Accounting for Inventory
Chapter 6
6-1
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Inventory
• Items held by the company for re-sale
 Current asset on the Balance Sheet
• Items sold shifted to Cost of Goods Sold
 Expense on the Income Statement
• Sales revenue based on retail price of
inventory
• Cost of Goods Sold based on cost of
inventory
6-2
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Gross Profit
•
•
•
•
Sales Revenue minus Cost of Goods Sold
Also called Gross Margin
Represents markup on products
“Gross” because expenses have not been
deducted
6-3
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Learning Objective 1
Account for inventory
6-4
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Two Systems
•
•
•
•
Periodic
Count items to
determine quantity on
hand
Used for inexpensive
items
Used by small
businesses
Low cost
Perpetual
• Running record of
inventory kept by
computer program
• Used by large
businesses
• Scanners and bar
codes used to record
transactions
6-5
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Net cost of purchases
Purchase price
+ Freight-in
Transportation costs
- Purchase returns
Unsuitable goods
returned to seller
- Purchase allowances
Reduction in
amount owed
- Purchase Discounts
For early payment
= Net cost of purchases
6-6
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Discount terms
• Companies offer incentive for early payment
• 2/10, n/30
 2% discount if bill paid in ten days
 Full amount due in 30 days
• Purchase discounts
 Company receives discount if it makes payment early
 Reduces cost of inventory
• Sales discounts
 Company offers discount to customers for early
payment
 Reduces cash received on accounts receivable
6-7
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Perpetual Entries
To record purchases of inventory on account
JOURNAL
Date
Accounts
Debit
Credit
Inventory
Accounts payable
6-8
5-8
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Perpetual Entries
• To record sale of inventory on account
• Two entries required
JOURNAL
Date
Accounts
Debit
Accounts receivable
Sales
Credit
Retail price
Cost of goods sold
Inventory
Cost
6-9
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Net Sales
Sales revenue
- Sales returns
Unsuitable goods
returned to company
- Sales allowances
Reduction in
amount owed
- Sales Discounts
For early payment
= Net Sales
6-10
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Learning Objective 2
Understand the various inventory methods
6-11
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Inventory Costing Methods
• To determine the cost of inventory sold or
on hand, the units are multiplied by the
unit cost
• Inventory items are often purchased at
different prices throughout the year
• Company selects a costing method to
determine which unit cost to use
6-12
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Inventory Costing Methods
•
•
•
•
Specific-unit-cost
Average cost
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
6-13
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Specific-unit-cost
• Each item in inventory can be separately
identified
• Used for unique items
 Cars, fine jewelry
• Too expensive for homogeneous items
6-14
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Average-cost
• An average of inventory costs
Cost of goods available
= Average cost per unit
Number of units available
Average cost per unit x units sold = Cost of goods sold
Average cost per unit x units on hand = Ending inventory
6-15
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FIFO
• Oldest items assumed to be sold first
• Ending inventory will consist of most
recent items purchased
6-16
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LIFO
• Newest items are assumed to be sold first
• Ending inventory consists of oldest items
in inventory
6-17
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E6-15
Units Cost
Beginning inventory
5 $160
$800
Oct. 15 Purchase
11 $170 $1,870
Oct. 26 Purchase
5 $180
$900
Units available
21
$3,570
Subtract units in
Ending inventory
8 units
ending inventory
from units available
Units sold
______ units
6-18
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E6-15
Specific Unit Cost
Ending inventory =
3 @ $160 = $480
5 @ $180 = $900
$1,380
Cost of goods sold =
2 @ $160 = $ 320
11 @ $170 = $1,870
$2,190
6-19
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E6-15
Average Cost
Cost of goods available
= Average cost per unit
Number of units available
$3570
= $170
21
Average cost per unit x units sold = Cost of goods sold
$170 x 13 units = $2,210
Average cost per unit x units on hand = Ending inventory
$170 x 8 units = $1,360
6-20
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E6-15
FIFO
Ending inventory =
Newest items
3 @ $180 = $900
5 @ $170 = $540
Cost of goods sold =
Oldest items
Highest ending
inventory
$1,440
What is the price
of the oldest
items?
