6 Inventories

Learning Objectives
1 Discuss how to classify and determine inventory.

Apply inventory cost flow methods and discuss their

2 financial effects.

Indicate the effects of inventory errors on the financial

3 statements.

Explain the statement presentation and analysis of

4 inventory.

6-1
LEARNING Discuss how to classify and determine
OBJECTIVE
1
inventory.

Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

◆ Inventory ◆ Raw Materials

◆ Work in Process
Helpful Hint
Regardless of the ◆ Finished Goods
classification, companies
report all inventories
under Current Assets on
the balance sheet.
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 Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw
materials, shoplifting, or employee theft.

Periodic System
3. Determine the inventory on hand.
4. Determine the cost of goods sold for the period.

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 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.

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 Determining Ownership of Goods

GOODS IN TRANSIT Illustration 6-2

Terms of sale

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.

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DO IT! 1 Rules of Ownership
Hasbeen Company completed its inventory count. It arrived at a total inventory value of
$200,000. You have been given the information listed below. Discuss how this information
affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing
$15,000.
2. The company did not include in the count purchased goods of $10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a cost of
$12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of $15,000 held on consignment should be deducted from the inventory
count.
2. The goods of $10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be $195,000
($200,000 - $15,000 + $10,000).
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LEARNING Apply inventory cost flow methods and
OBJECTIVE
2
discuss their financial effects.

Inventory is accounted for at cost.

◆ Cost includes all expenditures necessary to acquire goods
and place them in a condition ready for sale.
◆ Unit costs are applied to quantities to compute the total cost
of the inventory and the cost of goods sold using the
following costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Last-in, first-out (LIFO) Cost Flow
Assumptions
► Average-cost

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 Inventory Costing

Illustration: Crivitz TV Company purchases three identical

50-inch TVs on different dates at costs of $700, $750, and
$800. During the year Crivitz sold two sets at $1,200 each.
These facts are summarized below. Illustration 6-3
Data for inventory
costing example

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 Specific Identification

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 6-4

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 Specific Identification

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.

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 Cost Flow Assumptions

Cost flow assumptions

DO NOT need to be
consistent with the
physical movement of
the goods

Illustration 6-12
Use of cost flow methods in
major U.S. companies

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 Cost Flow Assumptions

Illustration: Data for Houston Electronics’ Astro condensers.

Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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 Cost Flow Assumptions

FIRST-IN, FIRST-OUT (FIFO)

◆ Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.

◆ Often parallels actual physical flow of merchandise.

◆ Companies determine the cost of the ending inventory

by taking the unit cost of the most recent purchase and
working backward until all units of inventory have been
costed.

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 FIRST-IN, FIRST-OUT (FIFO)
Illustration 6-6

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 Cost Flow Assumptions

LAST-IN, FIRST-OUT (LIFO)

◆ Costs of the latest goods purchased are the first to be
recognized in determining cost of goods sold.

◆ Seldom coincides with actual physical flow of

merchandise.

◆ Exceptions include goods stored in piles, such as coal or

hay.

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 LAST-IN, FIRST-OUT (LIFO)
Illustration 6-8

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 Cost Flow Assumptions

AVERAGE-COST
◆ Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.

◆ Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

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 AVERAGE-COST
Illustration 6-11

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 Financial Statement and Tax Effects
Illustration 6-13
INCOME STATEMENT EFFECTS Comparative effects of
cost flow methods

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 Financial Statement and Tax Effects

BALANCE SHEET EFFECTS

◆ A major advantage of the FIFO method is that in a period
of inflation, the costs allocated to ending inventory will
approximate their current cost.

◆ A major shortcoming of the LIFO method is that in a

period of inflation, the costs allocated to ending inventory
may be significantly understated in terms of current cost.

6-20 LO 2
 Financial Statement and Tax Effects

TAX EFFECTS
◆ Both inventory and net income are higher when companies
use FIFO in a period of inflation.

◆ LIFO results in the lowest income taxes (because of lower

net income) during times of rising prices.

Helpful Hint
A tax rule, often referred to as the
LIFO conformity rule, requires that if
companies use LIFO for tax
purposes they must also use
it for financial reporting purposes.

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 DO IT! 2 Cost Flow Methods

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LEARNING Indicate the effects of inventory errors
OBJECTIVE
3
on the financial statements.

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.

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 Income Statement Effects

Inventory errors affect the computation of cost of goods sold

and net income in two periods.
Illustration 6-15

Illustration 6-16

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 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.

◆ Ending inventory depends entirely on the accuracy of

taking and costing the inventory.

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 Income Statement Effects Illustration 6-17
Effects of inventory errors on
two years’ income statements

($3,000) $3,000
Combined income for Net Income
Net Income
2-year period is correct. understated overstated

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 Income Statement Effects

Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. stockholders’ equity

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 Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined

by using the basic accounting equation: Assets = Liabilities +
Stockholders’ Equity.
Errors in the ending inventory have the following effects.

Illustration 6-18
Effects of ending inventory
errors on balance sheet

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 DO IT! 3 Inventory Errors

Visual Company overstated its 2016 ending inventory by

$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and stockholders’ equity in 2016
and 2017.
Solution
2016 2017
Ending inventory $22,000 overstated No effect
Cost of goods sold $22,000 understated $22,000 overstated
Stockholders’ equity $22,000 overstated No effect

6-29 LO 3
LEARNING Explain the statement presentation and
OBJECTIVE
4
analysis of inventory.

Presentation
Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold is subtracted from

sales.

There also should be disclosure of the

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average-cost).

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 Lower-of-Cost-or-Net Realizable Value

When the value of inventory is lower than its cost

◆ Companies must “write down” the inventory to its net
realizable value.

