Chapter 6
Inventories
Mohammad Rakibul Islam Bhuiyan
Chapter Lecturer, Dept. of MIS, BRUR
6-1
Study Objectives
1. Describe the steps in determining inventory
quantities.
2. Explain the accounting for inventories and apply the
inventory cost flow methods.
3. Explain the financial effects of the inventory cost
flow assumptions.
4. Explain the lower-of-cost-or-market basis of
accounting for inventories.
5. Indicate the effects of inventory errors on the
financial statements.
6. Compute and interpret the inventory turnover ratio.
Chapter
6-2
Reporting and Analyzing Inventory
Determining Statement
Classifying Inventory Inventory
Inventory Presentation
Inventory Costing Errors
Quantities and Analysis
Finished Taking a Specific Income Presentation
goods physical identification statement Analysis
Work in inventory Cost flow effects
process Determining assumptions Balance sheet
Raw materials ownership of Financial effects
goods statement
and tax
effects
Consistent
use
Lower-of-
cost-or-
Chapter
6-3
market
Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
Merchandise Inventory Raw Materials
Work in Process
Finished Goods
Regardless of the classification, companies report all
inventories under Current Assets on the balance sheet.
Chapter
6-4
Chapter
6-5
Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand
2. Determine the cost of goods sold for the period.
Chapter
6-6 SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each
kind of inventory on hand.
Taken,
when the business is closed or when business
is slow.
at end of the accounting period.
Chapter
6-7 SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
Goods in transit should be included in the inventory of
the company that has legal title to the goods. Legal
title is determined by the terms of sale.
Chapter
6-8 SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Terms of Sale
Illustration 6-1
Ownership of the goods
passes to the buyer when
the public carrier accepts
the goods from the seller.
Ownership of the goods
remains with the seller
until the goods reach the
buyer.
Chapter
6-9 SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Review Question
Goods in transit should be included in the
inventory of the buyer when the:
a. public carrier accepts the goods from the
seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
Chapter
6-10 SO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
In some lines of business, it is common to hold
the goods of other parties and try to sell the
goods for them for a fee, but without taking
ownership of goods.
These are called consigned goods.
Chapter
6-11 SO 1 Describe the steps in determining inventory quantities.
Inventory Costing
Unit costs can be applied to quantities on hand
using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Cost Flow
Last-in, first-out (LIFO) Assumptions
Average-cost
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-12
Inventory Costing
Specific Identification Method
An actual physical flow costing method in which
items still in inventory are specifically costed to
arrive at the total cost of the ending inventory.
Practice is relatively rare.
Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-13
Inventory Costing
Illustration: Assume that Crivitz TV Company purchases
three identical 46-inch TVs on different dates at costs
of $700, $750, and $800. During the year Crivitz sold
two sets at $1,200 each.
Illustration 6-2
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-14
Inventory Costing
Illustration: If Crivitz sold the TVs it purchased on
February 3 and May 22, then its cost of goods sold is
$1,500 ($700 $800), and its ending inventory is $750.
Illustration 6-3
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-15
Inventory Costing – Cost Flow Assumptions
Cost Flow Assumption
does not need to equal
Physical Movement of
Goods
Illustration 6-11
Use of cost flow methods in
major U.S. companies
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-16
Inventory Costing – Cost Flow Assumptions
Illustration: Assume that Houston Electronics uses a
periodic inventory system.
Illustration 6-4
A physical inventory at the end of the year determined that
during the year Houston sold 550 units and had 450 units in
inventory at December 31.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-17
Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Earliest goods purchased are first to be sold.
Often parallels actual physical flow of
merchandise.
Generally good business practice to sell oldest
units first.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-18
Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-19
Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-20
Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of
merchandise.
Exceptions include goods stored in piles, such as
coal or hay.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-21
Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Illustration 6-7
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-22
Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Illustration 6-7
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-23
Inventory Costing – Cost Flow Assumptions
“Average-Cost”
Allocates cost of goods available for sale on the
basis of weighted average unit cost incurred.
Assumes goods are similar in nature.
Applies weighted average unit cost to the units
on hand to determine cost of the ending
inventory.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-24
Inventory Costing – Cost Flow Assumptions
“Average Cost”
Illustration 6-10
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-25
Inventory Costing – Cost Flow Assumptions
“Average Cost”
Illustration 6-10
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-26
Inventory Costing – Cost Flow Assumptions
Financial Statement and Tax Effects
Illustration 6-12
Chapter
6-27 SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing – Cost Flow Assumptions
Review Question
The cost flow method that often parallels the
actual physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
Chapter SO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
6-28
Inventory Costing – Cost Flow Assumptions
Review Question
In a period of inflation, the cost flow method
that results in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
Chapter
6-29 SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing – Cost Flow Assumptions
Discussion Question
Q6-12 Casey Company has been using the FIFO
cost flow method during a prolonged period of
rising prices. During the same time period,
Casey has been paying out all of its net income
as dividends. What adverse effects may
result from this policy?
