978-1133939283 Chapter 7 Lecture Note

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Chapter 7

Inventory

Learning Objectives

1. Explain the concepts underlying inventory accounting.

2. Calculate inventory cost under the periodic inventory system using various costing

methods.

3. Explain the eects of inventory costing methods on income determination and income

taxes.

4. Calculate inventory cost under the perpetual inventory system using various costing

methods.

5. Use the retail method and gross pro!t method to estimate the cost of ending inventory.

6. Evaluate inventory level, and demonstrate the eects of inventory misstatements on

income measurement.

Section 1: Concepts

Concepts

 Accrual accounting (matching rule)

 Valuation

 Conservatism

 Disclosure

Lecture Outline

I. Merchandise inventory is a current asset.

A. The matching principle is applied to inventory valuation.

B. The higher the ending inventory, the lower the cost of goods sold and the higher

the gross pro!t and net income.

II. Inventory cost includes purchase price less discounts; freight-in, including insurance in

transit; and applicable taxes and taris.

III. Goods 2ows and cost 2ows

A. Goods 2ow is the actual physical 2ow of goods into and out of the company.

B. Cost 2ow is an assumption made about costs for accounting purposes.

C. Merchandise inventory also includes the following items:

1. Incoming goods shipped FOB shipping point

2. Outgoing goods shipped FOB destination

3. Goods consigned to another company

D. Merchandise inventory does not include the following items:

1. Incoming goods shipped FOB destination

2. Outgoing goods shipped FOB shipping point

3. Goods held on consignment from another company

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 2

IV. Inventory should be valued at the lower of cost or market.

A. First, inventory is valued at historical, or original, cost.

B. Market is de!ned as current replacement cost.

C. Cost is compared with market.

D. LCM is used by 80 percent of large companies.

Summary

Inventory, a current asset, is referred to as merchandise inventory by a retailer.

Manufacturers have three types of inventory: raw materials, work in process, and !nished

goods. This chapter focuses on inventory as it relates to merchandising concerns.

With inventory accounting, the matching principle is applied to inventory valuation to

arrive at the proper amount of net income. Cost of goods available for sale is assigned to

cost of goods sold and ending inventory. Recalling that cost of goods available less ending

inventory equals cost of goods sold, it can be seen that the higher the cost of ending

inventory, the lower the cost of goods sold and the higher the gross pro!t and net income.

The converse also is true.

Inventory cost is de!ned as the price paid to acquire the inventory and generally includes

invoice price less purchases discounts; freight-in, including insurance in transit; and

applicable taxes and taris.

Merchandise in transit is included in the buyer’s inventory if title to the goods has passed—

for example, FOB shipping point. Goods in transit shipped FOB destination belong to the

seller.

Merchandise sold but awaiting delivery is not included in the seller’s inventory.

When identical items of merchandise are purchased at dierent prices during the year, it

usually is impractical to monitor the actual goods ow and record the corresponding costs.

Instead, the accountant will make an assumption about the cost ow and will use one of

the methods discussed in Objective 2: (1) speci!c identi!cation; (2) average cost; (3) !rst-in,

!rst-out (FIFO); or (4) last-in, !rst-out (LIFO).

Sometimes companies enter into a consignment agreement through which goods are

transferred physically to another company without title transferring. Consigned goods

belong to the consignor.

The market value of inventory (current replacement cost) may fall below its cost because of

physical deterioration, obsolescence, or a decline in price level. Accordingly, inventory

should be valued using the lower-of-cost-or-market (LCM) rule. Companies must

disclose their use of LCM in their notes to the !nancial statements.

Relevant Examples and Exhibits

 Exhibit 1 Merchandise in Transit

 Exhibit 2 Management Choices in Accounting for Inventories

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 3

Teaching Strategy

If students are having any diCculty with the basic de!nition of merchandise inventory, refer

them to Chapter 5. Have them review the transactions and adjustments required to account

for merchandise inventory. This foundation is the best starting point for a discussion of the

measurement of inventory.

