CHAPTER
7
Inventory
Learning Objective 1
Identify what
items and costs
should be
included in
inventory and
cost of goods
sold.
Define Inventory and COGS. What
are some of their characteristics?
Goods either
manufactured or
purchased for
resale.



Inventory is reported
on balance sheet as
an asset.
When sold, inventory
is reported on income
statement as an
expense (cost of
goods sold).
COGS: the cost of
inventory sold during
the period.
Describe the Time Line of
Business.
BUY
raw materials or
goods for resale
SELL
finished
inventory
ADD
value
COMPUTE
ending inventory
cost of goods sold
What is Inventory?
Defined according to type
and nature of the company.
Merchandising:
Items to be resold.
For a supermarket, food is
inventory, the shopping cart is not.
Manufacturing:
• raw materials
• work in process
• finished goods
Define Each Manufacturing
Inventory
Raw materials
Goods acquired in a relatively
undeveloped state.
Eventually will compose a major
part of the finished product.
Work in process
Partly finished products.
Manufacturing plant contains workin-process inventory.
Finished goods
Completed products waiting for
What Costs are Included in
Inventory?
$
Costs incurred in buying
inventory and preparing it for
sale.
$ Cost of raw materials.
$ Cost of work-in-process
inventory.
Costs NOT included
in inventory costs:
$ Cost of finished
goods.


