1
Chapter 6
Inventories
2
Learning objectives
1. Define and identify the items included in inventory
at the reporting date
2. Determine the costs to be included in the value of
inventory
3. Describe the four inventory costing methods and
identify the three inventory costing methods that
are based on cost flow assumptions
4. Determine the cost of goods sold and ending
inventory under the perpetual inventory system
for each of the four inventory costing methods
3
Learning objectives
5. Compare the financial statement effects of the
three inventory cost flow assumptions
6. Explain the characteristics of each inventory
costing method
7. Record returns of merchandise using inventory
cards for each of the three inventory cost flow
assumptions (perpetual inventory)
8. Explain the lower of cost or market (LCM) rule
9. Explain the effect of inventory errors on the
financial statements
4
Learning objective 1
Define and identify the items
included in inventory at
the reporting date
5
Defining inventory
▪ Inventory can represent a significant item in the
financial statements
▪ Inventory can differ between business types and
can include:
Business Type
Type of inventory held
Retailer
Merchandise held for sale
Wholesaler
Merchandise held for sale
Manufacturer
Raw materials / Supplies
Work in process
Finished goods (Merchandise held for sale)
▪ We focus on merchandise inventory held for sale
6
Identifying inventory
▪ When inventory is held in the retail store or
warehouse of the business it is easy to identify who
is to report the goods at the reporting date
▪ But what happens when the goods are being
delivered from the seller to the buyer at reporting
date?
▪ Or if the goods are shipped on consignment to an
agent to be sold on behalf of the owner?
7
Goods in transit
▪ Party that owns the goods at the reporting date
reports them as part of their inventory
▪ Ownership determined by shipping terms
FOB shipping point:
▪ Buyer owns goods and reports them in inventory
FOB destination:
▪ Seller owns goods and reports them in inventory
8
Goods on consignment
▪ Goods owned by one party but held by another
party who sells the goods on their behalf
▪ Consignor (owner)
▪ Consignee (agent)
▪ Consignor owns the goods and reports them in
inventory, even though the consignee may have
physical custody of the goods
9
Learning objective 2
Determine the costs
to be included in the
value of inventory
10
Determining inventory costs
▪ Cost of inventory includes any expenditure incurred,
directly or indirectly, in bringing the inventory to the
condition and location where it is able to be sold.
▪ Includes:
– Purchase price (list price less any trade discount)
– Less purchase discounts
– Plus incidental costs
• transportation charges
• import duties
• costs incurred to insure the goods while in transit.
11
Learning objective 3
Describe the four inventory costing
methods and identify the
three inventory costing methods
that are based on cost flow
assumptions
12
Inventory cost flow assumptions
▪ Consider the situation where a business has a
storage container half full of liquid chocolate
▪ Next, they purchased more liquid chocolate to fill up
the container, purchased at a higher price
▪ During the period one third of the liquid chocolate
was sold
▪ Because the chocolate at the higher price was
mixed in with the lower priced chocolate, how do we
determine the cost to assign to cost of goods
sold (COGS) and ending inventory?
13
Inventory costing methods
▪ There are four inventory costing methods used to
assign the cost of goods available for sale to cost of
goods sold and ending inventory.
– specific identification
– first-in, first-out (FIFO)
– last-in, first-out (LIFO)
– average cost
▪ The last three are known as inventory cost flow
assumptions because they assume a flow of costs
through inventory to COGS
14
Specific identification
▪ Assigns the actual purchase cost of the item to
COGS and ending inventory
▪ As each item is purchased, some form of
identification is attached to track the cost of that
item from purchase to sale
▪ Uses actual costs to calculate:
– COGS
– Ending inventory
15
First-in, first-out (FIFO)
▪ Assumes the first units purchased are the first units
sold
▪ Assigns:
– Earliest costs to COGS
– Most recent costs to ending inventory
16
Last-in, first-out (LIFO)
▪ Assumes the last units purchased are the first units
sold
▪ Assigns:
– Most recent costs to COGS
– Earliest costs to ending inventory
17
Average cost
▪ Assigns an average cost of inventory available for
sale to both:
– COGS
– Ending inventory
▪ The average cost method is called the
– Moving average method under perpetual inventory
– Weighted average method under periodic inventory
(Appendix 6A)
18
Learning objective 4
Determine the cost of goods sold and
ending inventory under the
perpetual inventory system for
each of the four inventory costing
methods
19
Illustration of inventory costing methods
▪ We now illustrate how to calculate the cost of goods
sold and ending inventory under the perpetual
inventory system for each of the four inventory
costing methods using the following data:
Purchases
Date
Nov.
