ACCOUNTING PRINCIPLES I DISCUSSION GUIDE- CHAPTER 6 SPRING 2020
Define inventory.
ITEMS INCLUDED IN INVENTORY
All inventory on hand when the physical inventory is taken
+ Merchandise in transit that was purchased FOB Shipping Point
+ Merchandise in transit that was sold FOB Destination
+ Merchandise on consignment in other locations that is still owned by the company taking
the inventory count
– Merchandise included in the inventory on hand that belongs to another company but is
being held on consignment
= Inventory shown on the financial statements
Inventory costs include all costs to bring an item into salable condition and location. Inventory costs
include the cost of the item, minus any discount, minus returns and allowances, plus shipping or
transportation costs, storage, import duties, and insurance.
At least once each year, employees of a company physically counts (takes a physical inventory) of
actual inventory. The inventory balance is adjusted if the physical count differs from the actual
amount of inventory recorded in the inventory account.
What is the difference in the perpetual inventory and periodic inventory method?
There are three major inventory cost flow assumptions. Define each of them.
1. First-in, First-out (FIF0)-
2. Last-in, First-out-
3. Weighted Average-
EXAMPLES:
FIFO — Milk (or any perishable item). When shelves are restocked, the “older” milk is moved to the front, and
the “newer” milk is placed in back to encourage customers to buy the older milk first.
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LIFO — Packages of nails or screws at a hardware store. When shelves are restocked, the older packages are
slid to the back of the shelf or rack and the newer packages placed in front. Customers buy the newest hardware
first.
Average — Gasoline. When new gasoline is delivered to a gas station, it is dumped into the tank with any old
gas that has not been sold. Therefore, the customer is buying a mixture of old and new gas.
A company’s inventory costing method does not have to match how the products are actually sold.
INVENTORY VALUATION
Strictly Classical
Assume that Strictly Classical purchased 10,000 DVDs as follows:
No. of Discs
Date Purchased Cost/Unit Total Cost
Jan. 1 800 $7.00 $ 5,600
Mar. 8 2,200 $7.50 16,500
June 23 4,000 $7.25 29,000
Sept. 15 3,000 $7.40 22,200
Total 10,000 $73,300
If the year-end inventory reveals 1,000 discs on hand, what is the inventory value on the
balance sheet if the following sales occurred:
Sale date Units Sales Price
February 5 600 $15.00
March 30 1,800 16.00
July 25 3,800 18.00
Sept. 30 2,800 18.00
9,000
PERPETUAL INVENTORY SYSTEM
FIFO METHOD
JOURNAL
DATE DESCRIPTION DEBIT CREDIT
2019
Jan 1 Merchandise Inventory 5,600
Accounts Payable 5,600
Feb 5 Cash 9,000
Sales 9,000
Feb 5 Cost of Merchandise Sold 4,200
Merchandise Inventory 4,200
Mar 8 Merchandise Inventory 16,500
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Accounts Payable 16,500
Mar 30 Cash 28,800
Sales 28,800
Mar 30 Cost of Merchandise Sold 13,400
Merchandise Inventory 13,400
Jun 23 Merchandise Inventory 29,000
Accounts Payable 29,000
Jul 25 Cash 68,400
Sales 68,400
Jul 25 Cost of Merchandise Sold 27,700
Merchandise Inventory 27,700
Sep 15 Merchandise Inventory 22,200
Accounts Payable 22,200
Sep 30 Cash 50,400
Sales 50,400
Sep 30 Cost of Merchandise Sold 20,600
Merchandise Inventory 20,600
PERPETUAL INVENTORY SYSTEM
LIFO METHOD
JOURNAL
DATE DESCRIPTION DEBIT CREDIT
2019
Jan 1 Merchandise Inventory 5,600
Accounts Payable 5,600
Feb 5 Cash 9,000
Sales 9,000
Feb 5 Cost of Merchandise Sold 4,200
Merchandise Inventory 4,200
Mar 8 Merchandise Inventory 16,500
Accounts Payable 16,500
Mar 30 Cash 28,800
Sales 28,800
Mar 30 Cost of Merchandise Sold 13,500
Merchandise Inventory 13,500
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Jun 23 Merchandise Inventory 29,000
Accounts Payable 29,000
Jul 25 Cash 68,400
Sales 68,400
Jul 25 Cost of Merchandise Sold 27,500
Merchandise Inventory 27,500
Sep 15 Merchandise Inventory 22,200
Accounts Payable 22,200
Sep 30 Cash 50,400
Sales 50,400
Sep 30 Cost of Merchandise Sold 20,720
Merchandise Inventory 20,720
PERPETUAL INVENTORY SYSTEM
WEIGHTED AVERAGE COST METHOD
JOURNAL
DATE DESCRIPTION DEBIT CREDIT
2019
Jan 1 Merchandise Inventory 5,600
Accounts Payable 5,600
Feb 5 Cash 9,000
Sales 9,000
Feb 5 Cost of Merchandise Sold 4,200
Merchandise Inventory 4,200
Mar 8 Merchandise Inventory 16,500
Accounts Payable 16,500
Mar 30 Cash 28,800
Sales 28,800
Mar 30 Cost of Merchandise Sold 13,425
Merchandise Inventory 13,425
Jun 23 Merchandise Inventory 29,000
Accounts Payable 29,000 .
Jul 25 Cash 68,400
Sales 68,400
Jul 25 Cost of Merchandise Sold 27,665
Merchandise Inventory 27,665
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Sep 15 Merchandise Inventory 22,200
Accounts Payable 22,200
Sep 30 Cash 50,400
Sales 50,400
Sep 30 Cost of Merchandise Sold 20,650
Merchandise Inventory 20,650
COMPARISON OF
INVENTORY METHODS
Method Advantages Disadvantages
FIFO Ending inventory amount Creates “illusory profits”
on balance sheet during times of high
approximates current inflation
replacement costs
LIFO Matches current costs Ending inventory amount
against current on income statement
revenues on income may be substantially
statement different from current
replacement cost
During inflationary
periods, reduces income
taxes
Weighted Average Easy to understand Ending inventory
amount
Cost on income statement
Yields same answer may not represent current
whether prices start at $1 replacement cost
and increase to $2 or start
at $2 and decrease to $1 Lose tax advantage
available from LIFO when
prices are rising
Which method results in the least amount of income tax expense when there is inflation?
LIFO, because it results in the most expensive cost of goods sold (or cost or merchandise
sold).
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Which method results in the least amount of ending inventory when there is inflation?
FIFO, because it is assumed that the cheapest inventory is sold first, and the most
expensive
(last inventory purchased) remains in inventory.
LOWER OF COST OR MARKET
Example: Inventory was purchased on March 1, 2020 at a cost = $100
On March 31, 2020 the inventory has a market value = $90
The inventory account must be adjusted (written down) because inventory is no longer worth
$100. (the inventory has declined in value by $100 – 90 = $10.)
The journal entry to adjust or write down the inventory is:
Cost of Goods Sold 10
Merchandise Inventory 10
FINANCIAL ANALYSIS
Inventory turnover = Cost of Goods Sold/Average Inventory
Where Average Inventory = (Beginning Inventory + Ending Inventory)/2
What information is provided by this ratio?
What is the basic rule regarding this ratio? (See page 227)
Days’ Sales in Inventory = Ending Inventory/Cost of Goods Sold X 365 Days
What information is provided by this ratio?
What is the basic rule regarding this ratio? (See page 227)
