Advanced Accounting
Chapter 6: Inventory Planning and Valuation
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For most merchandising companies, merchandise inventory is the
largest asset
To be successful, must keep enough inventory on hand to meet the
customers’ needs but not too much to tie up money in inventory
Often use computer systems to track inventory – provide an easier
method of providing info to managers to allow them to make effective
buying decisions
Section 1: The Nature of Merchandise Inventory
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The cost of merchandise available for sale consists of:
o The cost of the beginning inventory
o The cost of the net purchases added to the inventory during
the fiscal period
At the end of the fiscal period, cost of merchandise available for
sale is divided into
o The cost of the ending inventory – it is a current asses that
will be charged as costs in future fiscal periods
o The cost of the merchandise sold during the current fiscal
period – the cost affects the amount of net income reported
for this fiscal period
Effects of Errors in Costing an Inventory
Reports and Items Affected
If Inventory is
Understated
Overstated
Income Statement:
Cost of Merchandise Sold
Overstated
Gross Profit
Understated
Net Income
Understated
Statement of Stockholder’s Equity:
Net Income
Understated
Retained Earnings
Understated
Stockholder’s Equity
Understated
Balance Sheet:
Merchandise Inventory
Understated
Total Assets
Understated
Stockholder’s Equity
Understated
Understated
Overstated
Overstated
Overstated
Overstated
Overstated
Overstated
Overstated
Overstated
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Items in the inventory are often referred to as goods
Cost of the goods includes
o Price paid to vendors for the merchandise
o Cost involved in getting the goods to the place of business
and ready for sale
Two methods of figuring inventory
o Physical inventory – actually counting – snapshot in time
o Continuous or perpetual inventory – show number of items
purchased and sold – can figure relatively accurately at any
time
Goods in transit – on the way from the distributor to the business,
who does it belong to?
o FOB shipping point: free on board shipping means that the
buyer pays for transportation charges and the title passes to
the buyer as soon as vendor delivers to transportation
service, goods considered part of business’s inventory
o FOB destination: means that the vendor pays transportation
charges, title passes when reach the business, considered
part of vendor inventory
Goods on Consignment
o Consignee agrees to receive, care for, and attempt to sell
the consigned goods
o If goods are sold, consignee takes a commission and gives
rest on money to consignor
o Title does NOT pass to the consignee
o Part of consignor’s inventory
o Consignee has implied liability if anything happens to the
goods before they are sold
For each inventory item, the record shows the number on hand,
the number purchases, and the number sold
Stock record shows purchases and sales and current balance on
hand
Stock ledger is where all the stock records are kept
Purchase order is a form authorizing a seller to deliver goods with
payment to be made later
Unit prices are not recorded on the stock records – just purchases
and sales
Periodic inventory is the type where actually count, weigh, or
measure the goods – usually only take inventory once each fiscal
period
Even if use perpetual inventory often take a physical inventory once
a year to check the accuracy
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Periodic inventory info is recorded on an inventory records – unit
prices are recorded here
Section 2: Inventory Costing
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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
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
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
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Add the LIFO costs of all entries to determine the LIFO cost
of total # of units in ending inventory
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
weighted-average price per unit by the units in ending
inventory
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
During a period of increasing prices, FIFO usually results in the lowest
cost of merchandise sold
During a period of decreasing prices, LIFO usually results in the lowest
cost of merchandise sold
Lower of Cost or Market Inventory Costing Method
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Market refers to the current replacement cost of the merchandise
item
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IF the unit price is higher than the market price at the end of a
fiscal period, the inventory cost is reduced to the current market
price.
If the unit price is lower than the market price, the inventory cost is
maintained at the unit price
Two amounts are needed to apply the lower of cost or market
method:
o The cost of inventory using FIFO, LIFO or weighted average
o The current market price of the inventory
The two amounts are then compared, and the lower of the two is
used to cost the inventory.
Section 3: Estimating the Inventory
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A business that keeps periodic inventory records and prepares
monthly interim financial statements needs a cost to use for
monthly ending merchandise inventory
So can estimate the monthly ending inventory
Estimating inventory by using the previous years’ percentage of
gross profit on operations is the gross profit method of estimating
inventory
o This assumes that a continuing relationship exists between
gross profit and net sales
Retail Method of Estimating Inventory
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Retail Method of estimating inventory: estimating inventory by
using a percentage based on both cost and retail prices
Must keep separate records of both cost and retail prices for net
purchases, net sales and beginning merchandise inventory
Steps:
Record the Jan. 1 beginning inventory at cost from the
merchandise inventory account in the general ledger
Enter the beginning inventory at retail which is obtained
from the separate record or retail prices
Enter net purchases to date at cost (subtract purchases
discounts and purchases returns and allowances from
purchases)
Enter net purchases to date at retail, from the retail records
Calculate merchandise available for sale at cost and at retail
by adding lines 1 and 2
Record net sales to date at retail
Record net sales to date at cost (subtract sales discounts
and sales returns and allowances from sale)
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Calculate estimated ending inventory at retail by subtracting
line 4 from line 3
Determine estimated ending inventory at cost by multiplying
line 5 by the percentage that is figured by (merchandise
available for sale at cost / merchandise available for sale at
retail)
Many businesses use the gross profit method because do not have
to keep separate records for cost and retail prices
Merchandise Inventory Turnover
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The more rapidly a business sells merchandise, the more change it
has to make a satisfactory net income
Two measurements: merchandise inventory turnover rate and the
average number of days’ sales in merchandise inventory
Merchandise Inventory Turnover Ratio
Jan. 1 MI + Dec. 31 MI / 2 = Average Merchandise Inventory
Cost of Merchandise Sold / Average Merchandise Inventory =
Merchandise Inventory Turnover Ratio
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A low merchandise inventory turnover ratio usually indicates a low
return on investment
Average Number of Days’ Sales in Merchandise Inventory
Day in Year / Merchandise Inventory Turnover Ratio = Average
Number of Days’ Sales in Merchandise Inventory
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Rounded to the nearest day
The higher the number of days in merchandise inventory, the
longer merchandise tends to remain unsold.
A business can reduce the MITR and the # of days by reducing the
size of inventory kept on hand. Can also increase the amount of
merchandise sold during a month or year.