CHAPTER 6
INVENTORIES
LEARNING OBJECTIVES
1. DISCUSS HOW TO CLASSIFY DETERMINE
INVENTORY.
2. APPLY INVENTORY COST FLOW METHODS AND
DISCUSS THEIR FINANCIAL EFFECTS.
3. INDICATE THE EFFECTS OF INVENTORY ERRORS ON
THE FINANCIAL STATEMENTS.
CHAPTER REVIEW
Classifying Inventory
1. (L.O. 1) Inventory has two common characteristics: (a) it is owned by the company and (b) it is in
a form ready for sale in the ordinary course of business.
Determination of Inventory Quantities
3. The determination of inventory quantities involves (a) taking a physical inventory of goods on
hand and (b) determining the ownership of goods.
4. Taking a physical inventory involves counting, weighing or measuring each kind of inventory on
hand. Internal control procedures should be followed in taking the inventory in order to minimize
errors.
Inventory Costing
7. (L.O. 2) Inventory is accounted for at cost which includes all expenditures necessary to acquire
goods and place them in a condition ready for sale. After a company has determined the quantity
of units of inventory, it applies unit costs to the quantities to determine the total cost of the
inventory and the cost of goods sold.
Specific Identification
8. The specific identification method identifies the particular units sold so that the cost of the
specific unit sold is charged to the cost of goods sold. This method is possible when a company
FIFO
10. The FIFO method assumes that the costs of the earliest goods purchased are the first to be sold.
a. This method often parallels the actual physical flow of the merchandise.
b. Under this method, the ending inventory is based on the latest units purchased.
LIFO
11. The LIFO method assumes that the costs of the latest units purchased are the first to be sold.
a. This method seldom coincides with the actual physical flow of inventory.
Average-Cost
12. The average-cost method assumes that the goods available for sale are similar in nature.
a. Under this method, the cost of goods available for sale is allocated on the basis of weighted-
Financial Statement Effects
13. In periods of rising prices, FIFO produces a higher net income, LIFO the lowest, and average cost
falls in the middle. The reverse is true when prices are falling.
14. Companies adopt different inventory costing methods because of:
a. Balance sheet effects: the inventory costs are closer to current costs under FIFO than under
Net Realizable Value
15. The value of inventory for companies in certain industries can drop due to changes in technology
or fashions. This situation requires valuing inventory at the lower-of-cost-or-net realizable value
(LCNRV) in the period in which the price decline occurs.
Effects of Inventory Errors
17. (L.O. 3) The effects of inventory errors on the current year’s income statement are:
Cost of
Inventory Error Goods Sold Net Income
Beginning inventory understated Understated Overstated
18. The effects of ending inventory errors on the balance sheet are:
Ending
Inventory Assets Liabilities Owner’s Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated
÷
Goods Available
for Sale at Retail
19. In the financial statements:
a. Inventory is usually classified as a current asset after receivables in the balance sheet, and
Inventory Turnover
20. (L.O. 4) The inventory turnover measures the number of times on average the inventory is
sold during the period.
*Applying Perpetual Inventory
*21. (L.O. 5) Each of the inventory cost flow methods may be used in a perpetual inventory system.
a. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of
Estimating Inventories
*22. (L.O. 6) Inventories may have to be estimated when (a) management wants monthly or quarterly
financial statements or (b) a fire or other type of casualty makes it impossible to take a physical
inventory.
Gross Profit Method
*23. The gross profit method is widely used to estimate the ending inventory. Two steps are involved
in using this method.
a. The estimated cost of goods sold is determined by subtracting the estimated gross profit from
net sales.
determine the estimated cost of the ending inventory.
Retail Inventory Method
*24. The retail inventory method is used by retail companies to estimate the cost of the inventory.
The steps in using this method are:
a.
Goods Available
for Sale at Retail
–
Net
Sales
Ending
Inventory
at Retail
=
LECTURE OUTLINE
A. Classifying and Determining Inventory.
1. Inventory of a merchandising company has two common characteristics:
a. It is owned by the company.
b. It is in a form ready for sale to customers in the ordinary course of
business.
