Chapter

6-1
 Chapter 6
Inventories

Chapter
6-2 Accounting Principles, Ninth Edition
 Study
Study Objectives
Objectives
1. Describe the steps in determining inventory
quantities.
2. Explain the accounting for inventories and apply
the inventory cost flow methods.
3. Explain the financial effects of the inventory cost
flow assumptions.
4. Explain the lower-of-cost-or-market basis of
accounting for inventories.
5. Indicate the effects of inventory errors on the
financial statements.
6. Compute and interpret the inventory turnover
Chapter
ratio.
6-3
 Reporting
Reporting and
and Analyzing
Analyzing Inventory
Inventory

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

Finished Taking a Specific Income Presentation

goods physical identification statement Analysis
Work in inventory Cost flow effects
process Determining assumptions Balance sheet
Raw materials ownership of Financial effects
goods statement
and tax
effects
Consistent
use
Lower-of-
cost-or-
Chapter
6-4
market
 Classifying
Classifying Inventory
Inventory

Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
Merchandise Raw Materials
Inventory
Work in Process
Finished Goods

Regardless of the classification, companies report all

inventories under Current Assets on the balance sheet.

Chapter
6-5
Chapter
6-6
 Determining
Determining Inventory
Inventory Quantities
Quantities

Physical Inventory taken for two

reasons:System
Perpetual
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted
raw materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand
2. Determine the cost of goods sold for the
period.
Chapter
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.

Chapter
6-8 SO 1 Describe the steps in determining inventory quantities.
 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.
Chapter
6-9 SO 1 Describe the steps in determining inventory quantities.
 Determining
Determining Inventory
Inventory Quantities
Quantities
Illustration 6-1
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.

Chapter
6-10 SO 1 Describe the steps in determining inventory quantities.
 Determining
Determining Inventory
Inventory Quantities
Quantities

Review Question
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.

Chapter
6-11 SO 1 Describe the steps in determining inventory quantities.
 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.

Chapter
6-12 SO 1 Describe the steps in determining inventory quantities.
 Inventory
Inventory Costing
Costing

Unit costs can be applied to quantities

on hand using the following costing
methods:

Specific Identification
Cost Flow
First-in, first-out (FIFO)
Assumptio
Last-in, first-out (LIFO) ns

Average-cost

Chapter SO 2 Explain the accounting for

6-13
inventories and apply the inventory
 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.

Chapter SO 2 Explain the accounting for

6-14
inventories and apply the inventory
 Inventory
Inventory Costing
Costing

Illustration: Assume that Crivitz TV Company

purchases three identical 46-inch TVs on different
dates at costs of $700, $750, and $800. During the
year Crivitz sold two sets at $1,200 each.
Illustration 6-2

Chapter SO 2 Explain the accounting for

6-15
inventories and apply the inventory
 Inventory
Inventory Costing
Costing

Illustration: 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 6-3

Chapter SO 2 Explain the accounting for

6-16
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions

Cost Flow
Assumption
does not need to
equal

Physical Movement
Illustration 6-11
of Goods
Use of cost flow methods in
major U.S. companies

Chapter SO 2 Explain the accounting for

6-17
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
Illustration: Assume that Houston Electronics uses
a periodic inventory system. Illustration 6-4

A physical inventory at the end of the year determined that

during the year Houston sold 550 units and had 450 units in
inventory at December 31.
Chapter SO 2 Explain the accounting for
6-18
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“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.

Chapter SO 2 Explain the accounting for

6-19
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5

Chapter SO 2 Explain the accounting for

6-20
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“First-In-First-Out (FIFO)”
Illustration 6-5

Chapter SO 2 Explain the accounting for

6-21
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“Last-In-First-Out (LIFO)”
Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of

merchandise.

Exceptions include goods stored in piles, such

as coal or hay.

Chapter SO 2 Explain the accounting for

6-22
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“Last-In-First-Out Illustration 6-7
(LIFO)”

Chapter SO 2 Explain the accounting for

6-23
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“Last-In-First-Out
Illustration 6-7
(LIFO)”

Chapter SO 2 Explain the accounting for

6-24
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“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.

Chapter SO 2 Explain the accounting for

6-25
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“Average Cost” Illustration 6-10

Chapter SO 2 Explain the accounting for

6-26
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
“Average Cost” Illustration 6-10

Chapter SO 2 Explain the accounting for

6-27
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
Financial Statement and Tax Effects
Illustration 6-12

Chapter
6-28 SO 3 Explain the financial effects of the inventory cost flow
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
Review Question
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.

Chapter SO 2 Explain the accounting for

6-29
inventories and apply the inventory
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
Review Question
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.

