Merchandise Inventory
Presentations for Chapter 7 by Glenn Owen
Key Points






Inventory and how it affects the financial statements.
Four issues that must be addressed when accounting
for inventory.
General rules for including items in inventory and
attaching costs to these items.
Differences between the perpetual and periodic
methods and trade-offs involved in choosing between
them.
The three cost flow assumptions - average,
FIFO, and LIFO.
The lower-of-cost-or-market rule.
Inventory as a % of Total Assets
Company (Industry)
General Electric (Manufacturing)
Chevron Oil (Oil drilling and refining)
Super Value (Grocery)
Tommy Hilfiger (Clothing)
Yahoo (Internet search engine)
Cisco (Internet systems)
SBC Communications (Telcom services)
Wendy’s (Restaurant services)
Bank of America (Banking services)
Merrill Lynch (Investment services)
Inventory
/Total Assets
.02
03
.23
.09
.00
.04
.00
.02
.00
.00
Inventory as a % of Current Assets
Company (Industry)
General Electric (Manufacturing)
Chevron Oil (Oil drilling and refining)
Super Value (Grocery)
Tommy Hilfiger (Clothing)
Yahoo (Internet search engine)
Cisco (Internet systems)
SBC Communications (Telcom services)
Wendy’s (Restaurant services)
Bank of America (Banking services)
Merrill Lynch (Investment services)
Inventory
/Current Assets
.07
.13
.68
.26
.00
.11
.00
.13
.00
.00
Important Issues
Acquisition of
Inventory:
What costs to
capitalize?
Sell Inventory:
Which cost flow
assumption?
Carry
Inventory:
Which method?
Ending
Inventory:
Lower-of-cost-ormarket rule
Acquiring Inventory:
What Costs to Capitalize?

What items or units to include?
– General rule
– Consignments
– Goods in transit

What costs to attach?
– General rule
– Cash discounts

Determining the costs of manufacturing
inventories
Carrying Inventory: The
Perpetual or Periodic Method

Perpetual
– Up-to-date record in inventory account
– Cost of goods sold computed for each sale

Periodic
– Inventory purchases are recorded as incurred
– Inventory and cost of goods sold determined at the end of
each period

Costs and benefits
– Perpetual requires more bookkeeping
but provides more useful information
Selling Inventory:
Which Cost Flow Assumption?







Specific identification
Averaging
FIFO - First-in, first-out
LIFO - Last-in, first-out
Effects on financial statements
Effects on federal income taxes
Trade-offs
Effects of the Three Inventory
Cost Flow Assumptions
FIFO
Sales
Cost of goods sold
Gross profit
Expenses
Net income
before taxes
Federal income taxes
Net income after taxes
Ending inventory
Cost of goods sold
Total inventory cost
Averaging
LIFO
Effects of the Three Inventory
Cost Flow Assumptions
FIFO
Sales
Cost of goods sold
Gross profit
Expenses
Net income
before taxes
Federal income taxes
Net income after taxes
$525
155
$370
150
Ending inventory
Cost of goods sold
Total inventory cost
$255
155
$410
$220
75
$145
Averaging
LIFO
Effects of the Three Inventory
Cost Flow Assumptions
FIFO
Averaging
Sales
Cost of goods sold
Gross profit
Expenses
Net income
before taxes
Federal income taxes
Net income after taxes
$525
155
$370
150
$525
179
$346
150
$220
75
$145
$196
67
$129
Ending inventory
Cost of goods sold
Total inventory cost
$255
155
$410
$231
179
$410
LIFO
Effects of the Three Inventory
Cost Flow Assumptions
FIFO
Averaging
LIFO
Sales
Cost of goods sold
Gross profit
Expenses
Net income
before taxes
Federal income taxes
Net income after taxes
$525
155
$370
150
$525
179
$346
150
$525
205
$320
150
$220
75
$145
$196
67
$129
$170
58
$112
Ending inventory
Cost of goods sold
Total inventory cost
$255
155
$410
$231
179
$410
$205
205
$410
Inventory Cost Flow Assumptions:
Effects on Federal Income Taxes

