CHAPTER 6

INVENTORIES

LEARNING OBJECTIVES

1. DISCUSS HOW TO CLASSIFY DETERMINE

INVENTORY.

2. APPLY INVENTORY COST FLOW METHODS AND

DISCUSS THEIR FINANCIAL EFFECTS.

3. INDICATE THE EFFECTS OF INVENTORY ERRORS ON

THE FINANCIAL STATEMENTS.

4. EXPLAIN THE STATEMENT PRESENTATION AND

ANALYSIS OF INVENTORY.

*5. APPLY THE INVENTORY COST FLOW METHODS TO

PERPETUAL INVENTORY RECORDS.

*6. DESCRIBE THE TWO METHODS OF ESTIMATING

INVENTORIES.

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 CHAPTER REVIEW
Classifying Inventory

1. (L.O. 1) Inventory has two common characteristics: (a) it is owned by the company and (b) it is in
a form ready for sale in the ordinary course of business.

2. A manufacturer’s inventory is usually classified into three categories:

a. Finished goods that are completed and ready for sale.
b. Work in process that is in various stages of production but not yet completed.
c. Raw materials that are on hand waiting to be used in production.

Determination of Inventory Quantities

3. The determination of inventory quantities involves (a) taking a physical inventory of goods on
hand and (b) determining the ownership of goods.

4. Taking a physical inventory involves counting, weighing or measuring each kind of inventory on
hand. Internal control procedures should be followed in taking the inventory in order to minimize
errors.

5. For goods in transit, legal title is determined by the terms of sale. When the terms are:
a. FOB (free on board) shipping point, ownership of the goods passes to the buyer when the
public carrier accepts the goods from the seller.
b. FOB destination, legal title to the goods remains with the seller until the goods reach the
buyer.

6. Under a consignment arrangement, the holder of the goods (called the consignee) does not own
the goods. Ownership remains with the shipper of the goods (consignor) until the goods are actually
sold to a customer. Consigned goods should be included in the consignor’s inventorynot the
consignee’s inventory.

Inventory Costing

7. (L.O. 2) Inventory is accounted for at cost which includes all expenditures necessary to acquire
goods and place them in a condition ready for sale. After a company has determined the quantity
of units of inventory, it applies unit costs to the quantities to determine the total cost of the
inventory and the cost of goods sold.

Specific Identification

8. The specific identification method identifies the particular units sold so that the cost of the
specific unit sold is charged to the cost of goods sold. This method is possible when a company
sells a limited variety of high unit-cost items that can be clearly identified from the time of
purchase through the time of sale.

9. The allocation of inventoriable costs may be made under any of the following assumptions as to
the flow of costs (a) first-in, first-out (FIFO), (b) last-in, first-out (LIFO), or (c) average-cost.

FIFO

10. The FIFO method assumes that the costs of the earliest goods purchased are the first to be sold.
a. This method often parallels the actual physical flow of the merchandise.
b. Under this method, the ending inventory is based on the latest units purchased.

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LIFO

11. The LIFO method assumes that the costs of the latest units purchased are the first to be sold.
a. This method seldom coincides with the actual physical flow of inventory.
b. Under this method, all goods purchased during the period are assumed to be available for
the first sale, regardless of the date of purchase.
c. The ending inventory is found by taking the unit cost of the oldest goods and working forward
until all units of inventory are costed.

Average-Cost

12. The average-cost method assumes that the goods available for sale are similar in nature.
a. Under this method, the cost of goods available for sale is allocated on the basis of weighted-
average unit cost.
b. The formula for determining the weighted-average unit cost is: Cost of goods available for
sale divided by total units available for sale.

Financial Statement Effects

13. In periods of rising prices, FIFO produces a higher net income, LIFO the lowest, and average cost
falls in the middle. The reverse is true when prices are falling.

14. Companies adopt different inventory costing methods because of:

a. Balance sheet effects: the inventory costs are closer to current costs under FIFO than under
LIFO.
b. Income statement effects: in addition to the effects on net income in (13) above, LIFO enables
the company to avoid reporting paper or phantom profit as economic gain.
c. Tax effects: in a period of inflation LIFO results in the lowest income taxes.

