Chapter 15
Accounting for Merchandise Inventory
Chapter Overview
This chapter discusses the business dilemma of having the right quantities of inventory available for sale to
customers. Having too small of an inventory risks running short of inventory and missing out on sales
revenue. Having too much of an inventory risks having too much of the company’s money tied up in
inventory overstocks. Chapter 11 discussed the periodic inventory system which checks and updates
inventory only at the end of the accounting period. Managers do not know the actual amount of inventory on
hand nor the actual cost of goods sold until the end of the period.
Learning Objectives
After studying Chapter 15, your students should gain proficiency in the following:
2. Explain Using Subsidiary Ledgers in Calculating Cost of Ending Inventory in a Perpetual System.
4. Estimate Ending Inventory by the Retail and Gross Profit Methods.
Chapter 15 Assignment Grid
Estimated Level
Learning Time in of
Assignment Topic(s) Objective(s) Minutes Difficulty
Discussion Questions and Critical Thinking/Ethical Case
1 Perpetual vs. Periodic Inventory 1 5 Easy
2 Perpetual Inventory Accounts 1 5 Easy
3 Perpetual Inventory Entries 1 5 Easy
4 Perpetual Inventory Entries 1 5 Easy
Concept Checks
1 Transaction Analysis 1 5 Easy
2 Perpetual Inventory Entries 1 10 Easy
3 Perpetual Inventory Entries 1 10 Easy
Exercises (Set A)
E15A-1 Perpetual Inventory Entries 1 20 Easy
E15A-2 Perpetual Inventory Entries 1, 2 20 Easy
E15A-3 Perpetual Inventory Entries 1, 2 20 Easy
Exercises (Set B)
E15B-1 Perpetual Inventory Entries 1 20 Easy
E15B-2 Perpetual Inventory Entries 1, 2 20 Easy
Problems (Set A)
15A-1 Perpetual Inventory Entries 1 20 Medium
15A-2 Subsidiary Inventory Ledger 1, 2 40 Hard
15A-3 Perpetual Inventory Computations 1, 2 30 Medium
15A-4 Periodic Inventory Computations 3 30 Medium
Estimated Level
Learning Time in of
Assignment Topic(s) Objective(s) Minutes Difficulty
Problems (Set B)
15B-1 Perpetual Inventory Entries 1 20 Medium
15B-2 Subsidiary Inventory Ledger 1, 2 40 Hard
Financial Report Problem
Reading Amazon’s Annual Report 3 10 Easy
Keeping It Real
Suarez Computer Center 3 45 Medium
Learning Unit 15-1: Transactions for a Perpetual and Periodic
Inventory System
Summary: Perpetual inventory system is an inventory system of a company that keeps a continuous
(perpetual) record of inventory on hand and of the cost of goods sold. A periodic inventory system needs a
final physical inventory to calculate the cost of the goods sold. A major weakness of the periodic system is
that inventory is checked and counted only at the end of the accounting period; and, therefore, managers do
not know the actual amount of inventory on hand or the actual cost of goods sold until the end of the
accounting period. The perpetual system of accounting for merchandise inventory provides this information
on a transaction-by-transaction basis. In the perpetual inventory system we have two key accounts:
Merchandise Inventory and Cost of Goods Sold. The Merchandise Inventory account is an asset account that
will reveal the current balance of inventory at all times (perpetually). This account is the same one used in the
previous discussion of the periodic inventory system, but in the periodic system the balance of the
Merchandise Inventory is correct only at the end of each accounting period. In the perpetual system entries
are recorded to the Merchandise Inventory account each time the store purchases new merchandise and each
Key Concepts: Perpetual inventory system
Lecture Outline:
1. A perpetual inventory is:
a. Perpetual inventory system keeps a continuous record of inventory on hand and the cost of goods
sold.
b. Merchandise Inventory account is an asset account representing the current balance of inventory.
c. Cost of goods Sold account is a cost account and is treated similar to an expense account.
i. As merchandise is sold, an entry will be recorded to remove the cost of the inventory from the
merchandise inventory account and transferred to the cost of goods sold account.
d. The entries involving inventory when a perpetual inventory system is used:
The purchase of inventory is recorded as:
Dr. Merchandise Inventory XX (Cost)
Cr. Accounts Payable XX (cost)
When the inventory is sold, there are two entries:
The other entry records the transfer of goods from the inventory account to cost of
goods sold account and is recorded at the cost paid for the inventory:
Dr. Cost of Goods Sold XX (Cost)
Cr. Merchandise Inventory XX (Cost)
If the merchandise is returned to the seller, there are two entries for the seller and one
2. Comparing the perpetual and periodic inventory systems:
a. In a perpetual system:
i. Merchandise inventory is an active account that shows the movement of inventory.
ii. Cost of goods sold is an actual account that is updated with every transaction.
b. Periodic system:
i. Less control
ii. Inventory is not updated constantly.
c. Inventory internal controls – periodic and perpetual system uses:
i. Physical inventory is taken at least once a year to verify the accuracy of inventory records
ii. Detect inventory recording errors
Teaching Tips/Strategy: Differentiate and compare the periodic inventory system and the perpetual
inventory systems entries, refer to Figure 15.6. To emphasize all procedures of a perpetual inventory system,
start with the Success Coach LU 15-1 and then discuss the Discussion Questions #1 – #4. Demonstrate the
journal entries in Exercise 15A-1, and assign Exercise 15B-2.
