Heintz & Parry
20th Edition
College
Accounting
Chapter
13
Accounting for
Merchandise
Inventory
1
Explain the impact of
merchandise inventory
on the financial
statements.
•
Errors in inventory will cause errors on the:

Income statement

Statement of owner’s equity

Balance sheet
o
Since this year’s ending inventory becomes next
year’s beginning inventory, financial statements for the
following year will also contain errors
INCOME STATEMENT
Sales
Cost of goods sold:
Beginning merch. inventory
Add purchases (net)
Cost of goods available for sale
Less ending merch. inventory
20-1
80
20
40
60
(20)
Let’s first look at the income statement with
the ending inventory correctly stated at $20.
20-2
INCOME STATEMENT
Sales
Cost of goods sold:
Beginning merch. inventory
Add purchases (net)
Cost of goods available for
Less
saleending merch. inventory
20-1
80
20
40
60
(20)
(40)
Cost of goods sold
Now let’s look at
Gross profit
40
Operating expenses the other financial (10)
statements.
Net income
30
20-2
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
Net income
30
Erv Bultman, capital, December 31
130
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
20
130
INCOME STATEMENT
20-1
Sales
Cost of goods sold:
Beginning merch. inventory
20
Add purchases (net)
40
Cost of goods available for sale 60
Less ending merch. inventory
(20)
Cost of goods sold
Gross profit
Operating expenses
20-1’s ending inventory
Net income
becomes 20-2’s beginning
inventory.
20-2
80
80
20
(40)
40
(10)
30
INCOME STATEMENT
Sales
Cost of goods sold:
Beginning merch. inventory
Add purchases (net)
Cost of goods available for sale
Less ending merch. inventory
Cost of goods sold
Gross profit
Operating expenses
Net income
20-1
20-2
80
20
40
60
(20)
(40)
40
(10)
30
80
20
40
60
(20)
(40)
40
(10)
30
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
130
Net income
30
30
Erv Bultman, capital, December 31
130
160
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
20
20
130
160
What would be the effect on the financial
statements for 20-1 and 20-2 if the ending
inventory was reported as $15 instead of $20?
INCOME STATEMENT
20-1
Sales
Cost of goods sold:
Beginning merch. inventory
20
Add purchases (net)
40
Cost of goods available for sale 60
Less ending merch. inventory (15)
Cost of goods sold
Gross profit
Operating expenses
Net income
20-2
80
Understated
ending inventory
results in
understated net
income.
(45)
35
(10)
25
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
Net income
25
Erv Bultman, capital, December 31
125
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
Understated net income
results in understated
owner’s equity.
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
Net income
25
Erv Bultman, capital, December 31
125
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
15
125
Current assets and
owner’s equity will
be understated.
INCOME STATEMENT
20-1
Sales
Cost of goods sold:
Beginning merch. inventory
20
Add purchases (net)
40
Cost of goods available for sale 60
Less ending merch. inventory (15)
Cost of goods sold
Gross profit
Understated beginning
Operating expenses
inventory results in
Net income overstated net income.
20-2
80
80
15
40
55
20
(45)
35
(10)
25
(35)
45
(10)
35
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
125
Net income
25
35
125
Erv Bultman, capital, December 31
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
15
125
Owner’s equity is correct by the end of 20-2.
160
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
125
Net income
25
35
125
Erv Bultman, capital, December 31
160
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
Current assets and
owner’s equity will be
correct by the end of 20-2.
15
20
125
160
What would be the effect on the financial
statements for 20-1 and 20-2 if the ending
inventory was reported as $25 instead of $20?
INCOME STATEMENT
Sales
Cost of goods sold:
Beginning merch. inventory
Add Purchases (net)
Cost of goods available for
Less
saleending merch. inventory
20-1
80
20
40
60
(25)
(35)
Cost of goods sold
Gross profit
45
Operating expensesOverstated ending
(10)
inventory results in
Net income
overstated net income. 35
20-2
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
Net income
35
Erv Bultman, capital, December 31
135
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
Overstated net income
results in overstated
owner’s equity.
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
Net income
35
135
Erv Bultman, capital, December 31
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
Current assets and
owner’s equity will be
overstated.
25
135
INCOME STATEMENT
20-1
Sales
Cost of goods sold:
Beginning merch. inventory
20
Add purchases (net)
40
Cost of goods available for sale 60
Less ending merch. inventory
(25)
Cost of goods sold
Gross profit
Overstated beginning
Operating expenses
inventory results in
understated net
Net income
income.
20-2
80
80
25
40
65
20
(35)
45
(10)
35
(45)
35
(10)
25
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
135
Net income
35
25
135
Erv Bultman, capital, December 31
160
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
25
135
Owner’s equity is correct by
the end of 20-2.
STMT. OF OWNER’S EQUITY 20-1
20-2
Erv Bultman, capital, January 1 100
135
Net income
35
25
135
Erv Bultman, capital, December 31
160
BALANCE SHEET (Partial)
Current assets:
Merchandise inventory
Owner’s equity:
Erv Bultman, capital
25
20
135
160
Current assets and
owner’s equity will be
correct by the end of
20-2.
2
Describe the two
principal systems of
accounting for
merchandise
inventory—the periodic
system and the
perpetual system.
•
PERIODIC
INVENTORY
SYSTEM