◆ Net realizable value: Amount that a company expects to

realize (receive from the sale of inventory).

◆ Example of conservatism.

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 Lower-of-Cost-or-Net Realizable Value

Illustration: Assume that Ken Tuckie TV has the following

lines of merchandise with costs and market values as
indicated.

Illustration 6-20
Computation of
lower-of-cost-or-net
realizable value

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 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 stock-outs and lost
sales.

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 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

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 Analysis
Illustration: Wal-Mart reported in its 2014 annual report a beginning
inventory of $43,803 million, an ending inventory of $44,858 million,
and cost of goods sold for the year ended January 31, 2014, of
$358,069 million. The inventory turnover formula and computation for
Wal-Mart are shown below.
Illustration 6-21

Days in Inventory: Inventory turnover of 8.1 times divided into 365

is approximately 45.1 days. This is the approximate time that it
takes a company to sell the inventory.

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 DO IT! 4 LCNRV and Inventory Turnover

Tracy Company sells three different types of home heating stoves

(gas, wood, and pellet). The cost and net realizable value of its
inventory of stoves are as follows.
Cost Net Realizable Value
Gas $ 84,000 $ 79,000
Wood 250,000 280,000
Pellet 112,000 101,000
Determine the value of the company’s inventory under the
lower-of-cost-or-net realizable value approach.
Solution Lowest value for each inventory type is gas $79,000,
wood $250,000, and pellet $101,000. The total
inventory value is the sum of these amounts, $430,000.
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LEARNING APPENDIX 6A: Apply the inventory cost flow
5
OBJECTIVE methods to perpetual inventory records.

Illustration Illustration 6A-1

Inventoriable units and costs

Assuming the Perpetual Inventory System, compute Cost of Goods Sold

and Ending Inventory under FIFO, LIFO, and average-cost.

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 First-In, First-Out (FIFO)

Perpetual Inventory System Illustration 6A-2

Cost of Goods Ending Inventory

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Sold
LO 5
 Last-In, First-Out (LIFO)

Perpetual Inventory System Illustration 6A-3

Cost of Goods Ending Inventory

6-39
Sold
LO 5
 Average-Cost

Moving Average Method

Illustration 6A-4

Cost of Goods Ending Inventory

Sold

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6-41
 Solution of P6-3A
Cost of goods available for sale
Date Particulars Unit Rate Amount
Janu 1 Beginning inventory 160 20 3200
Mar 15 Purchase 400 23 9200
July 20 Purchase 250 24 6,000
Sept 4 Purchase 330 26 8580
Dec 2 Purchase 100 29 2900
Total 1240 29880

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 Solution of
Cost of ending inventory (FIFO)
Date Unit Rate Amount
Sept 4 140 26 3640
Cost of goods sold=
Dec 2 100 29 2900 29880-6540=23340
240 6540

Cost of ending inventory (LIFO)

Date Unit Rate Amount Cost of goods sold=
Janu 1 160 20 3200 29880-5040=24840
Mar 15 80 23 1840
240 5040

Cost of ending inventory (Average)

Average cost per unit=29880/1240=24.097
Ending Inventory= 240×24.097=5783
Cost
6-43 of goods sold= 1000×24.097= 24097 LO 5
6-44
 Solution of P6.5A
Computation of sales revenue

Date Particulars Unit Rate Amount

June 10 sales 110 70 7700
June 11 Sales return (15) 70 (1050)
June 25 Sales 65 76 4940
Total 160 11,590

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 Computation of cost of goods sold and ending inventory (LIFO)
Date Particular Purchase Cost of goods sold Balance
s
Unit Rate Amount Unit Rate Amount Unit Rate Amount
June 1 Beg. Inv 40 40 1600
June 4 Purcha. 135 43 5805 40 40 1600
135 43 5805
June Sale 110 43 4730 40 40 1600
10 25 43 1075
June Sales (15) 43 (645) 40 40 1600
11 retturn 25 43 1075
15 43 645
June Purchase 55 46 2530 40 40 1600
18 25 43 1075
15 43 645
55 46 2530
June Purch. (10) 46 (460) 40 40 1600
18 return 25 43 1075
15 43 645
45 46 2070
June Sales 45 46 2070 40 40 1600
25 (65) 15 43 645 20 43 860
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 Computation of cost of goods sold and ending inventory (LIFO)

Date Particular Purchase Cost of goods sold Balance

s
Unit Rate Amount Unit Rate Amount Unit Rate Amount

June Sales 45 46 2070 40 40 1600

25 (65) 15 43 645 20 43 860
5 43 215
June Purchase 35 50 1750 40 40 1600
28 20 43 860
35 50 1750
Total 215 9625 160 7015 95 4210

(iii) Gross profit = sale – COGS=11590-7015=4575

(iv) Gross profit rate= GP/sales = 4575/11590=
39.47%

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 Computation of cost of goods sold and ending inventory (Average)

Date Particular Purchase Cost of goods sold Balance

s
Unit Rate Amount Unit Rate Amount Unit Rate Amount
June 1 Beg. Inv 40 40 1600
June 4 Purcha. 135 43 5805 175 42.31 7405

June Sale 110 42.31 4655 65 42.31 2750

10
June Sales (15) 42.31 (635) 80 42.31 3385
11 retturn
June Purchase 55 46 2530 135 43.81 5915
18
June Purch. (10) 46 (460) 125 43.64 5455
18 return
June Sales 65 43.64 2837 60 43.64 2618
25 (65)
June Purchas 35 50 1750 95 45.98 4368
28 e
Totals
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