Financial and Managerial Accounting, 9th Edition
5-1
CHAPTER 5
INVENTORIES AND COST OF SALES
Related Assignment Materials
Student Learning Objectives
Questions
Quick Studies*
Exercises*
Problems*
AA, BTN, DA
Conceptual objectives:
C1. Identify the items and costs of
merchandise inventory.
1, 2, 7
5-1, 5-2, 5-3,
5-17
5-1, 5-2
AA 5-1,
BTN 5-6
Analytical objectives:
A1. Analyze the effects of
inventory methods for both
financial and tax reporting.
3
5-19, 5-20, 5-21,
5-22
5-5, 5-7
5-8
DA 5-2,
BTN 5-1, BTN 5-2,
BTN 5-4, BTN 5-5
A2. Analyze the effects of
inventory errors on current and
future financial statements.
4, 5
5-24
5-17
5-6
using both inventory turnover and
AA 5-3, BTN 5-3
Procedural objectives:
P1. Compute inventory in a perpetual
system using the methods of
specific identification, FIFO,
LIFO, and weighted average.
1
5-4, 5-5, 5-6, 5-7,
5-11, 5-12, 5-13,
5-14
5-3, 5-4, 5-8,
5-9, 5-11, 5-12,
5-14, 5-15
5-1, 5-3,
5-8
DA 5-1, DA 5-2,
DA 5-3, BTN 5-4
P2. Compute the lower of cost or
market amount of inventory.
6
5-23
5-16
5-5, SP
LIFO, and weighted average.
(Appendix 5A)
and gross profit methods to
estimate inventory.
(Appendix 5B)
*See additional information on next page that pertains to these quick studies, exercises, and problems.
SP refers to the Serial Problem
AA refers to Accounting Analysis
BTN refers to Beyond the Numbers
Req. 2a
3:42
Req. 2b
3:28
Req. 2c
4:36
Req. 2d
2:30
Req. 3
1:49
Req. 4
1:02
P3
5-7
Periodic SI, FIFO, LIFO, and WA
4:39
P4
5-8
Retail Inventory Estimation
1:25
Financial and Managerial Accounting, 9th Edition
Additional Information on Related Assignment Material
See Chapter 1 of the Instructor’s Resource Manual for more information on materials for this text available in
Connect.
Connect
Available on the instructor’s course-specific website, Connect:
• All numerical Quick Studies, all Exercises and Problems Set A.
o Connect also provides algorithmic versions for Quick Study, Exercises, and Problems.
Hints/Guided Examples
Please note that the Guided Examples are labeled as “Hints” in Connect assignments. The animated PowerPoints without
Need-to-Know Videos
LO
Need–to–
Know
Title
Time
C1
5-1
Inventory Items and Costs
2:34
P1
5-2
Perpetual SI, FIFO, LIFO, and WA
9:52
P2
5-3
LCM Method
1:57
A2
5-4
Effects of Inventory Errors
3:30
Impacts; and Inventory Errors
Req. 1
1:17
Req. 2a
2:17
Req. 2b
1:44
Req. 2c
2:03
Req. 2d
2:30
Req. 3
1:58
Req. 4
1:00
COMPREHENSIVE
2
5-6
Periodic Method: Computing Inventory Using LIFO,
FIFO, WA, and SI; Financial Statement Impacts;
and Inventory Errors
Req. 1
1:15
Financial and Managerial Accounting, 9th Edition
5-3
Concept Overview Videos
LO
Title
Time
C1
Identify the items and costs of merchandise inventory.
Determining Inventory Items
0:17
Goods in transit
Goods on consignment
Goods damaged or obsolete
Determining Inventory Costs
Inventory Controls and Taking a Physical Count
P1
Compute inventory in a perpetual system using the methods of specific
identification, FIFO, LIFO, and weighted average.
Perpetual Inventory System
1:33
First-In, First-Out Method
1:21
Last-In, First-Out Method
1:20
Weighted Average Method
0:54
Comprehensive Illustration – Background Information
1:33
Comprehensive Illustration – Specific Identification
1:28
Comprehensive Illustration – FIFO
2:08
Comprehensive Illustration – LIFO
2:24
Comprehensive Illustration – Weighted Average
2:23
P2
Compute the lower of cost or market amount of inventory.
Lower of Cost or Market Definition
1:47
Lower of Cost or Market Illustration
0:41
Lower of Cost or Market Journal Entry
0:48
A1
Analyze the effects of inventory methods for both financial and tax reporting.
1:18
0:50
Tax Effects of Costing Methods
0:42
A2
Analyze the effects of inventory errors on current and future financial statements.
Financial Statement Effects of Inventory Errors
1:29
Income Statement Effects
0:32
Inventory Error Example
1:55
Year 1 Impact
1:16
Year 2 Impact
1:09
Balance Sheet Effects and Year 3 Impact
1:29
inventory.