Merchandise inventory
account balance =
most recent physical
inventory

Purchases account
used for all
merchandise
purchases

Current inventory and
cost of goods sold are
only computed at the
end of the period
•
PERPETUAL
INVENTORY SYSTEM

Merchandise inventory
account reflects current
inventory

Purchases are debited to
Merchandise Inventory
and cost of goods sold
are credited to
Merchandise Inventory

Generally, there is no
need for end-of-year
adjustments
EXAMPLE:
Purchased
merchandise
on account,
$100.
DATE
1
2
3
DESCRIPTION
Purchases
Accounts Payable
4
5
6
7
8
9
10
11
The periodic system
uses a purchases
account.
PR DEBIT CREDIT
100 00
100 00
DATE
1
2
3
DESCRIPTION
Merchandise Inventory
PR DEBIT CREDIT
100 00
Accounts Payable
4
5
6
7
8
9
10
11
The perpetual system records purchases directly in the
merchandise inventory account.
100 00
EXAMPLE: Paid freight charge, $30.
DATE
1
2
3
DESCRIPTION
Freight-In
Cash
4
5
6
7
8
9
10
11
The periodic system separates
freight charges into their own
account.
PR DEBIT CREDIT
30 00
30 00
DATE
1
2
3
DESCRIPTION
Merchandise Inventory
PR DEBIT CREDIT
30 00
Cash
4
5
6
7
8
9
10
11
The perpetual system considers freight
charges part of the cost of merchandise
and includes them in the inventory
account.
30 00
EXAMPLE: Sold
merchandise on
account, $80. The cost
of the merchandise was
$50.
DATE
1
2
3
DESCRIPTION
Accounts Receivable
PR DEBIT CREDIT
80 00
Sales
4
5
6
7
8
9
10
11
The periodic system only records the
selling price of merchandise sold.
No attempt is made to reduce the
inventory account for items sold.
80 00
DATE
1
2
3
DESCRIPTION
Accounts Receivable
PR DEBIT CREDIT
80 00
Sales
4
5
6
7
8
9
10
11
The perpetual system also records
the selling price of merchandise
sold.
80 00
DATE
1
2
3
4
5
DESCRIPTION
Accounts Receivable
PR DEBIT CREDIT
80 00
Sales
Cost of Goods Sold
Merchandise Inventory
6
7
8
9
10
11
In addition, the perpetual system removes
the cost of merchandise sold from
inventory.
80 00
50 00
50 00
EXAMPLE:
Merchandise
costing $10 was
returned to the
supplier.
DATE
1
2
3
DESCRIPTION
Accounts Payable
Purchases Ret. and Allow.
4
5
6
7
8
9
10
11
The periodic system maintains
a separate account for returns.
PR DEBIT CREDIT
10 00
10 00
DATE
1
2
3
DESCRIPTION
Accounts Payable
PR DEBIT CREDIT
10 00
Merchandise Inventory
4
5
6
7
8
9
10
11
Since the merchandise was recorded in
the inventory account when purchased, it
is removed from the account when
returned.
10 00
EXAMPLE: Customers returned
merchandise sold for $20. The cost of
the merchandise was $15.
DATE
1
2
3
DESCRIPTION
PR DEBIT CREDIT
Sales Returns and Allowances
20 00
Accounts Receivable
4
5
6
7
8
9
10
11
The periodic system
maintains a separate
account for returns.
20 00
DATE
1
2
3
DESCRIPTION
PR DEBIT CREDIT
Sales Returns and Allowances
20 00
Accounts Receivable
4
5
6
7
8
9
10
11
The perpetual system
records the returned sale.
20 00
DATE
1
2
3
4
5
6
7
8
9
10
11
DESCRIPTION
PR DEBIT CREDIT
Sales Returns and Allowances
20 00
Accounts Receivable
Merchandise Inventory
Cost of Goods Sold
It also must adjust the
cost of goods sold and
merchandise inventory
accounts.
20 00
15 00
15 00
EXAMPLE: Paid for merchandise costing $100.
The supplier granted a 2% discount for prompt
payment.
DATE
1
2
3
4
5
6
7
8
9
10
11
DESCRIPTION
Accounts Payable
PR DEBIT CREDIT
100 00
Purchases Discounts
Cash
Discounts are
recorded in a
separate
account.
2 00
98 00
DATE
1
2
3
DESCRIPTION
Accounts Payable
PR DEBIT CREDIT
100 00
Merchandise Inventory
Cash
4
5
6
7
8
9
10
11
The perpetual system does not record
discounts in a separate account. It
reduces Merchandise Inventory directly
for the discount amount.
2 00
98 00
3
Compute the costs
allocated to the ending
inventory and cost of
goods sold using
different inventory
methods.
•
Counting the goods on hand at the end of the
period
 Used in the PERIODIC system to allocate
merchandise costs between sold and unsold
goods
 In the PERPETUAL system, it is compared to
the accounting records to determine if what is
actually held agrees with what is reported in the
accounting records
 Done after regular business hours
 The ideal time to count the goods is when the
quantity on hand is at its lowest levels
o
A fiscal year that starts and ends when inventory is at
its lowest level is known as natural business year
•
Two special situations:

