Chapter 6
Inventories
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Managing Inventories
• Objective 1
– Explain the management decisions related to inventory
accounting, evaluation of inventory level, and the effects
of inventory misstatements on income measurement.
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6-2
Inventory
• Considered a current asset because it will normally
be sold within a year’s time or within a company’s
operating cycle.
Merchandising Entities
– Merchandise Inventory
consists of all goods
owned and held for sale
in the regular course of
business
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Manufacturing Entities
– Maintain other types of
inventories
• Raw Materials
• Work in Process
• Finished Goods
6-3
Components of Work in Process
and Finished Goods Inventory
• Cost of the raw materials that go into the product
• Cost of the labor used to convert the raw materials
to finished goods
• Overhead costs that support the production process
(indirect materials like paint, glue; indirect labor
such as salaries of supervisors; factory rent;
depreciation of plant assets)
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6-4
Inventory Decisions
A primary objective of accounting is to determine
income properly by matching costs of the period to
revenues.
• Inventory processing systems
• Costing methods
• Valuation methods
Result in different amounts of
reported net income, taxes
paid, and cash flows
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6-5
Inventory Turnover
• Measurement of the number of times a
company’s average inventory is sold
during an accounting period.
Inventory Turnover =
Toyota’s Inventory
Turnover
=
=
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Cost of Goods Sold
Average Inventory
$155,495 m
($15,281 m + $13,799 m) ÷ 2
10.7 times
6-6
Days’ Inventory On Hand
Indicates the average number of days required
to sell the inventory on hand.
Number of Days in a Year
Inventory Turnover
Days’ Inventory on Hand =
Toyota’s Days’ Inventory
on Hand
=
=
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365 days
10.7 times
34.1 days
6-7
Inventory Turnover for Selected
Industries
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6-8
Supply Chain Management
 Computerized system that a company uses to order
and track inventory goods
 A just-in-time operating environment helps reduce
inventory levels by coordinating orders and
shipments of products so that they arrive “just in
time” for customer orders
Using these procedures and processes means that
less money is tied up with carrying inventory
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6-9
Effects of Inventory Misstatements
on Income Measurement
If inventory is
overstated…
Cost of goods
sold is
understated
Income before
income taxes is
overstated
If inventory is
understated…
Cost of goods
sold is
understated
Income before
income taxes is
understated
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6-10
Inventory Errors: Examples
Column 1
Inventory
Correctly Stated
Net Sales
Beg. Inv.
Net purchases
Cost of goods
available for sale
End. Inv.
Column 2
Inventory
Overstated
Column 3
Inventory
Understated
$100,000
$100,000
$100,000
$12,000
$12,000
$12,000
58,000
58,000
58,000
$70,000
$70,000
$70,000
10,000
16,000
4,000
Cost of Goods Sold
$ 60,000
$54,000
$ 66,000
Gross margin
$ 40,000
46,000
$ 34,000
32,000
32,000
32,000
$ 8,000
$14,000
$ 2,000
Operating expenses
Income before
income taxes
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Cengage Learning.
Mifflin Company.
All rights All
reserved
rights. reserved.
6-11
Inventory Cost and Valuation
• Objective 2
– Define inventory cost, contrast goods flow and cost flow,
and explain the lower-of-cost-or-market (LCM) rule.
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6-12
Inventory Cost
• Includes:
–
–
–
–
Invoice price less purchases discounts
Freight-in, including insurance in transit
Applicable taxes and tariffs
Cost for ordering, receiving, and storing
• In principle, should be included in inventory cost
• In practice, are usually considered expenses of the period
(too difficult to allocate to specific inventory items)
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6-13
Goods Flow and Cost Flow
• Goods Flow
Actual physical
movement of goods in
the operation of the
company
Cost Flow
Association of costs with
their assumed flow in the
operation of the company
Not always the same
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6-14
Lower-of-Cost-or-Market Rule
 Cost is usually the most appropriate basis for the valuation
of inventory.
 Sometimes inventory should be shown on financial
statements at less than its cost.
 Physical deterioration, obsolescence, or decline in price level
may cause a loss to occur.
 The lower-of-cost-or-market (LCM) rule requires that
when the replacement cost of inventory falls below
historical cost, based on one of the conventional inventory
costing methods, the inventory is written down to the lower
value and a loss is recorded.