Description
Units
Unit
cost
Sales
Total
cost
Units
Selling
price
Inventory
Sales
revenues
Units
1 Beginning inventory
50
x
$1 = $50
50
7 Purchases
75
x
$2 = $150
125
17 Purchases
15
x
$3 = $45
140
27 Sales
60
x
$5 =
$300
80
20
Specific identification - (perpetual)
▪ Allocates actual costs to COGS & ending inventory
▪ Of the 60 units sold on
November 27, the
business specifically
identified the number of
units sold at each unit
cost
Units identified as sold, Nov. 27
Units
Unit cost
Total cost
35
1
35
20
2
40
5
3
15
60
90
21
Specific identification - (perpetual)
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
7
17
27
75
15
2
3
150
45
Units
Unit
cost
Total
cost
50
1
50
50
1
50
75
2
150
50
1
50
75
2
150
15
3
45
35
1
35
15
1
15
20
2
40
55
2
110
5
3
15
10
3
30
22
Specific identification - (perpetual)
▪ COGS = the sum of all items in the cost of goods
sold (total cost) column (i.e. all sales)
▪ Ending inventory
= the sum of the
items in the
inventory balance
(total cost) column
for the last entry
only
Cost of Goods Sold
Units
Unit
cost
Inventory Balance
Total
cost
Units
Unit
cost
Total
cost
35
1
35
15
1
15
20
2
40
55
2
110
5
3
15
10
3
30
90
80
60
155
23
First-in, first-out (FIFO) - (perpetual)
▪ Assumes the first units purchased are the first units
sold
▪ Assigns:
– Earliest costs to COGS
– Most recent costs to end inventory
24
First-in, first-out (FIFO) - (perpetual)
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
7
17
27
75
15
2
3
150
45
Units
Unit
cost
Total
cost
50
1
50
50
1
50
75
2
150
50
1
50
75
2
150
15
3
45
50
1
50
65
2
130
10
2
20
15
3
45
25
First-in, first-out (FIFO) - (perpetual)
▪ COGS = the sum of all items in the cost of goods
sold (total cost) column (i.e. all sales)
▪ Ending inventory
= the sum of the
items in the
inventory balance
(total cost) column
for the last entry
only
Cost of Goods Sold
Units
Unit
cost
Inventory Balance
Total
cost
Units
Unit
cost
Total
cost
50
1
50
65
2
130
10
2
20
15
3
45
70
80
60
175
26
Last-in, first-out (LIFO) - (perpetual)
▪ Assumes the last units purchased are the first units
sold
▪ Assigns:
– Most recent costs to COGS
– Earliest costs to end inventory
27
Last-in, first-out (LIFO) - (perpetual)
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
7
17
27
75
15
2
3
150
45
Units
Unit
cost
Total
cost
50
1
50
50
1
50
75
2
150
50
1
50
75
2
150
15
3
45
15
3
45
50
1
50
45
2
90
30
2
60
28
Last-in, first-out (LIFO) - (perpetual)
▪ COGS = the sum of all items in the cost of goods
sold (total cost) column (i.e. all sales)
▪ Ending inventory
= the sum of the
items in the
inventory balance
(total cost) column
for the last entry
only
Cost of Goods Sold
Units
Unit
cost
Inventory Balance
Total
cost
Units
Unit
cost
Total
cost
15
3
45
50
1
50
45
2
90
30
2
60
135
80
60
110
29
Average cost - (perpetual)
▪ Assigns an average cost of inventory available for
sale to both:
– COGS
– Ending inventory
▪ The average cost method is called the moving
average method under perpetual inventory
because a new average cost of goods available for
sale is calculated after each purchase
30
Average cost - (perpetual)
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
Units
Unit
cost
Total
cost
50
1.00
50
7
75
2.00
150
125
1.60
200
17
15
3.00
45
140
1.75
245
80
1.75
140
27
60
1.75
105
Inventory Balance:
Nov. 7 = ($50 + $150) ÷ (50 + 75) units = $200 ÷ 125 = $1.60
Nov. 17 = ($200 + $45) ÷ (125 + 15) units = $245 ÷ 140 = $1.75
31
Average cost - (perpetual)
▪ COGS = the sum of all items in the cost of goods
sold (total cost) column (i.e. all sales)
▪ Ending inventory
= the balance
reported in the
inventory balance
(total cost) column
for the last entry
only
Cost of Goods Sold
Units
60
60
Unit
cost
1.75
Inventory Balance
Total
cost
Units
105
80
105
80
Unit
cost
1.75
Total
cost
140
140
32
Learning objective 5
Compare the financial statement
effects of the three
inventory cost flow
assumptions
33
Financial statement effects
▪ When prices are constant throughout the period
each method yields the same results
▪ When prices change throughout the accounting
period, each method almost always assigns
different costs to COGS and ending inventory
34
Financial statement effects
Income statement
Sales Revenues
Specific
identification
FIFO
LIFO
Moving
average