Goods held for sale on CONSIGNMENT
o

Goods held on consignment remain the property of
the shipper (consignor)
Goods IN TRANSIT
o
If goods are shipped FOB shipping point, the BUYER
pays for shipping and goods belong to the buyer as
soon as they are shipped
o
If goods are shipped FOB destination, the seller pays
for shipping and the goods belong to the seller until
they are received by the buyer
EXAMPLE: A physical inventory found 50
bicycles (Model ZX007) on hand. All of this
particular model were purchased for $60 each.
Number of
Cost per
=
bikes on hand
unit
50
$60
=
Ending
inventory
$3,000
Computing ending inventory is simple if all
purchases were made at the same price.
What if each time we restocked this bicycle the
price had changed?
On hand at start of period
Units
40
Unit Price Total Cost
$62
$ 2,480
Purchased during period:
60
80
2nd purchase
70
3rd purchase
No. of units available for sale 250
50
On hand at end of period
No. of units sold during period 200
1st purchase
65
67
68
Cost of these
200 sold?
3,900
5,360
4,760
$16,500
What if each time we restocked this bicycle the
price had changed?
On hand at start of period
Units
40
Unit Price Total Cost
$62
$ 2,480
Purchased during period:
3,900
60
65
2nd purchase
80
67
5,360
3rd purchase
70
68
4,760
No. of units available for sale 250
$16,500
Depends on
On hand at end of period
50 the inventory
No. of units sold during period 200 method used.
1st purchase
Method #1 – Specific Identification Method
•
Used when each unit of inventory can be specifically
identified

