CHAPTER 6 NOTES
Reporting and Analyzing Inventory
Steps in Determining Inventory Quantities
There are two different types of companies that have inventory. Merchandisers and
Manufacturers.
 In a merchandising company, inventory consists of many different items. These items have two
common characteristics: (1) They are owned by the company, and (2) they are in a form ready for
sale to customers. Only one inventory classification, __________ ________________, is needed
to describe the many different items that make up the total inventory.
 In a manufacturing company, some inventory may not yet be ready for sale. Inventory is usually
classified into three categories: _____________ ________ inventory—items that are completed
and ready for sale, _______ ___ __________—that portion of manufactured inventory that has
been placed into the production process but is not yet complete, and _____ _____________
inventory—the basic goods that will be used in production but have not yet been placed into
production.
o
By observing the levels and changes in the levels of these three inventory types,
financial statement users can gain insight into management’s ____________ plans.
No matter whether they are using a periodic or perpetual inventory system, all companies need to
determine inventory quantities at the end of the accounting period.
 If using a perpetual system, companies take a physical inventory at year-end for two purposes: to
check the __________ of their perpetual inventory records, and to determine the amount of inventory
______ due to wasted raw materials, shoplifting or employee theft.
 Companies using a periodic inventory system must take a physical inventory for two different
purposes: to determine the inventory on hand at the balance sheet date, and to determine the ______
__ ________ _________ for the period.
Determining inventory quantities involves two steps: (1) taking the __________ inventory of goods
on hand and (2) determining the _____________ of goods.
 Taking a physical inventory involves actually counting, weighing, or measuring each kind of
inventory on hand.
 To determine ownership of goods, two questions must be answered: Do all of the goods included in
the count belong to the company? Does the company own any goods that were not included in the
count?
 To arrive at an accurate count, ownership of goods in transit (on board a truck, train, ship, or plane)
must be determined. Goods in transit should be included in the inventory of the company that has
_____ ______ to the goods. Legal title is determined by the terms of the sale.
6-1
 When the terms are FOB (free on board) shipping point, ownership of the goods passes to the
buyer when the public carrier accepts the goods from the seller.
 When the terms are FOB destination, ownership of the goods remains with the seller until the goods
reach the buyer.
 In some lines of business, it is customary to hold the goods of other parties and try to sell the goods
for them for a fee, but without taking ownership of the goods. These are called consigned goods.
Consigned goods belong to the ________ and not the person who has physical custody of the
goods.
The Basis of Accounting for Inventories and Application of Inventory Cost Flow
Methods under a Periodic Inventory System
“Inventory Costing” means that _____ ______ are applied to quantities in order to determine total cost
of Cost of Goods Sold (COGS) and Ending Inventory. Determining ending inventory can be complicated
if the units on hand for a specific item of inventory have been purchased at _______ prices. Therefore,
there are a number of inventory costing methods:
 There is no accounting requirement that the cost flow assumption be ________ with the
physical movement of the goods.
 Specific identification is practical when a company can __________ __________ which particular
units were sold and which are still in ending inventory.
 When items are indistinguishable from one another, making it impossible or impractical to track each
item's cost, one of the three cost flow assumptions may be used:
 First-in, First-out (FIFO) method assumes that the __________ goods purchased are the first to
be sold. Under FIFO, the cost of the ending inventory is obtained by taking the unit cost of the
most ________ purchase and working backward until all units of inventory have been costed.
Example to illustrate FIFO- a Bicycle shop
Beginning inventory
-0Purchases:
6/2
500 @ $100 =
6/8
400 @ 125 =
6/25
350 @ 130 =
Goods available
1,250
Ending inventory
250 @ 130 =
Cost of goods sold 1,000
-0$ 50,000
50,000
45,500
$145,500
32,500
$113,000
6-2
When using FIFO, one assumes the first units in are the first units sold. You can prove the amount
calculated above with the following breakdown of which items were sold:
500 @ $100 =
400 @ 125 =
100 @ 130 =
$ 50,000
50,000
13,000
$113,000
Cost of goods sold

Last-in, First-out (LIFO) method assumes that the last goods purchased are the first to be sold.
LIFO ________ coincides with the actual physical flow of inventory. Under LIFO, the cost of
the ending inventory is obtained by taking the unit cost the __________ goods available for sale
and working forward until all units of inventory have been costed.
Example of using LIFO Cost assumptionBeginning inventory
-0Purchases:
6/2
500 @ $100 =
6/8
400 @ 125 =
6/25
350 @ 130 =
Goods available
1,250
Ending inventory
250 @ 100 =
Cost of goods sold 1,000
-0$ 50,000
50,000
45,500
$145,500
25,000
$120,500
When using LIFO, one assumes the last units in are the first units sold. Again, you can prove that
COGS should be $120,500 with the following breakdown:
350 @ $130 =
400 @ 125 =
250 @ 100 =
$ 45,500
50,000
25,000
$120,500
Cost of goods sold
(BE 6-2)

