Accounting Principles

Thirteenth Edition
Weygandt ● Kimmel ● Kieso

Chapter 6

Inventories
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Chapter Outline
Learning Objectives
LO 1 Discuss how to classify and determine inventory.
LO 2 Apply inventory cost flow methods and discuss their
financial effects.
LO 3 Indicate the effects of inventory errors on the
financial statements.
LO 4 Explain the statement presentation and analysis of
inventory.

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Classifying and Determining Inventory
Classifying Inventory

Merchandising Manufacturing
company company

One classification: Three classifications:

• Merchandise • Raw materials
inventory • Work in process
• Finished goods

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Determining Inventory Quantities (1 of 2)
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
1. Determine the inventory on hand at the balance
sheet date
2. Determine the cost of goods sold for the period
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Determining Inventory Quantities (2 of 2)
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand
Companies often “take inventory”
• when business is closed or business is slow
• at the end of accounting period

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Determining Inventory Quantities (3 of 3)
Determining Ownership of Goods
Goods in Transit
• Purchased goods not yet received
• Sold goods not yet delivered
• Included in inventory of company that has legal title to
goods

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Goods in Transit (1 of 3)

Freight costs incurred by the seller are an operating expense.

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Goods in Transit (2 of 3)
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

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Goods in Transit (3 of 3)
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. Answer: terms of sale are FOB shipping point

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Determining Ownership of Goods
Consigned Goods
Goods of other parties held by the company for sale;
ownership of the goods remains with other parties –
company earns a fee for sale.
Many car, boat, and antique dealers sell goods on
consignment to:
• keep inventory costs down
• avoid risk of purchasing an item that they will not be
able to sell

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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. As a new member of Hasbeen’s accounting
department, 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 sold inventory with a cost of
$12,000 which was in transit (terms: FOB shipping point).

Inventory = $200,000 − $15,000 + $10,000 = $195,000

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Inventory Methods and Financial Effects
(1 of 2)

Inventory is accounted for at 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 total cost of
inventory and cost of goods sold using the following cost
flow assumptions:
o Specific identification
o First-in, first-out (FIFO)
o Last-in, first-out (LIFO)
o Average-cost

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Inventory Methods and Financial
Effects (2 of 2)
Illustration: Crivitz TV Company purchases three identical
50-inch TVs on different dates at costs of $720, $750, and
$800. During the year Crivitz sold two sets at $1,200 each.
These facts are summarized below.
Purchases
February 3 1 TV at $720
March 5 1 TV at $750
May 22 1 TV at $800
Sales
June 1 2 TVs For $2,400 ($1,200 × 2)
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Specific Identification (1 of 2)
If Crivitz sold the TVs it purchased on February 3 and May
22, then its cost of goods sold is $1,520 ($720 + $800),
and its ending inventory is $750.

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Specific Identification (2 of 2)
• Possible only when a company sold a limited variety of
high-unit-cost items that could be identified clearly
from the time of purchase through the time of sale.
• Practice is relatively rare.
• Most companies make assumptions (cost flow
assumptions) about which units were sold.

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Cost Flow Assumptions (1 of 9)
Cost flow assumptions DO NOT need to be consistent
with the physical movement of the goods

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Cost Flow Assumptions (2 of 9)
Illustration: Data for Houston Electronics’ Astro condensers.

Cost of goods sold formula in a periodic system is:

Beginning Inventory + Purchases − Ending Inventory = Cost of
Goods Sold
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Cost Flow Assumptions (3 of 9)
First-In, First-Out (FIFO)
• Costs of earliest goods purchased are first to be
recognized in determining cost of goods sold
• Often parallels actual physical flow of merchandise
• Companies determine cost of ending inventory by
taking unit cost of most recent purchase and working
backward until all units of inventory have been costed

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First-In, First-Out (FIFO) (1 of 2)

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Cost Flow Assumptions (4 of 9)
Last-In, First-Out (LIFO)
• Costs of latest goods purchased are 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)

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Cost Flow Assumptions (5 of 9)
Average-Cost
• Allocates cost of goods available for sale on basis of
weighted-average unit cost incurred
• Applies weighted-average unit cost to units on hand to
determine cost of ending inventory

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Average-Cost

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Financial Statement and Tax Effects of Cost
Flow Methods
Each of the three cost flow methods is acceptable for use.
• Reebok International Ltd. and Wendy’s International
currently use the FIFO method
• Campbell Soup Company, Krogers, and Walgreen Drugs
use LIFO for part or all of their inventory
• Bristol-Myers Squibb, Starbucks, and Motorola use the
average-cost method
• Stanley Black & Decker Manufacturing Company uses LIFO
for domestic inventories and FIFO for foreign inventories

