CHAPTER
7
Inventories
Principles of
Accounting
12e
Needles
Powers
Crosson
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Concepts Underlying Inventory Accounting
 Manufacturing companies have three kinds of
inventory:
– Raw materials (goods used in making products)
– Work in process (partially completed products)
– Finished goods ready for sale
 For a merchandising company, inventory
consists of all goods owned and held for sale
in the regular course of business.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrual Accounting and Valuation of
Inventories
 Inventory accounting applies accrual accounting to the
determination of the cost of inventory sold.
– Inventory cost includes the following: invoice price less purchases
discounts; freight-in, including insurance in transit; applicable taxes
and tariffs.
– Inventory valuation depends on the prices of goods, which can
vary during the year. Thus, it is necessary to make an assumption
about the order in which items have been sold.
 Goods flow refers to the actual physical measurement of
goods in the operations of a company.
 Cost flow refers to the association of costs with their assumed
flow.
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Merchandise in Transit
 Outgoing goods shipped FOB destination are
included in the seller’s merchandise inventory,
whereas those shipped FOB shipping point are
not.
 Incoming goods shipped FOB shipping point are
included in the buyer’s merchandise inventory, but
those shipped FOB destination are not.
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Merchandise Not Included in Inventory
 Goods to which the company does not hold title
should not be included in its physical inventory.
These include:
– Goods sold but not yet delivered to the buyer
– Goods held on consignment—merchandise that its
owner (the consignor) places on the premises of another
company (the consignee) with the understanding that
payment is expected only when the merchandise is sold
and that unsold items may be returned to the consignor
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Conservatism and the
Lower-of-Cost-or-Market (LCM) Rule
 If the market value of inventory falls below its
historical cost because of physical deterioration,
obsolescence, or decline in the price level, a loss
has occurred. This loss is recognized by writing the
inventory down to market, or its current
replacement cost.
– When the replacement cost of inventory falls below its
historical cost, the lower-of-cost-or-market (LCM) rule
requires that the inventory be written down to the lower
value and that a loss be recorded.
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Inventory Cost Under the
Periodic Inventory System
 The value assigned to the ending inventory is the
result of two measurements: quantity and cost.
– Under the periodic inventory system, quantity is
determined by taking a physical inventory.
– Cost is determined by using one of the following
methods: specific identification, average-cost, first-in,
first-out (FIFO), or last-in, first-out (LIFO).
– The choice of method depends on the nature of the
business, the financial effects, and the cost of
implementation.
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Specific Identification Method
 The specific identification method identifies the
cost of each item in the ending inventory.
– It can be used only when it is possible to identify the
units as coming from specific purchases.
– Although this method may appear logical, most
companies do not use it for the following reasons:
 It is usually impractical, if not impossible, to keep track of the
purchase and sale of individual items.
 When a company deals in items that are identical but bought
at different prices, deciding which items were sold becomes
arbitrary.
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Average Cost Method
 Under the average-cost method (or weighted average
method), inventory is priced at the average cost of the
goods available for sale during the period. Average cost
is computed as follows:
Average Cost = Total Cost of Goods Available for Sale
Total Units Available for Sale
- The average cost method tends to level out the effects
of cost increases and decreases because the cost of the
ending inventory is influenced by all the prices paid
during the year and the cost of the beginning inventory.
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First-In, First-Out (FIFO) Method
 The first-in, first-out (FIFO) method assumes that
the costs of the first items acquired should be
assigned to the first items sold.
– The costs of the goods on hand at the end of a period
are assumed to be from the most recent purchases, and
the costs assigned to goods that have been sold are
assumed to be from the earliest purchases.
– Thus, the FIFO method values the ending inventory at
the most recent costs and includes earlier costs in the
cost of goods sold.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Last-In, First-Out (LIFO) Method
 The last-in, first-out (LIFO) method of costing
inventories assumes that the costs of the last items
purchased should be assigned to the first items
sold and that the cost of the ending inventory
should reflect the cost of the goods purchased
earliest.
– The effect of LIFO is to value inventory at the earliest
prices and to include the cost of the most recently
purchased goods in the cost of goods sold.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Inventory Decisions
 In a period of rising prices, LIFO, which charges
the most recent prices to the cost of goods sold,
results in the lowest gross margin.
 In a period of rising prices, FIFO, which charges
the earliest prices to the cost of goods sold,
produces the highest gross margin.
 The gross margin under the average-cost method
falls between the gross margins produced by LIFO
and FIFO.
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Effects on Income Taxes
 The Internal Revenue Service governs how
inventories must be valued for federal income tax
purposes.
– IRS regulations give companies a wide choice of
inventory costing methods, including specific
identification, average-cost, FIFO, and LIFO.
– During a period of rising prices, a company using LIFO
will pay higher income taxes if it lets the inventory at
year end fall below the level at the beginning of the
year. This is called a LIFO liquidation—that is, units
sold exceed units purchased for the period.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Inventory Cost Under the
Perpetual Inventory System
 Under the perpetual inventory system, inventory is
updated as purchases and sales take place.
 The cost of goods sold is accumulated as sales are
made and costs are transferred from the Inventory
account to the Cost of Goods Sold account.
 The cost of the ending inventory is the balance of
the Inventory account.
 Goods are valued using one of these methods:
specific identification, average-cost, FIFO, or LIFO.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Specific Identification Method
 The detailed records of purchases and sales
maintained under the perpetual system facilitate
the use of the specific identification method.
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Average-Cost Method
 Under the perpetual system, an average is
computed after each purchase or series of
purchases.
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FIFO Method
 When costing inventory with the FIFO or LIFO
methods, it is necessary to keep track of the
components of inventory because, as sales are
made, the costs must be assigned in the proper
order.
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Valuing Inventory by Estimation
 The most commonly used methods for estimating
the value of the ending inventory are:
– the retail method, which estimates the cost of the
ending inventory by using the ratio of cost to retail
price. It can be used to estimate the cost without taking
time to determine the cost of each item in the inventory.
– the gross profit method (or gross margin method),
which assumes that the ratio of gross margin for a
business remains relatively stable from year to year.
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Gross Profit Method
 The gross profit method is used in place of the
retail method when records of the retail prices of
the beginning inventory and purchases are not
available.
 This method is acceptable for estimating the cost
of inventory for insurance claims and for interim
reports, but it is not acceptable for valuing
inventory in the annual financial statements.
 The gross profit method involves three steps.
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Inventory Turnover
 Inventory turnover is the average number
of times a company sells an amount equal
to its average level of inventory during a
period.
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Days’ Inventory on Hand
 Day’s inventory on hand is the average
number of days it takes a company to sell
an amount equal to its average inventory.
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Inventory Management
 To reduce their levels of inventory, many
merchandisers and manufacturers use
supply-chain management in conjunction
with a just-in-time operating environment.
– With supply-chain management, a company
uses the Internet to order and track goods that
it needs immediately.
– A just-in-time (JIT) operating environment is
one in which goods arrive just at the time they
are needed.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Inventory Misstatements and Fraud
 Inventory is particularly susceptible to fraudulent
financial reporting.
– It is easy to overstate or understate inventory by
including end-of-the-year purchase and sale
transactions in the wrong fiscal year or by simply
misstating inventory by mistake.
– A misstatement can also occur because of deliberate
manipulation of operating results motivated by a desire
to enhance the market’s perception of the company,
obtain bank financing, or achieve compensation
incentives.
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Inventory Misstatements Illustrated
 Because the ending inventory in one period
becomes the beginning inventory in the following
period, a misstatement in inventory valuation
affects both periods.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.