Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso, Trenholm
1
Chapter 6
Reporting and Analysing
Inventory
1.
2.
3.
4.
After studying Chapter 6, you should be able
to:
Explain the recording of purchases and sales of
inventory under a periodic inventory system.
Explain how to determine cost of goods sold under a
periodic inventory system.
Describe the steps in determining inventory
quantities.
Identify the unique features of the statement of
earnings for a merchandising company under a
periodic inventory system.
2
Chapter 6
Reporting and Analysing
Inventory
5.
6.
7.
8.
After studying Chapter 6, you should be able
to:
Explain the basis of accounting for inventories and
apply the inventory cost flow methods under a
periodic inventory system.
Explain the financial statement effects of each of the
inventory cost flow assumptions.
Explain the lower of cost and market basis of
accounting for inventories.
Calculate and interpret the inventory turnover ratio.
3
Merchandise Inventory
Owned by the
company
In form ready
for sale to
customers
4
Manufacturing Inventory
Finished goods inventory
Work in process
Raw materials
5
Comparing Periodic and
Perpetual Inventory Systems
Inventory Purchased
Item Sold
Perpetual
Perpetual
End of
Period
No Entry
Record Purchase of Inventory
Inventory Purchased
Record Revenue and
Cost of Goods Sold
Item Sold
End of
Period
Periodic
Record Purchase of Inventory
Record Revenue Only
Compute Cost
of Goods Sold
Sales Revenues
(Periodic Inventory System)
Record when earned-revenue
recognition principle
ONLY one entry is made for each
sale in a periodic inventory system
One to record sale
NONE to record cost of goods sold
as in a perpetual inventory system
7
Sales -
assume a sale of $3,800
on account
Cash
Accounts
Receivable
May 4 3,800
Sales
May 4 3,800
Sales Returns &
Allowances
Merchandise
Inventory
X
Cost of Goods
Sold
X
Sales Returns and Allowances
Flip side of purchase returns and allowance
On buyer’s books
GENERAL JOURNAL
May 8 Accounts Payable
Purchase Returns and Allowances
Debit Credit
300
300
To record goods returned that were purchased on account
On seller’s books
GENERAL JOURNAL
May 8 Sales Returns and Allowance
Accounts Receivable
Debit Credit
300
To record return of goods delivered to Sauk Stereo
ONLY ONE ENTRY NEEDED IN PERIODIC INVENTORY SYSTEM
300
9
Sales Discounts
Flip side of purchase discounts
On buyer’s books
GENERAL JOURNAL
Debit Credit
May 14 Accounts Payable
Cash
Purchase Discounts
3,500
3,430
70
To record payment within discount period
On seller’s books
GENERAL JOURNAL
Debit Credit
May 14 Cash
Sales Discounts
Accounts Receivable
3,430
70
To record collection within discount period
3,500
10
Purchases of Merchandise
Perpetual inventory system
Merchandise Inventory-one accountused to accumulate the cost of goods
purchased
Periodic inventory system
Separate accounts used to accumulate
the cost of goods purchased
11
Normal Balances
Cost of Goods Purchased Accounts
Account
Normal Balance
Purchases
Debit
Purchase Returns and Allowances
Purchase Discounts
Freight In
Credit
Credit
Debit
12
Merchandise Purchases
On May 4 the company bought $ 3,800 worth
of merchandise from PW Audio Supply, Inc.
Purchase
Purchase
Returns & All.
Purchases
Discounts
May 4 3,800
Freight-In
Accounts
Payable
May 4 3,800
Cash
Purchase Returns and Allowances
On May 8 the company returned $300 worth
of merchandise to PW Audio Supply, Inc.
Purchases
May 4 3,800
Freight-In
Purchase
Returns & All.
Purchase
Discounts
May 8 300
Accounts
Payable
May 8 300 May 4 3,800
Cash
Freight - In
On May 9 the company paid $ 150 to have
the merchandise inventory delivered to them.
Purchases
May 4 3,800
Freight-In
May 9 150
Purchase
Returns & All.
