Chapter 7 Inventories 129
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.
• Consignor – The name for the manufacturer in a consigned inventory arrangement.
• Lower-of-Cost-or-Market (LCM) Method – A method of valuing inventory that reports the
inventory at the lower of its cost or current market value (net realizable value).
• Net Realizable Value – The estimated selling price of an item of inventory less any direct costs
of disposal, such as sales commissions.
Relevant Example Exercises and Exhibits
• Example Exercise 7-6 Lower-of-Cost-or-Market Method
• Example Exercise 7-7 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,
the value of the inventory is reduced to its market price (or “net realizable value”). This is the lower–
of-cost-or-market principle. The market cost is determined based on normal quantities purchased. Net
realizable value is the estimated selling price less any costs to sell or dispose of the items.
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
the estimated selling price less any costs to sell or dispose of the items.
Use the following Group Learning Activity to review these concepts.
GROUP LEARNING ACTIVITY—Valuing Inventory at Other than Cost
TM 7-16 presents three inventory items. Divide your class into small groups and ask them to determine
the value that each item should carry.
130 Chapter 7 Inventories
The solutions to this exercise are as follows:
1. DVD Players: 100 units $125 = $12,500
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 7-17):
In Chapter 1, you learned that the cost concept requires accountants to record all items purchased at their
cost. In Chapter 7, 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?
Possible response: Valuing assets at a realistic realizable amount is not restricted to inventory. Other
assets such as accounts receivable are “adjusted” in value on the balance sheet to reflect a realistic
realizable value (Chapter 9). Inventory often will become dated and devalued over time, and keeping its
value at cost would result in financial statements providing an inflated value.
Review the following material with your students:
1. Merchandise inventory is reported in the Current Assets section of the balance sheet.
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)
Use the following Group Learning Activity to review the Current Assets section of the balance sheet.
GROUP LEARNING ACTIVITY—Current Assets Section of the Balance
Sheet
TM 7-18 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 7-19
contains the solution.
Objective 6 also explains how errors in the physical inventory count affect a company’s financial
statement. A Group Learning Activity that asks students to analyze inventory errors is given below.
Chapter 7 Inventories 131
LECTURE AID—Inventory Errors
TM 7-3 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.
The physical inventory count is the basis for recording the adjusting entry for inventory shrinkage.
Remind students that the adjusting entry to reduce merchandise inventory for shrinkage is:
Cost of Merchandise Sold……… XXX
Merchandise Inventory… XXX
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.
Remind students that an incorrect value for Cost of Merchandise Sold affects a company’s reported net
income. If net income is not computed accurately, this incorrect amount will be closed into the owner’s
capital account, causing owner’s equity to be misstated.
The following group learning activity will allow students to analyze the financial effect of inventory
errors on the income statement and the balance sheet.
GROUP LEARNING ACTIVITY—Inventory Errors
TM 7-4 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 7-5.
WRITING EXERCISE—Effect of Misstatements of Inventory on Financial
Statements
Ask your students to write a response to the following question (also on TM 7-6):
Why is it important to be accurate when taking a physical inventory count?
Possible response: If inventory is understated, total assets will be understated. On the income statement,
cost of merchandise sold will be overstated, resulting in gross profits being understated and net income
being understated. If net income is understated, owner’s equity will be understated as well, reflected on
the balance sheet.
132 Chapter 7 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
inventory such as storage and property taxes. Inventory turnover (cost of merchandise sold/average
inventory) measures the relationship between the cost of merchandise and the amount of inventory carried
during the period. The larger this ratio is, the more efficient the business is in managing inventory. The
number of days’ sales in inventory measures the length of time it takes to acquire, sell, and replace the
inventory. It is calculated as number of days’ sales in inventory = average inventory/average daily cost of
merchandise sold. This ratio is considered to be better as it gets smaller; the less number of days in
inventory means it is sold faster.
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 7-8 Inventory Turnover and Number of Days’ Sales in Inventory
SUGGESTED APPROACH
The following Lecture Aid will help you in presenting the inventory ratios to your students. Follow that
information with a short Demonstration Problem.
The textbook compares the inventory turnover and number of days’ sales in inventory for BestBuy and
Zale Corporation. Use the text material to stress that the differences in these two retailers can be clearly
seen in their inventory ratios.
Chapter 7 Inventories 133
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
In effect, this ratio measures how many times during a year a company purchased and sold its average
inventory balance. For example, if a company usually carries an average of $100 in inventory and its sales
were $800 during a year, that company sold (or turned over) its average inventory eight times.
The ratio uses average inventory instead of the ending balance in the inventory account in order to smooth
out any seasonal fluctuations in inventory balances. In determining this average, it is ideal to average
inventory balances at the end of each month for a year. However, in many cases, monthly data are not
available, so the beginning and end of the year inventory amounts are averaged.