$
$
$
$
300
300
300
300
90
70
135
105
Gross profit
210
230
165
195
Expenses
100
100
100
100
Net income
110
130
65
95
155
175
110
140
Cost of goods sold
Balance sheet
Inventory
35
Financial statement effects
▪ When prices are rising we can generalize the
effects on the financial statement items
FIFO
Moving
average
LIFO
Cost of goods sold
Lowest
Middle
Highest
Gross profit
Highest
Middle
Lowest
Net income
Highest
Middle
Lowest
Ending balance of inventory
Highest
Middle
Lowest
▪ The opposite effect occurs when prices are falling
(The effects of the specific identification method can not be
generalized. Therefore this method is excluded from the
analysis)
36
Learning objective 6
Explain the characteristics of each
inventory costing method
37
Characteristics of costing methods
Specific identification:
▪ Accurately matches sales revenues to the actual
costs incurred to earn those revenues
– Reports actual gross profit
– Reports actual cost of ending inventory
▪ Can be costly to implement
38
Characteristics of costing methods
First-in, first-out (FIFO)
▪ Ending inventory is reported in the balance sheet
closest to its current replacement cost
▪ When prices rise:
– Reports lower COGS
– Reports higher gross profit (and higher net income)
– So can overstate income
39
Characteristics of costing methods
Last-in, first-out (LIFO)
▪ Matches sales revenues to the current costs
incurred to earn those revenues
▪ Taxation advantages for corporations when prices
are rising
▪ When prices rise:
– Inventory not reported at current replacement costs
40
Characteristics of costing methods
Average cost
▪ Tends to smooth out net income and inventory
▪ Neither cost of goods sold or ending inventory are
reported at their current costs
▪ Under perpetual inventory, a new average cost is
calculated each time a purchase is made, which can
be time consuming and difficult to track
41
Learning objective 7
Record returns of merchandise using
inventory cards for each of the
three inventory cost flow
assumptions
(perpetual inventory)
42
Recording returns
▪ The perpetual inventory system tracks the
movement of inventory at the time it occurs
▪ Therefore purchase returns and sales returns must
also be tracked at the time of the return
▪ But what cost do we use when recording the return?
43
Recording returns
▪ The specific identification method uses the actual
cost of the items returned for both purchase and
sales returns, so will not be illustrated
▪ The difficulty is deciding what cost to record the
return under the three inventory cost flow
assumptions
– FIFO
– LIFO
– Moving average
▪ Let’s start with purchase returns
44
Purchase returns
▪ Purchase returns are always recorded using the
actual value of the refund, regardless of the cost
flow assumption
▪ The return is to be recorded as a negative entry
into the Purchases column for all inventory cost
flow assumptions
45
Purchase returns
For example:
▪ A business purchased 300 units at $2 each on
November 5
▪ The business then returned 100 of these units
purchased at $2 on November 8
46
FIFO purchase return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
5
300
2
600
6
8
150
(100)
2
(200)
1
150
Units
Unit
cost
Total
cost
450
1
450
450
1
450
300
2
600
300
1
300
300
2
600
300
1
300
200
2
400
47
LIFO purchase return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
5
300
2
600
6
8
150
(100)
2
(200)
2
300
Units
Unit
cost
Total
cost
450
1
450
450
1
450
300
2
600
450
1
450
150
2
300
450
1
450
50
2
100
48
Moving average purchase return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
5
300
2.00
600
6
8
150
(100)
2.00
(200)
1.40
210
Units
Unit
cost
Total
cost
450
1.00
450
750
1.40
1050
600
1.40
840
500
1.28
640
▪ A new moving average cost is calculated after each
purchase and after each purchase return
49
Sales returns
▪ Sales returns are recorded following the same
inventory cost flow assumption used in their original
sale
▪ The return is to be recorded as a negative entry
into the Cost of Goods Sold column for all
inventory costing methods
50
Sales returns
For example:
▪ A different business sold 195 units on November 13
▪ The customer then returned 100 of these units on
November 19
▪ Each cost flow assumption will record a different
