Chapter 7: Inventory
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Chapter 7: Inventory
1. Acquisition of inventory: What costs to
capitalize?
2. Recording inventory activity: Which
method?
3. Selling inventory: Which cost flow
assumption?
4. Ending inventory: Lower-of-cost-or market
valuation.
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1. Acquiring Inventory

What items or units to include?
– General rule: (1) held for sale and (2) complete
and unrestricted ownership.
– Consignments: belong to consignor, ownership
not based on physical possession.
– Goods in transit
 FOB Shipping Point: belongs to the
purchaser while in transit (once inventory
leaves seller’s facilities).
 FOB Destination: belongs to seller while in
transit (until inventory reaches purchaser’s
facilities).
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Class Exercise E7-1
Error if Dallas includes in ending inventory at 12/31?
1. FOB Shipping Point (purchase):
2. FOB Shipping Point (sale):
3. FOB Destination (sale):
4. FOB Destination (purchase):
5. FOB Destination (purchase):
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Inventory Errors

Inventory errors are unique in financial reporting
because they involve multiple accounts and
multiple periods.
 Because of the carryover nature of inventory,
some inventory errors reverse out by the end of
the second year involved.
 To analyze, use basic inventory formula.
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Class Problem-Inventory Error
Assume that the ending inventory of 2004 was
undervalued by $9,000. If the error goes
undetected in 2005, what effect would the
error have on the balance sheet and income
statement accounts for 2004 and 2005.
Analyze using the following relationships:
BI + P - EI = COGS
NI
A = L + SE
Note that the asset account in inventory error
analysis is ending inventory, and the
equity effect is retained earnings,
specifically the effect on net income.
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Class Problem- Inventory Error
Analysis (O = overstated, U = understated):
BI + P - EI = COGS
NI
A = L + SE
04:
05:
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Acquiring inventory - contd.

What costs to attach? General rule: all costs
associated with purchase or manufacture,
including shipping to facility.
– Freight-in (transportation-in) adds to the
cost of inventory.
– Purchase returns reduce the cost of
purchases (contra) for returned inventory.
– Purchase allowances reduce the cost of
purchases (contra) for reduced prices due to
damage or errors.
– Purchase discounts from early cash
payments (contra) reduce the cost of
purchases.
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2. 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 through physical count.

Costs and benefits
– Perpetual requires more bookkeeping but provides more
useful information.
– General application: Periodic used for external reporting;
perpetual used for internal tracking of units.
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Figure 7.3, Perpetual System
December 10 Purchase of 100 units @ $20:
Inventory
2,000
Accts. Pay.
2,000
December 20 Sale of 50 units @ $30:
Cash
1,500
Sales
1,500
COGS
1,000
Inventory
1,000
December 30 AJE to recognize loss of 5 units @$20
each (170 on hand, books show 175)
Loss
100
Inventory
100
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Figure 7.3, Periodic System
December 10 Purchase of 100 units @ $20:
Purchases
2,000
Accts. Pay.
2,000
December 20 Sale of 50 units @ $30:
Cash
1,500
Sales
1,500
(no COGS entry until the end of the period)
December 31 AJE/CJE to recognize EI and COGS:
(Note: BI given at $2,500 and EI of 175 units (125 BI + 100
Purchase -50 Sold) valued at $20 per unit, or $3,500)
Inventory (end)
3,500
COGS
1,000
Purchases
2,000
Inventory (begin)
2,500
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This AJE under periodic system follows
the formula for COGS:
BI + Purchases (net) - EI = COGS
2,500 +
2,000 - 3,500 = 1,000
(Alternative: BI + P(net) = EI + COGS)
Note that Purchases (net) =
Purchases
+ Freight-in
- Purchase Discounts (see next slide)
- Purchase Returns
- Purchase Allowances
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Purchase Discounts - Gross Method
Assume purchase of $100 on account on 6/1/05,
terms 2/15 (2% discount if paid within15 days), n/30.
GJE to record purchase on 6/1/05:
Purchases
100
Accounts Payable
100
GJE to record payment, if on or before 6/16/05:
Accounts Payable 100
Purchase Discounts
2
Cash
98
GJE to record payment, if after 6/16/05:
Accounts Payable 100
Cash
100
(Purch Disc. is contra to Purchases; part of COGS calc.)
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Class Problem: E7-3 (Periodic)
March 3 purchase:
March 10 purchase:
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Class Problem: E7-3 (Periodic)
March 20 payment (3% discount taken):
April 25 payment (no discount taken):
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Class Exercise: Exercise 7-4, Part (a)
Note:
Cost of goods available for sale = GAS, and
GAS = Beginning inventory + Purchases (net)
GAS = EI + COGS
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Class Exercise: Exercise 7-4, Part (a)
for 2003
Find Beginning inventory (2003):
Find GAS (2003):
Find EI (2003):
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Class Exercise: Exercise 7-4, Part (a)
for 2002
Find Beginning inventory (2002):
Find GAS (2002):
Find Purchases:
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3. Cost Flow Assumptions

Given: BI + P (net) = EI + COGS
 How to assign costs of inflows [BI + P(net)] to
EI and COGS?
Methods:
 Specific identification
 Average for both COGS and EI
 FIFO - (first-in, first-out) for COGS
– and LISH (last-in, still here) for EI

LIFO - (last-in, first-out) for COGS
– and FISH (first-in, still here) for EI
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Class Problem - Cost Flows
Given the following activity for January:
Cost
Total
Units
per Unit Cost
Begin Inventory 20
$ 9.00 $180
Purchase 1/10
40
10.00 400
Purchase 1/22
30
11.00 330
Total available
90 units
$910
Sales
- 55 units
Ending inventory?
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Class Problem - Cost Flows
Note that, for illustrative purposes, only
the periodic system is shown here.
 The perpetual system give similar
results, but is more cumbersome to
illustrate.
 In fact, using the FIFO method, the
perpetual and periodic systems yield
exactly the same results.

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FIFO(LISH)

FIFO for COGS (top down)

LISH for EI (bottom up)
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LIFO(FISH)

LIFO for COGS (bottom up)

FISH for EI (top down)
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Average

First calculate average:

Now COGS:

Now EI:
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Comparison of FIFO, LIFO, and
Average

In times of rising prices:
highest COGS:
lowest COGS
highest EI
lowest EI
highest Net Income
lowest Net Income
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Additional LIFO issues:

LIFO and taxes
– Why use LIFO for taxes?
– Why use LIFO for financial statements?
 LIFO and market valuation
– Should market value a company higher or
lower if they use LIFO?
 LIFO liquidation
– What happens to net income with liquidation
of an old LIFO layer?
 LIFO reserve
– what information is contained in this
disclosure?
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4. 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.
 Problem: can create hidden reserves

– Recognizes price decreases immediately
– Defers price increase recognition until sold
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Class Issues for Discussion: ID7-4
a. AJE (in millions)- reduce EI and recognize loss:
b. Sale next year (new basis = 40):
c. Loss of $12 in first year; gain of $8 in second
year:
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