CHAPTER 6
INVENTORIES
LEARNING OBJECTIVES
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. DISCUSS THE PRESENTATION AND ANALYSIS OF
INVENTORY.
*7. APPLY THE INVENTORY COST FLOW METHODS TO
PERPETUAL INVENTORY RECORDS.
*8. DESCRIBE THE TWO METHODS OF ESTIMATING
INVENTORIES.
CHAPTER REVIEW
Classifying Inventory
1. (L.O. 1) Merchandise inventory has two common characteristics: (a) it is owned by the company
2. A manufacturer’s inventory is usually classified into three categories:
Determination of Inventory Quantities
3. The determination of inventory quantities involves (a) taking a physical inventory of goods on
4. Taking a physical inventory involves counting, weighing or measuring each kind of inventory on
errors.
5. For goods in transit, legal title is determined by the terms of sale. When the terms are:
buyer.
6. Under a consignment arrangement, the holder of the goods (called the consignee) does not own
consignee’s inventory.
Inventory Costing
7. (L.O. 2) Inventory is accounted for at cost which includes all expenditures necessary to acquire
inventory and the cost of goods sold.
Specific Identification
8. The specific identification method identifies the particular units sold so that the cost of the
purchase through the time of sale.
9. The allocation of inventoriable costs may be made under any of the following assumptions as to
the flow of costs (a) first-in, first-out (FIFO), (b) last-in, first-out (LIFO), or (c) average-cost.
FIFO
LIFO
11. The LIFO method assumes that the costs of the latest units purchased are the first to be sold.
c. The ending inventory is found by taking the unit cost of the oldest goods and working forward
until all units of inventory are costed.
Average-Cost
12. The average-cost method assumes that the goods available for sale are similar in nature.
average unit cost.
b. The formula for determining the weighted-average unit cost is: Cost of goods available for
Financial Statement Effects
13. (L.O. 3) In periods of rising prices, FIFO produces a higher net income, LIFO the lowest, and
14. Companies adopt different inventory costing methods because of:
LIFO.
b. Income statement effects: in addition to the effects on net income in (13) above, LIFO enables
Lower-of-Cost-or-Market
15. (L.O. 4) The value of inventory for companies in certain industries can drop due to changes in
16. Market is defined as the current replacement cost of the goods, not selling price.
Effects of Inventory Errors
17. (L.O. 5) The effects of inventory errors on the current year’s income statement are:
Cost of
Inventory Error Goods Sold Net Income
Beginning inventory understated Understated Overstated
Beginning inventory overstated Overstated Understated
Ending inventory understated Overstated Understated
Ending inventory overstated Understated Overstated
18. The effects of ending inventory errors on the balance sheet are:
Ending
Inventory Assets Liabilities Owner’s Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated
19. In the financial statements:
a. Inventory is usually classified as a current asset after receivables in the balance sheet, and
cost of goods sold is subtracted from sales in the income statement.
b. There should be disclosure of (1) the major inventory classifications, (2) the basis of accounting,
and (3) the costing method.
Inventory Turnover
20. (L.O. 6) The inventory turnover measures the number of times on average the inventory is
sold during the period.
Cost of Goods Sold ÷ Average Inventory = Inventory Turnover
*Applying Perpetual Inventory
*21. (L.O. 7) Each of the inventory cost flow methods may be used in a perpetual inventory system.
a. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of
goods sold.
b. Under the LIFO method, the most recent purchase prior to sale is allocated to the units sold.
c. When the moving-average method is used, a new average is computed after each
purchase by dividing the cost of goods available for sale by the units on hand.
Estimating Inventories
inventory.
Gross Profit Method
*23. The gross profit method is widely used to estimate the ending inventory. Two steps are involved
in using this method.
net sales.
b. The estimated cost of goods sold is subtracted from cost of goods available for sale to
determine the estimated cost of the ending inventory.
Retail Inventory Method
a.
b.
c.
Goods Available
for Sale at Cost
÷
Goods Available
for Sale at Retail
=
Cost-to–
Retail Ratio
Ending
Inventory X
at Retail
Cost-to–
Retail =
Ratio
Estimated Cost
of Ending
Inventory
Goods Available
for Sale at Retail
–
Net
Sales
Ending
Inventory
at Retail
=
LECTURE OUTLINE
A. Classifying and Determining Inventory.
1. Inventory of a merchandising company has two common characteristics:
a. It is owned by the company.
business.