During inflationary times, the LIFO
assumption is an attractive alternative
 LIFO conformity rule
Inventory Cost Flow Assumptions:
Trade-offs

Income and asset measurement
 Economic consequences
 Income taxes and liquidity
 Bookkeeping costs
 LIFO liquidation /purchasing
 Debt and compensation contracts
 Capital market
Ending Inventory:Applying the
Lower-of-Cost-or-Market Rule

Based on conservatism, ending inventory is
valued at cost or market value, whichever is
lower.
 Hidden reserves
– Recognizes price decreases immediately
– Defers price increase recognition until sold
Review Problem
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


Dec. 1 - Jane Lee, owner, contributed $1,000.
Dec. 7 - Purchased 300 lbs. of rice for $1.00/lb.
Dec. 25 - Sold 300 lbs. of rice for $5.00/lb.
Dec. 27 - Purchased 150 lbs. of rice for $1.40/lb.
Dec. 28 - Sold 50 lbs. of rice for $5.00/lb.
Dec. 29 - Paid cash expenses of $400.
Dec. 31 - Paid income tax liability.
Income Statement:
Periodic FIFO Assumption
Sales (300 lb. x $5)
$1,500
Income Statement:
Periodic FIFO Assumption
Sales (300 lb. x $5)
Cost of goods sold
Gross profit
* Beginning inventory
+ Purchases ($300 + $210)
- Ending inventory (150 lb x $1.40)
= Cost of goods sold
$1,500
300 *
$1,200
$
0
510
(210)
$ 300
Income Statement:
Periodic FIFO Assumption
Sales (300 lb. x $5)
Cost of goods sold
Gross profit
Expenses
Net income before taxes
Income tax expense ($800 x .30)
Net income after taxes
* Beginning inventory
+ Purchases ($300 + $210)
- Ending inventory (150 lb x $1.40)
= Cost of goods sold
$1,500
300*
$1,200
400
$ 800
240
$ 560
$
0
510
(210)
$ 300
Balance Sheet:
Periodic FIFO Assumption
Cash
$1,350 *
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Balance Sheet:
Periodic FIFO Assumption
Cash
Inventory (150 lbs. x $1.40)
$1,350 *
210
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Balance Sheet:
Periodic FIFO Assumption
Cash
Inventory (150 lbs. x $1.40)
Total assets
$1,350 *
210
$1,560
Common stock
Retained earnings
Total liabilities and
stockholders’ equity
$1,000
560
$1,560
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $210) + $1,500 - $400 - $240 = $1,350
Income Statement:
Periodic LIFO Assumption
Sales (300 lb. x $5)
$1,500
Income Statement:
Periodic LIFO Assumption
Sales (300 lb. x $5)
Cost of goods sold
Gross profit
* Beginning inventory
+ Purchases ($300 + $210)
- Ending inventory (150 lb x $1.00)
= Cost of goods sold
$1,500
360 *
$1,140
$
0
510
(150)
$ 360
Income Statement:
Periodic LIFO Assumption
Sales (300 lb. x $5)
Cost of goods sold
Gross profit
Expenses
Net income before taxes
Income tax expense ($740 x .30)
Net income after taxes
* Beginning inventory
+ Purchases ($300 + $210)
- Ending inventory (150 lb x $1.00)
= Cost of goods sold
$1,500
360 *
$1,140
400
$ 740
222
$ 518
$
0
510
(150)
$ 360
Balance Sheet:
Periodic LIFO Assumption
Cash
$1,368 *
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368
Balance Sheet:
Periodic LIFO Assumption
Cash
Inventory (150 lbs. x $1.00)
$1,368 *
150
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368
Balance Sheet:
Periodic LIFO Assumption
Cash
Inventory (150 lbs. x $1.00)
Total assets
$1,368 *
150
$1,518
Common stock
Retained earnings
Total liabilities and
stockholders’ equity
$1,000
518
$1,518
* Cash =
Capital contribution - Purchases + Sales - Expenses - Taxes
$1,000 - ($300 + $150) + $1,500 - $400 - $222 = $1,368
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