Review how beginning and ending merchandise inventory !t into the computation of cost of

goods sold and gross margin. Point out explicitly that ending merchandise inventory for one

period is beginning inventory for the subsequent period.

Discuss management choices related to inventory by referring to Exhibit 2.

Discuss the concept of cost as the term has been used in the course to this point.

Enumerate costs that are incurred in obtaining inventory. Refer the student to Exhibit 1 to

highlight the transfer of ownership of inventory. Discuss the diCculty inherent in allocating

speci!c costs to each inventory item.

Misconceptions arise during the study of cost 2ows as they relate to merchandise inventory.

Take care to explain that the cost 2ows that are calculated to match the cost of goods sold to

the revenues of the period are not necessarily representative of the 2ow of inventory.

Students have a diCcult time separating the two concepts. Give examples of goods that

typically 2ow on a !rst-in, !rst-out basis—for example, cartons of milk. Give examples of

goods that typically 2ow on a last-in, !rst-out basis—for example, dirt and gravel. Tell

students that businesses that sell these products may use any one of the four inventory

costing methods.

Tie into the discussion the application of the conservatism principle and the matching rule.

With this introduction to the topic, begin to de!ne LCM as it applies to inventories.

Case 4 on retail business inventories is appropriate for class discussion.

Section 2: Accounting Applications

Accounting Applications

 Calculate inventory cost under the periodic inventory system using:

oSpeci!c identi!cation method

oAverage-cost method

oFirst-in, !rst-out (FIFO) method

oLast-in, !rst-out (LIFO) method

 Calculate inventory cost under the perpetual inventory system using:

oSpeci!c identi!cation method

oAverage-cost method

oFirst-in, !rst-out (FIFO) method

oLast-in, !rst-out (LIFO) method

 Use the retail method to estimate the cost of ending inventory

 Use the gross pro!t method to estimate the cost of ending inventory

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 4

Lecture Outline

I. Under the speci!c identi!cation method, ending inventory can be identi!ed as having

come from speci!c purchases.

A. At this point, it might be helpful to solve a problem that will illustrate the four

inventory methods discussed in Objective 2, such as Exercise 7.

B. The speci!c identi!cation method is used primarily for high-priced items such as

automobiles, furniture, and expensive jewelry.

II. Under the average-cost method, an average cost per unit is calculated on goods

available for sale to determine ending inventory and cost of goods sold.

A. An advantage of the average-cost method is that cost increases and decreases are

leveled out.

B. A disadvantage of the average-cost method is that the most current costs are not

used in income determination.

III. Under FIFO, the !rst goods purchased are assumed to be the !rst sold.

A. In a period of rising prices, FIFO will produce the highest net income of the four

methods.

B. FIFO is criticized for magnifying the eects of the business cycle on income.

IV. Under LIFO, the goods purchased most recently are assumed to be the !rst sold.

A. LIFO matches current costs with current revenues, and the eects of the business

cycle are smoothed out.

B. Disadvantages of LIFO include reporting the lowest net income of the four methods

in in2ationary times, often an unrealistic inventory valuation, the distortion of

balance sheet measures like working capital and current ratio, and the lack of IFRS

acceptance.

V. During periods of rising prices, FIFO provides a higher gross margin than LIFO. The

average-cost method produces gross margin that is between those of FIFO and LIFO. No

generalization can be made about the speci!c identi!cation method.

A. During periods of falling prices, LIFO produces a higher gross margin than FIFO.

VI. Eects on the !nancial statements

A. In general, LIFO best follows the matching rule.

B. In general, FIFO provides a more current ending inventory value for balance sheet

purposes.

VII. Eects on income taxes

A. The inventory method chosen for tax purposes must be applied consistently.

B. When LIFO is used for tax purposes, it must also be used for !nancial reporting.

C. A LIFO liquidation occurs when the quantity of ending inventory is less than the

quantity of beginning inventory. This generally produces higher income before

taxes.

