7
Inventories
7-1
Inventories
After studying this chapter, you should be able to:
7-2
1
Describe the importance of control over
inventories.
2
Describe three inventory cost flow
assumptions and how they impact the
income statement and balance sheet.
3
Determine the cost of inventory under the
perpetual inventory system, using the
FIFO, LIFO, and average cost methods.
Inventories (continued)
Describe the cost of inventory under the
4
After studying this chapter, you should be able to:
periodic inventory system, using the
FIFO, LIFO, and average cost methods.
7-3
5
Compare and contrast the use of the
three inventory costing methods.
6
Describe and illustrate the reporting of
merchandise inventory in the financial
statements.
1
Describe the
importance of control
over inventory.
7-4
1
Two primary objectives of
control over inventory are:
1. Safeguarding the inventory,
and
2. Properly reporting it in the
financial statements.
7-5
1
• The purchase order authorizes the
purchase of the inventory from an
approved vendor.
• The receiving report establishes an
initial record of the receipt of the
inventory.
• The amount of inventory is always
available in the subsidiary inventory
ledger.
7-6
1
Controls for safeguarding inventory
should include security measures to
prevent damage and customer or
employee theft. Some examples of
security measures include the
following:
1. Storing inventory in areas that are
restricted to only authorized
employees.
7-7
1
2. Locking high-priced inventory
in cabinets.
3. Using two-way mirrors, cameras,
security tags, and guards.
7-8
1
A physical inventory or count
of inventory should be taken
near year-end to make sure
that the quantity of inventory
reported in the financial
statements is accurate.
7-9
2
Describe the three inventory
cost flow assumptions and
how they impact the income
statement and balance
sheet.
7-10
7-10
2
Inventory Costing Methods
7-11
2
May 10 Purchase
18 Purchase
24 Purchase
Total
1
1
1
3
$ 9
13
14
$36
Average cost per unit $12 ($36 ÷ 3 units)
7-12
2
Assume that one unit is sold on May 30 for $20.
Depending upon which unit was sold, the gross profit
varies from $11 to $6 as shown below:
7-13
2
Under the specific identification
inventory cost flow method, the
unit sold is identified with a
specific purchase.
Not practical unless each inventory
unit can be separately identified.
7-14
2
Under the first-in, first out (FIFO)
inventory cost flow method, the
first units purchased are assumed to
be sold and the ending inventory is
made up of the most recent
purchases.
7-15
2
Under the last-in, first out (LIFO)
inventory cost flow method, the
last units purchased are assumed
to be sold first and the ending
inventory is made up of the first
units purchased.
7-16
2
Under the average inventory cost
flow method, the cost of the units
sold and in ending inventory is an
average of the purchase costs.
7-17
2
Exhibit 1
Effect of Inventory Costing Methods
on Financial Statements
FIFO Method
Income Statement
Sales
$20
Cost of merchandise sold
9
Gross profit
$11
7-18
(continued)
2
Exhibit 1
Effect of Inventory Costing Methods
on Financial Statements (continued)
LIFO Method
Income Statement
Sales
$20
Cost of merchandise sold
14
Gross profit
$ 6
7-19
(continued)
2
Exhibit 1
Effect of Inventory Costing Methods
on Financial Statements (continued)
Average Cost
Method
Income Statement
Sales
$20
Cost of merchandise sold
12
Gross profit
$ 8
$36 ÷ 3 = $12
$12 × 2 = $24
7-20
2
Exhibit 2
7-21
Inventory Costing Methods*
*Firms may be counted more than once for using multiple methods
2
Example Exercise 7-1
Cost Flow Methods
The three identical units of Item QBM are purchased during
February, as shown below.
Item QBM
Units
Cost
Feb. 8
15
26
Purchase
Purchase
Purchase
Total
Average cost per unit
1
1
1
$ 45
48
51
3
$144
$48 ($144 ÷ 3 units)
Assume that one unit is sold on February 27 for $70.
Determine the gross profit for February and ending inventory
on February 28 using (a) first-in, first-out (FIFO); (b) last-in,
first-out (LIFO); and (c) average cost methods.
