Chapter Eight
Inventory
Inventory
• Assets a company holds that will
ultimately be sold to its customers
• Often the largest current asset that a firm
holds
• Can take the form of finished goods, raw
materials, or work in process
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8-2
The Purchasing Cycle
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8-3
Shipping Terms
FOB shipping point: FOB destination:
• Buyer pays the
• Seller pays the
transportation costs
transportation costs
• Purchase is recorded • Purchase is recorded
by the buyer when the
by the buyer when
inventory is shipped by the inventory is
the vendor
received
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8-4
The Sales Cycle
Customer
purchase
Record sale
and cost of
sale
Increase Cash or A/R
Increase Sales
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Credit
payment
received
by firm
Decrease Inventory
Increase Cost of
Goods Sold
8-5
Accounting for Inventory
Initially record at full cost
(purchase price plus shipping, handling,
shipping insurance, and taxes)
Perpetual
Inventory System
Periodic
Inventory System
Inventory account
adjusted for every
purchase or sale
Inventory account
adjusted only at end
of accounting period
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8-6
Perpetual Inventory System
Illustration
When Vanya Co. purchases an inventory item on
account for $10, the following entry is made:
Inventory
Accounts Payable
10
10
When the item is sold for $15 to a customer on
account, the following entries are made:
Accounts Receivable
Sales
Cost of Sales
Inventory
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15
15
10
10
8-7
Periodic Inventory System
Illustration
Vanya Co. purchases an inventory item on account for
$10 and the following entry is made:
Purchases
Accounts Payable
10
10
When the item is sold for $15 to a customer on
account, the following entry is made:
Accounts Receivable
Sales
15
15
The Inventory account is not updated until the end of
the period by performing a physical count of
inventory.
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8-8
Costing Inventory
As inventories turn over, with items rapidly
entering and exiting the pool of items, how
should the value of inventory be determined?
Cost-Flow Methods:
• Specific Identification
• Average Cost
• First-in, first-out (FIFO)
• Last-in, first-out (LIFO)
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8-9
Specific Identification Method
Each item bought and sold is matched
with its actual cost
•
•
•
Inventory account reflects the physical flow of
goods
Ideal for a firm that has low sales volume and
can easily track its goods
When an item is sold, its actual cost is used to
increase Cost of Sales and decrease Inventory
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8 - 10
Average-Cost Method
Cost of an inventory item is the average of
the costs of all goods available for sale at
that point in time
•
•
Suited for firms that carry homogeneous items,
such as grocery and office supply stores
A new average cost must be computed after
each purchase
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8 - 11
Average-Cost Method:
Computing the Average Cost
1. Add the cost of new purchases to any
previous inventory balance.
2. Divide this total by the number of units
on hand.
3. Yields new average cost of units of
inventory.
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8 - 12
Average-Cost Method: Illustration
Shoe Warehouse has a beginning inventory that
consists of 25 pairs of shoes at $60 per pair.
SW purchases 100 pairs at $70 per pair and makes the
following entry:
Inventory
Cash
7,000
7,000
Compute the average unit cost after the purchase:
Beg. Inventory (25 x $60)
$1,500
Purchase (100 x $70)
7,000
$8,500  125 = $68
Continue
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8 - 13
Average-Cost Method: Illustration
Shoe Warehouse sells 80 pairs of shoes at $125
per pair. When recording the cost of sales, use the
newly computed average unit cost of $68.
Cash (80 x $125)
Sales
Cost of Sales (80 x $68)
Inventory
10,000
10,000
5,440
5,440
Remember: After each purchase, the new
average cost per unit must be computed
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8 - 14
First-in, First-Out (FIFO)
Method
Assumes that the first item into inventory
is the first item sold to the customer
•
•
Inventory is carried at more current costs and
cost of sales consists of older costs
Under a perpetual system, the Inventory and
Cost of Sales accounts are updated after each
purchase and sale.
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8 - 15
FIFO: Illustration
Shoe Warehouse inventory activity:
• Jan. 1, purchased 25 pairs of shoes at $60 per pair.