See notes page for discussion
Chapter
6-30 SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Using Cost Flow Methods Consistently
Method should be used consistently, enhances
comparability.
Although consistency is preferred, a company
may change its inventory costing method.
Illustration 6-14
Disclosure of change in
cost flow method
Chapter
6-31 SO 3 Explain the financial effects of the inventory cost flow assumptions.
Chapter
6-32
Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
Companies can “write down” the inventory to its
market value in the period in which the price
decline occurs.
Market value = Replacement Cost
Example of conservatism.
Chapter SO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.
6-33
Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the
following lines of merchandise with costs and market
values as indicated.
Illustration 6-15
Chapter SO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.
6-34
Inventory Errors
Common Cause:
Failure to count or price inventory correctly.
Not properly recognizing the transfer of
legal title to goods in transit.
Errors affect both the income statement and
balance sheet.
Chapter
6-35 SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of
goods sold and net income. Illustration 6-16
Illustration 6-17
Chapter
6-36 SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
An error in ending inventory of the current period
will have a reverse effect on net income of the
next accounting period.
Over the two years, the total net income is correct
because the errors offset each other.
The ending inventory depends entirely on the
accuracy of taking and costing the inventory.
Chapter
6-37 SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Illustration 6-18
2010 2011
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000
Combined income for ($3,000) $3,000
2-year period is correct. Net Income Net Income
understated overstated
Chapter
6-38 SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Review Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
Chapter
6-39 SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Balance Sheet Effects
Effect of inventory errors on the balance sheet is
determined by using the basic accounting equation:.
Illustration 6-16
Illustration 6-19
Chapter
6-40 SO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted
from sales.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost or LCM), and
3) costing method (FIFO, LIFO, or average).
Chapter
6-41
Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying
costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stockouts and
lost sales.
Chapter
6-42 SO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Inventory turnover measures the number of times
on average the inventory is sold during the period.
Cost of Goods Sold
Inventory
=
Turnover Average Inventory
Days in inventory measures the average number of
days inventory is held.
Days in Year (365)
Days in
=
Inventory Inventory Turnover
Chapter
6-43 SO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Illustration: Wal-Mart reported in its 2008 annual
report a beginning inventory of $33,685 million, an ending
inventory of $35,180 million, and cost of goods sold for the
year ended January 31, 2008, of $286,515 million. The
inventory turnover formula and computation for Wal-Mart
are shown below.
Illustration 6-21
Days in Inventory: Inventory turnover of 8.3 times divided
into 365 is approximately 44 days. This is the approximate
time that it takes a company to sell the inventory.
Chapter
6-44 SO 6 Compute and interpret the inventory turnover ratio.
Cost Flow Methods in Perpetual Systems
Example Appendix 6A
Assuming the Perpetual Inventory System, compute Cost of Goods
Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Chapter
6-45 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Cost Flow Methods in Perpetual Systems
“First-In-First-Out (FIFO)” Illustration 6A-2
Cost of Goods Sold
Ending Inventory
Chapter
6-46 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Cost Flow Methods in Perpetual Systems
“Last-In-First-Out (LIFO)” Illustration 6A-3
Cost of Goods Sold
Ending Inventory
Chapter
6-47 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Cost Flow Methods in Perpetual Systems
“Average Cost” (Moving-Average System)
Illustration 6A-4
Cost of Goods Sold Ending Inventory
Chapter
6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Estimating Inventories
Gross Profit Method
The gross profit method estimates the cost of ending
inventory by applying a gross profit rate to net sales.
Illustration 6B-1
Chapter
6-49 SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
Illustration: Kishwaukee Company’s records for January show
net sales of $200,000, beginning inventory $40,000, and cost of
goods purchased $120,000. The company expects to earn a 30%
gross profit rate. Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Illustration 6B-2
Chapter
6-50 SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
Retail Inventory Method
Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.
Illustration 6B-3
Chapter
6-51 SO 8 Describe the two methods of estimating inventories.
Estimating Inventories
Illustration:
Illustration 6B-4
Note that it is not necessary to take a physical inventory to
determine the estimated cost of goods on hand at any given time.
Chapter
6-52 SO 8 Describe the two methods of estimating inventories.