7-22
7-22
Example Exercise 7-1 (continued)
2
Follow My Example 7-1
Gross Profit
Ending Inventory
(a) First-in, first-out (FIFO): $25 ($70 – $45)
$99 ($48 + $51)
(b) Last-in, first-out (LIFO):
$19 ($70 – $51)
$93 ($45 + $48)
(c) Average cost:
$22 ($70 – $48)
$96 ($48 × 2)
For Practice: PE 7-1A, PE 7-1B
7-23
7-23
3
Determine the cost of
inventory under the
perpetual inventory system,
using the FIFO, LIFO, and
average cost methods.
7-24
3
First-In, First-Out Method
On January 1, the firm had 100 units
of Item 127B that cost $20 per unit.
Item 127B
Jan.
7-25
1
Inventory
Units
Cost
100
$20
3
First-In, First-Out Method
On January 4, the firm sold 70 units
of 127B at $30 each.
Item 127B
Jan.
7-26
1
4
Inventory
Sale
Units
Cost
100
70
$20
3
Exhibit 3
7-27
Entries and Perpetual Inventory Account (FIFO)
3
First-In, First-Out Method
On January 10, the firm purchased
80 units at $21 each.
Item 127B
Jan.
7-28
1
4
10
Inventory
Sale
Purchase
Units
Cost
100
70
80
$20
21
3
Exhibit 3
Entries and Perpetual Inventory
Account (FIFO) (continued)
10 Merchandise Inventory
Accounts Payable
Date
Jan. 1
7-29
1,680
1,680
3
First-In, First-Out Method
On January 22, the firm sold 40 units
for $30 each.
Item 127B
Jan.
7-30
1
4
10
22
Inventory
Sale
Purchase
Sale
Units
Cost
100
70
80
40
$20
21
3
Exhibit 3
Date
Jan. 1
7-31
Entries and Perpetual Inventory
Account (FIFO) (continued)
3
First-In, First-Out Method
On January 28, the firm sold 20
units at $30 each.
Item 127B
Jan.
7-32
1
4
10
22
28
Inventory
Sale
Purchase
Sale
Sale
Units
Cost
100
70
80
40
20
$20
21
3
Exhibit 3
Date
Jan. 1
7-33
Entries and Perpetual Inventory
Account (FIFO) (continued)
3
First-In, First-Out Method
On January 30, purchased one hundred
additional units of Item 127B at $22 each.
Item 127B
Jan.
7-34
1
4
10
22
28
30
Inventory
Sale
Purchase
Sale
Sale
Purchase
Units
Cost
100
70
80
40
20
100
$20
21
22
3
Exhibit 3
7-35
Entries and Perpetual Inventory
Account (FIFO) (continued)
3
Exhibit 3
Entries and Perpetual Inventory
Account (FIFO) (concluded)
Cost of
merchandise sold
7-36
January 31
inventory
3
Example Exercise 7-2
Perpetual Inventory Using FIFO
Beginning inventory, purchases, and sales for Item ER27
are as follows:
Nov. 1 Inventory 40 units at $5
5 Sale
32 units
11 Purchase 60 units at $7
21 Sale
45 units
Assuming a perpetual inventory system and the first-in,
first-out (FIFO) method, determine (a) the cost of the
merchandise sold for the November 21 sale and (b) the
inventory on November 30.
7-37
7-37
Example Exercise 7-2 (continued)
3
Follow My Example 7-2
a) Cost of merchandise sold (November 21):
8 units @ $5
$40
37 units @ $7
259
45 units
$299
b) Inventory, November 30:
$161 = (23 units × $7)
For Practice: PE 7-2A, PE 7-2B
7-38
7-38
3
Last-In, First-Out Method
On January 1, the firm had 100 units
of Item 127B that cost $20 per unit.
Item 127B
Jan.
7-39
1
Inventory
Units
Cost
100
$20
3
Last-In, First-Out Method
On January 4, the firm sold 70 units
of 127B at $30 each.
Item 127B
Jan.
7-40
1
4
Inventory
Sale
Units
Cost
100
70
$20
3
Exhibit 4
7-41
Entries and Perpetual Inventory Account (LIFO)
3
Last-In, First-Out Method
On January 10, the firm purchased
80 units at $21 each.
Item 127B
Jan.
