6
Inventories
Learning Objectives
After studying this chapter, you should be able to:
[1] Determine how to classify inventory and inventory quantities.
[2] Explain the accounting for inventories and apply the inventory cost flow
methods.
[3] Explain the financial effects of the inventory cost flow assumptions.
[4] Explain the lower-of-cost-or-market basis of accounting for inventories.
[5] Indicate the effects of inventory errors on the financial statements.
[6] Compute and interpret the inventory turnover.
6-1
Preview of Chapter 6
Accounting Principles
Weygandt Kimmel Kieso
6-2
Classifying Inventory
Merchandising
Company
One Classification:

Inventory
Helpful Hint Regardless of the
classification, companies report
all inventories under Current
Assets on the balance sheet.
6-3
Manufacturing
Company
Three Classifications:

Raw Materials

Work in Process

Finished Goods
(See page 324)
6-4
Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw
materials, shoplifting, or employee theft.
Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
6-5
LO 1 Determine how to classify inventory and inventory quantities.
Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory
on hand.
Taken,
6-6

when the business is closed or business is slow.

at the end of the accounting period.
LO 1 Determine how to classify inventory and inventory quantities.
6-7
Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.
Goods in transit should be included in the inventory of the company
that has legal title to the goods. Legal title is determined by the
terms of sale.
6-8
LO 1 Determine how to classify inventory and inventory quantities.
Determining Inventory Quantities
Goods in Transit
Illustration 6-2
Terms of sale
Ownership of the goods
passes to the buyer when the
public carrier accepts the
goods from the seller.
Ownership of the goods
remains with the seller until
the goods reach the buyer.
6-9
LO 1 Determine how to classify inventory and inventory quantities.
Determining Inventory Quantities
Review Question
Goods in transit should be included in the inventory of the
buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
6-10
LO 1 Determine how to classify inventory and inventory quantities.
Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
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.
Many car, boat, and antique dealers sell goods on
consignment, why?
6-11
LO 1 Determine how to classify inventory and inventory quantities.
Inventory Costing
Inventory is accounted for at cost.
6-12

Cost includes all expenditures necessary to acquire goods and
place them in a condition ready for sale.

Unit costs are applied to quantities to determine the total cost
of the inventory and the cost of goods sold using the following
costing methods:
►
Specific identification
►
First-in, first-out (FIFO)
►
Last-in, first-out (LIFO)
►
Average-cost
Cost Flow
Assumptions
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Inventory Costing
Illustration: Crivitz TV Company purchases three identical 50inch TVs on different dates at costs of $700, $750, and $800.
During the year Crivitz sold two sets at $1,200 each. These facts
are summarized below.
Illustration 6-3
6-13
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Inventory Costing
Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its ending
inventory is $750.
Illustration 6-4
6-14
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Inventory Costing
Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of the
ending inventory.
6-15

Practice is relatively rare.

Most companies make assumptions (cost flow assumptions)
about which units were sold.
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Inventory Costing
Cost Flow
Assumption
does not need to be
consistent with the
physical movement of
goods
Illustration 6-12
Use of cost flow methods in
major U.S. companies
6-16
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Illustration: Data for Houston Electronics’ Astro condensers.
Illustration 6-5
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
6-17
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
First-In, First-Out (FIFO)
6-18

Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.

Often parallels actual physical flow of merchandise.

Companies determine the cost of the ending inventory
by taking the unit cost of the most recent purchase and
working backward until all units of inventory have been
costed.
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
First-In, First-Out (FIFO)
Illustration 6-6
COST OF GOODS AVAILABLE FOR SALE
STEP 1: ENDING INVENTORY
6-19
STEP 2: COST OF GOODS SOLD
LO 2
Cost Flow Assumptions
First-In, First-Out (FIFO)
Illustration 6-6
Helpful Hint Another way of
thinking about the calculation
of FIFO ending inventory is the
LISH assumption—last in still here.
6-20
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Last-In, First-Out (LIFO)
6-21

Costs of the latest goods purchased are the first to be
recognized in determining cost of goods sold.

Seldom coincides with actual physical flow of
merchandise.

Exceptions include goods stored in piles, such as coal or
hay.
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Last-In, First-Out (LIFO)
Illustration 6-8
COST OF GOODS AVAILABLE FOR SALE
STEP 1: ENDING INVENTORY
6-22
STEP 2: COST OF GOODS SOLD
LO 2
Cost Flow Assumptions
Last-In, First-Out (LIFO)
Helpful Hint Another way of
thinking about the calculation
of LIFO ending inventory is the
FISH assumption—first in still here.
Illustration 6-8
6-23
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Average-Cost
6-24

Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.

Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Average-Cost
Illustration 6-11
COST OF GOODS AVAILABLE FOR SALE
STEP 1: ENDING INVENTORY
6-25
STEP 2: COST OF GOODS SOLD
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Cost Flow Assumptions
Average-Cost
Illustration 6-11
6-26
LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.
Financial Statement and Tax Effects
Comparative effects of cost flow methods
Illustration 6-13
HOUSTON ELECTRONICS
Condensed Income Statements
6-27
LO 3 Explain the financial effects of inventory cost flow assumptions.
Inventory Costing
Using Cost Flow Methods Consistently

Method should be used consistently, enhances
comparability.

Although consistency is preferred, a company may change
its inventory costing method.
Illustration 6-15
Disclosure of change in
cost flow method
6-28
Cost Flow Assumptions
Review Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
6-29
LO 3 Explain the financial effects of inventory cost flow assumptions.
Cost Flow Assumptions
Review Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
6-30
Helpful Hint A tax rule,
often referred to as the LIFO
conformity rule, requires that
if companies use LIFO for tax
purposes, they must also use it
for financial reporting purposes.
This means that if a company
chooses the LIFO method to
reduce its tax bills, it will also
have to report lower net income
in its financial statements.
LO 3 Explain the financial effects of inventory cost flow assumptions.
(See page 324)
6-31
Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
6-32

Companies “write down” the inventory to its market value in
the period in which the price decline occurs.

Market value = Replacement Cost

Example of conservatism.
International Note Under
U.S. GAAP, companies cannot
reverse inventory write-downs
if inventory increases in
value in subsequent periods.
IFRS permits companies to
reverse write-downs in some
circumstances.
LO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.
Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines
of merchandise with costs and market values as indicated.
Illustration 6-16
6-33
LO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.
Inventory Errors
Common Cause:
6-34

Failure to count or price inventory correctly.

Not properly recognizing the transfer of legal title to goods
in transit.

Errors affect both the income statement and balance sheet.
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold
and net income.
Illustration 6-17
Illustration 6-18
6-35
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
6-36

An error in ending inventory of the current period will have a
reverse effect on net income of the next accounting
period.

Over the two years, the total net income is correct because
the errors offset each other.