VIII. A company’s choice of inventory method will aect not only its pro!tability, but also its

liquidity and cash 2ows.

IIIX. The speci!c identi!cation method is applied the same way in the perpetual system as

in the periodic system and produces the same results.

X. Using the average-cost method in a perpetual system, a moving average is computed

after each purchase.

IV. Using FIFO and LIFO in a perpetual system, list each inventory layer separately.

XIV. FIFO will yield the same ending inventory !gure under the perpetual system as under

the periodic system.

XIII. LIFO will usually produce dierent !gures for ending inventory and cost of goods sold in

a perpetual system than in a periodic system.

XIVI. At this point, it might be helpful to solve a problem that illustrates the four inventory

methods in a periodic and a perpetual system, such as Exercise 7A.

XVII. The retail method can be used when the relationship between cost and selling price is

relatively constant. Applying this method is complicated by retail prices that change

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 5

during the year, dierent markups that exist on dierent types of merchandise, and

sales volumes of dierent types of merchandise that vary.

A. With the retail method, records must be kept at cost and at retail.

B. Applying the retail method involves four steps.

1. Compute goods available for sale at cost and at retail.

2. Compute a cost-to-retail ratio.

3. Subtract sales from goods available for sale at retail to obtain ending

inventory at retail.

4. Multiply ending inventory at retail by the cost-to-retail ratio to determine

ending inventory at cost.

XVI. The gross pro!t method can be used when the gross pro!t ratio remains relatively

constant.

A. The gross pro!t method is used in place of the retail method when records of retail

prices of beginning inventory and purchases are not kept.

B. The gross pro!t method is generally used when inventory is destroyed or stolen.

C. Applying the gross pro!t method involves three steps.

1. Compute goods available for sale (at cost) by adding purchases to beginning

inventory.

2. Compute estimated cost of goods sold by deducting the estimated gross

margin from sales.

3. Subtract estimated cost of goods sold from cost of goods available for sale to

obtain estimated ending inventory.

Summary

Under the speci)c identi)cation method, the units of ending inventory can be identi!ed

as having come from speci!c purchases. The 2ow of costs re2ects the actual 2ow of goods in

this case. This method is not common because it is usually impractical as a result of the

volume of transactions and because it permits companies to manipulate income by choosing

to sell the high- or low-cost items.

Under the average-cost method, the average cost per unit is !rst computed for the goods

available for sale during the period. This is accomplished by dividing the cost of goods

available for sale by the units available for sale. Then the average cost per unit is multiplied

by the number of units in ending inventory to obtain the cost of ending inventory. This

method has the advantage of leveling the eects of variations in cost. It does not, however,

use the most recent costs, which are most relevant in determining cost of goods sold.

Under the )rst-in, )rst-out (FIFO) method, the cost of the !rst items purchased is

assigned to the !rst items sold. During periods of rising prices, FIFO yields the highest net

income of the four methods. FIFO is criticized for magnifying the eects of the business

cycle on income.

Under the last-in, )rst-out (LIFO) method, the last items purchased are assumed to be

the !rst items sold. Therefore, ending inventory is assumed to consist of items from the

earliest purchases. During periods of rising prices, LIFO yields the lowest net income of the

four methods, but it best matches current merchandise costs with current sales prices. The

eects of the business cycle are smoothed out under LIFO, but inventory valuation is often

unrealistic.

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 6

During periods of rising prices, FIFO produces a higher gross margin than LIFO, and the

average-cost method produces gross margin that is somewhere between those of FIFO and

LIFO. During periods of falling prices, the reverse is true. Even though LIFO best follows the

matching rule, FIFO provides a more current ending inventory !gure for balance sheet

purposes.