•
Examples: cars, motorcycles, furniture, appliances,
and fine jewelry
Practical only for businesses in which sales volume
is relatively low and inventory unit value is relatively
high
Let’s apply this method to
the bicycle example.
Inventory was maintained using the specific
identification method. The identity of the 200
bicycles sold is as follows:
On hand at start of period
Units Unit Price
40
$62
Total Cost
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
65
67
68
30 of the
beginning
inventory
were sold
3,900
5,360
4,760
$16,500
Inventory was maintained using the specific
identification method. The identity of the 200
bicycles sold is as follows:
On hand at start of period
Units Unit Price
40
$62
Total Cost
$ 2,480
60
80
70
250
50
200
3,900
5,360
4,760
$16,500
Purchased during period:
1st purchase
2nd purchase
3rd purchase
No. of units available for sale
On hand at end of period
No. of units sold during period
65
67
68
50 from
the 1st
purchase
were sold
Inventory was maintained using the specific
identification method. The identity of the 200
bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
2nd purchase
3rd purchase
No. of units available for sale
On hand at end of period
No. of units sold during period
60
80
70
250
50
200
65
67
68
60 from the
2nd
purchase
were sold
3,900
5,360
4,760
$16,500
Inventory was maintained using the specific
identification method. The identity of the 200
bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
2nd purchase
3rd purchase
No. of units available for sale
On hand at end of period
No. of units sold during period
60
80
70
250
50
200
65
67
68
60 from the
3rd
purchase
were sold
3,900
5,360
4,760
$16,500
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Units
30
50
60
60
Total
200
Unit Price
Total
$62
$ 1,860
65
3,250
67
4,020
68
4,080
$13,210
Cost of goods (the 200 bicycles) sold
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Total
Units
10
10
20
10
50
Unit Price
$62
65
67
68
Total
$ 620
650
1,340
680
$3,290
This ending inventory will be reported on the
income statement and the balance sheet.
Method #2 – First-In, First-Out (FIFO) Method
•
Assumes that the first goods purchased were the
first goods sold

•
Therefore, the latest goods purchased remain in
inventory
Follows the natural flow of goods

Especially true of grocery stores, fresh fruit stands,
and computer software businesses
Let’s apply this method to the
bicycle example.
Inventory was maintained using the FIFO
method. The identity of the 200 bicycles sold is
as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
All of these were
assumed sold
65
67
68
3,900
5,360
4,760
$16,500
Inventory was maintained using the FIFO
method. The identity of the 200 bicycles sold is
as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
All of these were
67
5,360
assumed sold
68
4,760
$16,500
Inventory was maintained using the FIFO
method. The identity of the 200 bicycles sold is as
follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
67
5,360
All of these were
68
4,760
assumed sold
$16,500
Inventory was maintained using the FIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
40
65
60
67
80
68
3,900
5,360
4,760
180 considered
sold$16,500
so far
Inventory was maintained using the FIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
67
5,360
68
4,760
20 of these were
$16,500
assumed sold
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Units
40
60
80
20
Unit Price
$62
65
67
68
The remaining units from the
3rd purchase are the 50 units
in ending inventory.
Total
$2,480
3,900
5,360
1,360
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Units
40
60
80
20
Total
200
Unit Price
Total
$62
$ 2,480
65
3,900
67
5,360
68
1,360
$13,100
Cost of goods (the 200 bicycles) sold
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Total
Units
0
0
0
50
Unit Price
$62
65
67
68
50
This ending inventory will be reported
on the income statement and the
balance sheet.
Total
$
0
0
0
3,400
$3,400
Method #3 – Weighted-Average Method
•
Computes an average cost per unit using the
following formula:

Total cost of units available for sale divided by the
units available for sale
Let’s apply this method to
the bicycle example.
Inventory was maintained using the weightedaverage method.
On hand at start of period
Units Unit Price
40
$62
Total Cost
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
65
67
68
3,900
5,360
4,760
$16,500
$16,500 = $66/unit
250
Cost of goods sold 200 units @ $66 = $13,200
Ending inventory
50 units @ $66 =
One of the advantages of
the weighted-average
method is its simplicity.
3,300
Method #4 – Last-In, First-Out (LIFO) Method
•
Assumes that the sales in the period were made
from the most recently purchased goods

•
Therefore, the earliest goods purchased remain in
inventory
The use of this method is justified because:


The actual physical flow of goods in some
businesses is actually last-in, first-out
It matches the most current costs of items
purchased against the current sales revenue
Inventory was maintained using the LIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
5,360
4,760
$16,500
All of these
65
67
68
were assumed
sold
Inventory was maintained using the LIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
67
5,360
68of these 4,760
All
were assumed
$16,500
sold
Inventory was maintained using the LIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
70
67
5,360
80
68considered
4,760
150
sold so
far
$16,500
Inventory was maintained using the LIFO method.
The identity of the 200 bicycles sold is as follows:
On hand at start of period
Units Unit Price Total Cost
40
$62
$ 2,480
Purchased during period:
1st purchase
60
2nd purchase
80
3rd purchase
70
No. of units available for sale 250
On hand at end of period
50
No. of units sold during period 200
3,900
65
67of these 5,360
50
were
68 assumed 4,760
sold $16,500
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Units
0
50
80
70
200
Unit Price
Total
$62
$
0
65
3,250
67
5,360
68
4,760
$13,370
Beginning inventory
1st purchase
2nd purchase
3rd purchase
Total
Units
40
10
0
0
Unit Price
$62
65
67
68
50
This ending inventory will be
reported on the income statement
and the balance sheet.
Total
$2,480
650
0
0
$3,130
•
•
The assumed cost flows (FIFO, weighted-average,
and LIFO) do not have to match the actual physical
movement of goods
Any one of the methods may be used under any set
of physical flow conditions
Sales
Cost of goods sold:
Beg. inventory
Purchases
Goods avail. for sale
Specific
Identification
$18,000
$ 2,480
14,020
$16,500
Goods available for sale
is the same for all four
methods!
FIFO
$18,000
$ 2,480
14,020
$16,500
FIFO
Weighted-Average
$18,000
$18,000
$ 2,480
14,020
$16,500
$ 2,480
14,020
$16,500
LIFO
$18,000
$ 2,480
14,020
$16,500
Specific
Identification
$18,000
Sales
Cost of goods sold:
Beg. inventory
$ 2,480
Purchases
14,020
Goods avail. for sale $16,500
3,290
Less ending
inventory
Cost of goods sold
13,210
FIFO
$18,000
$ 2,480
14,020
$16,500
3,400
Ending inventory and cost of
goods sold differ with each
method.
13,100
FIFO
$18,000
Weighted-Average
$18,000
$ 2,480
14,020
$16,500
3,400
13,100
$ 2,480
14,020
$16,500
3,300
13,200
LIFO
$18,000
$ 2,480
14,020
$16,500
3,130
13,370
Specific
Identification
$18,000
Sales
Cost of goods sold:
Beg. inventory
$ 2,480
Purchases
14,020
Goods avail. for sale $16,500
3,290
Less ending
inventory
13,210
Cost of goods sold
$ 4,790
Gross profit
FIFO
$18,000
$ 2,480
14,020
$16,500
3,400
13,100
$ 4,900
FIFO
$18,000
$ 2,480
14,020
$16,500
3,400
13,100
$ 4,900
Weighted-Average
$18,000
$ 2,480
14,020
$16,500
3,300
LIFO
$18,000
$ 2,480
14,020
$16,500
3,130
13,200
$ 4,800
When prices are rising (as with the
bicycles), FIFO results in the largest
gross profit.
13,370
$ 4,630
FIFO
Weighted-Average
$18,000
$18,000
$ 2,480
14,020
$16,500
3,400
13,100
$ 4,900
LIFO
$18,000
$ 2,480
14,020
$16,500
3,130
$ 2,480
14,020
$16,500
3,300
13,200
$ 4,800
LIFO results in the smallest gross
profit, therefore creating the
smallest tax liability.
13,370
$ 4,630
•
Merchandise Inventory is a controlling account

