Chapter Six
Accounting for Inventories
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
LO 1
Explain how different
inventory cost flow
methods (specific
identification, FIFO,
LIFO, and weighted
average) affect
financial statements.
6-2
Inventory Cost Flow Methods
Specific
Identification
First-in, FirstOut (FIFO)
Four
Common
Inventory
Cost Flow
Methods
Last-in, FirstOut (LIFO)
Weighted
Average
6-3
Specific Identification
When a company’s
inventory consists of
many high-priced,
low-turnover goods
the record keeping
necessary to use
specific identification
is more practical.
6-4
Specific Identification
Assume TMBC Company
purchased two identical
inventory items: the first for
$100 and the second for $110.
Using specific identification,
when the first item is sold,
cost of goods sold would be
$100. When the second item
is sold, cost of goods sold
would be $110.
6-5
First-in, First-out
The first-in, first-out
cost flow method
requires that the cost
of the items
purchased first be
assigned to Cost of
Goods Sold.
6-6
First-in, First-out
Assume TMBC Company
purchased two identical
inventory items: the first for
$100 and the second for $110.
Using first-in, first-out, the
cost assigned to the first item
sold would be $100 (the first
cost in). The cost of goods sold
assigned to the second item
sold would be $110.
6-7
Last-in, First-out
The last-in, first-out
cost flow method
requires that the cost
of the items
purchased last be
assigned to Cost of
Goods Sold.
6-8
Last-in, First-out
Assume TMBC Company
purchased two identical
inventory items: the first for
$100 and the second for $110.
Using last-in, first-out, the
cost assigned to the first item
sold would be $110 (the last
cost in). The cost of goods
sold assigned to the second
item sold would be $100.
6-9
Weighted Average
The weighted average
cost flow method
assigns the average
cost of the items
available to Cost of
Goods Sold.
6-10
Weighted Average
Assume TMBC Company
purchased two identical
inventory items: the first for
$100 and the second for $110.
Using weighted average, the
cost assigned to the first item
sold would be $105 (the
average cost).
Total Cost
$210
=
= $105
Total Number
2
6-11
Physical Flow
Our discussions about
inventory cost flow
methods pertain to the
flow of costs through the
accounting records, not
the actual physical flow
of goods.
Cost flows can be done on
a different basis than
physical flow.
6-12
Effect of Cost Flow on Income
Statement
The cost flow method a company uses can
significantly affect the gross margin
reported in the income statement.
Weighted
FIFO
LIFO
Average
Sales
$ 120 $ 120 $
120
Cost of Goods Sold
100
110
105
Gross Margin
$
20 $
10 $
15
6-13
Effect of Cost Flow on Balance
Sheet
Since total product costs are allocated
between costs of goods sold and ending
inventory, the cost flow method used affects
its balance sheet as well.
Ending Inventory
Weighted
FIFO
LIFO
Average
$ 110 $ 100 $
105
6-14
6-15
LO 2
Demonstrate the
computational
procedures for FIFO,
LIFO, and weighted
average.
6-16
Inventory Cost Flow Under a Perpetual
System
TMBC Inventory
Jan. 1
Goods Available for Sale
Beginning Inventory 10 units at $200 =
Mar. 18 First purchase
Aug. 21 Second purchase
20 units @ $220
=25 units @ $250
=55 Units
Total cost of bikes (goods) available for sale =
$2,000
$4,400
$6,250
$12,650
Sold 43 bikes for $350 each
First-in, FirstOut (FIFO)
Last-in, FirstOut (LIFO)
Weighted
Average
6-17
Inventory Cost Flow Under a Perpetual
System
Goods Available for Sale must be
allocated between the Cost of Goods
Sold and Ending Inventory
We use one of these three methods:
First-in, FirstOut (FIFO)
Last-in, FirstOut (LIFO)
Weighted
Average
6-18
First-in, First-out Inventory Cost
Flow
FIFO Cost of Goods Sold
Jan. 1
Beginning inventory 10 units @ $ 200 = $ 2,000
Mar. 18 First purchase
20 units @ $ 220 = 4,400
Aug. 21 Second purchase
13 units @ $ 250 = 3,250
Total cost of the 43 bikes sold
$ 9,650
6-19
Last-in, First-out Inventory Cost
Flow
LIFO Cost of Goods Sold
Aug. 21 Second purchase
25 units @ $ 250 = $ 6,250
Mar. 18 First purchase
18 units @ $ 220 =
3,960
Total cost of the 43 bikes sold
$ 10,210
6-20
Weighted Average Inventory
Cost Flow
Weighted Average Cost of Goods Sold
Total cost of the 43 bikes sold 43 units @ $ 230 = $ 9,890
Total Cost
$12,650
=
= $230
Total Number
55
6-21
Comparative
Financial Statements
$350 x 43 =
MDSE AVAIL. $12,650
Mdse Avail – CGS = E.INV.
