BUSN 7008

FINANCIAL STATEMENTS & REPORTING

Lecturer: Dr. Lijuan (Lily) Zhang

Week 7: Retail Inventory (Textbook Chapter 5)

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LEARNING OBJECTIVES

1. Define accounting principles related to inventory

2. Define inventory costing methods
3. Account for perpetual inventory using the three most
common costing methods
4. Compare the effects of the three most common inventory
costing methods
5. Apply the lower-of-cost-and-net-realisable-value rule to
inventory
6. Measure the effects of inventory errors
ACCOUNTING PRINCIPLES AND INVENTORIES

 The relevance principle implies that a firm’s financial

statements should report sufficient information to enable
outsiders to make knowledgeable decisions about the
business
 The comparability principle states that businesses should
consistently use the same accounting methods and
procedures from period to period
 The materiality principle states that a business need report
only information that is significant in its financial statements
 The conservatism principle means reporting items in the
financial statements at amounts that lead to the gloomiest
immediate financial results
Lower-of-cost-and-net-realisable-value rule (NRV)
 RETAIL OPERATIONS

A retail business has a current asset account called

Inventory
Revenue for a retailer
 Primary source of revenue is the sale of inventory
 Often known as sales revenue or sales

Expenses for a retailer

1. Cost of sales (COS) = total cost of inventory sold during the period
2. Other expenses = expenses incurred in the process of earning sales
revenue

Gross profit is sales revenue less COS

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RETAIL OPERATIONS CONTINUED

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 Focus INVENTORY SYSTEMS
1. Perpetual inventory system VS. 2. Periodic inventory system
 maintains a running record of all goods  detailed inventory records of goods on hand
(inventory) bought and sold are not maintained throughout the period
 the number of inventory units and dollar  physical count of inventory at the end of the
amounts are perpetually (constantly period to determine cost of goods on hand
updated) (inventory)
 Cost of Sales (COS) is determined at time a  COS indirectly determined only at end of
sale occurs accounting period

Journal entries:
Purchase: Dr. Inventory XXX
Cr. Accounts payable/ Cash XXX

Sale
Dr. Accounts receivable/ cash XXX
Cr. Sales Revenue XXX

Dr. Cost of sales XXX

Cr. Inventory XXX
INVENTORY COSTING METHODS

 The specific-unit-cost method uses the specific cost of each

unit of inventory to determine ending inventory and to
determine cost of sales
 The FIFO (first-in, first-out) inventory costing method bases
the cost of sales on the oldest purchases
 Under the LIFO (last-in, first-out) inventory costing method,
ending inventory comes from the oldest costs (first purchases)
of the period. The cost of sales is based on the most recent
purchases (new costs)
 Under the average-cost inventory costing method, the
business calculates a new average cost per unit after each
purchase
 The different inventory costing methods produce different
amounts for ending inventory and cost of goods sold
FIRST-IN, FIRST-OUT (FIFO) METHOD –
INVENTORY RECORD

All purchases and sales are on credit.

Selling price is $ 80 per unit
FIRST-IN, FIRST-OUT (FIFO) METHOD
JOURNAL ENTRIES

Date Account title Dr Cr

Jul 5 Inventory (6 × $45) (A+) 270
Accounts payable (L+) 270
Purchased inventory on credit.

Jul 15 Accounts receivable (4 × $80) (A+) 320

Sales revenue (R+) 320

Sale on credit.

Jul 15 Cost of sales (2 @ $40 + 2 @ $45) 170

(E+)
Inventory (A–) 170
Cost of sales.
FIRST-IN, FIRST-OUT (FIFO) METHOD –
JOURNAL ENTRIES
Date Account title Dr Cr
Jul 26 Inventory (9 × $47) (A+) 423
Accounts payable (L+) 423
Purchased inventory on credit.

Jul 31 Accounts receivable (10 × $80) (A+) 800

Sales revenue (R+) 800

Sale on credit.

Jul 31 Cost of sales (4 @ $45 + 6 @ $47) 462

(E+)
Inventory (A–) 462
Cost of sales.
LAST-IN, FIRST-OUT (LIFO) METHOD –
INVENTORY RECORD
LAST-IN, FIRST-OUT (LIFO) METHOD –
JOURNAL ENTRIES
Date Account title Dr Cr
Jul 5 Inventory (6 × $45) (A+) 270
Accounts payable (L+) 270
Purchased inventory on credit.