Ending inventory depends entirely on the accuracy of taking
and costing the inventory.
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Illustration 6-19
Sales
2014
Incorrect
Correct
$
$
80,000
$
80,000
90,000
$
90,000
Beginning inventory
20,000
20,000
12,000
15,000
Cost of goods purchased
40,000
40,000
68,000
68,000
Cost of goods available
60,000
60,000
80,000
83,000
Ending inventory
12,000
15,000
23,000
23,000
Cost of good sold
48,000
45,000
57,000
60,000
Gross profit
32,000
35,000
33,000
30,000
Operating expenses
10,000
10,000
20,000
20,000
Net income
$
Combined income for
2-year period is correct.
6-37
2013
Incorrect
Correct
22,000
$
25,000
($3,000)
Net Income
understated
$
13,000
$
10,000
$3,000
Net Income
overstated
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
6-38
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Errors
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:.
Illustration 6-17
Illustration 6-20
6-39
LO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
sales.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost or LCM), and
3) costing method (FIFO, LIFO, or average).
6-40
Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).
2. Low Inventory Levels – may lead to stockouts and lost
sales.
6-41
LO 6 Compute and interpret the inventory turnover.
Statement Presentation and Analysis
Inventory turnover measures the number of times on
average the inventory is sold during the period.
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
Days in inventory measures the average number of days
inventory is held.
Days in
Inventory
6-42
Days in Year (365)
=
Inventory Turnover
LO 6 Compute and interpret the inventory turnover.
Statement Presentation and Analysis
Illustration: Wal-Mart reported in its 2011 annual report a beginning
inventory of $32,713 million, an ending inventory of $36,318 million, and
cost of goods sold for the year ended January 31, 2011, of $315,287
million. The inventory turnover formula and computation for Wal-Mart are
shown below.
Illustration 6-22
Days in Inventory: Inventory turnover of 9.1 times divided into 365 is
approximately 40.1 days. This is the approximate time that it takes a
company to sell the inventory.
6-43
LO 6 Compute and interpret the inventory turnover.
APPENDIX 6A
Cost Flow Methods
Illustration:
Perpetual
Inventory
System
Illustration 6A-1
HOUSTON ELECTRONICS
Astro Condensers
Assuming the Perpetual Inventory System, compute Cost of Goods Sold
and Ending Inventory under FIFO, LIFO, and Average cost.
6-44
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6A
Cost Flow Methods
First-In, First-Out (FIFO)
Cost of Goods
Sold
6-45
Perpetual
Inventory
System
Illustration 6A-2
Ending Inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6A
Cost Flow Methods
Last-In, First-Out (LIFO)
Cost of Goods
Sold
6-46
Perpetual
Inventory
System
Illustration 6A-3
Ending Inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6A
Cost Flow Methods
Perpetual
Inventory
System
Average-Cost
Illustration 6A-4
Cost of Goods
Sold
6-47
Ending Inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6B
Estimating Inventories
Gross Profit Method
A method of estimating the cost of ending inventory by applying a
gross profit rate to net sales. A company needs to know
► its net sales, cost of goods available for sale, and gross profit
rate.
Illustration 6B-1
6-48
LO 8 Describe the two methods of estimating inventories.
APPENDIX 6B
Estimating Inventories
Illustration: Kishwaukee Company records show net sales of
$200,000, beginning inventory $40,000, and cost of goods purchased
$120,000. In the preceding year, the company realized a 30% gross
profit rate. It expects to earn the same rate this year. Compute the
estimated cost of the ending inventory at January 31 under the gross
profit method.
Illustration 6B-1
Illustration 6B-2
6-49
APPENDIX 6B
Estimating Inventories
Retail Inventory Method
► Retail companies establish a relationship between cost and sales
price.
► Company applies cost-to-retail percentage to ending inventory at
retail prices to determine inventory at cost.
Illustration 6B-3
6-50
LO 8
APPENDIX 6B
Estimating Inventories
Illustration: Note that it is not necessary to take a physical inventory
to determine the estimated cost of goods on hand at any given time.
Illustration 6B-4
Illustration 6B-1
The major disadvantage of the retail method is that it is an averaging technique.
It may produce an incorrect inventory valuation if the mix of the ending inventory
is not representative of the mix in the goods available for sale.
6-51
LO 8
A Look at IFRS
Key Points

The requirements for accounting for and reporting inventories
are more principles-based under IFRS. That is, GAAP provides
more detailed guidelines in inventory accounting.

The definitions for inventory are essentially similar under IFRS
and GAAP. Both define inventory as assets held-for-sale in the
ordinary course of business, in the process of production for
sale (work in process), or to be consumed in the production of
goods or services (e.g., raw materials).
6-52
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Key Points

Who owns the goods—goods in transit or consigned goods—
as well as the costs to include in inventory, are accounted for
the same under IFRS and GAAP.

Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in which
specific identification must be used.
6-53
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Key Points

A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO for
inventory valuation. IFRS prohibits its use. FIFO and averagecost are the only two acceptable cost flow assumptions
permitted under IFRS.

IFRS requires companies to use the same cost flow
assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.
6-54
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Key Points

In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
estimated selling expenses. GAAP, on the other hand, defines
market as essentially replacement cost.
6-55
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Key Points

Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new basis is now considered its
cost. As a result, the inventory may not be written back up to
its original cost in a subsequent period. Under IFRS, the writedown may be reversed in a subsequent period up to the
amount of the previous write-down. Both the write-down and
any subsequent reversal should be reported on the income
statement as an expense. An item-by-item approach is
generally followed under IFRS.
6-56
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Key Points

Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.

Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.

IFRS allows companies to report inventory at standard cost if it
does not differ significantly from actual cost. Standard cost is
addressed in managerial accounting courses.
6-57
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
Looking to the Future
One convergence issue that will be difficult to resolve relates to the use
of the LIFO cost flow assumption. As indicated, IFRS specifically
prohibits its use. Conversely, the LIFO cost flow assumption is widely
used in the United States because of its favorable tax advantages. In
addition, many argue that LIFO from a financial reporting point of view
provides a better matching of current costs against revenue and,
therefore, enables companies to compute a more realistic income.
6-58
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
IFRS Self-Test Questions
Which of the following should not be included in the inventory of a
company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping
point.
d) None of the above.
6-59
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
IFRS Self-Test Questions
Which method of inventory costing is prohibited under IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-60
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS
IFRS Self-Test Questions
Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.
6-61
LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.