Chapter
6-1

Chapter
6-2
Financial Accounting, Fifth Edition

Study Objectives
1.
Describe the steps in determining inventory quantities.
2.
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
3.
Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
4.
Explain the lower-of-cost-or-market basis of accounting for inventories.
5.
Compute and interpret the inventory turnover ratio.
6.
Describe the LIFO reserve and explain its importance for comparing results of different companies.
7.
Apply the inventory cost flow methods to perpetual inventory records.
8.
Indicate the effects of inventory errors on the financial statements.
Chapter
6-3

Classifying
Inventory
Finished goods
Work in process
Raw materials
Determining
Inventory
Quantities
Taking a physical inventory
Determining ownership of goods
Inventory
Costing
Specific identification
Cost flow assumptions
Financial statement and tax effects
Consistent use
Lower-of-costor-market
Analysis of
Inventory
Inventory turnover ratio
LIFO reserve
Chapter
6-4

Classifying Inventory
One Classification:
Merchandise
Inventory
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Chapter
6-5
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

Chapter
6-6

Determining Inventory Quantities
Perpetual System
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 Inventory Quantities
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 Inventory Quantities
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 Inventory Quantities
Illustration 6-1
Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
Chapter
6-10
Ownership of the goods remains with the seller until the goods reach the buyer.
SO 1 Describe the steps in determining inventory quantities.

Determining Inventory 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 Inventory Quantities
Consigned Goods
Goods held for sale by one party although ownership of the goods is retained by another party.
Chapter
6-12
SO 1 Describe the steps in determining inventory quantities.

Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average-cost
Cost Flow
Assumptions
Chapter
6-13
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory 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. These facts are summarized below.
Illustration 6-2
Chapter
6-14
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing
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
6-15
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing
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
6-16
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
does not need to equal
Physical Movement of
Goods
Illustration 6-11
Use of cost flow methods in major U.S. companies
Chapter
6-17
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration: Data for Houston Electronics’ Astro condensers.
Illustration 6-4
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
Chapter
6-18
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
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
6-19
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration 6-5
Solution on notes page
Chapter
6-20
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration 6-5
Chapter
6-21
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
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
6-22
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration 6-7
Solution on notes page
Chapter
6-23
SO 2 Explain the basis of accounting for inventories and apply the cost flow methods under a periodic inventory system.
inventory

Inventory Costing – Cost Flow Assumptions
Illustration 6-7
Chapter
6-24
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
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
6-25
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration 6-10
Solution on notes page
Chapter
6-26
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Illustration 6-10
Chapter
6-27
SO 2 Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.

Inventory Costing – Cost Flow Assumptions
Sales
Cost of goods sold
Gross profit
Admin. & selling expense
Income before taxes
Income tax expense
Net income
FIFO Average LIFO
$9,000 $9,000 $9,000
6,200 6,600 7,000
2,800 2,400 2,000
330 330 330
2,470 2,070 1,670
140 120 110
$2,330 $1,950 $1,560
Chapter
6-28
Inventory balance $5,800 $5,400 $5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
Lowest
Highest
FIFO Average LIFO
Sales
Cost of goods sold
$9,000 $9,000 $9,000
6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense 330 330 330
Income before taxes
Income tax expense
Net income
2,470
140
2,070
120
1,670
110
$2,330 $1,950 $1,560
Chapter
6-29
Inventory balance $5,800 $5,400 $5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
Highest
Lowest
FIFO Average LIFO
Sales
Cost of goods sold
$9,000 $9,000 $9,000
6,200 6,600 7,000
Gross profit 2,800 2,400 2,000
Admin. & selling expense 330 330 330
Income before taxes
Income tax expense
Net income
2,470
140
2,070
120
1,670
110
$2,330 $1,950 $1,560
Chapter
6-30
Inventory balance $5,800 $5,400 $5,000
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow 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
6-31
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing – Cost Flow 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
6-32
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Chapter
6-33

Inventory Costing
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
6-34
LO 3 Explain the financial statement and tax effects of each of the inventory cost flow assumptions.

Inventory Costing
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
6-35
SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing
Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.
Inventory
Categories
TVs
Radios
$ 60,000
45,000
DVD recorders 48,000
DVDs 14,000
Total inventory
Cost
Data
Market
Data
$ 55,000
52,000
45,000
12,800
Lower of
Cost or Market
$ 55,000
45,000
45,000
12,800
$157,800
Chapter
6-36
SO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Analysis of Inventory
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
6-37
SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Inventory turnover measures the number of times on average the inventory is sold during the period.
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
Chapter
6-38
Days in inventory measures the average number of days inventory is held.
Days in
Inventory
=
Days in Year (365)
Inventory Turnover
SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Illustration: The following data are available for
Wal-Mart.
Chapter
6-39
Inventory
Turnover
2007
=
Days in inventory
2007
=
$264,152
(33,685 + 31,910) / 2
= 8.1 times
365 Days
8.1
= 45.1 Days
SO 5 Compute and interpret the inventory turnover ratio.