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6-15
Disclosure of Inventory Methods
Cisco Annual Report
Inventories: Inventories are stated at the lower of
cost or market. Cost is computed…on a first-in,
first-out basis. The company provides allowances
on excess and obsolete inventories.
Users should pay attention to the inventory
disclosures in the notes to financial statements.
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6-16
Inventory Cost Under the Periodic
Inventory System
• Objective 3
– Calculate inventory cost under the periodic inventory
system using various costing methods.
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6-17
Inventory Costing Methods
Inventory cost is determined using one of the
following generally accepted methods, each based on
a different assumption of cost flow:
1. Specific identification method
2. Average-cost method
3. First-in, first-out method
4. Last-in, last-out method
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6-18
Specific Identification Method
• Identifies the cost of each item in ending inventory
as coming from a specific purchase
• May be used for high-priced articles
• Disadvantages
– Difficulty and impracticality of keeping track of the
purchase and sale of individual items
– When items are identical but purchased at different costs,
deciding which items were sold becomes arbitrary
(company can raise or lower income by choosing the
lower- or higher-cost items)
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6-19
Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory Data
April 1
Inventory
April 6
Purchase
April 25 Purchase
Goods available for sale
Sales
On hand April 30
160 units
440 units
400 units
1,000 units
560 units
440 units
@ $10.00
@ $12.50
@ $14.00
$ 1,600
5,500
5,600
$12,700
Specific Identification Method
Cost of Goods Sold =
100 units @ $10.00
$ 1,000
$12,700 – 5,460 = $7,240
2,500
200 units @ $12.50
1,960
140 units @ $14.00
440 units
$5,460 Ending Inventory
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6-20
Average-Cost Method
• Computes the average cost of all goods available for
sale during the period to determine the value of
ending inventory
• Tends to level out the effects of cost increases and
decreases
• Is criticized by some who believe that recent costs
are more relevant for income measurement and
decision making
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6-21
Average-Cost Method
Inventory is priced
at the average cost
of the goods
available for sale
during the period
Inventory Data
April 1
Inventory
April 6
Purchase
April 25 Purchase
Goods available for sale
Sales
On hand April 30
160 units
@ $10.00
440 units
@ $12.50
400 units
@ $14.00
1,000 units
560 units
440 units
$ 1,600
5,500
5,600
$12,700
Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost
$12,700 ÷ 1,000 units = $12.70
Ending Inventory = 440 @ $12.70 = $5,588
Cost of goods avail for sale $12,700
Less April 30 inventory
5,588
Cost of goods sold
$7,112
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6-22
First-In, First-Out (FIFO) Method
• Based on the assumption that the costs of the first
items acquired should be assigned to the first items
sold.
• The cost of ending inventory reflects the cost of
merchandise from the most recent purchases.
• The costs assigned to cost of goods sold are from
the earliest purchases.
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6-23
Effect of FIFO Method
• Values the ending inventory at the most recent costs
and include earlier costs in cost of goods sold.
• During periods of consistently rising prices
– FIFO yields the highest possible amount of net income
• Cost of goods sold will show earliest, lower costs incurred
• During periods of consistently falling prices
– FIFO yields the lowest possible amount of net income
• Cost of goods sold will show most recent, higher costs
incurred
• A major criticism of FIFO is that it magnifies the
effects of the business cycle on income.
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6-24
First-In, First-Out Method
Assumes that the
first units purchased
will be the first units
sold; Ending
inventory is priced
using the most
recent purchases
Inventory Data
April 1
Inventory
April 6
Purchase
April 25 Purchase
Goods available for sale
Sales
On hand April 30
160 units
@ $10.00
440 units
@ $12.50
400 units
@ $14.00
1,000 units
560 units
440 units
First-In, First-Out Method
(Value Remaining Inventory)
400 units @ $14.00 from purchase of April 25
40 units @ $12.50 from purchase of April 6
440 units at a cost of
$ 1,600
5,500
5,600
$12,700
$5,600
500
$6,100
Cost of goods avail for sale $12,700
Less April 30 inventory
6,100
Cost of goods sold
$6,600
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6-25
Last-In, First-Out (LIFO) Method
• Based on the assumption that the costs of the last
items acquired should be assigned to the first items
sold.
• The cost of ending inventory reflects the cost of
merchandise purchased earliest.
• The costs assigned to cost of goods sold are from
the most recent purchases.
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6-26
Effect of LIFO Method
• Values the ending inventory at the earlier costs and
include most recent costs in cost of goods sold.
