit

Ending Number of Average cost

inventory units on hand per unit

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 Average Cost
Inventory (at FIFO Cost)

Beg bal $100

Purchases:
No. 1 (25 units @ $14) 350 Cost of goods sold (40 units @
No. 2 (25 units @ $18) 450 average cost of $15 per unit) 600

Ending (20 units @ average 300

Balance cost of $15 per unit)

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Problem 6-62A

Date Units Cost per Total

unit cost
Beg. inventory 72 tents $17 $1,224
Oct. 4 103 tents $19 $1,957
Oct. 19 158 tents $21 $3,318
Oct. 25 43 tents $22 $946

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Problem 6-62A Average Cost
Average cost Cost of goods available *
per unit
Number of units available*

*Goods available = Beginning inventory + Purchases

$19.80 $7,445
$1,224 + $1,957 +$3,318 + $946
(rounded)
72 +103
376+158 + 43
units

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Problem 6-62A Average Cost
Cost of Number of Average
$19.80 cost
$6,415
goods sold 324 tents
units sold per unit
(rounded)

Ending Number of $19.80

Average cost
$1,030
inventory 52 tents
units on hand per unit
(rounded)

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Problem 6-62A FIFO
Date Units Cost per Total
unit cost
Beg. inventory 72 tents $17 $1,224
Oct. 4 103 tents $19 $1,957
Oct. 19 158 tents $21 $3,318
Oct. 25 43 tents $22 $946

Cost of goods sold

Ending inventory
72 tents $17 $1,224 Newest items on
Oldest 43 tents $22hand $946
103 tents items
$19sold $1,957
first 9 tents $21 $189
149 tents $21 $3,129
52 tents $1,135
324 tents $6,310

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Problem 6-62A LIFO
Date Units Cost per Total
unit cost
Beg. inventory 72 tents $17 $1,224
Oct. 4 103 tents $19 $1,957
Oct. 19 158 tents $21 $3,318
Oct. 25 43 tents $22 $946

Cost of goods sold

Ending inventory
43 tents $22 $946 Oldest items on
52 tents $17 $884
158 tents hand
Newest$21
items sold $3,318
first
103 tents $19 $1,957
20 tents $17 $340
324 tents $6,561
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Impact of Inventory Methods on
Financial Statements
Increasing inventory prices
Cost of goods Ending
sold inventory
FIFO Lowest because Highest because
based on older based on more
costs, which are recent and
less expensive expensive costs
LIFO Highest because Lowest because
based on more based on older
recent costs, costs, which are
which are more less expensive
expensive

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Impact of Inventory Methods on
Financial Statements
Decreasing inventory prices
Cost of goods Ending
sold inventory
FIFO Highest because Lowest because
based on older based on more
costs, which are recent, less
more expensive expensive costs
LIFO Lowest because Highest because
based on more based on older,
recent costs which more expensive
are less expensive costs

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Comparison of Inventory Methods
COST OF GOODS SOLD ENDING INVENTORY
• LIFO provides a more • FIFO provides a more
realistic net income up-to-date inventory
figure cost
▫ More recent costs ▫ More recent costs on
included in Cost of the Balance Sheet
Goods Sold

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32
Principles Related to Inventories

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Comparability Principle
• Business should use the same accounting
methods from year-to-year
• Allows investors to compare financial statements
from one period to the next
• Companies are permitted to change methods
▫ Must disclose effect on net income

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Net Realizable Value
• Inventory is reported at the lower of:
▫ Cost, or
▫ Net realizable value (NRV)
• Net realizable value is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make
the sale.
• If NRV is lower, inventory is written down

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 Net Realizable Value
• If NRV is lower, inventory is written down
JOURNAL
Date Accounts and explanation Debit Credit
Cost of goods sold
Inventory
Wrote down inventory to market
• If the NRV of inventory had been above cost, it would
have made no adjustment for NRV.
▫ report the inventory at cost, which is the lower of cost and
NRV

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Use gross profit percentage and inventory
turnover to evaluate operations.

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Gross Profit Percentage

Gross profit

Net sales revenue

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Inventory Turnover

Cost of Goods Sold

Average Inventory

(Beginning inventory + Ending inventory)/2

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Cost of Goods Sold Model

Cost of Goods Sold:

Beginning Inventory
+ Purchases
= Cost of goods available for sale
- Ending Inventory
= Cost of goods sold

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Using Cost of Goods Sold Model

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Rearranging the Cost of Goods Sold
Model

Cost of goods sold (based on plan for next period)

+ Ending inventory (based on plan for next period)
= Goods available as planned
- Beginning inventory (actual amount)
= Purchases (amount manager should buy)

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Gross Profit Method
Beginning inventory $$$$
Purchases $$$$
Goods available for sale $$$$
Estimated cost of goods sold:
Net sales revenue $$$$
Less estimated gross profit ($$$)
Estimated cost of goods sold $$$$
Estimated cost of ending inventory $$$

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Exercise 6-26A
Beginning inventory $47,500
Purchases 30,900
Goods available for sale 78,400
Estimated cost of goods sold:
Net sales revenue $62,100
Less estimated gross profit (35% x $62,100) $21,735
Estimated cost of goods sold 40,365
Estimated cost of ending inventory $38,035

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Show how inventory errors affect the financial
statements

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 Effect of Inventory Errors
Period 1 Period 2
Cost of Gross Cost of Goods Gross
Goods Sold Profit and Sold Profit and
Net Income Net Income
Period 1
Ending Understated Overstated Overstated Understated
Inventory
overstated
Period 2
Ending Overstated Understated Understated Overstated
Inventory
understated
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Copyright ©2014 Pearson Education. 47