• Jan. 3, purchased 100 pairs at $70 per pair.
• Jan. 8, sold 80 pairs at $125 per pair.
• Using the FIFO method, how will the sale and
cost of the sale on Jan. 8 be recorded?
Cash
Sales
Cost of Sales [(25 x $60) + (55 x $70)]
Inventory
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10,000
10,000
5,350
5,350
8 - 16
Last-in, First-Out (LIFO)
Method
Assumes that the last item into inventory
is the first item sold to the customer
•
•
Inventory is carried at older costs and cost of
sales consists of recent costs
Under a perpetual system, the Inventory and
Cost of Sales accounts are updated after each
purchase and sale.
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8 - 17
LIFO: Illustration
• Shoe Warehouse inventory activity:
• Jan. 1, purchased 25 pairs of shoes at $60 per pair.
• Jan. 3, purchased 100 pairs at $70 per pair.
• Jan. 8, sold 80 pairs at $125 per pair.
• Using the LIFO method, how will the sale on
Jan. 8 as well as the cost of the sale be
recorded?
Cash
Sales
10,000
Cost of Sales (80 x $70)
Inventory
5,600
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10,000
5,600
8 - 18
Comparing LIFO and FIFO
LIFO
• Results in lower pretax
earnings and tax
payments
• Closer match between
earnings and current-cost
income
• Requires more complex
record keeping
• Risk of LIFO liquidation
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FIFO
• Results in higher pretax
earnings and tax
payments
• Stronger correlation
between inventory
amount and current
replacement cost
• Easier record keeping
8 - 19
Critical Thinking
• Discussion: What factors do you think
businesses consider when choosing one
inventory method over another?
• When businesses choose inventory methods,
they consider the flow of merchandise, type of
merchandise, how each method will impact net
income and income tax, and what method
competitors use. Some methods are more
suitable to distinct goods while others are more
suitable to homogeneous goods.
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8 - 20
Choosing an Inventory Method
Four Key Questions:
1. What cost-flow assumption will be used
for tax purposes?
• If firms use LIFO for tax purposes, they must
use FIFO for reporting purposes.
2. Which cost-flow assumption will result in
the most cash flow?
• In times of rising prices, LIFO results in
lower income and lower tax payments,
which means that the firm will have more
cash left after paying taxes.
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8 - 21
Choosing an Inventory Method
(continued)
Four Key Questions:
3. What cost-flow assumptions are
competitors using?
•
Choose a method equivalent to competitors
so that financial results and ratios will be
comparable.
4. Which cost-flow assumption is easiest to
implement?
•
The FIFO method requires less record
keeping as compared to the other methods.
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8 - 22
Special LIFO Issues
• Use of LIFO causes older, less current values
to be reported as inventory amounts
Current costs - Inventory valued using LIFO = LIFO Reserve
Disclose in notes to the financial
statements
• Change in the LIFO reserve from one period to
another is called the LIFO effect
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8 - 23
LIFO Liquidation
• If a period’s ending inventory is ever lower
than its beginning inventory, it is assumed
that older, less costly inventory has been
sold = LIFO liquidation
• Effect: Cost of sales does not reflect
current costs and gross profit is inflated.
Thus higher earnings are reported (not the
intended effect of the LIFO method).
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8 - 24
Inventory Pools
• Tracking entire inventory as a whole or in
pools of like items reduces the danger of
LIFO liquidation.
• A reduction in one inventory item within
the pool is likely to be offset by an
increase in another item in the pool.
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8 - 25
Dollar-Value LIFO
• Based on the assumption that inventory is
a quantity of value rather than a quantity
of physical goods.
• Increases and decreases in inventory are
measured in dollar amounts, not numbers
of items.
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8 - 26
Dollar-Value LIFO Illustration
Komanda Co. begins using FIFO on Jan. 1, 2004
and has a beginning inventory of $35,000. At year
end 2004, ending inventory is $42,000.
1. Determine whether inventory has increased or
decreased in real dollars. (Prices in the firm’s
industry have risen such that the price index is
107 percent at year end.)