Chapter
6-30 SO 3 Explain the financial effects of the inventory cost flow
 Inventory
Inventory Costing
Costing –– Cost
Cost Flow
Flow
Assumptions
Assumptions
Discussion Question

Q6-12 Casey Company has been using the

FIFO cost flow method during a prolonged
period of rising prices. During the same
time period, Casey has been paying out all
of its net income as dividends. What
adverse effects may result from this
policy?
See notes page for discussion
Chapter
6-31 SO 3 Explain the financial effects of the inventory cost flow
 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.
Illustration 6-14
Disclosure of
change in cost flow
method

Chapter
6-32 SO 3 Explain the financial effects of the inventory cost flow
Chapter
6-33
 Inventory
Inventory Costing
Costing

Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
Companies can “write down” the inventory to
its market value in the period in which the
price decline occurs.
Market value = Replacement Cost
Example of conservatism.

Chapter SO 4 Explain the lower-of-cost-or-

6-34
market basis of accounting for
 Inventory
Inventory Costing
Costing

Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the
following lines of merchandise with costs and market
values as indicated.
Illustration 6-15

Chapter SO 4 Explain the lower-of-cost-or-

6-35
market basis of accounting for
 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 balance sheet.

Chapter
6-36 SO 5 Indicate the effects of inventory errors on the financial
 Inventory
Inventory Errors
Errors

Income Statement Effects

Inventory errors affect the computation of cost of
goods sold and net income. Illustration 6-16

Illustration 6-17

Chapter
6-37 SO 5 Indicate the effects of inventory errors on the financial
 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.

Chapter
6-38 SO 5 Indicate the effects of inventory errors on the financial
 Inventory
Inventory Errors
Errors
2010 2011
Illustration 6-18
I ncorrect Correct I ncorrect 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 profi t 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 ($3,000) $3,000

2-year period is Net Income Net Income
understated overstated
correct.
Chapter
6-39 SO 5 Indicate the effects of inventory errors on the financial
 Inventory
Inventory Errors
Errors

Review Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.

Chapter
6-40 SO 5 Indicate the effects of inventory errors on the financial
 Inventory
Inventory Errors
Errors

Balance Sheet Effects

Effect of inventory errors on the balance sheet is
determined by using the basic accounting
equation:. Illustration 6-16

Illustration 6-19

Chapter
6-41 SO 5 Indicate the effects of inventory errors on the financial
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis

Presentation
Balance Sheet - Inventory classified as current
asset.

Income Statement - Cost of goods sold

subtracted from sales.

There also should be disclosure of

1) major inventory classifications,
2) basis of accounting (cost or LCM), and
3) costing method (FIFO, LIFO, or average).
Chapter
6-42
 Statement
Statement Presentation
Presentation and
and Analysis
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

stockouts and lost sales.

Chapter
6-43 SO 6 Compute and interpret the inventory turnover ratio.
 Statement
Statement Presentation
Presentation and
and Analysis
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
Chapter
6-44 SO 6 Compute and interpret the inventory turnover ratio.
 Statement
Statement Presentation
Presentation and
and Analysis
Analysis
Illustration: Wal-Mart reported in its 2008 annual
report a beginning inventory of $33,685 million, an ending
inventory of $35,180 million, and cost of goods sold for the
year ended January 31, 2008, of $286,515 million. The
inventory turnover formula and computation for Wal-Mart
are shown below.
Illustration 6-21

Days in Inventory: Inventory turnover of 8.3 times

divided into 365 is approximately 44 days. This is the
approximate time that it takes a company to sell the
Chapterinventory.
6-45 SO 6 Compute and interpret the inventory turnover ratio.
 Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual
Systems
Systems
Example Appendix 6A

Assuming the Perpetual Inventory System, compute Cost of

Goods Sold and Ending Inventory under FIFO, LIFO, and
Average cost.
Chapter
6-46 SO 7 Apply the inventory cost flow methods to perpetual inventory
 Cost
Cost Flow
Flow Methods
Methods inin Perpetual
Perpetual
Systems
Systems
“First-In-First-Out (FIFO)” Illustration 6A-2

Cost of Goods Sold

Ending Inventory
Chapter
6-47 SO 7 Apply the inventory cost flow methods to perpetual inventory
 Cost
Cost Flow
Flow Methods
Methods inin Perpetual
Perpetual
Systems
Systems
“Last-In-First-Out (LIFO)” Illustration 6A-3

Cost of Goods Sold

Ending Inventory
Chapter
6-48 SO 7 Apply the inventory cost flow methods to perpetual inventory
 Cost
Cost Flow
Flow Methods
Methods inin Perpetual
Perpetual
Systems
Systems
“Average Cost” (Moving-Average
System) Illustration 6A-4

Cost of Goods Sold Ending Inventory

Chapter
6-49 SO 7 Apply the inventory cost flow methods to perpetual inventory
 Estimating
Estimating Inventories
Inventories

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

Chapter
6-50 SO 8 Describe the two methods of estimating inventories.
 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

Chapter
6-51 SO 8 Describe the two methods of estimating inventories.
 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

Chapter
6-52 SO 8 Describe the two methods of estimating inventories.
 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.
Chapter
6-53 SO 8 Describe the two methods of estimating inventories.
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Chapter
6-54