• This assumption does not agree with the actual
physical movement of goods in most businesses.
– Current value of inventory may be unrealistic.
– Balance sheet measures (such as working capital and
current ratio) may be distorted and must be interpreted
carefully.
– Prohibited by IFRS
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6-27
Effect of LIFO Method (cont’d)
• Strong logical argument for LIFO
– Fairest determination of income occurs if the current
costs of merchandise are matched against current sales
prices.
• Smoothes out fluctuations in the business cycle
– As prices move upward or downward, cost of goods sold
will show costs closer to the price level at the time the
goods were sold.
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6-28
Last-In, First-Out Method
Ending inventory
is priced using the
earliest purchases
Inventory Data
April 1
Inventory
April 6
Purchase
April 25 Purchase
Goods available for sale
Sales
On hand April 30
160 units
@ $10.00
440 units
@ $12.50
400 units
@ $14.00
1,000 units
560 units
440 units
Last-In, First-Out Method
160 units @ $10.00 from April 1 inventory
280 units @ $12.50 from purchase of April 6
440 units at a cost of
$ 1,600
5,500
5,600
$12,700
$ 1,600
3,500
$5,100
Cost of goods avail for sale $12,700
Less April 30 inventory
5,100
Cost of goods sold
$7,600
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6-29
Impacts of Inventory Cost Flow
Assumptions
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6-30
Stop & Review
Q. Do the FIFO and LIFO inventory methods
result in different quantities of ending
inventory?
A. The quantities of ending inventory are the same
under FIFO and LIFO. These
methods affect the valuation of the
inventory, not the quantities
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6-31
Impact of Inventory Decisions
• Objective 4
– Explain the effects of inventory costing methods on
income determination and income taxes.
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6-32
Impact on Gross Margin
April Example: Period of Rising Inventory Purchase Prices
Specific
Identification
Method
Sales
Cost of goods sold
Beg.inventory
Purchases
Cost of goods
avail. for sale
Less end. inv.
COGS
Gross margin
Average-Cost
Method
First-In, First-Out Last-In, First-Out
Method
Method
$10,000
$10,000
$10,000
$10,000
$1,600
11,100
$1,600
11,100
$1,600
11,100
$1,600
11,100
$12,700
5,460
$12,700
5,588
$12,700
6,100
$12,700
5,100
$7,240
$7,112
$6,600
$7,600
$2,760
$2,888
$3,400
$2,400
In times of declining prices: FIFO results in lowest
gross margin, LIFO results in highest gross margin.
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Highest
gross
margin
Lowest
gross
margin
6-33
Usage of Costing Methods
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6-34
LIFO Method
• Best suited for the income statement because it
matches revenues and cost of goods sold.
• Not the best measure of the current balance sheet
value of inventory, particularly during a prolonged
period of price increases and decreases.
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6-35
FIFO Method
• Best suited to the balance sheet because the ending
inventory is closest to current values.
• Gives a more realistic view of the current financial
assets of a business.
• Does not provide as good a matching of current
costs and revenues for income statement purposes.
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6-36
Inventory and Income Taxes
• Method chosen must be used consistently from year
to year (may change with IRS approval if there is a
good reason, exception—a change from LIFO).
• If a company uses LIFO for tax purposes, the IRS
requires the same method for financial reporting.
• IRS will not allow lower-of-cost-or-market
inventory valuation if LIFO is used.
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6-37
Effects on Income Taxes
In periods of rising prices…
FIFO and
Average Cost
LIFO
Profit may be
overstated
Inventory may be valued at a cost
far below current prices
Business will pay
excess income
taxes
LIFO liquidation may occur;
inventory quantity at year end falls
below the beginning-of-year level
Business will pay higher income
taxes
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6-38
Stop & Review
Q. Which inventory costing method assumes
results in the highest gross margin in times of
rising inventory costs?
A. First-in, first-out method (FIFO)
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6-39
Chapter Review
1. Explain the management decisions related to
inventory accounting, evaluation of inventory
level, and the effects of inventory misstatements
on income measurement.
2. Define inventory cost, contrast goods flow and
cost flow, and explain the lower-of-cost-or-market
(LCM) rule.
3. Calculate inventory cost under the periodic
inventory system using various costing methods.
4. Explain the effects of inventory costing methods
on income, inventory balance, and income taxes.
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6-40