Learning Unit 15-2: Using a Subsidiary Ledger for Inventory;
Calculating Cost of Ending Inventory Using a Perpetual System
Summary: How do stores such as Wal-Mart keep track of the thousands of items that they keep in inventory?
The answer is found in the use of a subsidiary ledger for inventory and the use of computers to maintain the
subsidiary ledger. The Merchandise Inventory account becomes a control account keeping track of the total
balance of inventory, while the details are kept in separate inventory records in a subsidiary ledger for
Key Concepts: None
Lecture Outline:
Subsidiary ledgers are used to keep track of the costs and balances of a variety of inventory items.
1. The subsidiary ledger for merchandise inventory operates similar to the subsidiary ledger for accounts
receivable or accounts payable.
a. The purchase of inventory is recorded in the general journal, posted to the general ledger, and also to
the subsidiary ledger (See Figure 15.7)
Teaching Tips/Strategy: For classroom demonstration purposes use Exercises 15A-2 and 15A-3. Assign
Exercises 15B-2 and 15B-3.
Learning Unit 15-3: Inventory Methods to Calculate Ending Inventory
in a Periodic System
Summary: For a small business or any business using the periodic inventory system, the method used to
assign costs to ending inventory will have a direct effect on the company’s cost of goods sold and gross profit.
If all inventory brought into a store had the same cost, it would be simple to calculate the ending inventory,
and we would not have to have this discussion. Unfortunately, things are not that easy. Often the same
products are purchased and brought into the store at different costs during the same accounting period. On the
Consignment means that a business (the consignor) is selling its merchandise through an agent (the
consignee) who does not own the merchandise but who has possession of it. Consigned merchandise belongs
to the consignor and should not be included in the consignee’s inventory cost. If the merchandise is not
saleable, it should not be added to the cost of the inventory. For merchandise that is saleable but at a lower
cost, the value of that inventory should be estimated at a conservative figure and added to the cost of the
inventory.
Over the years, four generally accepted methods have been developed to assign a cost to ending inventory.
The reason these methods are needed is that often inventory is made up of many past purchases at different
Lecture Outline: The method used to assign costs to ending inventory will have a direct effect on the
company’s cost of goods sold and gross profit. The flow of moving inventory and the method chosen to cost it
do not have to match. There are four generally accepted methods used to compute inventory:
1. Specific Invoice (Identification) – the method of valuing inventory where each item is identified with a
specific invoice.
a. Pros:
2. First-In, First-Out Method (FIFO) – the method of valuing inventory that assumes the oldest goods are
sold first. Therefore, the items in ending inventory are the newest goods purchased.
a. Pros:
i. The cost flow tends to follow the physical flow. Most businesses try to sell the old goods
b. Cons:
i. During periods of inflation this method will produce higher income on the income
statement and thus more taxes to be paid.
ii. Recent costs are not matched with recent sales, because we assume old goods are sold
first.
3. Last-In, First-Out Method (LIFO) – the method of valuing inventory that assumes the newest goods are
sold first. Therefore, the items in ending inventory are the oldest goods purchased.
a. Pros:
i. Cost of goods sold is recorded at or near current costs, because costs of latest goods
acquired are used.
ii. LIFO matches current costs with current selling prices.
b. Cons:
4. Weighted-Average Method – the method of valuing inventory where each item is assigned the same unit
cost (a weighted-average). This unit cost is found by dividing cost of goods available for sale by the total
number of units for sale.
a. Pros:
i. Weighted-average takes into account the number of units purchased at each amount, not a
b. Cons:
i. Current prices have no more significance than prices of goods bought months earlier.
ii. Compared with other methods, the most recent costs are not matched with current sale.
This fact is important in financial reporting so as to provide an accurate picture of the
company.
iii. Cost of ending inventory is not as up-to-date as it could be using another method.
5. When can the inventory method be changed? Repeated switching of methods is not permitted because
significant changes would occur in the profit being reported.
a. Principle of Consistency – the accounting principle that requires companies to follow the same
6. Items to be included in the cost of inventory
a. Goods in transit – should be added to the buyer’s inventory if ownership of the inventory has
Teaching Tips/Strategy: Explain and demonstrate the different methods of determining the value of
inventory. Start by using the Blueprint for the concepts. Also, use the Success Coach 15-3. For class
discussion use Discussion Questions #6 – #9, and for classroom demonstration use Concept Check #5.
Use the “Ten-Minute Quiz” questions #2, #3, #4, #5 and #6 to reinforce the Learning Objective
concepts.