2. In a manufacturing company, some inventory may not yet be ready for sale.
As a result, manufacturers usually classify inventory into three categories:
ACCOUNTING ACROSS THE ORGANIZATION
JIT can save a company a lot of money, but it isn’t without risk. An unexpected
disruption in the supply chain can cost a company a lot of money. Japanese
automakers experienced such a disruption when an earthquake damaged a
company that supplies 50% of the automaker’s piston rings.
What steps might companies take to avoid such a serious disruption in the
future?
Answer: The manufacturer of the piston rings should spread its manufacturing
facilities across a few locations that are far enough apart that they
B. Determining Inventory Quantities.
1. All companies need to determine inventory quantities at the end of the
accounting period. Companies using a perpetual system take a physical
inventory for the following reasons:
2. Determining inventory quantities involves two steps: (1) taking a physical
inventory of goods on hand and (2) determining the ownership of goods.
a. Taking a physical inventory involves actually counting, weighing, or
measuring each kind of inventory on hand.
b. Determining the ownership of goods.
(1) Goods in transit should be included in the inventory of the com–
pany that has legal title to the goods. Legal title is determined
by the terms of the sale:
(2) Consigned goods are goods held by one party although ownership
of the goods is retained by another party. If an inventory count
C. Inventory Costing.
1. Inventory is accounted for at cost.
2. Cost includes all expenditures necessary to acquire goods and place them
in condition ready for sale.
3. Cost of goods available for sale includes:
a. The cost of beginning inventory.
D. Specific Identification.
1. Specific identification requires that companies keep records of the original
cost of each individual inventory item.
E. Cost Flow Assumptions—FIFO, LIFO, and Average-Cost.
1. The FIFO (first-in, first-out) method assumes that the earliest goods pur-
chased are the first to be recognized in determining cost of goods sold.
a. FIFO often parallels the actual physical flow of merchandise because
it generally is good business practice to sell the oldest units first.
b. Under LIFO, companies obtain the cost of the ending inventory by
taking the unit cost of the earliest goods available for sale and working
forward until all units of inventory have been costed.
3. The average-cost method assumes that the goods are similar in nature.
a. Under this method, the cost of goods available for sale is allocated
on the basis of the weighted-average unit cost.
F. Financial Statement and Tax Effects of Cost Flow Methods.
1. Income statement effects.
a. Each dollar of difference in ending inventory results in a corresponding
dollar difference in income before income taxes.
2. Balance sheet effects.
a. A major advantage of the FIFO method is that in a period of infla-
tion, the costs allocated to ending inventory will approximate their
current cost.
b. A major shortcoming of the LIFO method is that in a period of infla-
tion, the costs allocated to ending inventory may be significantly
understated in terms of current cost.
3. Tax effects. LIFO results in lower income taxes, because of lower net
income, than either FIFO or average cost in a period of rising prices.
INTERNATIONAL INSIGHT
ExxonMobil Corporation uses LIFO to value its inventory for financial reporting
and tax purposes. International accounting standards do not allow the use of LIFO,
which makes the net income of foreign oil companies such as BP not directly
comparable to U.S. companies.
What are the arguments for and against the use of LIFO?
Answer: Proponents of LIFO argue that it is conceptually superior because it
matches the most recent cost with the most recent selling price. Critics
G. Lower-of-Cost-or-Net Realizable Value.
1. The value of inventory for companies in certain industries can drop very
quickly due to changes in technology or fashions. This situation requires
a departure from the cost basis of accounting. This is done by valuing the
inventory at the lower–of–cost-or–net realizable value (LCNRV) in the period
in which the price decline occurs.
2. Companies apply LCNRV to the items in inventory after they have used
one of cost flow methods to determine cost. Under LCNRV, companies
recognize the loss in the period in which the price decline occurs.
b. Under the LCNRV basis, net realizable value refers to the net
amount that a company expects to realize (receive) from the sale of
H. Inventory Errors.
1. The effects of inventory errors on net income of the current year are:
a. An error in beginning inventory will have a reverse effect on net
income (overstatement of inventory results in understatement of net
income).
b. An error in ending inventory will have a similar effect on net income
(overstatement of inventory results in overstatement of net income).
