College Accounting – Chapter 6
Merchandise Inventory
1. WHAT ARE THE ACCOUNTING PRINCIPLES AND CONTROLS THAT RELATE TO
MERCHANDISE INVENTORY?
a. Accounting Principles
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The consistency principle states that businesses should use the same accounting
methods and procedures from period to period.
The disclosure principle holds that a company should report enough information for
outsiders to make knowledgeable decisions about the company. The company should
report information that is relevant and has faithful representation.
The materiality concept states that a company must perform strictly proper accounting
only for significant items. Information is significant – or, in accounting terms, material –
when it would cause someone to change a decision.
Conservatism in accounting means exercising caution in reporting items in the financial
statements. A business should report the least favorable figures in the financial statements
when two or more possible options are presented.
b. Control Over Merchandise Inventory
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Good controls ensure that inventory purchases and sales are properly authorized and
accounted for by the accounting system. This can be accomplished by taking the following
measures:
o Ensure merchandise inventory is not purchased without proper authorization, including
purchasing only from approved vendors and within acceptable dollar ranges.
o After inventory is purchased, the order should be tracked and properly documented
when received. At time of delivery, a count of inventory should be completed and each
item should be examined for damage.
o Damaged inventory should be properly recorded and then should either be used,
disposed of, or returned to the vendor.
o A physical count of inventory should be completed at least once a year to track
inventory shrinkage due to theft, damage, and errors.
o When sales are made, the inventory sold should be properly recorded and removed
from the inventory count. This will prevent the company from running out of inventory,
often called a stockout.
2. HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED UNDER A PERPETUAL
INVENTORY SYSTEM?
Ending Merchandise Inventory = Number of units on hand X Unit cost
Cost of Goods Sold = Number of unit sold X Unit cost
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With the exception of the specific identification method, each inventory costing method
approximates the flow of inventory costs in a business and is used to determine the amount of
cost of goods sold and ending merchandise inventory.
a. Specific Identification Method
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The specific identification method uses the specific cost of each unit of inventory to
determine ending inventory and to determine cost of goods sold.
Notice that under the specific identification method, when inventory is sold, a specific cost is
assigned to it. This method requires the business to keep detailed records of inventory sales
and purchases and to also be able to carefully identify the inventory that is sold.
b. First-In, First-Out (FIFO) Method
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Under the first-in, first-out (FIFO) method, the cost of goods sold is based on the oldest
purchases – that is, the first units to come in are assumed to be the first units to go out of the
warehouse (sold).
The total cost spent on inventory that was available to be sold during a period is called the
Cost of Goods Available for Sale.
c. Last-In, First-Out (LIFO) Method
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Last-In, First-Out (LIFO) method is the opposite of FIFO. Under the last-in, first-out (LIFO)
method, ending inventory comes from the oldest costs (beginning inventory and earliest
purchases) of the period.
Under the LIFO inventory costing method, companies sell their newest inventory first.
d. Weighted-Average Method
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Under the weighted-average method, the business computes a new weighted average cost
per unit after each purchase.
3. HOW ARE FINANCIAL STATEMENTS AFFECTED BY USING DIFFERENT INVENTORY
COSTING METHODS?
a. Income Statement
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When inventory costs are rising, LIFO results in the highest cost of goods sold and the lowest
gross profit. Lower profits mean lower taxable income; thus, LIFO lets companies pay the
lowest income taxes when inventory costs are rising. Low tax payments conserve cash, and
that is the main benefit of LIFO. The downside of LIFO is that the company reports low net
income.
b. Balance Sheet
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Only one of two things can happen to the inventory – either it remains in the warehouse
(ending merchandise inventory) or it can be sold (Cost of Goods Sold).
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Ending merchandise inventory can be calculated by determining first the cost of goods
available for sale (beginning merchandise inventory plus inventory purchased) and then
subtracting merchandise inventory sold (Cost of Goods Sold).
When using the FIFO inventory costing method, ending merchandise inventory will be the
highest when costs are increasing.