6-22
Inventory Cost Flow When Sales and
Purchases Occur Intermittently
In our previous examples,
all purchases were made
before any goods were
sold. This section
addresses more realistic
conditions when sales
transactions occur
intermittently with
purchases.
6-23
Never Stop Energy Bar
This table shows beginning inventory, purchases & sales
transactions for Never Stop during 2008.
Never Stop
Date
Jan. 1
Feb. 14
Apr. 5
June 21
Aug. 18
Sept. 2
Nov. 10
Transaction
Beginning inventory
Purchased
Sold
Purchased
Sold
Purchased
Sold
100
200
220
160
100
280
330
units
units
units
units
units
units
units
Description
@ $ 20.00 = $ 2,000
@ $ 21.50 =
4,300
@ $ 30.00 =
6,600
@ $ 22.50 =
3,600
@ $ 30.00 =
3,000
@ $ 23.50 =
6,580
@ $ 30.00 =
9,900
Let’s use FIFO to determine the cost of goods sold and
inventory at the end of 2008.
6-24
-100
120
=
=
=
6-25
Never Stop: First-in, First-out
FIFO Cost of Goods Sold for April 5
Jan. 1
Beginning inventory 100 units @ $ 20.00 = $ 2,000
Feb. 14 Purchased
120 units @ $ 21.50 =
2,580
Total cost of goods sold for April 5 sale
$ 4,580
FIFO
Sales (650 @ $30)
$ 19,500
Cost of Goods Sold
14,365
Gross Margin
$ 5,135
6-26
Weighted Average and LIFO
Cost Flows
When maintaining
perpetual
inventory records,
using the
weighted average
or LIFO cost flow
methods leads to
timing difficulties.
Further discussion of
these methods is
beyond the scope of
this text.
6-27
LO 3
Apply the lower-ofcost-or-market rule
to inventory
valuation.
6-28
Lower of Cost or Market (LCM)
Inventory must be reported at lower of
cost or market.
Market is defined
as current
replacement cost
(not sales price).
Consistent with
the conservatism
principle.
Applied three ways:
(1) separately to each
individual item.
(2) to major classes or
categories of assets.
(3) to the whole
inventory.
6-29
Lower of Cost or Market (LCM)
To illustrate lower of cost or market, assume
The Mountain Bike Company has in ending
inventory 100 t-shirts purchased at a cost of
$14 each.
Cost Market LCM
Situation 1 $ 14 $ 18 $ 14
Situation 2 $ 14 $ 11 $ 11
6-30
A company with 4 types of
inventory must apply LCM:
6-31
LO 4
Explain how fraud
can be avoided
through inventory
control.
6-32
Fraud Avoidance in
Merchandising Businesses
Because inventory and cost of goods sold accounts
are so significant, they are attractive targets for
concealing fraud.
Because of this, auditors and financial analysts
carefully examine them for signs of fraud.
6-33
If Ending Inventory is overstated then
Cost of Goods Sold will be understated.
6-34
If Cost of Goods Sold is understated,
then Gross Margin is overstated.
Resulting in overstatement
of Net Income.
6-35
Then, on the balance sheet Inventory is
overstated and Retained Earnings is overstated.
6-36
LO 5
Use the gross margin
method to estimate
ending inventory.
6-37
6-38
Estimating the Ending Inventory
Balance
Many
companies use
the gross
margin method
to estimate the
current period’s
ending
inventory.
6-39
The Gross Margin Method
 Calculate the expected gross
margin ratio using prior period’s
income statement.
 Multiply the expected gross margin
ratio by the current period’s sales
to estimate the amount of gross
margin.
 Subtract the estimated gross
margin from sales to estimate cost
of goods sold.
 Subtract the estimated cost of
goods sold from the amount of
goods available for sale to
estimate the ending inventory.
6-40
16,500
22000 x .25=5,500
7,100
*Historically, gross margin has amounted to
approximately 25 percent of sales.
6-41
LO 6
Explain the
importance of
inventory turnover to
a company’s
profitability.
6-42
Inventory Turnover
This measures how quickly a company
sells its merchandise inventory.
Cost of Goods Sold
Inventory
This is the first step in calculating
the average number of days to sell
inventory.
6-43
Average Number of Days to Sell
Inventory
This measures how many days, on
average, it takes to sell inventory.
365
Inventory Turnover
Other things being equal, the
company with the lower average
number of days to sell inventory is
doing better.
6-44
6-45
End of Chapter Six
6-46