Jul 15 Accounts receivable (4 × $80) (A+) 320

Sales revenue (R+) 320

Sale on credit.

Jul 15 Cost of sales (4 @ $45) (E+) 180

Inventory (A–) 180
Cost of sales.
LAST-IN, FIRST-OUT (LIFO) METHOD –
JOURNAL ENTRIES
Date Account title Dr Cr
Jul 26 Inventory (9 × $47) (A+) 423
Accounts payable (L+) 423
Purchased inventory on credit.

Jul 31 Accounts receivable (10 × $80) (A+) 800

Sales revenue (R+) 800

Sale on credit.

Jul 31 Cost of sales (9 @ $47 + 1 @ $45) 468

(E+)
Inventory (A–) 468
Cost of sales.
AVERAGE-COST METHOD – INVENTORY
RECORD
AVERAGE-COST METHOD – JOURNAL ENTRIES
Date Account title Dr Cr
Jul 5 Inventory (6 × $45) (A+) 270
Accounts payable (L+) 270
Purchased inventory on credit.

Jul 15 Accounts receivable (4 × $80) (A+) 320

Sales revenue (R+) 320

Sale on credit.

Jul 15 Cost of sales (4 @ $43.75) (E+) 175

Inventory (A–) 175
Cost of sales.
AVERAGE-COST METHOD – JOURNAL ENTRIES
Date Account title Dr Cr
Jul 26 Inventory (9 × $47) (A+) 423
Accounts payable (L+) 423
Purchased inventory on credit.

Jul 31 Accounts receivable (10 × $80) (A+) 800

Sales revenue (R+) 800

Sale on credit.

Jul 31 Cost of sales (10 @ $46.00) (E+) 460

Inventory (A–) 460
Cost of sales.
COMPARING FIFO, LIFO AND AVERAGE COST
FREIGHT IN
Freight in: is the transportation cost to ship goods
INTO the purchaser’s warehouse.
If the buyer pays the freight in, freight in becomes
part of he cost of inventory.

Example: Smart Touch purchased inventory on credit, $1680,

plus freight in, $80.

Dr. Inventory 1760

Cr. Accounts payable 1760

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ADJUSTING INVENTORY BASED ON A
PHYSICAL COUNT

 The Inventory account should stay current at all times in a

perpetual inventory system
 The actual amount of inventory on hand may differ from
what the books show - theft, damage and errors may occur
For this reason, businesses take a physical count of
inventory at least once a year
 The business then adjusts the Inventory account based on
the physical count
Example: Greg’s Inventory account shows a balance of $40 500
for inventory on 31 Dec. The physical count of inventory is only
$40 200 on that date.
Dr. Cost of sales (40500-40200) 300
Cr. Inventory 300
LOWER-OF-COST-AND-NET-REALISABLE-VALUE RULE (NRV)
 NRV requires that inventory be reported in the financial statements at
whichever is lower:
 the historical cost of the inventory, or
 the net realisable value of the inventory
 Net realisable value generally means the estimated proceeds of sale
less, where applicable, all further costs to complete the product and less
all costs of marketing, selling and distributing the inventory to customers
 If the NRV falls below cost, the standard requires the business to write
down the value of its inventory to reflect the decline
 The comparison of cost and NRV has to be made separately for each
item of inventory, where practical, or otherwise to groups of similar items

Example :
Smart Touch paid $3000 for its USB01 inventory. By 31 July, the NRV of the
inventory is estimated to be $2200.
Entry to write down the inventory to NRV is:
Dr. Cost of sales (3000-2200) 800
Cr. Inventory 800
 SUMMARY: CHAPTER 6

 The accounting principles are the foundations that guide how we record
transactions
 Inventory costing methods include specific-unit-cost, FIFO, LIFO and
average cost
 Specific-unit-cost identifies the specific cost of each unit of inventory that
is in ending inventory and each item that is in cost of goods sold
 Under FIFO, the cost of goods sold is based on the oldest purchases
 Under LIFO, the cost of goods sold is based on the newest purchases
 Under the average-cost method, the business calculates a new average
cost per unit after each purchase