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Income Statement Effects (1 of 5)

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Balance Sheet Effects (1 of 2)
• A major advantage of the FIFO method is that in a
period of inflation, costs allocated to ending inventory
will approximate their current cost
• A major shortcoming of the LIFO method is that in a
period of inflation, costs allocated to ending inventory
may be significantly understated in terms of current
cost

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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
• A tax rule requires that if companies use LIFO for tax
purposes they must also use it for financial reporting
purposes (LIFO conformity rule)

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Using Inventory Cost Flow Methods
Consistently
• Method should be used consistently to enhance
comparability
• Although consistency is preferred, a company may
change its inventory costing method
Quaker Oats Notes to the Financial Statements
Note 1: Effective July 1, the Company adopted the LIFO cost flow
assumption for valuing the majority of U.S. Grocery Products
inventories. The Company believes that the use of the LIFO method
better matches current costs with current revenues. The effect of
this change on the current year was to decrease net income by
$16.0 million.
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Cost Flow Assumptions (6 of 9)
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

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Cost Flow Assumptions (7 of 9)
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. Answer: FIFO method
b. LIFO method
c. average cost method
d. gross profit method

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Cost Flow Assumptions (8 of 9)
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

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Cost Flow Assumptions (9 of 9)
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method
b. Answer: LIFO method
c. average cost method
d. gross profit method

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Do It! 2: Cost Flow Methods
The accounting records of Shumway Ag Implements show
the following data.
Beginning inventory 4,000 units at $ 3
Purchases 6,000 units at $ 4
Sales 7,000 units at $12

Determine the cost of goods sold during the period under

a periodic inventory system using (a) the FIFO method, (b)
the LIFO method, and (c) the average-cost method.

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Do It! 2: FIFO Method
Determine cost of goods sold under a periodic inventory.

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Do It! 2: LIFO Method
Determine cost of goods sold under a periodic inventory.

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Do It! 2: Average-Cost Method
Determine cost of goods sold under a periodic inventory.

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Effects of Inventory Errors (1 of 2)
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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Effects of Inventory Errors (2 of 2)
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
Cost of Cost of
Beginning Ending
+ Goods − = Goods
Inventory Inventory
Purchased Sold

Cost of
When Inventory Error: Goods Sold Is: Net Income Is:
Understates beginning inventory Understated Overstated
Overstates beginning inventory Overstated Understated
Understates ending inventory Overstated Understated
Overstated ending inventory Understated Overstated

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Income Statement Effects (2 of 5)
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
• An error in ending inventory of current period will have
a reverse effect on net income of next accounting
period
• Over two years, total net income is correct because
errors offset each other
• Ending inventory depends entirely on accuracy of taking
and costing inventor

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Income Statement Effects (3 of 5)

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Income Statement Effects (4 of 5)
Understating ending inventory will overstate:
a. assets
b. cost of goods sold
c. net income
d. stockholders’ equity

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Income Statement Effects (5 of 5)
Understating ending inventory will overstate:
a. assets
b. Answer: cost of goods sold
c. net income
d. stockholders’ equity

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Balance Sheet Effects (2 of 2)
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.
Ending Stockholders’
Inventory Error Assets Liabilities Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated

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Do It! 3: Inventory Errors
Visual Company overstated its 2019 ending inventory by
$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and owner’s equity in 2019
and 2020.
Solution
2019 2020
Ending inventory $22,000 overstated No effect
Cost of goods sold $22,000 understated $22,000 overstated
Owner’s equity $22,000 overstated No effect

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Statement Presentation and Analysis (1
of 2)
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
net sales.
There also should be disclosure of
1. major inventory classifications
2. basis of accounting (cost or LCM)
3. cost method (FIFO, LIFO, or average-cost)

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Lower-of-Cost-or-Net Realizable Value
(1 of 2)
When the value of inventory is lower than its cost
• Companies must “write down” inventory to its net
realizable value
• Net realizable value: Amount that company expects to
realize (receive from the sale of inventory)
• Example of conservatism