value for cost of goods sold for the sale and for the
sales return
51
FIFO sales return
▪ FIFO assumes that the cost of the goods returned
are the most recent costs assigned to inventory
when the sale was made
52
FIFO sales return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
13
18
19
385
5
120
3
360
75
4
300
1925
Units
Unit
cost
Total
cost
120
3
360
180
4
720
105
4
420
105
4
420
385
5
1925
(75)
4
(300)
25
3
75
(25)
3
(75)
180
4
720
385
5
1925
53
LIFO sales return
▪ LIFO assumes the cost of the goods returned to be
the oldest costs assigned to the goods at the time
the sale was made
54
LIFO sales return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
13
18
19
385
5
180
4
720
15
3
45
1925
Units
Unit
cost
Total
cost
120
3
360
180
4
720
105
3
315
105
3
315
385
5
1925
(15)
3
(45)
120
3
360
(85)
4
(340)
85
4
340
385
5
1925
55
Moving average sales return
▪ The moving average method records the sales
return at the moving average cost of the inventory
at the time of the return rather than at the time
of the original sale
56
Moving average sales return
Purchases
Date
Nov.
Units
Unit
cost
Cost of Goods Sold
Total
cost
Units
Unit
cost
Inventory Balance
Total
cost
1
13
18
19
195
385
5.00
3.60
702
1925
(100)
4.70
(470)
Units
Unit
cost
Total
cost
300
3.60
1080
105
3.60
378
490
4.70
2303
590
4.70
2773
57
Learning objective 8
Explain the
lower of cost or market
(LCM) rule
58
Lower of cost or market rule
▪ Inventories are initially accounted for on a cost
basis
▪ Inventories may subsequently be valued at less
than cost if:
– Purchase price decreases
– Can not sell goods at normal selling prices
– Damaged goods
– Obsolete goods
▪ To test if this is the case, businesses are required to
apply the lower of cost or market (LCM) rule
59
Lower of cost or market rule
▪ The lower of cost or market (LCM) rule requires
inventories to be reported at current market value
when the market value is lower than the cost
recorded for the item
60
Lower of cost or market rule
▪ The market value of an item is defined as the
current replacement cost of the inventory item
provided that:
a) market value is not to be greater than net realizable value
b) market value is not to be lower than the net realizable value
less an allowance for a normal profit margin
▪ The net realizable value of an item is the selling
price less costs incurred to sell the item
61
Lower of cost or market rule
▪ The lower of cost or market rule can be applied to
one of the following:
1. Items
2. Categories
3. Entire balance
▪ Each of the three methods results in a different
amount to be reported in ending inventory and a
different loss recognized in the income statement
▪ See your textbook for a detailed example
62
Journal entry to adjust inventory to LCM
▪ Calculate the amount to be adjusted
– (Current cost – Market value)
▪ Record the journal entry
Date
Account and explanation
Post
Ref.
Debit
Credit
2011
Nov.
▪ fds
30 Cost of Goods Sold
2,000
Inventory
2,000
(To adjust inventory from cost to market value.)
▪ Alternatively, a specific account can be debited,
such as Loss on Write-Down of Inventory
63
Lower of cost or market
▪ The written down value becomes the new cost of
the item for subsequent accounting periods
▪ Even if the market value of the goods rises in
subsequent accounting periods, the goods are not
to be revalued upward to the old higher cost
▪ This is consistent with the lower of cost or market
rule
64
Learning objective 9
Explain the effect of inventory errors
on the financial statements
65
Effects of inventory errors
▪ Inventory errors can occur in many ways, e.g.
– Taking inventory
– Using an inventory costing method
– Applying the lower of cost or market rule
– Transcription errors
▪ Affects both the income statement and the balance
sheet
66
Effects of inventory errors
Income statement:
▪ Affects the current period, and has an equal and
opposite effect in the following period
– ending balance of inventory is used in determining COGS
– ending balance of inventory in one period becomes the
opening balance of inventory in the following period
▪ Affects:
– Cost of goods sold
– Gross profit
– Net income
67
Effects of inventory errors
Balance sheet:
▪ Affects the current period only
▪ Affects:
– Inventory
68