Average Beginning Inventory + Ending Inventory
Inventory = 2
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:
Average Daily Cost of Cost of Merchandise Sold
Merchandise Sold = 365
Point out that businesses generally work to reduce the amount of inventory they carry. Holding inventory
creates many costs, such as costs to store, insure, and move inventory items. These costs can be
dramatically reduced by lowering inventory levels. Therefore, increases in the inventory turnover ratio
and decreases in the number of days’ sales in inventory are usually viewed as favorable trends.
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
134 Chapter 7 Inventories
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The inventory turnover would be computed as follows:
Average Inventory = $66,250 [($65,000 + $67,500)/2]
Inventory Turnover = 6.9 ($456,250/$66,250)
The number of days’ sales in inventory would be computed as follows:
Average Daily Cost of Merchandise Sold = $1,250 ($456,250/365)
Number of Days’ Sales in Inventory = 54 ($67,500/$1,250)
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/article2.html
On this site, Effective Inventory Management, Inc., shares insights on the inventory turnover formula.
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
illustrated in Exhibit 14. The second method is known as the gross profit method and uses the gross profit
from the previous year to estimate this year’s inventory. It also requires four steps and is demonstrated in
Exhibit 15.
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 7 Inventories 135
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.
2. Determining inventory lost in a disaster, such as a fire, flood, tornado, hurricane, or earthquake.
3. Perpetual inventory records are not maintained.
You will also want to demonstrate the two methods for estimating inventory using the following
problems. Because the gross profit method requires fewer steps than the retail method, it is preferable to
cover it first.
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
If you know the beginning inventory, cost of merchandise purchased, and cost of merchandise sold, you
can determine the ending inventory that should be on hand. The problem is this: What if you do not know
your cost of merchandise sold? For example, cost of merchandise sold is not tracked under the periodic
inventory system. If a fire has destroyed your business, you may no longer have the accounting records
that showed your cost of merchandise sold. Explain that you can calculate cost of merchandise sold using
the following methodology:
Sales – Gross Profit on Sales = Cost of Merchandise Sold
GROUP LEARNING ACTIVITY—Gross Profit Method of Estimating
Inventory
TM 7-20 presents information your students can use in solving a gross profit method problem. Divide the
class into small groups and ask them to solve this problem using the previous equations. The solution is
shown on TM 7-21. After your students have solved this problem, remind them that the gross profit
method works best with companies that have a stable markup on merchandise.
136 Chapter 7 Inventories
DEMONSTRATION PROBLEM—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.
To use the retail method, a merchandiser must track his or her beginning inventory and all inventory
purchases, both at their cost and their retail value.
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
Solution:
Cost Retail Value
Beginning inventory $15,000 $ 22,400
Merchandise purchases 52,000 77,600
Merchandise available for sale $67,000 $100,000
Ratio of cost to retail price = 67 percent
Sales (at retail prices) 68,000
Ending inventory at retail $32,000
Ratio of cost to retail price × 67%
Ending inventory at cost $21,440
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.
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 Remembering
DQ 2 1 Easy 5 min. Analytic Measurement Inventories Reporting Remembering
PE 2B Perpetual inventory using FIFO 3 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
PE 3A Perpetual inventory using LIFO 3 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
PE 3B Perpetual inventory using LIFO 3 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
PE 4A Perpetual inventory using weighted average 3 Easy 10 min. Analytic Measurement Inventories Reporting Applying x
EX 3 Perpetual inventory using FIFO 2,3 Easy 15 min. Analytic Measurement Inventories Reporting Applying x
EX 4 Perpetual inventory using LIFO 2,3 Easy 15 min. Analytic Measurement Inventories Reporting Applying x x
EX 5 Perpetual inventory using LIFO 2,3 Easy 15 min. Analytic Measurement Inventories Reporting Applying x x
EX 6 Perpetual inventory using FIFO 2,3 Easy 15 min. Analytic Measurement Inventories Reporting Applying x x
EX 18 Effect of errors in physical inventory 6 Easy 5 min. Analytic Measurement Inventories Reporting Applying
EX 19 Error in inventory 6 Moderate 5 min. Analytic Measurement Inventories Reporting Applying x
EX 20 Inventory turnover 7 Moderate 10 min. Analytic Measurement Inventories Reporting Applying x x
EX 21 Inventory turnover and number of days’ sales in inventory 7 Moderate 15 min. Analytic Measurement Inventories Reporting Applying x x
PR 5A Periodic inventory by three methods 2,4 Challenging 1.5 hours Analytic Measurement Inventories Reporting Applying x x
PR 6A Lower-of-cost-or-market inventory 6 Challenging 1.5 hours Analytic Measurement Inventories Reporting Applying
PR 7A Retail method; gross profit method Appendix Challenging 1.5 hours Analytic Measurement Inventories Reporting Applying
PR 1B FIFO perpetual inventory 2,3 Moderate 45 min. Analytic Measurement Inventories Reporting Applying x x
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