Net Realizable Value

15. The value of inventory for companies in certain industries can drop due to changes in technology
or fashions. This situation requires valuing inventory at the lower-of-cost-or-net realizable value
(LCNRV) in the period in which the price decline occurs.

16. Net realizable value refers to the net amount that a company expects to realize (receive) from the
sale of inventory.

Effects of Inventory Errors

17. (L.O. 3) The effects of inventory errors on the current year’s income statement are:

Cost of
Inventory Error Goods Sold Net Income
Beginning inventory understated Understated Overstated
Beginning inventory overstated Overstated Understated
Ending inventory understated Overstated Understated
Ending inventory overstated Understated Overstated

18. The effects of ending inventory errors on the balance sheet are:

Ending
Inventory Assets Liabilities Owner’s Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated

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19. In the financial statements:
a. Inventory is usually classified as a current asset after receivables in the balance sheet, and
cost of goods sold is subtracted from sales in the income statement.
b. There should be disclosure of (1) the major inventory classifications, (2) the basis of accounting,
and (3) the costing method.

Inventory Turnover

20. (L.O. 4) The inventory turnover measures the number of times on average the inventory is
sold during the period.

Cost of Goods Sold ÷ Average Inventory = Inventory Turnover

*Applying Perpetual Inventory

*21. (L.O. 5) Each of the inventory cost flow methods may be used in a perpetual inventory system.
a. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of
goods sold.
b. Under the LIFO method, the most recent purchase prior to sale is allocated to the units sold.
c. When the moving-average method is used, a new average is computed after each
purchase by dividing the cost of goods available for sale by the units on hand.

Estimating Inventories

*22. (L.O. 6) Inventories may have to be estimated when (a) management wants monthly or quarterly
financial statements or (b) a fire or other type of casualty makes it impossible to take a physical
inventory.

Gross Profit Method

*23. The gross profit method is widely used to estimate the ending inventory. Two steps are involved
in using this method.
a. The estimated cost of goods sold is determined by subtracting the estimated gross profit from
net sales.
b. The estimated cost of goods sold is subtracted from cost of goods available for sale to
determine the estimated cost of the ending inventory.

Retail Inventory Method

*24. The retail inventory method is used by retail companies to estimate the cost of the inventory.
The steps in using this method are:

a. Goods Available Net = Ending

–
for Sale at Retail Sales Inventory
at Retail

b. Goods Available Goods Available Cost-to-

÷ = Retail Ratio
for Sale at Cost for Sale at Retail

c. Ending Cost-to- Estimated Cost

Inventory X Retail = of Ending
at Retail Ratio Inventory

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 LECTURE OUTLINE

A. Classifying and Determining Inventory.

1. Inventory of a merchandising company has two common characteristics:

a. It is owned by the company.

b. It is in a form ready for sale to customers in the ordinary course of

business.

2. In a manufacturing company, some inventory may not yet be ready for sale.
As a result, manufacturers usually classify inventory into three categories:

a. Finished goods; manufactured items that are completed and ready

for sale.

b. Work in process; the portion of manufactured inventory that has been

placed into the production process but is not yet complete.

c. Raw materials; the basic goods that will be used in production but have
not yet been placed into production.

ACCOUNTING ACROSS THE ORGANIZATION

JIT can save a company a lot of money, but it isn’t without risk. An unexpected
disruption in the supply chain can cost a company a lot of money. Japanese
automakers experienced such a disruption when an earthquake damaged a
company that supplies 50% of the automaker’s piston rings.

What steps might companies take to avoid such a serious disruption in the
future?

Answer: The manufacturer of the piston rings should spread its manufacturing
facilities across a few locations that are far enough apart that they
would not all be at risk at once. In addition, the automakers might
consider becoming less dependent on a single supplier as well as
having weather contingency plans.
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B. Determining Inventory Quantities.

1. All companies need to determine inventory quantities at the end of the

accounting period. Companies using a perpetual system take a physical
inventory for the following reasons:

a. To check the accuracy of their perpetual inventory records.

b. To determine the amount of inventory lost due to wasted raw materials,

shoplifting, or employee theft.