•
A subsidiary ledger is maintained with an
account for each type of merchandise
Goods sold are usually assigned cost on either a
FIFO, moving-average, or LIFO basis
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost of Goods Sold
Cumulative
Cost/
Cost/
Units Unit Total Units Unit CGS
CGS
Jan.
1
(BI)
There were 40 bicycles in
inventory at the beginning of
the year.
Let’s return to the example of the 200 bicycles
sold.
Inventory on Hand
Cumulative
Cost/
Layer
CGS
CGS
Layer Units Unit
Cost
Cost of Goods Sold
Cost/
Units Unit
(1)
40
$62
$2,480
Each of the 40 units
were purchased at
$62.
Total
$2,480
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Cost of Goods Sold
Cumulative
Cost/
Units
Unit
CGS
CGS
Jan.
1 (BI)
Feb. 15
30
$62
The 30 bicycles sold came from
the $62 bicycles in beginning
inventory.
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Units
Cost/
Unit
Total
Cost of Goods Sold
Cost/
Cumulative
Units
CGS
Unit CGS
Jan.
1 (BI)
Feb. 15
30
$62
$1,860
$ 1,860
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cost/
Cumulative
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
30
$62
$1,860
$ 1,860
Total
(1)
40
$62
$2,480
$2,480
(1)
10
$62
$ 620
$ 620
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
Jan.
1 (BI)
Feb. 15
Mar. 1
30
60
$65
$3,900
$62
$1,860
$ 1,860
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
30
$62
$1,860
$ 1,860
Total
(1)
40
$62
$2,480
$2,480
(1)
(1)
(2)
10
10
60
$62
$62
65
$ 620
$ 620
3,900
$ 620
Now there are two layers in inventory…10
bicycles from the beginning inventory and the
60 bicycles just purchased.
$4,520
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
Jan.
1 (BI)
Feb. 15
Mar. 1
30
60
$65
$3,900
April 1
On April 1, 40 units
were sold.
$62
$1,860
$ 1,860
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
30
$62
$1,860
$ 1,860
Total
(1)
40
$62
$2,480
$2,480
(1)
(1)
(2)
10
10
60
$62
$62
65
$ 620
$ 620
3,900
$ 620
FIFO assumes the first-in are the first
sold….40 sold = 10 from the beginning
inventory and the 30 from the 3/1
purchase.
$4,520
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
Jan.
1 (BI)
Feb. 15
Mar. 1
60
April 1
$65
30
$62
$1,860
10
$62
$ 620
30
65
1,950
$ 1,860
$3,900
$ 4,430
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
30
$62
$1,860
10
$62
$ 620
30
65
1,950
$ 1,860
$ 4,430
Total
(1)
40
$62
$2,480
$2,480
(1)
(1)
(2)
(2)
10
10
60
30
$62
$62
65
$65
$ 620
$ 620
3,900
$1,950
$ 620
$4,520
$1,950
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
Jan.
1 (BI)
Feb. 15
Mar. 1
60
$65
May 15
$67
$62
$1,860
10
$62
$ 620
30
65
1,950
$ 1,860
$3,900
April 1
80
30
$5,360
$ 4,430
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
30
$62
$1,860
10
$62
$ 620
30
65
1,950
$ 1,860
Total
(1)
40
$62
$2,480
$2,480
(1)
(1)
(2)
(2)
10
10
60
30
$62
$62
65
$65
$ 620
$ 620
3,900
$1,950
$ 620
$ 4,430
$4,520
$1,950
(2)
(3)
30
80
$65
67
$1,950
$5,360
$7,310
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Cost of Goods Sold
Units
Cost/
Unit
May 15
80
$67
$5,360
June 30
On June 30, 90 units were
sold.
Cumulative
CGS
CGS
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30
$65
$1,950
(3)
80
67
5,360
90 bicycles sold = 30 (layer 2)
+ 60 (layer 3)
Total
$7,310
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
May 15
June 30
80
$67
$5,360
30
$65
$1,950
60
67
4,020
$10,400
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30
$1,950
$65
(3)
80
67
5,360
30
$65 $1,950
20 $67
$1,340
(3)
60
67
4,020
$10,400
Total
$7,310
$1,340
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
May 15
80
$67
$5,360
June 30
Aug. 28
70
$68
$4,760
30
$65
$1,950
60
67
4,020
$10,400
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30
$1,950
$65
(3)
80
67
5,360
30
$65 $1,950
20 $67
$1,340
(3)
60
67
4,020
Total
$7,310
$1,340
$10,400
(3)
(4)
20
70
$67
68
$1,340
4,760
$6,100
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
May 15
80
$67
$5,360
June 30
30
$65
$1,950
60
67
4,020
Aug. 28
70
$68
$4,760
Oct. 30
40 units were sold on Oct. 30.
$10,400
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30 $65
$1,950
(3)
80
67
5,360
30
$65 $1,950
20 $67
$1,340
(3)
60
67
4,020
Total
$7,310
$1,340
$10,400
(3)
(4)
20
70
$67
68
$1,340
40 units sold =
20 (layer 3) + 20 (layer 4)
4,760
$6,100
Let’s return to the example of the 200 bicycles
sold.
Date
Purchases
Cost/
Units
Unit
Total
Units
Cost of Goods Sold
Cost/
Cumulative
Unit
CGS
CGS
May 15
80
$67
$5,360
30
June 30
$65 $1,950
60
67
4,020
20
$67
$1,340
20
68
1,360
$10,400
Aug. 28
70
Oct. 30
$68
$4,760
$13,100
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30
$1,950
$65
(3)
80
67
5,360
30
$65 $1,950
20 $67
$1,340
(3)
60
67
4,020
20
$67
$1,340
20
68
1,360
Total
$7,310
$1,340
$10,400
(3)
(4)
(4)
20
70
50
$67
68
$68
$13,100
Cost of goods sold for the year
$1,340
4,760
$3,400
$6,100
$3,400
Let’s return to the example of the 200 bicycles
sold.
Cost of Goods Sold
Inventory on Hand
Cost/
Cumulative
Cost/
Layer
Units Unit
CGS
CGS
Layer Units Unit
Cost
(2)
30
$1,950
$65
(3)
80
67
5,360
30
$65 $1,950
20 $67
$1,340
(3)
60
67
4,020
20
$67
$1,340
20
68
1,360
Total
$7,310
$1,340
$10,400
(3)
(4)
(4)
20
70
50
$67
68
$68
$1,340
4,760
$3,400
$13,100
$6,100
$3,400
Ending inventory
•
An asset that increases in value while being held…