LIFO produces the lowest ending merchandise inventory with weighted-average again in the
middle.
Period of Rising Inventory Costs:
Specific
FIFO
LIFO
Identification
Income Statement:
Cost of Goods Sold
Net Income
Balance Sheet:
Ending Merchandise Inventory
Varies
Varies
Lowest
Highest
Highest
Lowest
Middle
Middle
Varies
Highest
Lowest
Middle
Period of Declining Inventory Costs:
Specific
FIFO
Identification
Income Statement:
Cost of Goods Sold
Net Income
Balance Sheet:
Ending Merchandise Inventory
WeightedAverage
LIFO
WeightedAverage
Varies
Varies
Highest
Lowest
Lowest
Highest
Middle
Middle
Varies
Lowest
Highest
Middle
4. HOW IS MERCHANDISE INVENTORY VALUED WHEN USING THE LOWER-OF-COST-ORMARKET RULE?
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The Lower-of cost-or-Market (LCM) Rule is the rule that merchandise inventory should be
reported in the financial statements at whichever is lower- its historical cost or its market value.
a. Computing the Lower-of-Cost-or-Market
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For inventories, market value generally means the current replacement cost (that is, the cost to
replace the inventory on hand).
If the replacement cost of inventory is less than its historical cost, the business must adjust the
inventory value. This requires an adjustment to the Merchandise Inventory account.
If the merchandise inventory’s market value is greater than cost, then we don’t adjust the
Merchandise Inventory account because of the conservatism principle.
b. Recording the Adjusting Journal Entry to Adjust Merchandise Inventory
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Merchandise Inventory is an asset account and goes down while Cost of Goods Sold is an
equity account and goes up.
5. WHAT ARE THE EFFECTS OF MERCHANDISE INVENTORY ERRORS ON THE FINANCIAL
STATEMENTS?
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Businesses perform a physical count of their merchandise inventory at the end of the fiscal or
accounting period. For the financial statements to be accurate, it is important to get a correct
count.
An error in ending merchandise inventory creates a whole string of errors in other related
accounts.
Recall that one period’s ending merchandise inventory becomes the next period’s beginning
inventory.
Ending merchandise inventory is subtracted to compute cost of goods sold in one period and
the same amount is added as beginning merchandise inventory in the next period.
6. HOW DO WE USE INVENTORY TURNOVER AND DAYS’ SALES IN INVENTORY TO
EVALUATE BUSINESS PERFORMANCE?
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There are two ratios that help owners and managers monitor their inventory levels: Inventory
Turnover and Days’ Sales in Inventory.
a. Inventory Turnover
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Inventory turnover measures how rapidly merchandise inventory is sold.
Inventory turnover = cost of goods sold / Average merchandise inventory
A high rate of turnover indicates ease in selling inventory; a low rate indicates difficulty.
b. Days’ Dales in Inventory
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Another key measure is the days’ sales in inventory ratio.
This ratio measures the average age number of days merchandise inventory is held by the
company and is calculated as follows: Days’ sale in inventory = 365 days / inventory turnover
Days’ sales in inventory also varies widely, depending on the business.
A lower days’ sales in inventory is preferable because it indicates that the company is able to
sell its inventory quickly, thereby reducing its inventory storage and insurance costs, as well as
reducing the risk of holding obsolete inventory.
7. HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED UNDER A PERIODIC
INVENTORY SYSTEM?
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Accounting is simpler in a periodic inventory system because the company keeps no daily
running record of inventory on hand.
8. HOW CAN THE COST OF ENDING MERCHANDISE INVENTORY BE ESTIMATED?
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A company can use the gross profit method, which uses the cost of goods sold formula and
the gross profit percentage to determine the cost of ending merchandise inventory.
The retail method is another method that can be used to estimate ending merchandise
inventory. In the retail method, the business uses its ratio of the goods available for sale at
cost to the goods available for sale at retail to determine the cost of estimated ending
merchandise inventory.