2. In a manufacturing company, some inventory may not yet be ready for sale.
As a result, manufacturers usually classify inventory into three categories:
a. Finished goods; manufactured items that are completed and ready
for sale.
not yet been placed into production.
ACCOUNTING ACROSS THE ORGANIZATION
JIT can save a company a lot of money, but it isn’t without risk. An unexpected
disruption in the supply chain can cost a company a lot of money. Japanese
automakers experienced such a disruption when an earthquake damaged a
future?
Answer: The manufacturer of the piston rings should spread its manufacturing
facilities across a few locations that are far enough apart that they
would not all be at risk at once. In addition, the automakers might
consider becoming less dependent on a single supplier as well as
having weather contingency plans.
B. Determining Inventory Quantities.
1. All companies need to determine inventory quantities at the end of the
accounting period. Companies using a perpetual system take a physical
inventory for the following reasons:
a. To check the accuracy of their perpetual inventory records.
shoplifting, or employee theft.
2. Determining inventory quantities involves two steps: (1) taking a physical
inventory of goods on hand and (2) determining the ownership of goods.
a. Taking a physical inventory involves actually counting, weighing, or
measuring each kind of inventory on hand.
b. Determining ownership of goods.
by the terms of the sale:
(a) When the terms are FOB (free on board) shipping point,
ownership of the goods passes to the buyer when the public
carrier accepts the goods from the seller.
(b) When the terms are FOB destination, ownership of the goods
C. Inventory Costing.
1. Inventory is accounted for at cost.
2. Cost includes all expenditures necessary to acquire goods and place them
in condition ready for sale.
3. Cost of goods available for sale includes:
a. The cost of beginning inventory.
b. The cost of goods purchased.
4. Cost of goods available for sale is allocated to either ending inventory or
to cost of goods sold.
D. Specific Identification.
1. Specific identification requires that companies keep records of the original
cost of each individual inventory item.
2. Bar coding, electronic product codes, and radio frequency identification
make it theoretically possible to do specific identification with nearly any
type of product.
3. This method, however, may enable management to manipulate net income.
E. Cost Flow Assumptions—FIFO, LIFO, and Average-Cost.
1. The FIFO (first-in, first-out) method assumes that the earliest goods pur-
chased are the first to be recognized in determining cost of goods sold.
a. FIFO often parallels the actual physical flow of merchandise because
it generally is good business practice to sell the oldest units first.
b. Under FIFO, companies obtain 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.
2. The LIFO (last-in, first-out) method assumes that the latest goods pur-
chased are the first to be recognized in determining cost of goods sold.
b. Under LIFO, companies obtain the cost of the ending inventory by
taking the unit cost of the earliest goods available for sale and working
c. The company then applies the weighted-average unit cost to the units
on hand to determine the cost of ending inventory.
F. Financial Statement and Tax Effects of Cost Flow Methods.
1. Income statement effects.
revenues.
c. Some argue that the use of LIFO in a period of inflation enables
the company to avoid reporting paper (or phantom) profit as eco-
nomic gain.
2. Balance sheet effects.
current cost.
b. A major shortcoming of the LIFO method is that in a period of infla-
understated in terms of current cost.
3. Tax effects. LIFO results in lower income taxes, because of lower net
income, than either FIFO or average cost in a period of rising prices.
INTERNATIONAL INSIGHT
ExxonMobil Corporation uses LIFO to value its inventory for financial reporting
comparable to U.S. companies.
What are the arguments for and against the use of LIFO?
Answer: Proponents of LIFO argue that it is conceptually superior because it
matches the most recent cost with the most recent selling price. Critics
contend that it artificially understates the company’s net income and
G. Lower-of–Cost-or-Market.
1. The value of inventory for companies in certain industries can drop very
quickly due to changes in technology or fashions. This situation requires
a departure from the cost basis of accounting. This is done by valuing the
inventory at the lower–of-cost-or–market (LCM) in the period in which the
price decline occurs.