•
An asset that decreases in value while being
held…

•
No formal entry of the gain is made on the books
until asset is sold
An entry is made to recognize the loss
We should never anticipate gains, but we should
always anticipate and account for losses
•
•
•
Conservatism means that if the value of inventory
declines while it is being held, the loss should be
recognized in the period of the decline
The purpose of the lower-of-cost-or-market method
is to recognize such losses on the income
statement and to report the lower inventory
valuation on the balance sheet
―Cost‖

•
The dollar amount calculated using one of the four
inventory costing methods
―Market‖

The cost to replace the inventory
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
2
3
This company sells three products.
Item
Recorded
Purchase Cost
1
$ 8,000
End-of-Period
Market Value
2
3
The inventory of product #1
cost $8,000.
Lower-of-Costor-Market
Item
Recorded
Purchase Cost
End-of-Period
Market Value
1
$ 8,000
$ 7,000
2
3
But the price has fallen;
it now could be replaced
for $7,000.
Lower-of-Costor-Market
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
$ 8,000
$ 7,000
$ 7,000
2
3
“Market” is the lowest.
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
$ 8,000
$ 7,000
$ 7,000
2
9,000
10,000
9,000
3
7,000
$24,000
6,500
$23,500
6,500
$22,500
There are two ways to calculate
the lower-of-cost-or-market.
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
$ 8,000
$ 7,000
$ 7,000
2
9,000
10,000
9,000
3
7,000
$24,000
6,500
$23,500
6,500
$22,500
#1 – Applied to Total Inventory
The lower of all items at their
cost or all items at their market value
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
$ 8,000
$ 7,000
$ 7,000
2
9,000
10,000
9,000
3
7,000
$24,000
6,500
$23,500
6,500
$22,500
#2 – Applied to Each Item
Each item is evaluated;
the lowest amount is selected for each item
Item
Recorded
Purchase Cost
End-of-Period
Market Value
Lower-of-Costor-Market
1
$ 8,000
$ 7,000
$ 7,000
2
9,000
10,000
9,000
3
7,000
$24,000
6,500
$23,500
6,500
$22,500
Let’s assume it was applied to the total inventory. A
journal entry is needed to reduce Merchandise Inventory
to $23,500.
DATE
1
2
3
4
5
6
7
8
9
10
11
DESCRIPTION
PR DEBIT CREDIT
Loss on Write-Down of Inventory
Merchandise Inventory
To recognize loss in value of
inventory held
500
500
Expense
4
Estimate the ending
inventory and cost of
goods sold by using
the gross profit and
retail inventory
methods.
•
Estimating inventory is not a problem for
businesses using the perpetual inventory method