sales effort
general non-factory
administrative costs
Who Owns the Inventory?
When goods are in transit?
Q: Who owns the inventory on a truck or railroad car?
A: The party who is paying the shipping costs.
When goods are on consignment?
Q: Who owns inventory stocked in a warehouse?
A: The supplier until the inventory is sold. The
warehouse owner stocks and sells the inventory
and receives a commission on sales as payment
for services rendered.
Ending Inventory & COGS
Cost of goods
available for sale
=
Beginning
inventory
+
Net
purchases
The question is where is the inventory
that could have been sold this period?
Only two choices:
At period’s end, is allocated between
inventory still remaining (an asset), and
inventory sold during the period (an
expense, Cost of Goods Sold).
Learning Objective 2
Account for
inventory
purchases and
sales using both a
perpetual and a
periodic inventory
system.
What are the Two Methods for
Accounting for Inventory?
Perpetual
 Records are updated
when a purchase or sale
is made.
 Records reflect total
items in inventory or
sold at any given time.
 Most often used when
 each
item has a
relatively high
value, or
 the cost of running
out of or
overstocking an
item is expensive.
Periodic
 Records are not
updated when a
purchase or a sale is
made.
 Only the dollar amount
of the sale is recorded.
 Used when
 inventory
is
composed of a
large number of
diverse items,
 each with a
relatively low value.
Example: Accounting for
Inventory Purchases and Sales
Harper’s Hats recorded the following
transactions for 2001:
Beginning inventory
March 1 Purchase
March 1 Freight in
March 1 Purchase return
May 2 Purchase
May 2 Purchase discount
June 30 Sales
July 3 Sales return
Ending inventory
10 hats @ $10 each = $100
15 hats @ $15 each = $225
$10
3 hats @ $15 each = $ 45
10 hats @ $20 each = $200
2/10, n/30
20 hats (10 @ $10, 10 @ $15)
1 hat @ $15
= $ 15
13 hats
Example: 2001 Inventory
Date
Purchase
Units Total
Sale
Units Total
Jan. 1
Mar. 1
May 2
June 30
July 3
15
$225
(3)
($45)
10
$200
Balance `
Units Cost Total
10
$10 $100
10
15
12
$10 $100
$15 $225
$15 $180
10
12
10
$10 $100
$15 $180
$20 $200
2
10
$15 $ 30
$20 $200
3
10
$15 $ 45
$20 $200
10 $100
10 $150
(1) ($15)
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
Sales
Sales returns
Closing entries for
COGS
Perpetual
Periodic
All purchases
are added
directly to the
inventory
account.
At end of period,
Inventory
balance is
updated using
inventory count.
Temporary
purchases
account balance
is closed to
Inventory to
compute COGS.
Example: Journal Entries
for Purchases
Harper purchased 10 hats at $10 each
on January 1. Record the entries for
both the perpetual and the periodic
systems.
Jan. 1 Inventory . . . . . . . . . . . . . . . .
Accounts Payable. . . . . . .
PERPETUAL
100
Purchased 10 hats @ $10.
Jan. 1 Purchases . . . . . . . . . . . . . . .
Accounts Payable. . . . . . .
PERIODIC
100
Purchased 10 hats @ $10.
100
100
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
Sales
Sales returns
Closing entries for
COGS
Perpetual
All costs
are added
directly to
the
inventory
balance.
Periodic
At end of
period,
temporary
freight in
account balance
is closed to
Inventory to
compute COGS.
Example: Journal Entries
for Transportation Cost
Harper hired a trucking company to deliver its
March 1 purchase of 15 hats. The trucking
company charged $10. Record the entries for
both the perpetual and the periodic systems.
Mar. 1 Inventory . . . . . . . . . . . . . . . .
Cash. . . . . . . . . . . . . . . . . .
PERPETUAL
10
Delivery charge on 15 hats.
Mar. 1 Freight In. . . . . . . . . . . . . . . .
Cash. . . . . . . . . . . . . . . . . .
PERIODIC
10
Delivery charge on 15 hats.
10
10
Perpetual & Periodic
Journal Entries
Perpetual
Purchases
Transportation
costs
Purchase
returns
Purchase
discounts
Sales
Sales returns
Closing entries for
COGS
Inventory is
decreased.
Accounts
Payable is
decreased
by same
amount.
Periodic
If merchandise has
been paid for, the
supplier will
reimburse (debit
Cash).
At end of period,
temporary
purchase returns
account balance is
closed to
Inventory to
compute COGS.
Example: Journal Entries
for Purchase Returns
Of the 15 hats delivered on March 1, three
were defective and Harper returned them the
same day. Record the entries for both the
perpetual and the periodic inventory systems.
Mar. 1 Accounts Payable (or Cash)
Inventory . . . . . . . . . . . . . .
PERPETUAL
45
Returned 3 hats @ $15.
Mar. 1 Accounts Payable (or Cash)
Purchase Returns. . . . . . .
PERIODIC
45
Returned 3 hats @ $15.
45
45
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
Sales
Sales returns
Closing entries for
COGS
Perpetual
Periodic
Subtract the
discount
amount from
the inventory
account.
At end of period,
temporary
purchase
discounts account
balance is closed
to Inventory to
compute COGS.
Example: Journal Entries
for Purchase Discounts
On May 2, Harper purchased 10 hats at $20
each. The supplier offered terms of 2/10, n/30.
Record the entries for both the perpetual and
the periodic inventory systems.
May 2 Accounts Payable (or Cash)
Inventory . . . . . . . . . . . . . .
Cash . . . . . . . . . . . . . . . . . .
PERPETUAL
4
196
Purchase discount on 10 hats.
May 2 Accounts Payable (or Cash)
Purchase Discounts . . . . .
Cash . . . . . . . . . . . . . . . . . .
PERIODIC
200
Purchase discount on 10 hats.
200
4
196
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
The difference
in terms of
journal entries:
Perpetual
All
adjustments
are entered
directly in the
Inventory
account.
Periodic
All adjustments are
accumulated in an
array of temporary
holding accounts:
Purchases
Freight In
Purchase Returns
Purchase Discounts
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
Sales
Sales returns
Closing entries for
COGS
Perpetual
Periodic
Recognize
Only total sales
sales and
are known.
COGS on a
transactionby-transaction
basis.
Example: Journal Entries
for Sales
In June, Harper’s Hats sold 20 hats for $25
each (selling the old ones first). Record the
entries for both the perpetual and the periodic
systems.
Jun. 30 Accounts Receivable (or Cash)
Sales . . . . . . . . . . . . . . . . . . . .
Sold 20 hats @ $25.
Jun. 30 Cost of Goods Sold . . . . . . . . . .
Inventory (10 @ $10; 10 @ $15)
Record cost of goods sold.
PERPETUAL
Jun. 30 Accounts Receivable (or Cash)
Sales . . . . . . . . . . . . . . . . . . . .
Sold 20 hats @ $25.
No entry.
PERIODIC
500
500
250
250
500
500
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase returns
Purchase
discounts
Sales
Sales returns
Closing entries
for COGS
Perpetual
Periodic
Sales for
returned items
are canceled.
Sales for returned
items are
canceled.
Cost of returned
inventory is
No entry is made
removed from to adjust COGS.
COGS and
restored to the
inventory
account.
Example: Journal Entries
for Sales Returns
On July 3, one hat was returned from a late
June purchase. Record the entries for both
the perpetual and the periodic inventory
systems.
Jul. 3
Jul. 3
PERPETUAL
Jul. 3
PERIODIC
Sales Returns. . . . . . . . . . . . . . .
25
Accounts Receivable. . . . . . .
1 hat returned from June purchase.
25
Inventory. . . . . . . . . . . . . . . . . . .
15
Cost of Goods sold . . . . . . . .
15
Placed returned hat back into inventory.
Sales Returns. . . . . . . . . . . . . . .
25
Accounts Receivable. . . . . . .
1 hat returned from June purchase.
No entry.
25
Perpetual & Periodic
Journal Entries
Purchases
Transportation
costs
Purchase
returns
Purchase
discounts
Sales
Sales returns
Closing
entries for
COGS
Perpetual
Periodic
All journal entries Temporary holding
are posted to the accounts are
ledger.
accumulated and
added to Inventory.
Results in new
balances for
Inventory and
COGS.
Numbers are
verified by
physical count.
Inventory account
balance is reduced
by the amount of
COGS.
Example: Accounting for
Inventory Purchases and Sales
Harper’s Hats recorded the
following transactions for 2001:
Beginning inventory
March 1 Purchase
March 1 Freight in
March 1 Purchase return
May 2 Purchase
May 2 Purchase discount
June 30 Sales
July 3 Sales return
Ending inventory
10 hats @ $10 each = $100
15 hats @ $15 each = $225
$10
3 hats @ $15 each = $ 45
10 hats @ $20 each = $200
2/10, n/30
20 hats (10 @ $10, 10 @ $15)
1 hat @ $15
= $ 15
13 hats
Example: Closing Entries for
Cost of Goods Sold
Perpetual: the inventory account will have
an ending balance of $255.
Inventory
1/1
3/1
3/1
5/2
100
225
10
200
6/30
3/1
15
255
250
7/3
45
Bal.
6/30
7/3
Bal.
COGS
250
235
15
Example: Closing Entries for
Cost of Goods Sold
Periodic: the inventory account will be
debited by $386, which
represents the net purchases for
the year.
Jul. 31 Inventory. . . . . . . . . . . . . . . . . . .
Purchase Returns. . . . . . . . . . . .
Purchase Discounts. . . . . . . . . .
Freight In. . . . . . . . . . . . . . . . .
Purchases. . . . . . . . . . . . . . . .
386
45
4
10
425
Periodic Inventory
With a periodic system, a physical
count is the only way to get the
information necessary to compute
COGS:
+
=
–
=
Beginning Inventory, January 1, 2001
Purchases for the year
Cost of goods available for sale during 2001
Ending Inventory, December 31, 2001
Cost of Goods Sold for 2001
Learning Objective 3
Calculate cost of goods
sold using the results of
an inventory count and
understand the impact of
errors in ending inventory
on reported cost of goods
sold.
Physical Count of Inventory
Essential to maintaining reliable
inventory accounting records.
Perpetual
Periodic
Physical count
either confirms
records are accurate
or highlights
shortages and
clerical errors.
The only way to get information
necessary to compute COGS:
 Quantity count.
 Inventory costing (assigning a
unit cost to each type of
merchandise).
 Ending inventory = quantity of
each type x its unit cost.
COGS Computation
Perpetual