Purchase
Discounts
May 8 300
Accounts
Payable
May 8 300 May 4 3,800
Cash
May 9 150
Purchase Discounts
Review - Company purchased $3,800 of
merchandise and returned $300. The credit terms
are 2/10, n/30 and the invoice was paid within the
discount period.
Original invoice
-Returns
Amount due before discount
2% discount
Net due
$3,800
300
3,500
70
$3,430
Purchase Discounts
On May 14, the company pays the balance due on
the account within the discount period
Purchases
Purchase
Returns & All.
May 4 3,800
Freight-In
May 9 150
May 8 300
Accounts
Payable
May 8 300 May 4 3,800
May 14 3,500
Purchase
Discounts
May 14 70
Cash
May 9
150
May 14 3,430
Net Purchases
Purchases
$325,000
Less: Purchase returns and allowances $ 10,400
Purchase discounts
6,800 17,200
Net purchases
307,800
Net purchases are gross purchases
adjusted for returns and discounts
18
Cost of Goods Purchased
Purchases
$325,000
Less: Purchase returns and allowances $ 10,400
Purchase discounts
6,800 17,200
Net purchases
307,800
Add: Freight-in
12,200
Cost of goods purchased
320,000
Cost of goods purchased is net
purchases plus freight-in
19
Comparison of Seller’s and
Buyer’s Entries
SELLER
Sale of goods
Cash (or receivables)
Sales
BUYER
Purchase of goods
xxx
Return of goods
Sales returns
xxx
Cash (or receivables)
Freight (destination)
Delivery expense
xxx
Cash (or payables)
Purchases
xxx
xxx
Cash (or payables)
xxx
Return of goods
Cash (or receivables)
xxx
Purchases returns
xxx
xxx
Freight (shipping point)
Freight In
xxx
xxx
Cash (or payables)
xxx
20
Determining Ending
Inventory
A physical inventory count
Determines ending inventory
Enables cost of goods sold to be
computed
Companies that use perpetual inventory
must also take a physical inventory to check
accuracy of “book inventory” to actual
inventory-added internal control feature
21
Taking a Physical
Inventory
Determining inventory quantities by
counting, weighting or measuring
each type of inventory
Determining ownership of goods,
including goods in transit, consigned
goods
22
Goods in Transit
Goods on board a truck, train, ship,
or plane at the end of the period
23
Goods in Transit
Who includes
goods in transit (on
board a truck, train,
ship, or plane at the
end of the period)
in inventory
Buyer?
Seller?
Company
with legal
title
24
Illustration 6-4
Ownership
passes to
owner here
Seller
FOB Shipping Point
Public
Carrier
Co
FOB Destination Point
Seller
Public
Carrier
Co
Buyer
Ownership
passes to
buyer here
Buyer
Consigned Goods
Goods in your store that you don’t
pay for until they sell
Company does not take ownership
26
Cost of Goods Sold
After taking a physical inventory
count, cost of goods sold is
determined
By calculation in statement of
earnings (no journal entry recorded
yet)
Journal entries (closing or adjusting)
are made later in the closing process
to record ending inventory
27
Computation of Cost of
Goods Sold
Beginning inventory
Add: Cost of goods purchased
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
$ 36,000
320,000
356,000
40,000
316,000
Remember: Purchases - purchase returns and
allowances – purchase discounts = Net purchases +
freight-in = Cost of goods purchased
28
Statement of Earnings
Presentation
Statement of earnings for a
merchandising company is the same
whether a periodic or perpetual
inventory system is used, except for
the level of detail in the cost of
goods sold section
29
INVENTORY SYSTEMS
COMPARED
PERPETUAL & PERIODIC INVENTORY SYSTEMS
30
Perpetual vs. Periodic
Journal Entries
PERPETUAL
Purchase of goods
Inventory
xxx
Cash (or payables)
PERIODIC
Purchase of goods
xxx
Freight (shipping point)
Inventory
xxx
Cash (or payables)
xxx
Return of goods
Cash (or receivables)xxx
Inventory
Purchases
xxx
Cash (or payables)
xxx
Freight (shipping point)
Freight In
xxx
Cash (or payables)
xxx
Return of goods
xxx
Cash (or Accts Rec) xxx
Purchase Returns
xxx
31
Perpetual vs. Periodic
Journal Entries
PERPETUAL
Sale of goods
Cash (or Accts Rec) xxx
Sales
Cost of goods sold xxx
Inventory
End of period
No entry necessary
PERIODIC
Sale of goods
xxx
Cash (or Accts Rec) xxx
Sales
xxx
xxx
End of period
Closing entry or adjusting entry
necessary
32
Inventory Costing
Specific
identification
Cost flow
assumptions
FIFO (First-in,
First-Out)
LIFO (Last-in,
First-Out)
Average cost
What makes
cost flow
assumptions
necessary?
