Chapter
6-1

6
Chapter
6-2
Accounting Principles, Eighth Edition

1.
Describe the steps in determining inventory quantities.
2.
Explain the accounting for inventories and apply the inventory cost flow methods.
3.
Explain the financial effects of the inventory cost flow assumptions.
4.
Explain the lower-of-cost-or-market basis of accounting for inventories.
5.
Indicate the effects of inventory errors on the financial statements.
6.
Compute and interpret the inventory turnover ratio.
Chapter
6-3

Reporting and Analyzing Inventory
Classifying
Inventory
Finished goods
Work in process
Raw materials
Determining
Inventory
Quantities
Taking a physical inventory
Determining ownership of goods
Chapter
6-4
Inventory
Costing
Specific identification
Cost flow assumptions
Financial statement and tax effects
Consistent use
Lower-ofcost-ormarket
Inventory
Errors
Statement
Presentation and Analysis
Income statement effects
Balance sheet effects
Presentation
Analysis

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.

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
6-6
LO 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
6-7
LO 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
6-8
LO 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
6-9
Ownership of the goods remains with the seller until the goods reach the buyer.
LO 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
6-10
LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Consigned Goods
• In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods.
• These are called consigned goods.
Chapter
6-11
LO 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
6-12
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Chapter
6-13
Young & Crazy Company makes the following purchases:
1.
One item on 2/2/08 for $10
2.
3.
One item on 2/15/08 for $15
One item on 2/25/08 for $20
Young & Crazy Company sells one item on 2/28/08 for
$90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended
Feb. 28, 2008, assuming the company used the Specific
Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of
30%.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Inventory
Balance = $ 30
Young & Crazy Company
Income Statement
For the Month of Feb. 2008
Purchase on
2/25/08 for $20
Purchase on
2/15/08 for $15
Purchase on 2/2/08 for $10
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
$ 90
15
75
14
12
7
Total expenses 33
Income before tax 42
Taxes 13
Net Income $ 29
Chapter
6-14
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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
6-15
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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
6-16
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Young & Crazy Company makes the following purchases:
1.
2.
One item on 2/2/08 for $10
One item on 2/15/08 for $15
3.
One item on 2/25/08 for $20
Young & Crazy Company sells one item on 2/28/08 for
$90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended
Feb. 2008, assuming the company used the FIFO ,
LIFO , and Average-cost flow assumptions? Assume a tax rate of 30%.
Chapter
6-17
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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
6-18
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Inventory
Balance = $ 35
Young & Crazy Company
Income Statement
For the Month of Feb. 2008
Purchase on
2/25/08 for $20
Purchase on
2/15/08 for $15
Purchase on
2/2/08 for $10
Chapter
6-19
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
$ 90
10
80
14
12
7
Total expenses 33
Income before tax 47
Taxes 14
Net Income $ 33
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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
6-20
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Inventory
Balance = $ 25
Young & Crazy Company
Income Statement
For the Month of Feb. 2008
Purchase on
2/25/08 for $20
Purchase on
2/15/08 for $15
Chapter
6-21
Purchase on
2/2/08 for $10
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
$ 90
20
70
14
12
7
Total expenses 33
Income before tax 37
Taxes 11
Net Income $ 26
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