7-42
1
4
10
Inventory
Sale
Purchase
Units
Cost
100
70
80
$20
21
3
Exhibit 4
Entries and Perpetual Inventory
Account (LIFO) (continued)
10 Merchandise Inventory
Accounts Payable
Date
Jan. 1
4
7-43
1,680
1,680
3
Last-In, First-Out Method
On January 22, the firm sold 40 units
for $30 each.
Item 127B
Jan.
7-44
1
4
10
22
Inventory
Sale
Purchase
Sale
Units
Cost
100
70
80
40
$20
21
3
Exhibit 4
Date
Jan. 1
4
7-45
Entries and Perpetual Inventory
Account (LIFO) (continued)
3
Last-In, First-Out Method
On January 28, the firm sold 20
units at $30 each.
Item 127B
Jan.
7-46
1
4
10
22
28
Inventory
Sale
Purchase
Sale
Sale
Units
Cost
100
70
80
40
20
$20
21
3
Exhibit 4
Date
Jan. 1
4
7-47
Entries and Perpetual Inventory
Account (LIFO) (continued)
3
Last-In, First-Out Method
On January 30, the firm purchased one hundred
additional units of Item 127B at $22 each.
Item 127B
Jan.
7-48
1
4
10
22
28
30
Inventory
Sale
Purchase
Sale
Sale
Purchase
Units
Cost
100
70
80
40
20
100
$20
21
22
3
Exhibit 4
Date
Jan. 1
4
10
7-49
Entries and Perpetual Inventory
Account (LIFO) (continued)
3
Exhibit 4
Entries and Perpetual Inventory
Account (LIFO) (concluded)
Cost of
Merchandise
Sold
7-50
January 31
Inventory
3
Example Exercise 7-3
Perpetual Inventory Using LIFO
Beginning inventory, purchases, and sales for Item
ER27 are as follows:
Nov. 1
5
11
21
Inventory
Sale
Purchase
Sale
40 units at $5
32 units
60 units at $7
45 units
Assuming a perpetual inventory system and the last-in,
first-out (LIFO) method, determine (a) the cost of the
merchandise sold for the November 21 sale and (b) the
inventory on November 30.
7-51
7-51
Example Exercise 7-3 (continued)
3
Follow My Example 7-3
a) Cost of merchandise sold:
$315 = (45 units × $7)
b) Inventory, November 30:
8 units @ $5
15 units @ $7
23
$ 40
105
$145
For Practice: PE 7-3A, PE 7-3B
7-52
7-52
3
Moving Average
When the average cost is used in a
perpetual system, an average unit cost for
each item is computed each time a purchase
is made. The unit cost is then used to
determine the cost of each sale until another
purchase is made and a new average is
computed. This averaging technique is
called a moving average.
7-53
4
Determine the cost of
inventory under the periodic
inventory system, using the
FIFO, LIFO, and average cost
methods.
7-54
4
First-In, First-Out Method
Using FIFO, the earliest
batch purchased is considered
the first batch of merchandise
sold. The physical flow does
not have to match the
accounting method chosen.
7-55
4
FIFO Method
Jan. 1
100 units @ $20
= $2,000
Jan. 10
80 units @ $21
=
1,680
Jan. 30
100 units @ $22
=
2,200
280 units available for
sale during year
$5,880
Cost of merchandise
available for sale
7-56
4
The physical count on January 31 shows that 150
units are on hand (conclusion: 130 units were
sold). What is the cost of the ending inventory?
Jan. 1
100Sold
unitsthese
@ $20
Sold 30 of the 80
=
$
0
Jan. 10
80 units @ $21
50 units @ $21
=
1,050
Jan. 30
100 units @ $22
=
2,200
Ending inventory
7-57
$3,250
4
Now we can calculate the cost of goods sold as
follows:
Beginning inventory, January 1 (Slide 55)
Purchases ($1,680 + $2,200)
Cost of merchandise available for sale
Ending inventory, January 31(Slide 56)
Cost of merchandise sold
7-58
$2,000
3,880
$5,880
3,250
$2,630
4
Exhibit 5
7-59
First-In, First-Out Flow of Costs
4
Last-In, First-Out Method
Using LIFO, the most recent batch
purchased is considered the first batch of
merchandise sold. The actual flow of goods
does not have to be LIFO. For example, a
store selling fresh fish would want to sell the
oldest fish first (which is FIFO) even though
LIFO is used for accounting purposes.