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Lower-of-Cost-or-Net Realizable Value
(2 of 2)
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as
indicated.
Net
Cost Realizable Lower-of-Cost-or-Net
Units per Unit Value per Unit Realizable Value
$ 55,000 ($550 ×
Flat-screen TVs 100 $600 $550 100)
Satellite radios 500 90 104 45,000 ($90 × 500)
DVD recorders 850 50 48 40,800 ($48 × 850)
DVDs 3,000 5 6 15,000 ($5 × 3,000)
Total inventory $155,800

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Statement Presentation and Analysis (2
of 2)
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 (1 of 2)
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 (2 of 2)
Illustration: Wal-Mart reported in its 2016 annual report a
beginning inventory of $45,141 million, an ending inventory of
$44,469 million, and cost of goods sold for the year ended January
31, 2016, of $360,984 million. The inventory turnover formula and
computation for Wal-Mart are shown below.

Cost of ÷ Average = Inventory

Goods Sold Inventory Turnover
$44,469  $45,141
$360,984 ÷ = 8.1 Times
2

Days in inventory = 365 ÷ 8.1 = 45.1 Days

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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: The 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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Do It! 4: Inventory Turnover (1 of 2)
Early in 2020, Westmoreland Company switched to a just-in-time
inventory system. Its sales revenue, cost of goods sold, and
inventory amounts for 2019 and 2020 are shown below.
2019 2020
Sales revenue $2,000,000 $1,800,000
Cost of goods sold 1,000,000 910,000
Beginning inventory 290,000 210,000
Ending inventory 210,000 210,000

Determine the inventory turnover and days in inventory for 2019

and 2020. Discuss the changes in the amount of inventory, the
inventory turnover and days in inventory, and the amount of sales
across the two years.
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Do It! 4: Inventory Turnover (2 of 2)
Solution:
2019 2020
Inventory
Turnover $1,000,000 $910,000
4 7
 $290,000  $210 ,000  $210,000  $50, 000 
2 2
Days in 365 ÷ 4 = 91.3 Days 365 ÷ 7 = 52.1 Days
inventory

The company experienced a very significant decline in its ending inventory as a

result of the just-in-time inventory. This decline improved its inventory turnover
and its days in inventory. However, its sales declined by 10%. It is possible that
this decline was caused by the dramatic reduction in the amount of inventory
that was on hand, which increased the likelihood of “stock-outs.” To determine
the optimal inventory level, management must weigh the benefits of reduced
inventory against the potential lost sales caused by stock-outs.
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Appendix 6A: Inventory Methods and the
Perpetual System

Illustration: Compute Cost of Goods Sold and Ending Inventory

under FIFO, LIFO, and average-cost.
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First-In, First-Out (FIFO) (2 of 2)

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Last-In, First-Out (FIFO)

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Moving Average

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Appendix 6B: Estimating Inventories
Gross Profit Method
A method of estimating the cost of ending inventory by
applying a gross profit rate to net sales.

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Gross Profit Method (1 of 2)
Illustration: Kishwaukee Company records show net sales
of $200,000, beginning inventory $40,000, and cost of
goods purchased $120,000. In the preceding year, the
company realized a 30% gross profit rate. It expects to
earn the same rate this year. Compute the estimated cost
of the ending inventory at January 31 under the gross
profit method.

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Gross Profit Method (2 of 2)
Illustration: Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Step 1: Net sales $200,000
Less: Estimated gross profit (30% × $200,000) 60,000
Estimated cost of goods sold $140,000

Step 2: Beginning inventory $ 40,000

Cost of goods purchased 120,000
Cost of goods available for sale 160,000
Less: Estimated cost of goods sold 140,000
Estimated cost of ending inventory $ 20,000
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Retail Inventory Method (1 of 2)
• Retail companies establish a relationship between cost and
sales price
• Applies cost-to-retail percentage to ending inventory at
retail prices to determine inventory at cost
Goods Available for Ending Inventory
Step 1: − Net Sales = at Retail
Sale at Retail

Step 2: Goods Available for Goods Available Cost-to-

÷ =
Sale at Cost for Sale at Retail Retail Ratio

Step 3: Ending Cost-to- Estimated Cost of

x =
Inventory at Retail Retail Ratio Ending Inventory

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Retail Inventory Method (2 of 2)
Illustration: It is not necessary to take a physical inventory to
determine the estimated cost of goods on hand at any given time.

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A Look at IFRS (1 of 3)
Key Points
Similarities
• 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.

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A Look at IFRS (2 of 3)
Key Points
Differences
• 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.

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A Look at IFRS (3 of 3)
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 L IFO 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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Copyright
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