There are several rules for the valuation of inventory for federal income tax purposes. For

example, a business has a wide choice of methods, but once a method has been chosen, it

must be applied consistently. In addition, several regulations apply to LIFO, among them the

requirement that LIFO be used for accounting record purposes when it is being used for tax

purposes. In most other cases, a company may choose dierent methods for income tax and

!nancial reporting purposes.

A LIFO liquidation occurs when sales have reduced inventories below the levels

established in prior years. When prices have been rising steadily, a LIFO liquidation produces

unusually high pro!ts.

Because the cost of ending inventory is needed to compute the cost of goods sold, it aects

income before income taxes dollar for dollar. It is most important to match cost of goods sold

with sales so that a proper determination of income before income taxes will result.

Generally, a company’s choice of inventory method will aect its pro!tability, but not its

cash 2ows, except as they aect income taxes. The use of LIFO, for example, will usually

produce a lower income before income taxes than will FIFO. However, the reduced tax

liability under LIFO will have a positive eect on cash 2ow. Liquidity-related measures such

as the current ratio, inventory turnover, and days’ inventory on hand will be aected by the

inventory method chosen.

The pricing of inventories under the perpetual system diers from pricing under the periodic

system. Under the perpetual system, the cost of goods sold is determined at the time of

sale, and the cost of ending inventory is determined after every inventory transaction.

The speci!c identi!cation method is the same under the perpetual system as under the

periodic system.

Using the average-cost method in a perpetual system, a moving average is computed after

each purchase rather than for all goods available for the period, which can produce dierent

results.

Using FIFO and LIFO in a perpetual system, it is important to list each inventory layer

separately so that costs can be assigned in the proper order. FIFO will yield the same ending

inventory !gure under the perpetual system as under the periodic system, whereas LIFO will

usually produce dierent !gures.

The retail method of inventory estimation can be used when there is an overall constant

relationship between the cost and the sales price for goods over a period of time. It can be

used whether or not the business makes a physical count of goods.

To apply the retail method, goods available for sale is !rst determined both at cost and at

retail. Then a cost-to-retail ratio is computed. Sales for the period are subtracted from goods

available for sale at retail to produce ending inventory at retail. Finally, ending inventory at

retail is multiplied by the cost-to-retail ratio to produce an estimate of ending inventory at

cost.

The gross pro)t method of inventory estimation assumes that the percentage of gross

pro!t for a business remains relatively stable from year to year. This method is used when

inventory records are lost or destroyed and when records of beginning inventory and

purchases at retail are not kept.

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 7

To apply the gross pro!t method, !rst determine the cost of goods available for sale by

adding purchases to beginning inventory. Then estimate the cost of goods sold by deducting

the estimated gross margin from sales. Finally, subtract the estimated cost of goods sold

from the cost of goods available for sale to arrive at estimated ending inventory.

Relevant Examples and Exhibits

 Exhibit 3 The impact of Costing Methods on the Income Statement and Balance Sheet

Under the Periodic Inventory System

 Exhibit 4 Eects of Inventory Costing Methods on Gross Margin

 Exhibit 5 Inventory Costing Methods Used by 500 Large Companies

 Exhibit 6 The Impact of Costing Methods on the Income Statement and Balance Sheet

Under the Perpetual Inventory System

 Exhibit 7 Retail Method of Inventory Estimation

 Exhibit 8 Gross Pro!t Method of Inventory Estimation

 Exhibit 9 Valuation of Inventory on the Balance Sheet Impacts Cost of Goods Sold on

the Income Statement

Teaching Strategy

Of the methods presented, the speci!c identi!cation method is the most easily understood.

Unfortunately, it also reinforces the tie between the 2ow of costs and the 2ow of physical

inventory. Beware of this pitfall. Short Exercise 2 pertains to the speci!c identi!cation

method.

The average-cost method is one of the methods that is more easily understood. If it is

discussed in the context of changing prices or of quantity discounts given on larger orders of

like items, students are likely to see the “fairness” of this method. As you go through each

example of inventory valuation, take care to keep the 2ow of costs and the 2ow of physical

inventory separate. Short Exercise 3 uses the average-cost method in a periodic inventory

system.