The accounting
records yield the COGS
for the period as well
as the amount of
inventory that should
be found with a
physical count.
The difference between
the records and actual
count = inventory lost,
stolen, or spoiled.
Periodic
Company does not
know what ending
inventory should be.
Assumes physical
count is the difference
between cost of goods
available for sale and
ending inventory.
Cannot tell whether
goods were sold, lost,
stolen, or spoiled.
What is the Income Effect of
an Error in Ending Inventory?
An error in
inventory results in
COGS being
overstated or
understated.
The inventory error
has the opposite
effect on gross
margin and net
income.
Any uncorrected
error will affect
the financial
statements for two
years.
Effects of Inventory Errors
Understate
Ending
Inventory
Understate
Purchases
Understate
Beginning
Inventory
Understate
Sales
OK
OK
LOW
Beginning inventory OK
Net purchases
OK
Goods available
OK
Ending inventory
LOW
Cost of goods sold HIGH
OK
LOW
LOW
OK
LOW
LOW
OK
LOW
OK
LOW
OK
OK
OK
OK
OK
Gross margin
Expenses
Net income
HIGH
OK
HIGH
HIGH
OK
HIGH
LOW
OK
LOW
Sales
OK
LOW
OK
LOW
Learning Objective 4
Apply the four inventory
cost flow alternatives:
specific identification,
FIFO, LIFO, and average
cost.
Inventory Cost Flow