1:05
2:01
0:45
Inventory Costing under a Periodic System
1:38
1:39
Financial and Managerial Accounting, 9th Edition
5-4
FIFO Illustration
1:22
LIFO Illustration
1:07
Weighted Average Illustration
1:20
P4B
Apply both the retail inventory and gross profit methods to estimate inventory.
Synopsis of Chapter Revisions
NEW opener—Amazon and entrepreneurial assignment.
Streamlined conceptual learning objectives.
New Exhibit 5.1 on shipping terms.
Revised Exhibit 5.4 so that format is consistent for all inventory calculations (which matches Connect).
Revised NTK 5-2 and NTK 5-6 solutions on specific identification for consistency with text.
Financial and Managerial Accounting, 9th Edition
5-5
Chapter Outline
I. Inventory Basics
A. Determining Inventory Items
Merchandise inventory includes all goods that a company owns and holds for sale. The following
inventory items require special attention:
1. Goods in Transit—if ownership has passed to the purchaser, the goods are included in the
2. Goods on Consignment—goods shipped by the owner, called the consignor, to another party, the
3. Goods Damaged or Obsolete
a. Damaged and obsolete (and deteriorated) goods are not reported in inventory if they cannot be
B. Determining Inventory Costs
1. The cost of an inventory item includes its invoice cost minus any discount, plus any incidental costs
(such as shipping, storage, and insurance).
2. The expense recognition principle states that inventory costs are expensed as cost of goods sold in
the period when inventory is sold.
C. Internal Controls and Taking a Physical Count
1. Events (theft, loss, damage, and errors) can cause the Inventory account balance to differ from the
actual inventory on hand.
II. Inventory Costing under a Perpetual System One of the most important issues in accounting for
inventory is determining the per unit cost assigned to inventory items. Merchandise Inventory is updated for
each purchase and sale of inventory. Cost of goods available for sale must be allocated between cost of
goods sold and ending inventory. The periodic system is covered in Appendix 6A.
1. Inventory Cost Flow Methods
Four methods are used to assign costs to inventory and cost of goods sold. Each method assumes a
particular pattern for how costs flow through inventory. Physical flow and cost flow need not be the
same.
1. First-In, First-Out (FIFO)—assumes costs flow in the order incurred. (Results are identical under
the periodic and perpetual systems.)
Financial and Managerial Accounting, 9th Edition
5-6
2. Last-In, First-Out (LIFO)—assumes costs flow in the reverse order incurred. (Results differ from
B. Inventory Costing Illustration
1. First-in, first-out (FIFO)— Assumes costs flow in the order incurred.
2. Last-in, first-out (LIFO)— Assumes costs flow in the reverse order incurred.
C. Financial Statement Effects of Costing Methods
1. When purchase prices do not change, each inventory costing method assigns the same amounts to
2. Rising Costs—when purchase costs regularly rise:
a. FIFO assigns the lowest amount to cost of goods sold, resulting in the highest gross profit and
3. Falling Costs— When costs regularly decline, the reverse occurs for FIFO and LIFO.
4. Method Advantages:
a. FIFO inventory on the balance sheet approximates its current replacement cost; it also mimics the
actual flow of goods for most businesses.
III. Valuing Inventory at LCM and Analyzing Inventory Errors
A. Lower of Cost or Market
Inventory is reviewed to ensure it is reported at the lower of cost or market (LCM).
1. Computing the Lower of Cost or Market—Market in the term LCM is replacement cost for LIFO,
but net realizable value for the other three methods.
Financial and Managerial Accounting, 9th Edition
5-7
6. Recording the Lower of Cost or Market—accounting rules require that inventory be adjusted to
market when market is less than cost, but inventory normally cannot be written up to market when
market exceeds cost.
B. Financial Statement Effects of Inventory Errors
An inventory error causes misstatements in cost of goods sold, gross profit, net income, current assets,
and equity. It also causes misstatements in the next period’s financial statements because ending
inventory of one period is the beginning inventory of the next.
1. Income Statement Effects
a. If ending inventory is understated, cost of goods sold is overstated and net income is
understated.
2. Balance Sheet Effects
a. If ending inventory is understated, assets and equity are understated.
IV. Decision Analysis—Inventory Turnover and Days’ Sales in Inventory
A. Inventory Turnover
1. Inventory turnover, also called merchandise inventory turnover, measures the number of times a
company’s average inventory was sold during an accounting period.
B. Days’ Sales in Inventory
5. Viewed as the buffer against out-of-stock inventory and useful in evaluating liquidity of
inventory.
1. Day’s sales in inventory measures the adequacy of inventory to meet sales demand.
2. It reveals how much inventory is available in terms of the number of days’ sales.
C. Analysis of Inventory Management
Inventory management is a major emphasis for most merchandisers; they must both plan and control
inventory purchases and sales. We prefer a high inventory turnover.
V. Inventory Costing under a Periodic System (Appendix 5A)
One of the most important issues in accounting for inventory is determining the per unit cost assigned to
inventory items.