2. Determining inventory quantities involves two steps: (1) taking a physical

inventory of goods on hand and (2) determining the ownership of goods.

a. Taking a physical inventory involves actually counting, weighing, or

measuring each kind of inventory on hand.

b. Determining the ownership of goods.

(1) Goods in transit should be included in the inventory of the com-

pany that has legal title to the goods. Legal title is determined
by the terms of the sale:

(a) When the terms are FOB (free on board) shipping point,
ownership of the goods passes to the buyer when the public
carrier accepts the goods from the seller.

(b) When the terms are FOB destination, ownership of the goods
remains with the seller until the goods reach the buyer.

(2) Consigned goods are goods held by one party although ownership
of the goods is retained by another party. If an inventory count
is taken, the goods would not be included in the holding party’s
inventory.

C. Inventory Costing.

1. Inventory is accounted for at cost.

2. Cost includes all expenditures necessary to acquire goods and place them
in condition ready for sale.

6-6 Copyright © 2015 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 12/e, Instructor’s Manual (For Instructor Use Only)
 3. Cost of goods available for sale includes:

a. The cost of beginning inventory.

b. The cost of goods purchased.

4. Cost of goods available for sale is allocated to either ending inventory or

to cost of goods sold.

D. Specific Identification.

1. Specific identification requires that companies keep records of the original

cost of each individual inventory item.

2. Bar coding, electronic product codes, and radio frequency identification

make it theoretically possible to do specific identification with nearly any
type of product.

3. This method, however, may enable management to manipulate net income.

E. Cost Flow Assumptions—FIFO, LIFO, and Average-Cost.

1. The FIFO (first-in, first-out) method assumes that the earliest goods pur-
chased are the first to be recognized in determining cost of goods sold.

a. FIFO often parallels the actual physical flow of merchandise because

it generally is good business practice to sell the oldest units first.

b. Under FIFO, companies obtain 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.

2. The LIFO (last-in, first-out) method assumes that the latest goods pur-
chased are the first to be recognized in determining cost of goods sold.

a. LIFO seldom coincides with the actual physical flow of inventory. All
goods purchased during the period are assumed to be available for the
first sale, regardless of the date of purchase.

Copyright © 2015 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 12/e, Instructor’s Manual (For Instructor Use Only) 6-7
 b. Under LIFO, companies obtain the cost of the ending inventory by
taking the unit cost of the earliest goods available for sale and working
forward until all units of inventory have been costed.

3. The average-cost method assumes that the goods are similar in nature.

a. Under this method, the cost of goods available for sale is allocated
on the basis of the weighted-average unit cost.

b. The weighted-average unit cost is computed by dividing cost of goods

available for sale by total units available for sale.

c. The company then applies the weighted-average unit cost to the units
on hand to determine the cost of ending inventory.

F. Financial Statement and Tax Effects of Cost Flow Methods.

1. Income statement effects.

a. Each dollar of difference in ending inventory results in a corresponding

dollar difference in income before income taxes.

b. In a period of inflation, FIFO produces a higher net income because

the lower unit costs of the first units purchased are matched against
revenues.

c. Some argue that the use of LIFO in a period of inflation enables

the company to avoid reporting paper (or phantom) profit as eco-
nomic gain.

2. Balance sheet effects.

a. A major advantage of the FIFO method is that in a period of infla-

tion, the costs allocated to ending inventory will approximate their
current cost.

6-8 Copyright © 2015 John Wiley & Sons, Inc. Weygandt, Accounting Principles, 12/e, Instructor’s Manual (For Instructor Use Only)
 b. A major shortcoming of the LIFO method is that in a period of infla-
tion, the costs allocated to ending inventory may be significantly
understated in terms of current cost.

3. Tax effects. LIFO results in lower income taxes, because of lower net
income, than either FIFO or average cost in a period of rising prices.