Kernel King buys and sells corn and had the
following transactions for 2002:
 June 10 Purchased 10 tons at $6 per ton.
 July 28 Purchased 10 tons at $9 per ton.
 October 10 Sold 10 tons at $11 per ton.
How much did Kernel King make in 2002?
Sales ($11 x 10 tons)
COGS (10 tons)
Gross margin
Case #1
Case #2
Case #3
Sold
Old Corn
Sold
New Corn
Sold
Mixed Corn
$110
60
$ 50
$110
90
$ 20
$110
75
$ 35
Specific Identification
Cost Flow
 Specifically identify the
cost of each unit sold.
 The individual cost of
each unit is charged
against revenue as
COGS.
 To compute COGS and
ending inventory, a firm
must know each unit sold
and its cost.
Inventory Cost Flow Methods
FIFO
The oldest units
are sold and the
newest units
remain in
inventory.
The cost of the
oldest units
purchased is
transferred to
COGS.
LIFO
The newest
units are sold
and the oldest
units remain in
inventory.
The cost of
the most
recent units
purchased is
transferred to
COGS.
Average Cost
An average cost is
computed for all
inventory available
for sale during the
period.
COGS is
computed by
multiplying the
number of units
sold by the average
cost per unit.
Comparison of
Inventory Methods
 LIFO gives a
better reflection
of COGS in the
income
statement.
 Therefore, LIFO
is a better
measure of
income.
 FIFO gives a
better measure
of inventory on
the balance
sheet.
 Therefore, FIFO
is a better
measure of
inventory value.
Learning Objective 5
Use financial
ratios to evaluate
a company’s
inventory level.
%
Why Use JIT Inventory
Management?

Money tied up in inventory
cannot be used for other
purposes.

JIT attempts to have exactly
enough inventory arrive
“just in time” for sale.

