Accounting
Chapter 22
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Merchandise inventory on hand is typically the largest asset of a
merchandising business
Cost of Merchandise inventory is reported on both the balance sheet and
income statement
The accuracy of the inventory cost will also assure that gross profit and
net income are reported correctly on the income statement
Section 1
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A merchandise inventory that is larger than needed may decrease net
income
Requires expensive store and warehouse space/storage
Uses capital that could be invested in other assets to earn a profit
Requires a business to spend money for expenses (taxes, insurance
premiums) that increase with the cost of merchandise inventory
Excess inventory may become obsolete and unsaleable
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Merchandise inventory that’s smaller than needed also decreases net
income:
Sales may be lost to competitors of items not hand
Sales may be lost to competitors if there is insufficient variety of
merchandise to satisfy customers
When small quantities are frequently ordered, the price per unit is higher
than if ordered in large quantities
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Quantity of item in inventory at the end of a fiscal period must be
determined to calculate the cost of merchandise sold.
o Periodic (Physical) Inventory: determined by counting, weighing, or
measuring items of merchandise on hand
o Perpetual (Book) Inventory: determined by keeping a continuous
record of increases, decreases, and balance on hand. Still will do a
physical inventory at end of fiscal period
Computers are most often used to keep track of inventory
Also need to know the ideal quantity of each item to keep on hand –
create the ideal minimum quantity and ideal reorder quantity
Inventory Record: a form used during a periodic inventory to record
information about each item of merchandise on hand.
Space to record the stock number, description, number of units on
hand, unit price, and total cost of each item
o Columns 1-3 are completed when business taking inventory
o Columns 4-5 are completed after take inventory
Businesses frequently established their fiscal period to end when inventory
is at a minimum because it takes less time and money to conduct the
inventory
Preparing an Inventory Record
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Write stock number and description before periodic inventory starts
Write the actual count in the No. of Units on Hand column
Write the unit price and calculate the total cost after the physical
inventory is completed – usually done by the accounting department
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Stock Record: a form used to show the kind of merchandise, quantity
received, quantity sold, and balance on hand.
o A separate stock record is prepared for each kind of merchandise
on hand
Stock Ledger: a file of stock records for all merchandise on hand
Perpetual inventory system provides day-to-day information about the
quantity of merchandise on hand
Minimum balance allowed is also listed on stock record and when reach
that reorder the amount listed
Purchase Information is recorded in the Increases column when
merchandise received
Sales Information is recorded in the Decreases column
New balance on hand is recorded after each purchase and sale
Perpetual records can have errors – they are corrected/adjusted when the
yearly physical inventory is taken
Perpetual inventory can be aided by Universal Product Codes (UPC)
Section 2
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Costs are not recorded on inventory records at the time a periodic
inventory is taken
After the quantities of merchandise on hand are counted, purchase
invoices are used to find merchandise unit prices
Total costs are then calculated using the quantities and unit prices
recorded on inventory records
Three Inventory Costing Methods
First-in, First-out (FIFO)
Last-in, First-out (LIFO)
Weighted-Average
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First-in, First-out inventory costing method: using the price of
merchandise purchased first to calculate the cost of merchandise sold first
Costing inventory using the FIFO method
Enter the total # of units on hand
From the most recent purchase, enter the # of units purchased – this #
may be larger or equal to the amount on hand, if so just enter the #
on hand and skip step 3
From the next most recent purchase, enter the # needed for FIFO units to
equal the # on hand – repeat until all total units on hand are
accounted for
Multiply the unit price of each appropriate purchases times the FIFO units
on hand to figure FIFO cost
Add the individual FIFO costs to determine the FIFO cost of the total # of
units in ending inventory
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Last-in, First-out inventory costing method: using the price of
merchandise purchased last to calculate the cost of merchandise sold first
– based on the idea that the most recent costs of merchandise should be
charged against current revenue
o Each item on the inventory records is recorded at the earliest prices
paid for the merchandise
Costing inventory using the LIFO method
Enter the total number of units on hand
Enter the # of units in beginning inventory. In some cases the # of units
of beginning inventory will be greater or equal to total # of units on
hand. In that case, enter the total # of units on hand and do not
complete Step 3
Then continue with the next latest until all LIFO units are accounted for
Multiply the unit price of beginning inventory times LIFO units on hand
and repeat as necessary
Add the LIFO costs of all entries to determine the LIFO cost of total # of
units in ending inventory
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In the LIFO method, the latest purchases are assumed to be sold first –
ending inventory consists of the units purchased the earliest and the
earliest purchase invoice costs are used to value the ending inventory
Latest = most recent and Earliest = furthest back
Weighted-average inventory costing method: using the average cost of
beginning inventory plus merchandise purchased during a fiscal period to
calculate the cost of merchandise sold.
Costing Inventory using the weighted-average method
Calculate the total cost of beginning inventory and each purchase by
multiplying the units by each unit price
Calculate the weighted-average price per unit by dividing total cost by the
# of units available
Calculate the cost of ending inventory by multiplying the weightedaverage price per unit by the units in ending inventory
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Cost of ending inventory determined using any of the three inventory
costing methods can be used to calculate the cost of merchandise sold
In period of rising prices
Net Income
FIFO
LIFO
Highest Lowest
Weighted-Average
Intermediate
Ending Inventory Cost Highest Lowest Intermediate
Cost of Merchandise
Lowest Highest Intermediate
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In period of declining prices FIFO and LIFO switch
Same inventory costing method should be used each fiscal period – all
three are acceptable – just need to be consistent in which one you use
Section 3
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Gross Profit Method of Estimating Inventory: estimating inventory by
using the previous year’s percentage of gross profit on operations
Often used to estimate the cost of ending inventory reported on the
monthly financial statements
It is less expensive than taking physical inventory or maintaining a
perpetual inventory system
STEP 1
Beginning Inventory, January 1 (prior period’s financial
statements)
Plus
Net purchases for January 1 to January 30 (general ledger)
Equals
Cost of Merchandise avaible for sale
STEP 2
Net Sales for January 1 to January 30 (general ledger)
Times
Previous year’s gross profit percentage (management)
Equals
Estimated Gross Profit on Operations
STEP 3
Net Sales for January 1 to January 30
Less
Estimated gross profit on operations
Equals
Estimated cost of merchandise sold
STEP 4
Cost of Merchandise Available for Sale
Less
Estimated cost of merchandise sold
Equals
Estimated Ending Merchandise Inventory
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When the gross profit method of estimating inventory is used for months
other than the first month of a fiscal period, the process is that same with
adjustments
Net Sales and purchases amounts – the previous month’s ending balance
is subtracted from the current month’s ending balance to calculate
sales/purchases for that month
Beginning Inventory is the previous month’s ending inventory – both are
estimated amounts