Chapter 6 Inventories 115
and 12 show the effects of the errors on the income statement. Misstatement of inventory will also have
an effect on the balance sheet. Exhibit 13 shows these effects.
Key Terms and Definitions
• Consigned Inventory – Merchandise that is shipped by manufacturers to retailers who act as the
manufacturer’s selling agent.
• Consignee – The name for the retailer in a consigned inventory arrangement.
Relevant Example Exercises and Exhibits
• Example Exercise 6-6 Lower-of-Cost-or-Market Method
• Example Exercise 6-7 Effect of Inventory Errors
• Exhibit 10 – Determining Inventory at Lower of Cost or Market (LCM)
• Exhibit 11 – Effect of Inventory Errors on Current Period’s Income Statement
• Exhibit 12 – Effects of Inventory Errors on Two Years’ Income Statements
• Exhibit 13 – Effect of Inventory Errors on Current Period’s Balance Sheet
SUGGESTED APPROACH
Inventory is carried on the financial statements at its cost unless one of the following conditions has
occurred:
1. If the net realizable value of the inventory is lower than the cost recorded in the accounting records,
2. If inventory items have been damaged or have become obsolete such that they cannot be sold at
normal prices, the value of these items is reduced to their net realizable value. Net realizable value is
GROUP LEARNING ACTIVITY—Valuing Inventory at Other than Cost
TM 6-16 presents three inventory items. Divide your class into small groups and ask them to determine
116 Chapter 6 Inventories
The solutions to this exercise are as follows:
2. CD Players: 50 units $75 = $3,750
3. Cassette Players: 25 units ($50 – $5 – $3.50) = $1,037.50
WRITING EXERCISE—Valuing Inventory at Other than Cost
Ask your students to practice their critical-thinking skills by writing a response to the following question
(also on TM 6-17):
In Chapter 1, you learned that the cost concept of accounting requires accountants to record all items
purchased at their cost. In Chapter 6, you have learned that inventory may be written down to its current
replacement cost or its net realizable value if these amounts are lower than original cost. Why do you
think the accounting profession has decided to violate the cost concept and reduce the value of inventory
in these circumstances?
Review the following material with your students:
2. The following information must be stated either in parentheses on the balance sheet or in a footnote
to the financial statements:
a. Inventory cost method (LIFO, FIFO, average cost)
b. Method of valuing inventory (cost or lower-of-cost-or-market)
GROUP LEARNING ACTIVITY—Current Assets Section of the Balance
Sheet
TM 6-18 presents information to prepare the Current Assets section of the balance sheet for Bostitch Art
Supplies. Divide your class into small groups and ask them to complete the balance sheet. TM 6-19
Chapter 6 Inventories 117
LECTURE AID—Inventory Errors
TM 6-3 emphasizes the importance of accurately counting a business’s ending inventory by listing the
financial statement items affected by physical inventory errors. In addition to knowing which items are
affected, students should be able to analyze whether a particular inventory error will overstate or
understate financial statement items.
If the physical inventory count is understated, too much shrinkage will be recorded. This will understate
Merchandise Inventory on the Balance Sheet and overstate Cost of Merchandise Sold on the Income
Statement.
If the physical inventory count is overstated, the accountant will not record enough shrinkage. This will
overstate Merchandise Inventory on the Balance Sheet and understate Cost of Merchandise Sold.
GROUP LEARNING ACTIVITY—Inventory Errors
TM 6-4 presents information concerning a business that has made an error in counting its ending
inventory. Divide the class into small groups and ask them to determine the effect of this error. Corrected
financial statements are shown on TM 6-5.
WRITING EXERCISE—Effect of Misstatements of Inventory on Financial
Statements
Ask your students to write a response to the following question (also on TM 6-6):
Why is it important to be accurate when taking a physical inventory count?
118 Chapter 6 Inventories
OBJECTIVE 7
Describe and illustrate the inventory turnover and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of inventory management.
The text presents various financial analyses of inventory and interpretations that may be made from them.
This will allow students to better understand the ways financial data related to inventory may be used and
evaluated after they have studied procedures for recording and reporting inventory transactions.
SYNOPSIS
This objective uses two ratios to analyze the efficiency and effectiveness of inventory management:
inventory turnover and number of days’ sales in inventory. Inventory management is important because a
business needs to keep enough stock to satisfy customers but also minimize the costs associated with
Key Terms and Definitions
• Inventory Turnover – The relationship between the volume of goods sold and inventory,
computed by dividing the cost of goods sold by the average inventory.
• Number of Days’ Sales in Inventory – The relationship between the volume of sales and
inventory, computed by dividing the inventory at the end of the year by the average daily cost of
goods sold.