The FIFO method is reasonable to students because it coincides with the physical 2ow of

properly rotated stock. This is a point for discussion. Take care, however, that students are

not lulled into assuming that a relationship exists between cost 2ows and the physical 2ow

of goods. It helps to tie the logic of FIFO to typically rising prices and the matching rule. This

separates the 2ows of costs and goods and focuses on the cost aspect only. Short Exercise 4

and Exercises 2A, 3A, and 4A include FIFO.

Since the LIFO method is contrary to logic and to the usual 2ow of goods, it is the most

eective for separating the 2ow of goods from the 2ow of costs. A discussion of reasons for

choosing this method may aid understanding. Take care to refer to the illustrations in the

text for both FIFO and LIFO, comparing the details. Short Exercise 5 and Exercises 2A, 3A

and 4A include LIFO. Case 1 is a good discussion case for the reasons for using LIFO.

Compare the eects of the dierent inventory methods on the !nancial statements, noting

that the level of sales is the same. Discuss, at length, the eects of changing prices and the

manipulation of ultimate tax liability by choosing one method over another.

Caution students that both GAAP and taxing agencies limit the ability to change from one

method to another without adequate reason.

Exercise 5A is a good illustration of the eects of inventory methods on cash 2ows.

Describe again a perpetual inventory system, contrasting it with a periodic system.

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 8

Short Exercises 7 through 9 and Exercises 6A and 7A apply inventory costing methods in a

perpetual system. Exercise 7a applies all four costing methods !rst in a periodic inventory

system and then in a perpetual inventory system.

Estimation of the valuation of inventory is introduced to give students an overview of

methods that are commonly used by !rms. The retail method is easily understood, although

care should be taken in explaining the math used to convert from cost to retail and vice

versa. Exercise 8A may be used in class to illustrate this estimation method.

Point out to students that for interim reporting, estimates of the value of inventories may be

appropriate. However, the costing methods previously discussed would still be used for

!nancial statement presentation. Refer to the illustration in the text, which presents

inventory value using the gross pro!t method and then converts that value to an estimated

cost. Take care to go through the math required for this method. Exercise 9A may be used in

class to illustrate this estimation method.

Section 3: Business Applications

Business Applications

 Evaluate the level of inventory

oInventory turnover

oDays’ inventory on hand

 Manage the level of inventory

oSupply-chain management

oJust-in-time operating environment

 Evaluate the eects of inventory misstatements on income measurement

Lecture Outline

I. In managing inventory levels, it is important to take into consideration both the cost of

handling, storing, and !nancing inventories and the cost of lost sales.

A. Inventory turnover (cost of goods sold divided by average inventory) is the number

of times, on average, inventory is sold during the period.

B. Days’ inventory on hand (365 divided by inventory turnover) is the number of days

it takes to sell inventory.

C. Inventory levels are minimized by using supply-chain management in a just-in-time

operating environment.

II. Beginning and ending inventory are an integral part of the calculation of cost of goods

sold and, therefore, income before income taxes.

A. When ending inventory is under– or overstated, income before income taxes will be

under– or overstated, respectively.

B. When beginning inventory is under– or overstated, income before income taxes will

be over– or understated, respectively.

C. Inventory errors are counterbalancing because their eects are reversed within

two accounting periods.

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 9

Summary

Management has several choices with regard to inventory. It must choose between the

periodic and the perpetual inventory systems. In addition, it must choose an inventory

costing method, such as speci!c identi!cation, average cost, FIFO, or LIFO. In some cases,

market value (replacement cost) is lower than historical cost. These choices have dierent

eects on net income, income taxes, and cash 2ows.

Inventory turnover is used to measure inventory levels and is computed by dividing cost

of goods sold by the average inventory. It indicates the number of times, on average,

inventory is sold during the period. Another related measure, days’ inventory on hand,

indicates the average number of days between the purchase and sale of inventory. It is

computed by dividing the number of days in a year by the inventory turnover.