7-60
4
LIFO Method
Jan. 1
100 units @ $20
=
$2,000
Jan. 10
80 units @ $21
=
1,680
Jan. 30
100 units @ $22
=
2,200
280 units available for
sale during year
$5,880
Cost of merchandise
available for sale
7-61
4
Assume again that the physical count on January
31 is 150 units (and that 130 units were sold).
What is the cost of the ending inventory?
Jan. 1
100 units @ $20
=
$2,000
Jan. 10
50 units @ $21
80 units @ $21
==
1,1,050
680
==
2,2000
$3,050
Sold 30 of the 80
Jan. 30
100Sold
unitsthese
@ $22
Ending inventory
7-62
4
Now we can calculate the cost of goods sold as
follows:
Beginning inventory, January 1 (Slide 60)
Purchases ($1,680 + $2,200)
Cost of merchandise available for sale
Ending inventory, January 31(Slide 61)
Cost of merchandise sold
7-63
$2,000
3,880
$5,880
3,050
$2,830
4
Exhibit 5
7-64
Last-In, First-Out Flow of Costs
4
Average Cost Method
The average cost method is
sometimes called the weighted
average method. It uses the
average unit cost for determining
cost of merchandise sold and the
ending merchandise inventory.
7-65
4
The weighted average unit cost is
determined as follows:
Total Cost of Units
Available for Sale
Average Unit Cost =
Units Available for Sale
7-66
4
Jan. 1
100 units @ $20
=
$2,000
Jan. 10
80 units @ $21
=
1,680
Jan. 30
100 units @ $22
=
2,200
280
$5,880
Average unit cost: $5,880 ÷ 280 = $21
Cost of merchandise sold: 130 units at $21 = $2,730
Ending merchandise inventory: 150 units at $21= $3,150
7-67
4
Now we can calculate the cost of goods
sold as follows:
Beginning inventory, January 1 (Slide 66) $2,000
Purchases ($1,680 + $2,200)
3,880
Cost of merchandise available for sale
$5,880
Ending inventory, January 31(Slide 66)
3,150
Cost of merchandise sold
$2,730
7-68
4
Example Exercise 7-4
Periodic Inventory Using FIFO, LIFO, Average Cost Methods
The units of an item available for sale during the year were as
follows:
Jan.
1
Inventory
Mar. 20Purchase
Oct. 30
Purchase
Available for sale
6 units @ $50
14 units @ $55
20 units @ $62
40 units
$ 300
770
1,240
$2,310
There are 16 units of the item in the physical inventory at
December 31. The periodic inventory system is used.
Determine the inventory cost by (a) the first-in, first-out (FIFO)
method, (b) the last-in, first-out (LIFO) method, and (c) the
average cost method.
7-69
7-69
Example Exercise 7-4 (continued)
4
Follow My Example 7-4
a) First-in, first-out (FIFO) method: $992 (16 units ×
$62)
b) Last-in, first-out (LIFO) method: $850 (6 units ×
$50) + (10 units × $55)
c) Average method: $924 (16 units × $57.75)
where average cost = $57.75 ($2,310 ÷ 40
units)
For Practice: PE 7-4A, PE 7-4B
7-70
7-70
5
Compare and contrast
the use of the three
inventory costing
methods.
7-71
5
Partial Income Statements
First-In, First-Out
Net sales
$3,900
Cost of merchandise sold:
Beginning inventory
$2,000
Purchases
3,880
Merchandise available for sale $5,880
Less ending inventory
3,250
Cost of merchandise sold
2,630
Gross profit
$1,270
7-72
5
Partial Income Statements
Average Cost
Net sales
$3,900
Cost of merchandise sold:
Beginning inventory
$2,000
Purchases
3,880
Merchandise available for sale $5,880
Less ending inventory
3,150
Cost of merchandise sold
2,730
Gross profit
$1,170
7-73
5
Partial Income Statements
Last-In, First-Out
Net sales
$3,900
Cost of merchandise sold:
Beginning inventory
$2,000
Purchases
3,880
Merchandise available for sale $5,880
Less ending inventory
3,050
Cost of merchandise sold
2,830
Gross profit
$1,070
7-74
5
Exhibit 7
7-75
Effects of Changing Costs (Prices):
FIFO and LIFO Cost Methods
5
Recap
Weighted
FIFO Average
LIFO
Ending inventory
$3,250 $3,150 $3,050
Cost of merchandise sold
$2,630 $2,730 $2,830
Gross profit
$1,270 $1,170 $1,070
7-76
6
Describe and illustrate the
reporting of merchandise
inventory in the financial
statements.
