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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 eects 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 eects 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 taris.
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
© 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.
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 taris.
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 dierent 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
© 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.
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
© 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.
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 eects 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 eects 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. Eects 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. Eects 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 aect 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 dierent !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
© 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.
Chapter 7: Inventory Instructor’s Manual, p. 5
during the year, dierent markups that exist on dierent types of merchandise, and
sales volumes of dierent 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 eects 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 eects 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
eects of the business cycle are smoothed out under LIFO, but inventory valuation is often
unrealistic.
© 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.
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 dierent 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 aects
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 aect its pro!tability, but not its
cash 2ows, except as they aect 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 eect on cash 2ow. Liquidity-related measures such
as the current ratio, inventory turnover, and days’ inventory on hand will be aected by the
inventory method chosen.
The pricing of inventories under the perpetual system diers 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 dierent
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 dierent !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.
© 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.
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 Eects 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
eective 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 eects of the dierent inventory methods on the !nancial statements, noting
that the level of sales is the same. Discuss, at length, the eects 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 eects of inventory methods on cash 2ows.
Describe again a perpetual inventory system, contrasting it with a periodic system.
© 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.
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 eects 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 eects are reversed within
two accounting 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.
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 dierent
eects 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 aects 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 eect, 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
Eects 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.
© 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.
Chapter 7: Inventory Instructor’s Manual, p. 10
Use Exercise 12A to demonstrate the eects and importance of inventory misstatements.
Student Engagement Tactics
5.Use a Jeopardy game format to test student comprehension of the eect 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 dierent 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.
© 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.