Average cost method assumes that the goods available for sale are homogeneous and allocates
the cost of goods available for sale on the basis of weighted average unit cost incurred. The
__________ ____________ unit cost is then applied to the units on hand to determine the cost
of the ending inventory.
Example of the average cost method- still using the bicycle shop illustration.
Goods available
500 @ $100 =
400 @ 125 =
350 @ 130 =
1,250
$ 50,000
50,000
45,500
$145,500
$145,5001,250=$116.40
6-3
per
unit
Beginning inventory
-0Purchases:
6/2
500 @ $100 =
6/8
400 @ 125 =
6/25
350 @ 130 =
Goods available
1,250
Ending inventory
250 @ 116.40 =
Cost of goods sold 1,000
-0$ 50,000
50,000
45,500
$145,500
29,100
$116,400
When using weighted-average, one assumes the units were homogeneous. Another way to find the
cost of the units sold is to multiply the number of units sold by the average cost.
Cost of goods sold
1,000 @ $116.40 =
$116,400
(BE 6-2, 6-3; Ex. 6-4)
Financial Statement and Tax Effects of Each of the Inventory Cost Flow
Assumptions
The reasons companies adopt different inventory cost flow methods are varied, but usually involve on the
three following factors:
 Income statement effects--In periods of increasing prices, FIFO reports the _______ net income,
LIFO the _________ net income and average cost falls in the middle. In periods of decreasing
prices, the opposite is true, FIFO will report the _______ net income, LIFO the _____, with
average cost in the middle.
 In a period of increasing prices, the use of _______ enables the company to avoid reporting paper or
phantom profit.
 Balance sheet effects--In a period of inflation, the costs allocated to ending inventory using FIFO
will approximate current costs. Conversely, During a period of increasing prices, the costs allocated
the ending inventory using LIFO will be significantly understated.
 Tax Effects--Both ___________ on the balance sheet and ____ _________ on the income statement
are higher when FIFO is used in a period of inflation. Many companies have switched to LIFO
because life yields the lowest net income and therefore, the lowest income tax liability in a period of
increasing prices.
 Consistency in cost flow methods is important for year-to-year comparisons. However, a company
can change its method; it just must disclose it in the notes to the financial statements
(BE 6-4, 6-5; P6-5A)
6-4
Lower of Cost or Market Basis of Accounting for Inventories
When the value of inventory is lower than its cost, the inventory is written down to its ______ _______
by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline
occurs. LCM is an example of the accounting concept of ____________________.
 Under the LCM basis, market is defined as ________ _________________ cost, not selling price.
 For a merchandising company, market is the cost of purchasing the same goods at the present
time from the usual suppliers in the usual quantities.
 The lower of cost or market basis may be applied to individual items of inventory, major
categories of inventory, or total inventory.
Compute and Interpret the Inventory Turnover Ratio
 Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The
ratio tells how many times the inventory is turning over during the year.
 Days in inventory, computed by dividing 365 days by the inventory turnover ratio, indicates
the average age of the inventory.
(BE 6-7)
LIFO Reserve and its Importance for Comparing Results of Different Companies
 Accounting standards require firms using LIFO to report the amount by which inventory would be
increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is
referred to as the _______ ___________. Reporting the LIFO reserve enables analysts to make
adjustments to compare companies that use different cost flow methods.
APPENDIX A: INVENTORY COST FLOW METHODS IN PERPETUAL
INVENTORY SYSTEMS
Recall: A company using the perpetual inventory system records _____ ___ ________ ______ at
the time of each sale.

FIFO- Under the FIFO cost flow assumption, the cost of the _________ goods on hand prior to
each sale is included in computing COGS. FIFO yields the ______ results under the perpetual
system as it does under the periodic system.

LIFO- Under this cost flow assumption, the cost of the most recent ________ prior to the sale are
used in computing COGS. LIFO yields _________ results under the perpetual system than it
does under the periodic system. This is primarily due to the _________ difference of when
COGS is computed. Under the periodic system COGS is figured at the end of the period, where
COGS under the perpetual system is figured at the time of each sale, using the most recent
purchase information.
6-5

Average Cost Method- Under the perpetual system, this is also known as the “_______
_________ method”. This method yields a different result under the perpetual system than the
periodic system because a ____ average is computed after every purchase. The new average is
applied to COGS and Ending Inventory.
(Ex 6-9)
APPENDIX B: EFFECTS OF INVENTORY ERRORS
Inventory errors affect the computation of both cost of goods sold (COGS) and ending inventory (EI)
of two accounting periods. (Because ending inventory of one period becomes the beginning inventory
of the next period.) If an inventory error goes uncorrected, combined income for the two accounting
periods would be correct.

Errors in Beginning Inventory or Ending Inventory affect both the income statement and the
balance sheet. An error in ending inventory of the current period will have a reverse effect on
net income of the next accounting period.
INCOME STATEMENT:
Type of Error
Cost of Goods Sold
Net Income
Beg. Inventory is understated
Beg. Inventory is overstated
Understated
Overstated
Overstated
Understated
End. Inventory is understated
End. Inventory is overstated
Overstated
Understated
Understated
Overstated
BALANCE SHEET:
Type of Error
Assets
Liabilities
Stockholders’ Equity
End. Inventory is overstated
End. Inventory is understated
Overstated
Understated
No effect
No Effect
Overstated
Understated
(Ex. 6-11)
6-6