7-77
6
Cost
Cost is the primary basis for
valuing and reporting inventories
in the financial statements.
However, inventory may be
valued at other than cost in the
following cases:
(continued)
7-78
6
1. The cost of replacing items in
inventory is below the recorded cost.
2. The inventory cannot be sold at
normal prices due to imperfections,
style changes, or other causes.
7-79
6
Market
Market, as used in lower of
cost or market, is the cost to
replace the merchandise on
the inventory date.
7-80
6
Cost and replacement cost can be
determined for the following:
1. Each item in the inventory.
2. Each major class or category of
inventory.
3. Total inventory as a whole.
7-81
6
Exhibit 8
7-82
Determining Inventory at
Lower of Cost or Market
6
Example Exercise 7-5
Lower-of-Cost-or-Market Method
On the basis of the following data, determine the value
of the inventory at the lower of cost or market. Apply
lower of cost or market to each inventory item as
shown in Exhibit 8.
Inventory
Commodity Quantity
C17Y
B563
7-83
7-83
10
7
Unit
Cost Price
$ 39
110
Unit
Market Price
$40
98
Example Exercise 7-5 (continued)
6
Follow My Example 7-5
For Practice: PE 7-5A, PE 7-5B
7-84
7-84
6
Net Realizable Value
Merchandise that is out of date,
spoiled, or damaged should be written
down to its net realizable value. This
is the estimated selling price less any
direct cost of disposal, such as sales
commissions.
7-85
6
Merchandise Inventory
on the Balance Sheet
Merchandise inventory is usually
presented in the Current Assets
section of the balance sheet,
following receivables.
7-86
6
Merchandise Inventory
on the Balance Sheet
The method of determining the
cost of inventory (FIFO, LIFO,
or weighted average) and the
method of valuing the inventory
(cost or the lower of cost or
market) should be shown.
7-87
6
7-88
6
Effect of Inventory Errors on
the Financial Statements
Some reasons causing inventory errors to
occur include the following:
1. Physical inventory on hand was miscounted.
2. Costs were incorrectly assigned to
inventory.
3. Inventory in transit was incorrectly
included or excluded from inventory.
4. Consigned inventory was incorrectly
included or excluded from inventory.
7-89
6
Exhibit 9
7-90
Effect of Inventory Errors on Current
Period’s Income Statement
6
7-91
Exhibit 10
Effect of Inventory Errors on Two
Years’ Income Statements
6
Exhibit 11
7-92
Effect of Inventory Errors on
Current Period’s Balance Sheet
6
Example Exercise 7-6
Effect of Inventory Errors
Zula Repair Shop incorrectly counted its
December 31, 2010 inventory as $250,000
instead of the correct amount of $220,000.
Indicate the effect of the misstatement on
Zula’s December 31, 2010 balance sheet and
income statement for the year ended December
31, 2010.
7-93
7-93
Example Exercise 7-6 (continued)
6
Follow My Example 7-6
Amount of Misstatement
Overstatement (Understatement)
Balance Sheet:
Merchandise inventory overstated
Current assets overstated
Total assets overstated
Owner’s equity overstated
Income Statement:
Cost of merchandise sold understated
Gross profit overstated
Net income overstated
$30,000
30,000
30,000
30,000
$(30,000)
30,000
30,000
For Practice: PE 7-6A, PE 7-6B
7-94
7-94
Appendix:
Estimating Inventory
Cost
7-95
Exhibit 12
7-96
Determining Inventory by the Retail Method
Exhibit 13
7-97
Estimating Inventory by
the Gross Profit Method
7-98