INTERNATIONAL INSIGHT

ExxonMobil Corporation uses LIFO to value its inventory for financial reporting
and tax purposes. International accounting standards do not allow the use of
LIFO, which makes the net income of foreign oil companies such as BP not
directly comparable to U.S. companies.

What are the arguments for and against the use of LIFO?

Answer: Proponents of LIFO argue that it is conceptually superior because it

matches the most recent cost with the most recent selling price. Critics
contend that it artificially understates the company’s net income and
consequently reduces tax payments. Also, because most foreign com-
panies are not allowed to use LIFO, its use by U.S. companies reduces
the ability of investors to compare results across companies.

G. Lower-of-Cost-or-Net Realizable Value.

1. The value of inventory for companies in certain industries can drop very
quickly due to changes in technology or fashions. This situation requires
a departure from the cost basis of accounting. This is done by valuing the
inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period
in which the price decline occurs.

2. Companies apply LCNRV to the items in inventory after they have used
one of cost flow methods to determine cost. Under LCNRV, companies
recognize the loss in the period in which the price decline occurs.

a. LCNRV is an example of the accounting concept of conservatism,

which means that the best choice among accounting alternatives is
the method that is least likely to overstate assets and net income.

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 b. Under the LCNRV basis, net realizable value refers to the net
amount that a company expects to realize (receive) from the sale of
inventory. Net realizable value is the estimated selling price in the
normal course of………………………………………..

H. Inventory Errors.

1. The effects of inventory errors on net income of the current year are:

a. An error in beginning inventory will have a reverse effect on net

income (overstatement of inventory results in understatement of net
income).

b. An error in ending inventory will have a similar effect on net income

(overstatement of inventory results in overstatement of net income).

c. If ending inventory errors are not corrected in the following period,

their effect on net income for that period is reversed, and total net
income for the two years will be correct.

2. Errors in ending inventory have no effect on liabilities and have the same
effect on total assets and total owners’ equity (overstatement of inventory
results in overstatement of total assets and owners’ equity).

I. Statement Presentation and Analysis.

1. Inventory is classified as a current asset immediately below receivables

in the balance sheet. Cost of goods sold is subtracted from sales revenue
in a multiple-step income statement.

2. There should be disclosure in the notes to the financial statements of:

a. the major inventory classifications.

b. the basis of accounting (cost, or lower of cost or market).

c. the costing method (FIFO, LIFO, or average cost).

3. Inventory turnover measures the number of times on average the inventory

is sold during the period.

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 4. A variant of the inventory turnover is to compute the number of days
inventory is held. It is computed by dividing 365 days by the inventory
turnover.

*J Inventory Cost Flow Methods in Perpetual Inventory Systems.

1. Under FIFO, companies charge to cost of goods sold the cost of the
earliest goods on hand prior to each sale. The results under FIFO in a
perpetual system are the same as in a periodic system.

2. Under LIFO, companies charge to cost of goods sold the cost of the most
recent purchase prior to sale. In a perpetual LIFO system, the company
allocates the latest units purchased prior to each sale to cost of goods sold.

3. Under the moving-average (average cost) method and a perpetual system,

companies compute a new average cost after each purchase. The aver-
age cost is computed by dividing the cost of goods available for sale by
the units on hand.

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*K Estimating Inventories—Gross Profit and Retail Inventory Methods.

1. Two circumstances explain why companies sometimes estimate inventories:

a. A casualty such as a fire, flood, or earthquake may make it impossible

to take a physical inventory.

b. Managers may want monthly or quarterly financial statements, but

a physical inventory is taken only annually.

2. There are two widely used methods of estimating inventories:

a. The gross profit method is used in preparing monthly financial state-

ments under a periodic system.

(1) Step 1: Net sales less estimated gross profit equals estimated
cost of goods sold.

(2) Step 2: Cost of goods available for sale less estimated cost of
goods sold (from Step 1) equals the estimated cost of ending
inventory.

(3) The gross profit method is based on the assumption that the
gross profit rate will remain constant.

(4) Companies should not use the gross profit method to prepare
financial statements at the end of the year.

b. When a store has many different types of merchandise at low unit

costs, the retail inventory method is often used.