•
$42,000  107% = $39,252
2. Compare beginning inventory to computed
amount.
•
$39,252 - $35,000 = $4,252
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Continue
8 - 27
Dollar-Value LIFO Illustration
3. To determine how the inventory should be
valued on the balance sheet, group
inventories into layers:
Layer 1: Base-year
Layer 2: Inventory
increase for 2004 in
terms of price index
Dollar-value LIFO
inventory at 12/31/04
Value
in Base-Year
Price
Index
Balance
Sheet Value
$35,000
100%
$35,000
4,252
107%
$39,252
4,550
$39,550
Record on the balance
sheet
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8 - 28
The Effect of Inventory Errors
Sales
Cost of Sales:
Beg. Inv.
Purchases
Available
Less End. Inv.
Cost of sales
Gross Profit
Other expenses
Income before taxes
Tax expense
Net income
Reported Amt
$105,000
25,000
60,000
85,000
(25,000)
60,000
45,000
(25,000)
20,000
(7,000)
$13,000
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Correct Amt
$105,000
25,000
60,000
85,000
(27,000)
58,000
47,000
(25,000)
22,000
(7,700)
$14,300
Effect of Error
$2,000 understated
$2,000 overstated
$2,000 understated
$2,000 understated
$700 understated
$1,300 understated
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Lower-of-Cost-or-Market Rule
for Valuing Inventory
If market value of inventory < original cost
Write down inventory to the lower
value and record the loss
How is the market value of the inventory
determined?
Continue
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8 - 30
Lower-of-Cost-or-Market Rule
Illustration
• Rockwood Co. purchases inventory at a cost of
$100. This inventory sells for $125, yielding a 20
percent gross profit. At the end of period, the
replacement cost has fallen to $80. Under the
LCM rule, in most cases, the inventory is
reflected at its replacement cost, the more
conservative value.
Accounting
Research
Bulletin No. 43
Inventory’s current replacement
cost should not exceed the net
realizable value and should not
be less than the net realizable
value less gross margin.
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8 - 31
Analyzing Inventory
• How well is inventory being managed?
• Are items in inventory turned (sold)
quickly?
• Does a firm have too much inventory?
• Is the inventory profitable?
Inventory
Turnover
Analysis Ratios
Days in Inventory Inventory Yield
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Inventory Turnover Ratio
Cost of Sales
Average Inventory
• Measures how quickly inventory flows
through a business
• The higher the ratio, the more effectively
management is controlling inventory
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8 - 33
Days in Inventory
365  Inventory Turnover Ratio
• Measures how many days, on average, a
firm holds inventory before selling it
• If a firm has a 3.76 inventory ratio, it would
hold inventory, on the average, for 97
days
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8 - 34
Check Your Understanding
Q If you purchase goods FOB shipping
point, are you responsible for shipping
charges?
A FOB shipping point requires the buyer to
pay the shipping charges.
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8 - 35
Check Your Understanding
Q If you want your accounting records
(Inventory account) to reflect an accurate
count of inventory at all times, which
system of accounting for inventory
purchases and sales would you use?
A Under the perpetual inventory system, the
Inventory account is adjusted each time
inventory is purchased or sold.
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8 - 36
Check Your Understanding
Q Must a company employ the same costflow assumption for all its inventory items?
A No. Companies may employ different
assumptions for various products.
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8 - 37
Check Your Understanding
Q Which inventory method is based on the
assumption that each inventory item
bought and sold can be matched with its
actual cost?
A Specific identification method
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8 - 38
Check Your Understanding
Q If your company seeks to lower its
externally reported net income, would it
use FIFO or LIFO to accomplish this goal?
A LIFO
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8 - 39
Check Your Understanding
Q What situation causes a LIFO liquidation?
A A LIFO liquidation occurs if a period’s
ending inventory is lower than its
beginning inventory.
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8 - 40
Check Your Understanding
Q If a company makes an error in counting
inventory and it overstates inventory, how
will net income be affected in the current
year?
A Net income will be overstated
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8 - 41