Inventories

Slide
6-1
 Remember how inventory affects the
balance sheet and the income statement:

Slide
6-2
 Relationship between inventory purchases,
goods available for sale, and cost of goods
sold:

Slide
6-3
 A critical issue for inventory accounting is the
frequency for which inventory values are updated.

Perpetual Inventory Method Periodic Inventory Method

Date Account Debit Credit Date Account Debit Credit
Ordering
Inventory $$$ Inventory Purchases $$$
Accounts Payable $$$ Accounts Payable $$$

Selling
Inventory
Accounts $$$ Accounts Receivable $$$
Receivable SSS Sales SSS
Sales
SSS
COGS SSS
Inventory

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6-4
 Inventories
Inventories

Determining Statement
Classifying Inventory Inventory
Inventory Presentation
Inventory Costing Errors
Quantities and Analysis

Finished Taking a Specific Income Presentation

goods physical identification statement Analysis using
Work in inventory Cost flow effects inventory
process Determining assumptions Statement of turnover
Raw materials ownership of Financial financial
goods statement and position
tax effects effects
Consistent use
Lower-of-cost-
or-net
realizable value

Slide
6-5
 Classifying
Classifying Inventory
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 statement of financial position.

Slide
6-6
 Determining
Determining Inventory
Inventory Quantities
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
3. Determine the inventory on hand
4. Determine the cost of goods sold for the period.

Slide
6-7
SO 1 Describe the steps in determining inventory quantities.
 Determining
Determining Inventory
Inventory Quantities
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.

Slide
6-8
 Determining
Determining Inventory
Inventory Quantities
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.

Slide
6-9
 Determining
Determining Inventory
Inventory Quantities
Quantities

Goods in Transit 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.

Slide
6-10
 Determining
Determining Inventory
Inventory Quantities
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.

Slide
6-11
 Inventory
Inventory Costing
Costing

Unit costs can be applied to quantities on hand

using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Cost Flow
Average-cost Assumptions

Slide
6-12
 Inventory
Inventory Costing
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.

Slide
6-13
 Inventory Costing Illustration

Here is information about the mountain bike inventory of Trekking

for the month of August.

Slide
6-14
 Specific Identification

Slide
6-15
 Specific Identification
P1

Income
Income Statement
Statement
Slide
Cost of Goods Sold
6-16 Cost of Goods Sold Balance
Balance Sheet
Sheet Inventory
Inventory
 Inventory
Inventory Costing
Costing

“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.

Slide
6-17
P1
First-In, First-Out (FIFO)

Slide
6-18
P1
First-In, First-Out (FIFO)

Slide
6-19
 Inventory
Inventory Costing
Costing

“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.

Slide
6-20
P1
Weighted Average

When a unit is sold, the average

cost of each unit in inventory is
assigned to cost of goods sold.
Cost of Goods Units on hand
Available for ÷ on the date of
Sale sale

Slide
6-21
P1
Weighted Average

Slide
6-22
P1
Weighted Average

Slide
6-23
 Inventory
Inventory Costing
Costing

Financial Statement and Tax Effects Illustration 6-9

Income
Statement
Effects

Slide
6-24
 Inventory
Inventory Costing
Costing

Statement of Financial Statement 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 shortcoming of the average-cost method is that in a

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

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6-25
 Inventory
Inventory Costing
Costing

Tax Effects
In a period of inflation:
 FIFO - inventory and net income higher.
 AVERAGE Cost - lower income taxes.

Slide
6-26
 Inventory
Inventory Costing
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.

Slide
6-27
 Inventory
Inventory Costing
Costing

Lower-of-Cost-or-Net Realizable Value

When the value of inventory is lower than its cost
Companies can “write down” the inventory to its net
realizable value in the period in which the price
decline occurs.
Net realizable value refers to the net amount that a
company expects to realize (receive) from the sale of
inventory.
It is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
Slide estimated selling expenses.
6-28
 Inventory
Inventory Costing
Costing

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 6-10

Slide
6-29
 Inventory
Inventory Errors
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

statement of financial position.

Slide
6-30
 Inventory
Inventory Errors
Errors

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income. Illustration 6-11

Illustration 6-12

Slide
6-31
 Inventory
Inventory Errors
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.

Slide
6-32
SO 5 Indicate the effects of inventory errors on the financial statements.
 Inventory
Inventory Errors
Errors
Illustration 6-13
2011 2012
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 2- ($3,000) $3,000

year period is correct. Net Income Net Income
understated overstated
Slide
6-33
SO 5 Indicate the effects of inventory errors on the financial statements.
 Inventory
Inventory Errors
Errors

Statement of Financial Position Effects

Effect of inventory errors on the statement of financial
position is determined by using the accounting equation:
Illustration 6-11

Illustration 6-14

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6-34
SO 5 Indicate the effects of inventory errors on the financial statements.
 Example: Correct Financial Statement

Slide
6-35
 Example: Ending Inventory Understated by $1,500

Slide
6-36
 Ending inventory understated by Correct
$1,500

COGS Overstated by $1,500

Net Income Understated by
$1,500

COGS Understated by $1,500

Net Income Overstated by
$1,500

Slide
6-37
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis

Presentation
Statement of Financial Position - Inventory classified as
current asset.
Income Statement - Cost of goods sold.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost, or lower-of-cost-or-net
realizable value), and
3) Cost method (specific identification, FIFO, or average-
cost).
Slide
6-38
 Estimating
Estimating Inventories
Inventories
Appendix 6B
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

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6-39
 Estimating
Estimating Inventories
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

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6-40
 Estimating
Estimating Inventories
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

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6-41
 Estimating
Estimating Inventories
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.

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6-42