•
Unverified amounts are generally reliable estimates
and can be used for ―interim‖ monthly or quarterly
financial statements
Businesses using the periodic inventory method
must use other methods to estimate ending
inventory and cost of goods sold

Two generally accepted methods:
o
o
Gross profit method
Retail inventory method
A business’s normal gross profit (net sales –
cost of goods sold) is used to estimate the cost
of goods sold and ending inventory.
3 STEPS
Example:
Inventory, start of period
Net purchases, first month
Net sales, first month
Normal gross profit as a percentage of
sales
$80,000
$70,000
$110,000
40%
Step #1: Compute the cost of goods available for sale.
Inventory, start of period
Net purchases, first month
Cost of goods avail. for sale
$80,000
70,000
$150,000
Example:
Inventory, start of period
Net purchases, first month
Net sales, first month
Normal gross profit as a percentage of
sales
$80,000
$70,000
$110,000
40%
Step #2: Estimate cost of goods sold by deducting the
normal gross profit from net sales.
Net sales
Normal gross profit
$110,000
44,000
$110,000 × 40%
Example:
Inventory, start of period
$80,000
Net purchases, first month
$70,000
Net sales, first month
$110,000
40%
Normal gross profit as a percentage of
sales
Step #2: Estimate cost of goods sold by deducting the
normal gross profit from net sales.
Net sales
Normal gross profit
Estimated cost of goods sold
$110,000
44,000
66,000
Example:
$80,000
Inventory, start of period
$70,000
Net purchases, first month
$110,000
Net sales, first month
40%
Normal gross profit as a percentage of
sales
Step #3: Estimate the ending inventory by deducting cost
of goods sold from the cost of goods available for sale.
Cost of goods available for sale
Estimated cost of goods sold
Estimated end-of-month inv.
$150,000
66,000
$ 84,000
Used by many retail businesses. Requires keeping
records of both the cost and selling (retail) prices of
all goods purchased.
5 STEPS
Step #1: Compute the cost of goods available for sale at
cost and retail.
Inventory, start of period
Net purchases during period
Goods available for sale
COST
RETAIL
$ 60,000
126,000
$186,000
$ 85,000
163,000
$248,000
Step #2: Compute the ending inventory at retail by
subtracting sales at retail from goods available for sale at
retail.
COST
$ 60,000
126,000
$186,000
Inventory, start of period
Net purchases during period
Goods available for sale
Less net sales for period
Inventory, end of period, at retail
RETAIL
$ 85,000
163,000
$248,000
180,000
$ 68,000
Step #3: Compute the cost-to-retail ratio by dividing the
cost of goods available for sale by the retail value of the
goods available for sale.
COST
$ 60,000
126,000
$186,000
Inventory, start of period
Net purchases during period
Goods available for sale
Less net sales for period
Inventory, end of period, at retail
Cost to Retail Ratio ($186,000 ÷ $248,000)
RETAIL
$ 85,000
163,000
$248,000
180,000
$ 68,000
75%
Step #4: Estimate the cost of the ending inventory by
multiplying the ending inventory at retail by the cost-toretail ratio.
Inventory, start of period
Net purchases during period
COST
$ 60,000
126,000
$186,000
Goods available for sale
Less net sales for period
Inventory, end of period, at retail
Cost to Retail Ratio ($186,000 ÷ $248,000)
Inventory, end of period,
at cost ($68,000 75%)
$(51,000)
RETAIL
$ 85,000
163,000
$248,000
180,000
$ 68,000
75%
Step #5: Estimate cost of goods sold by subtracting the
estimated ending inventory from the cost of goods
available for sale.
COST
RETAIL
Inventory, start of period
$ 60,000
$ 85,000
126,000
163,000
Net purchases during period
Goods available for sale
$186,000
$248,000
180,000
Less net sales for period
$ 68,000
Inventory, end of period, at retail
75%
Ratio ($186,000 ÷ $248,000)
Inventory, end of period,
at cost ($68,000 75%)
$(51,000)
Estimated cost of goods sold $135,000