Financial and Managerial Accounting, 9th Edition
5-8
A. Inventory Cost Flow Methods
Four methods are used to assign costs to inventory and cost of goods sold. Each method assumes a
particular pattern for how costs flow through inventory. Physical flow and cost flow need not be the
same.
1. First-In, First-Out (FIFO)—assumes costs flow in the order incurred. (Results are identical under
the periodic and perpetual systems.)
2. Last-In, First-Out (LIFO)—assumes costs flow in the reverse order incurred. (Results differ from
B. Under the periodic inventory system, Merchandise Inventory is updated at the end of each period to
reflect purchases and sales. Cost of goods available for sale must be allocated between cost of goods
sold and ending inventory.
1. Specific identification— At period-end, cost of goods sold is charged with the actual or invoice
cost, leaving actual costs of inventory available in the inventory account.
C. Financial Statement Effects of Costing Methods
1. Rising Costs:
a. FIFO assigns the lowest amount to cost of goods sold, resulting in the highest gross
2. Falling Costs: When costs regularly decline:
a. FIFO gives highest cost of goods sold and lowest gross profit and income.
b. LIFO gives lowest cost of goods sold and highest gross profit and income.
3. Method Advantages:
a. FIFO inventory on the balance sheet approximates its current replacement cost; it also
Financial and Managerial Accounting, 9th Edition
5-9
D. Tax Effects of Costing Methods
Since inventory costs affect net income, they have potential tax effects.
VI. Inventory Estimation Methods (Appendix 5B)
A. Retail Inventory Method – uses a three-step process to estimate ending inventory.
1. Step 1: Goods available for sale at retail minus net sales at retail equals ending inventory at
retail.
B. Gross Profit Method – estimates cost of ending inventory by applying the gross profit ratio to
net sales at retail. Often used when inventory is destroyed, lost or stolen. Uses a two-step
process.
1. Step 1: Net sales at retail times 1.0-gross profit ratio equals estimated cost of goods sold.
Financial and Managerial Accounting, 9th Edition
Chapter 5 Alternate Demonstration Problem #1 (Periodic)
The ABC Company had the following inventory record for the month of January:
# of
Unit
Date
Description
Items
Price
Item
1/1
Z12, Z13, Z14
Beginning
Required:
Assuming a periodic system is in use, determine the following:
1. Cost of goods available for sale.
2. Cost of goods sold and the ending inventory using each of the following methods:
a. FIFO
Financial and Managerial Accounting, 9th Edition
5-11
Solution: Chapter 5 Alternate Demonstration Problem #1
1. Cost of goods available for sale:
Date
Units
Unit Cost
Cost
inventory
1/11
Purchase
9
Total goods available for sale
14
$208
2. a. FIFO Periodic (FIFO under periodic and perpetual yields identical results).
Total goods available for sale
$208
Ending inventory
1/28
Purchase
5
$12
$60
Cost of goods sold
$148
b. LIFO Periodic:
Total goods available for sale
$208
Ending inventory
inventory
Cost of goods sold
$108
c. Weighted Average Periodic:
Units
Unit cost
Total cost
5
$20
$100
9
14
$208
Total cost of 14units available for sale
$208
Less ending inventory priced on a weighted average cost basis:
5 units at $14.86
Cost of goods sold
$134
d. Specific Identification:
Specific identification method: solution is identical to the solution shown in alternative
item that is sold.
Financial and Managerial Accounting, 9th Edition
5-12
Specific Identification Periodic
Date
Purchases
Sales at Cost
Inventory
Balance
1/1
Beginning
Inventory
5 @ $ 20 = $100
Z1–Z5
Financial and Managerial Accounting, 9th Edition
Chapter 5 Alternate Demonstration Problem #2 (Perpetual)
The ABC Company had the following inventory record for the month of January:
# of
Unit
Date
Description
Items
Price
Item
1/1
Beginning
Required:
Assuming a perpetual system is in use, determine the cost of goods sold and the ending
inventory using each of the following methods:
1. FIFO
5-14
Solution: Chapter 5 Alternate Demonstration Problem #2
1.
FIFO Perpetual
Date
Purchases
Sales at Cost
Inventory
Balance
1/28
5 @ $12 = $ 60
Total COGS
$ 40 + 108 = $148
1/1
Beginning
5 @ $20 = $100
2.
LIFO Perpetual
Date
Purchases
Sales at Cost
Inventory
Balance
1/1
1/11
3 @ $20 = $ 60
Total COGS
$40 + 84 = $124
Financial and Managerial Accounting, 9th Edition
Solution: Chapter 5 Alternate Demonstration Problem #2, continued
3.
Weighted Average Perpetual
Date
Purchases
Sales at Cost
Inventory
Balance
1/1
Beginning
Inventory
5 @ $20 = $100
12 @ $14 = $168
Total COGS
4.
Specific Identification Perpetual
Date
Purchases
Sales at Cost
Inventory
Balance
1/1
Beginning
Inventory
5 @ $ 20 = $100
Z1–Z5
Total COGS