5 @ $____ = $_____
8 @ $170 = $1,360
$2,160
6-21
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E6-15
LIFO
Ending inventory =
Oldest items
5 @ $160 = $800
3 @ $170 = $510
Cost of goods sold =
Newest items
$1,310
Highest Cost of
goods Sold
5 @ $180 = $ 900
8 @ $170 = $1,360
$2,260
6-22
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Increasing Costs
Cost of goods sold
• FIFO lowest
 Based on older costs
• LIFO highest
 Based on recent costs
Ending inventory
• FIFO highest
 Based on recent costs
• LIFO lowest
 Based on older costs
Opposite relationships exist when
costs are decreasing
6-23
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Tax Advantage of LIFO
Assuming inventory costs are increasing
LIFO results in higher COGS
Higher COGS results in lower net income
Lower net income results in lower taxes
Lower taxes results in greater cash flow
6-24
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Comparison of Inventory Methods
FIFO
• Balance sheet
 More recent costs
• Income Statement
 Does not match
current costs with
revenue
LIFO
• Balance Sheet
 Old, outdated costs
• Income Statement
 Matches current costs
with revenue
6-25
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Accounting Principles Related to
Inventory
• Consistency
 Companies should use same inventory
method from period to period
• Disclosure
 Companies should disclosed inventory
method used
• Conservatism
 Companies should “write down” inventory if
market price falls below cost
6-26
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Lower-of-Cost-or-Market (LCM)
• Inventory should be reported at whichever
is lower – cost or market
 Market = current replacement cost
• If cost is lower, no adjustment needed
• If market is lower,
 Inventory is decreased to market value
 Cost of goods sold is increased
6-27
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Learning Objective 3
Use gross profit percentage and inventory
turnover to evaluate operations
6-28
5-28
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Gross Profit Percentage
• Key indicator of ability to sell inventory at a
profit
Sales – Cost of Goods Sold = Gross profit
Gross profit
Net Sales Revenue
= Gross
profit
percentage
6-29
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Inventory Turnover
• How many times a company sells its
average level of inventory
• Compute average inventory
Beginning inventory + Ending inventory
2
• Inventory turnover
Cost of goods sold
Average inventory
6-30
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Learning Objective 4
Estimate inventory by the gross
profit method
6-31
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Estimating Inventory by the Gross
Profit Method
Cost of goods sold
computation - periodic
Gross profit method
Beginning Inventory
Beginning Inventory
+ Purchases
+ Purchases
= Goods available
= Goods available
- Ending inventory
- Cost of Goods sold
= Cost of Goods sold
= Ending inventory
Net sales x (1 – GP%)
6-32
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E6-26
Beginning inventory
$
48,000
Net purchases
$
106,000
Goods available
$
154,000
Sales
Cost ratio =
100% - GP%
$ 200,000
x Cost ratio
_____%
= Estimated COGS
Multiply Sales by
cost ratio
Estimated ending inventory
$ __________
$
34,000
6-33
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Learning Objective 5
Show how inventory errors affect the
financial statements
6-34
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Effects of Inventory Errors
• Error in ending inventory impacts two
periods
• First period
 Cost of goods sold
 Gross Profit & Net Income
Inverse with error
Direct with error
• Second period
 Beginning inventory
 Costs of Goods sold
 Gross Profit & Net Income
Direct with error
Direct with error
Inverse with error
6-35
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Effects of Inventory Errors
Period 1
Inventory error
COGS
GP &
Net
Inc
Period 2
COGS
GP &
Net
Inc
Period 1
Ending inventory overstated
U
O
O
U
Ending inventory understated O
U
U
O
Period 2
O = Overstated
U = Understated
6-36
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End of Chapter Six
6-37
5-37
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©2009Hall.
Prentice
All rights
Hall reserved.