Relevant Example Exercises and Exhibits
• Example Exercise 6-8 Inventory Turnover and Number of Days’ Sales in Inventory
SUGGESTED APPROACH
Chapter 6 Inventories 119
LECTURE AID—Financial Ratios Related to Inventories
Inventory turnover measures efficiency in managing inventories by comparing a company’s average
inventory to the total inventory sold. The formula is as follows:
Inventory Cost of Merchandise Sold
Turnover = Average Inventory
The number of days’ sales in inventory estimates the time (in days) it takes to acquire, sell, and replace
inventory. The formula for the number of days’ sales in inventory is as follows:
Number of Days’ Sales Inventory, end of year
in Inventory = Average Daily Cost of Merchandise Sold
where:
DEMONSTRATION PROBLEM—Inventory Ratios
Use the following data to calculate inventory turnover and number of days’ sales in inventory:
Cost of Merchandise Sold $456,250
Inventory, Beginning of Year 65,000
Inventory, End of Year 67,500
120 Chapter 6 Inventories
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The number of days’ sales in inventory would be computed as follows:
INTERNET ACTIVITY—Inventory Turnover
Instruct your students to search the Web using “Inventory Turnover” as their search criteria. At the time
this manual was written, the following site offered some interesting information:
http://www.effectiveinventory.com/articles/
APPENDIX
Estimate the cost of inventory, using the retail method and the gross profit method.
SYNOPSIS
If a circumstance arises that prevents a company from physically counting its inventory, there are two
methods used to estimate the amount of inventory. The first method, known as the retail inventory
method, requires costs and retail prices to be maintained. The four steps to complete this method are
Key Terms and Definitions
• Gross Profit Method – A method of estimating inventory cost that is based on the relationship of
gross profit to sales.
• Retail Inventory Method – A method of estimating inventory cost that is based on the
relationship of gross profit to sales.
Relevant Example Exercises and Exhibits
• Exhibit 14 – Determining Inventory by the Retail Method
• Exhibit 15 – Estimating Inventory by Gross Profit Method
Chapter 6 Inventories 121
SUGGESTED APPROACH
Begin by reviewing the reasons that a company may need to estimate its inventory. Reasons for
estimating inventory include the following:
1. Determining inventory balances for interim financial statements. Businesses using the periodic
inventory system may find it too costly to take a physical inventory each month.
3. Perpetual inventory records are not maintained.
You will also want to demonstrate the two methods for estimating inventory using the following
problems.
LECTURE AID—Retail Method of Estimating Inventory
The retail method can be used successfully by merchandisers who do not use a stable gross profit
percentage. One step in the retail method is to determine the markup on merchandise by comparing the
cost of inventory items to their retail value.
DEMONSTRATION PROBLEM—Retail Method of Estimating Inventory
Example: Malarky Enterprises has the following data for the current year of operations. Use these data to
estimate Malarky’s ending inventory.
Cost Retail Value
Beginning inventory $15,000 $22,400
Merchandise purchases 52,000 77,600
Sales (at retail prices) 68,000
122 Chapter 6 Inventories
You may also want to point out that retailers often take a physical inventory at retail prices and then use
the retail method to convert the inventory to its cost.
LECTURE AID—Gross Profit Method of Estimating Inventory
The gross profit method is based on the following equation.
Beginning Inventory
+ Cost of Merchandise Purchased
Merchandise Available for Sale
– Cost of Merchandise Sold
Ending Inventory
GROUP LEARNING ACTIVITY—Gross Profit Method of Estimating
Inventory
TM 6-20 presents information your students can use in solving a gross profit method problem. Divide the
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom‘s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 2 1 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 3 2 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 4 5 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 5 5 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 6 5 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 7 6 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 8 6 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 9 6 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
DQ 10 6 Easy 5 min. Analytic Measurement Inventories Reporting Knowledge x
PE 1A Cost flow methods 2 Easy 15 min. Analytic Measurement Inventories Reporting Application
PE 1B Cost flow methods 2 Easy 15 min. Analytic Measurement Inventories Reporting Application
PE 7B Effect of inventory errors 6 Easy 5 min. Analytic Measurement Inventories Reporting Application
PE 8A Inventory turnover and number of days’ sales in inventory 7 Moderate 10 min. Analytic Measurement Inventories Reporting Application x
PE 8B Inventory turnover and number of days’ sales in inventory 7 Moderate 10 min. Analytic Measurement Inventories Reporting Application x
EX 1 Control of inventories 1 Easy 5 min. Analytic Measurement Inventories Reporting Comprehension x
EX 13 Periodic inventory by three methods; cost of merchandise sold 2,4 Easy 20 min. Analytic Measurement Inventories Reporting Application x
EX 14 Comparing inventory methods 5 Easy 5 min. Analytic Measurement Inventories Reporting Application
EX 15 Lower-of-cost-or-market inventory 6 Easy 10 min. Analytic Measurement Inventories Reporting Application x x
EX 16 Merchandise inventory on the balance sheet 6 Easy 5 min. Analytic Measurement Inventories Reporting Application
EX 28 Gross profit method Appendix Easy 10 min. Analytic Measurement Inventories Reporting Application
PR 1A FIFO perpetual inventory 2,3 Moderate 45 min. Analytic Measurement Inventories Reporting Application x x
PR 2A LIFO perpetual inventory 2,3 Moderate 45 min. Analytic Measurement Inventories Reporting Application x x
PR 3A Weighted average cost method with perpetual inventory 2,3 Moderate 45 min. Analytic Measurement Inventories Reporting Application
CP 1 Ethics and professional conduct in business 1 Easy 5 min. Ethics Measurement Inventories Reporting Application x x
CP 2 LIFO and inventory flow 3,4 Easy 10 min. Analytic Measurement Inventories Reporting Comprehension x
CP 3 Costing inventory 3,4 Challenging 1 hour Analytic Measurement Inventories Reporting Application x
CP 4 Inventory ratios for Dell and HP 7 Moderate 30 min. Analytic Measurement Inventories Reporting Application x x
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