Analysis of Inventory
Illustration: The following data are available for
Wal-Mart.
Chapter
6-40
Inventory
Turnover
2006
=
Days in inventory
2006
=
$237,649
(31,910 + 29,419) / 2
= 7.7 times
365 Days
7.7
= 47.4 Days
SO 5 Compute and interpret the inventory turnover ratio.

Chapter
6-41

Analysis of Inventory
Companies using LIFO are required to report the amount that inventory would increase (or occasionally decrease) if the company had instead been using FIFO.
This amount is referred to as the LIFO reserve .
Illustration 6-17
Chapter
6-42
SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

Analysis of Inventory
The LIFO reserve can have a significant effect on ratios analysts commonly use.
Illustration 6-19
Chapter
6-43
SO 6 Describe the LIFO reserve and explain its importance for comparing results of different companies.

Cost Flow Methods in Perpetual Systems
Appendix 6A
Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods
Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Chapter
6-44
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems
Perpetual Inventory + FIFO Method
FIFO:
Transactions:
Date
Jan. 1
Apr. 15
Aug. 24
Sept. 10
Nov. 27
Units
100
200
300
(550)
400
Cost
450
Inventory Balance:
Layer 1 Layer 2
100
200
Layer 3
(100) (200)
300
(250)
-
$
$ -
10 $
$ -
-
11 $
$
50
12
600
Layer 4
400
400
$ 13
$ 5,200
Total
450
$ 5,800
Solution on notes page
Calculation of Cost of Goods Sold:
Beg. inventory
Purchases
Goods available
Ending inventory
COGS
Chapter
6-45
Units
100
900
1,000
(450)
550
Dollars
$ 1,000
11,000
12,000
(5,800)
$ 6,200
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems
Perpetual Inventory + LIFO Method
LIFO:
Transactions:
Date
Jan. 1
Apr. 15
Aug. 24
Sept. 10
Nov. 27
Units
100
200
300
(550)
400
Cost
450
Inventory Balance:
Layer 1 Layer 2
100
200
(50)
Layer 3
(200)
300
(300)
$
$
50
10
500
$
$ -
-
11
$ -
-
$ 12
Layer 4
400
400
$ 13
$ 5,200
Total
450
$ 5,700
Solution on notes page
Calculation of Cost of Goods Sold:
Beg. inventory
Purchases
Goods available
Ending inventory
COGS
Chapter
6-46
Units
100
900
1,000
(450)
550
Dollars
$ 1,000
11,000
12,000
(5,700)
$ 6,300
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems
Perpetual Inventory
Transactions:
Date
Jan. 1
Units
100
Apr. 15 200
Aug. 24 300
Sept. 10 (550)
Nov. 27 400
450
Cost
$ 10.00
11.00
12.00
11.33
13.00
Total
$ 1,000
2,200
3,600
(6,233)
5,200
$ 5,767
Cost of Goods Sold:
Beg. inventory
Purchases
Goods available
Ending inventory
COGS
+ Moving Average
Running Balances
Units
100
300
Cost
$ 1,000
3,200
600
50
450
6,800
567
5,767
Average
Cost
$ 10.00
10.67
11.33
11.33
12.46
Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.
Units Dollars
100 $ 1,000
900 11,000
1,000
(450)
550
12,000
(5,767)
$ 6,233
Chapter
6-47
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Cost Flow Methods in Perpetual Systems
Perpetual Inventory
Transactions:
Date Units
Jan. 1 100
Apr. 15 200
Aug. 24 300
Sept. 10 (550)
Nov. 27 400
450
Cost
$ 10.00
11.00
12.00
11.33
13.00
Total
$ 1,000
2,200
3,600
(6,233)
5,200
$ 5,767
Cost of Goods Sold:
Beg. inventory
Purchases
Goods available
Ending inventory
COGS
+ Moving Average
Running Balances
Units
100
Cost
$ 1,000
300
600
50
450
3,200
6,800
567
5,767
Average
Cost
$ 10.00
10.67
11.33
11.33
12.81
Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase.
Units Dollars
100
900
1,000
(450)
550
$ 1,000
11,000
12,000
(5,767)
$ 6,233
Chapter
6-48
SO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Errors
Appendix 6B
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
6-49
SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-B1
Illustration 6-B2
Chapter
6-50
SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Chapter
6-51
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.
SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Illustration 6-B3
Sales
Beginning inventory
Cost of goods purchased
Cost of goods available
Ending inventory
Cost of good sold
Gross profit
Operating expenses
Net income
2009
Incorrect Correct
$ 80,000
20,000
40,000
60,000
12,000
48,000
32,000
10,000
$ 22,000
$ 80,000
20,000
40,000
60,000
15,000
45,000
35,000
10,000
$ 25,000
2010
Incorrect Correct
$ 90,000
12,000
68,000
80,000
23,000
57,000
33,000
20,000
$ 13,000
$ 90,000
15,000
68,000
83,000
23,000
60,000
30,000
20,000
$ 10,000
Combined income for
2-year period is correct.
Chapter
6-52
($3,000)
Net Income understated
$3,000
Net Income overstated
SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Review Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold. c. net income. d. owner's equity.
Chapter
6-53
SO 8 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-B1
Illustration 6-B4
Chapter
6-54
SO 8 Indicate the effects of inventory errors on the financial statements.

Chapter
6-55
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