(1) Under the retail inventory method, a company’s records must show
both the cost and retail value of the goods available for sale.

(2) Step 1: Goods available for sale at retail less net sales equals
ending inventory at retail.

(3) Step 2: Goods available for sale at cost divided by goods avail-
able for sale at retail equals the cost-to-retail ratio.

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 (4) Step 3: Ending inventory at retail multiplied by the cost-to-retail
ratio equals the estimated cost of ending inventory.

(5) The major disadvantage of the retail method is that it is an averag-

ing technique. This may produce an incorrect inventory valuation
if the mix of the ending inventory is not representative of the
mix in the goods available for sale.

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A Look at IFRS

The major IFRS requirements related to accounting and reporting for inventories
are the same as GAAP. The major difference is that IFRS prohibits the use of the
LIFO cost flow assumption.

Relevant Facts

 IFRS and GAAP account for inventory acquisitions at historical cost and
value inventory at the lower-of-cost-or-net realizable value subsequent to
acquisition.
 Who owns the goods—goods in transit or consigned goods—as well as the
costs to include in inventory are essentially accounted for the same under
IFRS and GAAP.
 The requirements for accounting for and reporting inventories are more
principles based under IFRS. That is, GAAP provides more detailed
guidelines in inventory accounting.
 A major difference between IFRS and GAAP relates to the LIFO cost flow
assumption. GAAP permits the use of LIFO for inventory valuation. IFRS
prohibits its use. FIFO and average-cost are the only two acceptable cost
flow assumptions permitted under IFRS. Both sets of standards permit
specific identification where appropriate.

LOOKING TO THE FUTURE

One convergence issue that will be difficult to resolve relates to the use of the
LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use.
Conversely, the LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. In addition, many argue that LIFO from
a financial reporting point of view provides a better matching of current costs
against revenue and, therefore, enables companies to compute a more realistic
income.

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 20 MINUTE QUIZ

Circle the correct answer.

True/False

1. When prices are rising, FIFO results in a higher ending inventory than LIFO.
True False

2. We can use the LIFO inventory method only if we know that the newest units are always
sold first.
True False

3. Goods in transit would be included in the ending inventory of the buyer and the seller.
True False

4. Under the LCNRV basis, net realizable value is the estimated selling price in the normal
course of business.
True False

5. When beginning inventory is understated, net income will be understated.

True False

6. Cost of goods purchased less the ending inventory equals cost of goods sold.
True False

7. The LIFO method assumes that the earliest goods purchased are the first to be sold.
True False

8. The inventory turnover is computed by dividing the cost of goods sold by the ending
inventory.
True False

*9. The gross profit method estimates the cost of ending inventory by applying a gross profit
rate to net sales.
True False

*10. The retail inventory method and the gross profit method are both methods of inventory
estimation.
True False

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Multiple Choice

1. The cost flow method that results in the lowest income taxes when prices are rising is
a. average cost.
b. FIFO.
c. LIFO.
d. specific identification.

2. The data below are for Parrett Enterprises:

Beginning inventory 150 units at $2.00
Purchase—August 375 units at $1.50
Purchase—October 150 units at $3.00

A periodic inventory system is used; ending inventory is 330 units. What is the ending
inventory under FIFO?
a. $570
b. $743
c. $593
d. $720

3. Double-counting an inventory item at year end will result in

a. understated tax liability.
b. overstated cost of goods sold.
c. overstated net income.
d. understated beginning inventory for the next period.

*4. A retail company has goods available for sale of $300,000 at retail and $210,000 at cost,
and ending inventory of $80,000 at retail. What is the estimated cost of goods sold?
a. $220,000
b. $154,000
c. $210,000
d. $56,000

*5. Which method might be used to estimate inventory costs when physical inventories are
not taken?
a. First-in, first-out
b. Last-in, first-out
c. Average cost method
d. Gross profit method

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 ANSWERS TO QUIZ

True/False

1. True 6. False
2. False 7. False
3. False 8. False
4. True *9. True
5. False *10. True

Multiple Choice

1. c.
2. d.
3. c.
*4. b.
*5. d.

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