I. Statement Presentation and Analysis.
1. Inventory is classified as a current asset immediately below receivables
in the balance sheet. Cost of goods sold is subtracted from sales revenue
in a multiple-step income statement.
2. There should be disclosure in the notes to the financial statements of:
*J Inventory Cost Flow Methods in Perpetual Inventory Systems.
1. Under FIFO, companies charge to cost of goods sold the cost of the
earliest goods on hand prior to each sale. The results under FIFO in a
perpetual system are the same as in a periodic system.
*K Estimating Inventories—Gross Profit and Retail Inventory Methods.
1. Two circumstances explain why companies sometimes estimate inventories:
a. A casualty such as a fire, flood, or earthquake may make it impossible
to take a physical inventory.
b. Managers may want monthly or quarterly financial statements, but
a physical inventory is taken only annually.
2. There are two widely used methods of estimating inventories:
a. The gross profit method is used in preparing monthly financial state-
ments under a periodic system.
(1) Step 1: Net sales less estimated gross profit equals estimated
cost of goods sold.
b. When a store has many different types of merchandise at low unit
costs, the retail inventory method is often used.
(1) Under the retail inventory method, a company’s records must show
both the cost and retail value of the goods available for sale.
(4) Step 3: Ending inventory at retail multiplied by the cost–to-retail
ratio equals the estimated cost of ending inventory.
A Look at IFRS
The major IFRS requirements related to accounting and reporting for inventories
are the same as GAAP. The major difference is that IFRS prohibits the use of the
LIFO cost flow assumption.
Relevant Facts
• IFRS and GAAP account for inventory acquisitions at historical cost and
value inventory at the lower-of-cost-or-net realizable value subsequent to
acquisition.
• Who owns the goods—goods in transit or consigned goods—as well as the
costs to include in inventory are essentially accounted for the same under
IFRS and GAAP.
LOOKING TO THE FUTURE
One convergence issue that will be difficult to resolve relates to the use of the
LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use.
Conversely, the LIFO cost flow assumption is widely used in the United States
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. When prices are rising, FIFO results in a higher ending inventory than LIFO.
True False
2. We can use the LIFO inventory method only if we know that the newest units are always
sold first.
True False
3. Goods in transit would be included in the ending inventory of the buyer and the seller.
True False
4. Under the LCNRV basis, net realizable value is the estimated selling price in the normal
course of business.
True False
5. When beginning inventory is understated, net income will be understated.
True False
6. Cost of goods purchased less the ending inventory equals cost of goods sold.
True False
7. The LIFO method assumes that the earliest goods purchased are the first to be sold.
True False
8. The inventory turnover is computed by dividing the cost of goods sold by the ending
inventory.
True False
*9. The gross profit method estimates the cost of ending inventory by applying a gross profit
rate to net sales.
True False
*10. The retail inventory method and the gross profit method are both methods of inventory
estimation.
True False
Multiple Choice
1. The cost flow method that results in the lowest income taxes when prices are rising is
a. average cost.
b. FIFO.
c. LIFO.
d. specific identification.
2. The data below are for Parrett Enterprises:
Beginning inventory 150 units at $2.00
Purchase—August 375 units at $1.50
Purchase—October 150 units at $3.00
A periodic inventory system is used; ending inventory is 330 units. What is the ending
inventory under FIFO?
a. $570
b. $743
c. $593
d. $720
3. Double-counting an inventory item at year end will result in
a. understated tax liability.
b. overstated cost of goods sold.
c. overstated net income.
d. understated beginning inventory for the next period.
*4. A retail company has goods available for sale of $300,000 at retail and $210,000 at cost,
and ending inventory of $80,000 at retail. What is the estimated cost of goods sold?
a. $220,000
b. $154,000
c. $210,000
d. $56,000
*5. Which method might be used to estimate inventory costs when physical inventories are
not taken?
a. First-in, first-out
b. Last-in, first-out
c. Average cost method
d. Gross profit method
ANSWERS TO QUIZ
True/False
1. True 6. False
2. False 7. False
Multiple Choice
1. c.
2. d.