Inventory levels are minimized through supply-chain management, wherein a company

uses the Internet for business-to-business (B2B) ecommerce to manage its inventory and

purchasing, in a just-in-time operating environment, where goods arrive just at the time

they are needed.

In determining inventory levels, management must balance the cost of handling, storing,

and !nancing inventories with the cost of lost sales and dissatis!ed customers.

This year’s ending inventory automatically becomes next year’s beginning inventory.

Because beginning inventory also aects income before income taxes dollar for dollar, an

error in this year’s ending inventory results in misstated gross margin and income before

income taxes for both this year and next year. The eect, however, in the following period

will be opposite to that in the prior period.

1. When ending inventory is understated, income before income taxes for the period will

be understated.

2. When ending inventory is overstated, income before income taxes for the period will be

overstated.

3. When beginning inventory is understated, income before income taxes for the period

will be overstated.

4. When beginning inventory is overstated, income before income taxes for the period will

be understated.

Relevant Examples and Exhibits

 Inventory Turnover

 Days’ Inventory on Hand

 Example 1. Ending Inventory Correctly Stated at $5,000

 Example 2. Ending Inventory Overstated by $3,000

 Example 3. Ending Inventory Understated by $3,000

 Eects of Inventory Misstatements

Teaching Strategy

Review computations for inventory turnover and average days’ inventory on hand, and

explain how to interpret them. Point out that industry standards vary but that many

companies try to keep inventory levels at a minimum by using supply-chain management in

a just-in-time operating environment. Explain how just-in-time works.

Short Exercises 11 and 12 and Case 6 are pertinent to the evaluation of inventory levels.

or posted to a publicly accessible website, in whole or in part.

Chapter 7: Inventory Instructor’s Manual, p. 10

Use Exercise 12A to demonstrate the eects and importance of inventory misstatements.

Student Engagement Tactics

5.Use a Jeopardy game format to test student comprehension of the eect of inventory

cost 2ows on income, cash 2ows, taxes, and balance sheet valuation. At least one class

prior to the game, let students know the learning objectives on which they will be

quizzed.

6. Students could be assigned to teams based on prior exam scores to equalize the teams.

Each team could have three members. Provide tags with team numbers for students to

wear during the game. It makes scoring easier.

7. Using information from exercises SE 11, E1A, and the text, prepare answers so that

responses can be phrased with questions such as “What is LIFO?” or “What is FIFO?”

Particularly tough questions could be identi!ed as Double Jeopardy items worth double

points.

8. As a preliminary round, call out six answers, and have each team member write

responses in question form on a sheet of paper. Each individual score will be treated as

part of a team grade. Emphasize that responses must be legible so that another team

can grade it. If a response can’t be read, it will be counted as incorrect. The

recommended time limit to respond is 10 to 15 seconds. A stopwatch is helpful.

9. To determine who moves on to the !nal round, have Team 1 give its answer sheet to

Team 2, Team 2 to Team 3, etc., until the last team gives its answer sheet to Team 1.

Each correct answer wins one point. Double Jeopardy answers are worth two points.

10. The teams with the highest scores for round one move on to the !nal round. Assign

team names or keep the same numbers. Tags with the group name/number should be

easily visible from the scorers’ viewpoint. Ask one or two trusted students to keep

score.

11. In the !nal round, ask one team at a time a dierent question to be answered within ten

seconds. A limited use of recycled questions is OK as long as the same team does not

get the same question. This process continues for a stated number of rounds. “Sudden

death” could be played if more than one team remains.

12. Consider performance-based rewards. For example, the members of the team with the

highest score could be granted bonus quiz points or have a quiz waived. Additionally,

you could honor winners as reigning team champions, presenting them with !rst-place

ribbons.

or posted to a publicly accessible website, in whole or in part.