Changing
Prices
33
Illustration 6-7
Specific Identification
Cost of goods sold = $700 + $800 = $1,500
An actual physical flow costing method in
which items on hand are specifically costed to
arrive at the total cost of ending inventory
Illustration 6-9
FIFO method assumes earliest
goods purchased are the first to be
sold
Illustration 6-11
Allocation of the cost of goods
available for sale in average cost
method is made on the basis of
the weighted average unit cost
incurred
Illustration 6-12
Average cost method assumes that
goods available for sale are
homogeneous
Illustration 6-13
LIFO method assumes latest goods
purchased are the first to be sold
Use of Cost Flow Methods
by Canadian Companies
Other
3%
FIFO
43%
Average
51%
LIFO
3%
Each of the four
methods are
acceptable in
Canada
Very few
companies use
LIFO
39
Factors Used in Selecting
Inventory Cost Method
 Statement of earnings effects
LIFO gives best match of current
revenues to current costs
Balance sheet effects
FIFO gives best measurement of ending
inventory (approximates replacement
cost)
NO cash impact!
40
Financial Statement
Effects
EI
CGS
NE
FIFO
Average
LIFO
? What are effects on the balance
sheet and statement of earnings if
prices are assumed to be rising?
41
Financial Statement
Effects
FIFO
Average
LIFO
EI
CGS
NE
H
-L
L
-H
H
-L
? What are effects on the balance
sheet and statement of earnings if
prices are assumed to be rising?
42
Financial Statement
Effects
EI
CGS
NE
FIFO
Average
LIFO
? What are effects on the balance
sheet and statement of earnings if
prices are assumed to be falling?
43
Financial Statement
Effects
FIFO
Average
LIFO
EI
CGS
NE
L
-H
H
-L
L
-H
? What are effects on the balance
sheet and statement of earnings if
prices are assumed to be falling?
44
Financial Statement
Effects
EI
CGS
NE
FIFO
Average
LIFO
? What are effects on the balance
sheet and statement of earnings if
prices are assumed to be stable?
45
Financial Statement
Effects
FIFO
Average
LIFO
EI
----
CGS
----
NE
----
All three methods will give same results.
? What are effects on the balance sheet and
statement of earnings if prices are
assumed to be stable?
46
Lower of Cost and Market
(LCM)
When the value of the inventory
declines below cost, it is written
down to its market value
Market is defined as current
replacement cost or net realizable
value, not selling price
47
Lower of Cost and Market
(LCM)
Departure from cost principle
Follows conservatism concept
Used only after one of the cost flow
methods (Specific identification, FIFO,
LIFO, or average cost)
48
How Much Inventory
Should a Company Have?
Only enough for
sales needs
Excess
inventory costs
Storage costs
Interest costs
Obsolescence
49
Inventory Turnover
Inventory turnover =
Cost of goods sold
Average inventory
50
Days in Inventory
Days in inventory =
365 days
Inventory turnover
51
Decision Checkpoints
Which inventory
costing method
should be used?
How long is an
Inventory
item in
turnover ratio
inventory?
Days in
inventory
52
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Copyright © 2001 John Wiley & Sons Canada, Ltd. All
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these programs or from the use of the information
contained herein.
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