Learning Unit 15-4: Estimating Ending Inventory by the Retail and
Gross Profit Methods
Summary: The actual taking of a physical inventory is time consuming and expensive. Because of the time
and expense involved, most businesses take a physical inventory only once a year. For the business using the
periodic inventory system, the need to have an inventory cost figure more often may become necessary,
Key Concepts: Retail method, gross profit method.
Lecture Outline:
There is a need for estimating inventories when an estimate is accurate enough that a physical inventory is not
necessary or when a fire or other catastrophe causes inventory to be destroyed.
There are two methods for estimating inventory:
1. The retail method is a method used to determine the value of the ending inventory using a cost–to-retail
ratio. This method is often used to prepare interim financial statements. The information needed is:
a. Beginning inventory at cost and retail
b. Cost of net purchases at both cost and retail
c. Net sales at retail
d. Steps in calculating ending inventory:
iv. Multiply cost ratio times ending inventory at retail to arrive at ending inventory at cost.
2. Gross profit method is a method used to determine the value of the ending inventory using a
predetermined gross profit rate. Information needed:
a. Average gross profit rate (= gross profit/net sales)
b. Net sales, beginning inventory, and net purchases
c. Steps in calculating ending inventory:
3. How does an incorrect valuation of inventory affect financial statements?
If the inventory is Overstated Understated_____
Beginning Inventory Profit is understated Profit is overstated
Ending Inventory Profit is overstated Profit is understated
Teaching Tips/Strategy:
Use the “Ten-Minute Quiz” questions #7, #8, #9 and #10 to reinforce the Learning Objective concepts.
Name Date Section
CHAPTER 15
TEN-MINUTE QUIZ
Circle the letter of the best response.
1. On December 22, a business buys merchandise inventory under the terms F.O.B. destination. The
goods are shipped on December 31, arrive on January 4, and are paid for on January 14.
a. The business records the purchase of inventory on December 22.
b. The business records the purchase of inventory on December 31
c. The business records the purchase of inventory on January 4.
d. The business records the purchase of inventory on January 14.
2. Which inventory method during periods of inflation will always produce the lowest inventory cost?
a. FIFO b. LIFO
c. Both FIFO and LIFO d. Neither FIFO nor LIFO
3. Which method of inventory assumes recent costs are not matched with recent sales, because the
method assumes old costs are sold first?
a. FIFO b. LIFO
c. Both FIFO and LIFO d. Neither FIFO nor LIFO
4. A company had the following information regarding inventory
# items cost per unit
Beginning Balance 23 $10.00
Purchase: March 14 20 $10.50
Purchase: March 19 15 $11.00
Purchase: August 3 30 $11.50
Purchase: December 22 12 $12.50
If the ending inventory contained 25 items and the company uses FIFO, what is the value of ending
inventory?
a. $251.00 b. $274.50
c. $299.50 d. $349.00
5. A company had the following information regarding inventory
# items cost per unit
Beginning Balance 23 $10.00
Purchase: March 14 20 $10.50
Purchase: March 19 15 $11.00
Purchase: August 3 30 $11.50
Purchase: December 22 12 $12.50
If the ending inventory contained 25 items and the company uses LIFO, what is the value of ending
inventory?
a. $251.00 b. $274.50
c. $299.50 d. $349.00
6. A company had the following information regarding inventory
# items cost per unit
Beginning Balance 23 $10.00
Purchase: March 14 20 $10.50
Purchase: March 19 15 $11.00
Purchase: August 3 30 $11.50
Purchase: December 22 12 $12.50
If the ending inventory contained 25 items and the company uses weighted-average, what is the value
of ending inventory?
a. $251 b. $275
c. $300 d. $349
7. A company had a fire destroy all of its inventory but the accounting records allowed the following
information to be reconstructed.
Beginning Inventory $25,000
Net Purchases $330,000
Sales $510,000
Gross Profit Rate 35%
Using the gross profit method, what is the amount of gross profit?
a. $21,200 b. $23,500
c. $178,500 d. $331,500
8. A company had a fire destroy all of its inventory but the accounting records allowed the following
information to be reconstructed.
Beginning Inventory $25,000
Net Purchases $330,000
Sales $510,000
Gross Profit Rate 35%
Using the gross profit method, what is the amount of inventory destroyed?
a. $21,200 b. $23,500
c. $178,500 d. $331,500
9. A company uses the retail inventory method and had the following costs:
Cost Retail Price
Beginning Inventory $34,800 $68,100
Purchases $253,500 $508,500
Sales $490,000
How much is gross profit?
a. $28,830 b. $43,300
c. $245,000 d. $288,300
10. A company uses the retail inventory method and had the following costs:
Cost Retail Price
Beginning Inventory $34,800 $68,100
Purchases $253,500 $508,500
Sales $490,000
What is the value of ending inventory?
a. $28,830 b. $43,300
c. $245,000 d. $288,300
Answer Key to Chapter 15 Quiz
1. c