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
6-22
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Inventory
Balance = $ 30
Young & Crazy Company
Income Statement
For the Month of Feb. 2008
Purchase on
2/25/08 for $20
Purchase on
2/15/08 for $15
Chapter
6-23
Purchase on
2/2/08 for $10
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
$ 90
15
75
14
12
7
Total expenses 33
Income before tax 42
Taxes 13
Net Income $ 29
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
FIFO
Sales
Cost of goods sold
$90
10
Gross profit 80
Admin. & selling expense 33
Income before taxes
Income tax expense
Net income
47
14
$33
Average
$90
15
75
33
42
13
$29
LIFO
$90
20
70
33
37
11
$26
Chapter
6-24
Inventory balance $35 $30 $25
LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
Lowest
Highest
FIFO
Sales
Cost of goods sold
$90
10
Gross profit 80
Admin. & selling expense 33
Income before taxes
Income tax expense
Net income
47
14
$33
Average
$90
15
75
33
42
13
$29
LIFO
$90
20
70
33
37
11
$26
Chapter
6-25
Inventory balance $35 $30 $25
LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
Highest
Lowest
FIFO
Sales
Cost of goods sold
$90
10
Gross profit 80
Admin. & selling expense 33
Income before taxes
Income tax expense
Net income
47
14
$33
Average
$90
15
75
33
42
13
$29
LIFO
$90
20
70
33
37
11
$26
Chapter
6-26
Inventory balance $35 $30 $25
LO 3 Explain the financial effects 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
6-27
LO 3 Explain the financial effects 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
6-28
LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
Discussion Question
Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period,
Casey has been paying out all of its net income as dividends. What adverse effects may result from this policy?
Chapter
6-29
See notes page for discussion
LO 3 Explain the financial effects of the inventory cost flow assumptions.

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
6-30
LO 3 Explain the financial effects 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
6-31
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing
BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31.
Inventory
Categories
Cameras
Camcorders
VCRs
Cost
Data
$ 12,000
9,500
14,000
Market
Data
$ 12,100
9,700
12,800
Lower of
Cost or Market
$ 12,000
9,000
12,800
$ 33,800
Compute the lower-of-cost-or-market valuation for the company’s total inventory.
Chapter
6-32
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Errors
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
6-33
LO 5 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 6-16
Illustration 6-17
Chapter
6-34
LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Chapter
6-35
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.
LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Illustration 6-18
2008
Incorrect Correct
Sales
Beginning inventory
Cost of goods purchased
Cost of goods available
Ending inventory
Cost of good sold
Gross profit
Operating expenses
Net income
20,000
40,000
60,000
12,000
48,000
32,000
10,000
20,000
40,000
60,000
15,000
45,000
35,000
10,000
2009
Incorrect Correct
12,000
68,000
80,000
23,000
57,000
33,000
20,000
15,000
68,000
83,000
23,000
60,000
30,000
20,000
Combined income for
2-year period is correct.
Chapter
6-36
($3,000)
Net Income understated
$3,000
Net Income overstated
LO 5 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
6-37
LO 5 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 6-16
Illustration 6-19
Chapter
6-38
LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis
Chapter
6-39
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from sales.
There also should be disclosure of
1) major inventory classifications,
2)
3) basis of accounting (cost or LCM), and costing method (FIFO, LIFO, or average).
LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis
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
6-40
LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
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
6-41
Days in inventory measures the average number of days inventory is held.
Days in
Inventory
=
Days in Year (365)
Inventory Turnover
LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000.
Calculate inventory turnover and days in inventory for
J. Graff Company.
Inventory
Turnover
$270,000
($60,000 + 40,000) / 2
= 5.4
Chapter
6-42
Days in
Inventory
365
5.4
=
67.59 days
LO 6 Compute and interpret the inventory turnover ratio.

Inventory Cost Flow Methods in Perpetual Inventory
Systems
The following data from Houston Electronics will be used to illustrate inventory costing under a perpetual system.
Illustration 6A-1
Chapter
6-43
LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory
Systems
Computation of cost of goods sold and ending inventory under FIFO for Houston Electronics.
Illustration 6A-2
Cost of goods sold
Chapter
6-44
Ending inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory
Systems
Computation of cost of goods sold and ending inventory under LIFO for Houston Electronics.
Illustration 6A-3
Cost of goods sold
Chapter
6-45
Ending inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory
Systems
Computation of cost of goods sold and ending inventory under moving average for Houston Electronics.
Illustration 6A-4
Cost of goods sold Ending inventory
Chapter
6-46
LO 7 Apply the inventory cost flow methods to perpetual inventory records.

Chapter
6-47
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