Its purpose is to minimize
investment in inventories
while at the same time having enough
inventory on hand to meet customer
demand.
Evaluating Inventory Levels
Inventory Turnover
• Measures how many times
Cost of goods sold
Average inventory
a company turns over (or
replenishes) its inventory.
• Average inventory =
average of the beginning
and ending inventory
balances.
Number of Days’ Sales in
Inventory
365 days
Inventory turnover
Example: Evaluating
Inventory Management
Buster Boots had cost of goods sold of
$60,000 during 2002. The inventory account
decreased by $1,000 to $4,000 during the
same time. Calculate the inventory turnover
ratio and number of days’ sales in inventory.
Inventory
turnover
ratio
Cost of goods sold
Average inventory =
Number of
days’ sales
in
inventory
365 days
Inventory turnover =
$60,000
$4,500 = 13.33
365
13.33
= 27.38
Expanded Material
Learning Objective 6
Analyze the impact of
inventory errors on
reported cost of
goods sold.
!
What Is the Effect of These
Inventory Errors?
If a sale is recorded but the merchandise
remains in inventory and is counted in
ending inventory,
> COGS  understated
> gross margin  overstated
> net income  overstated
If a sale is not recorded, but inventory is
shipped and not counted in ending
inventory,
> COGS  overstated
> gross margin  understated
> net income  understated
Expanded Material
Learning Objective 7
Describe the complications
that arise when LIFO or
average cost is used with a
perpetual inventory system.
Using Average Cost or LIFO
with a Perpetual System


Using average cost or LIFO with perpetual
leads to complications.
The average cost of units available for sale
changes every time a purchase is made.
The identification of the “last in” units also
changes with every purchase.
With periodic,
One overall average cost is used for all
goods available for sale during the period.
The “last in” units are identified at the
end of the period.
Describe the Similarities of
Using FIFO for Perpetual and
Periodic Systems.
No complications arise as
no matter when sales
occur, the “first in” units
are always the same in
both systems.
 FIFO periodic and FIFO
perpetual yield the same
numbers for COGS and
ending inventory.

Expanded Material
Learning Objective 8
Apply the lower-ofcost-or-market method
of accounting for
inventory.
When Do You Report
Inventory Below Cost?
All inventory costing alternatives
report inventory at cost.
 Inventory is reported at less than
cost when:
 the future value of the inventory
is in doubt (damaged, used, or
obsolete), or
 it can be replaced new at a price
less than the original cost.

When Do You Report Inventory at
Net Realizable Value (NRV)?
 When
inventory is damaged, used, or
obsolete, it should be reported at no more
than its net realizable value (the amount it can
be sold for, less any selling costs).
 NRV
should be recognized as soon as a firm
determines that an economic loss has
occurred.
 Loss
is recognized when inventory is written
down, not when inventory is finally sold.
 Therefore,
assets are not being reported at
more than their future economic benefit.
Lower of Cost or Market
(LCM)
Ceiling: the maximum market amount at which
inventory can be carried on the books; equal to net
realizable value (selling price less estimated selling
costs).
LCM: A basis for
valuing inventory at the
lower of original cost or
current market value.
Floor: the minimum market amount at which inventory
can be carried on the books; equal to net realizable
value less a normal profit.
Example: LCM
Inventory
Item
A
B
C
D
Cost
34
42
52
38
Floor
20
32
44
50
Market
Replacement
Cost
32
36
42
32
NRV
Ceiling
30
46
62
68
Define market value as:
 replacement cost, if it falls between the ceiling and the floor.
 the floor, if the replacement cost is less than the floor.
 the ceiling, if the replacement cost is higher than the ceiling.
 When replacement cost, ceiling, and floor are compared,
market is always the middle value.
Compare the defined market value with the
original cost and choose the lower amount.
Expanded Material
Learning Objective 9
Explain the gross
margin method of
estimating
inventories.
?
Gross Margin Method
 There are times when a physical count of

inventory is either impossible or impractical.
 If perpetual is used, the inventory account
balance is assumed to be correct.
 If periodic is used, an estimate of the inventory
balance must be made.
Gross margin method.
 COGS and ending inventory are
estimated using available information:
 beginning inventory
 purchases
 historical gross margin percentage