105
chapter
7
Inventories
OPENING COMMENTS
Chapter 7 comprehensively covers the topic of inventories, including the effects of inventory errors,
internal controls, inventory costing methods, lower-of-cost-or-market adjustments, and estimating
inventory.
The inventory costing methods are presented for both the perpetual and periodic inventory systems. Since
Chapter 6, “Accounting for Merchandising Businesses,” emphasized the perpetual inventory system, you
will need to treat this chapter as if it were your students’ first significant exposure to the periodic
inventory system.
After studying the chapter, your students should be able to:
2. Describe three inventory cost flow assumptions and how they impact the income statement and
balance sheet.
4. Determine the cost of inventory under a periodic inventory system, using the FIFO, LIFO, and
weighted average cost methods.
6. Describe and illustrate the reporting of merchandise inventory in the financial statements.
7. Describe and illustrate the inventory turnover and the number of days’ sales in inventory in analyzing
the efficiency and effectiveness of inventory management.
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STUDENT FAQS
• Why do we have choices of inventory methods instead of just using one all the time? It just makes it
harder.
• Which inventory method is the best?
• Which method is used the most?
• Why can’t we switch methods each month?
• Are property taxes paid on inventory in most states?
• If cost of goods sold goes up, does gross profit always go down?
• Do you know what percent of people in the workforce work with inventory on a daily basis?
• By having different inventory methods that result in different costs of goods sold and gross profit,
aren’t you encouraging “playing with the numbers”?
• Why wouldn’t a company always select the inventory method that resulted in the highest net income,
so the business looks good?
• What is the difference between the “physical flow of goods” and the “flow of costs” through a
company?
• Wouldn’t a company have to use the inventory method that best matches the actual physical flow of
goods?
• What are some examples of when a company would want to change its inventory costing method?
OBJECTIVE 1
Describe the importance of control over inventory.
KEY TERMS
Physical Inventory Receiving Report
Purchase Order Subsidiary Inventory Ledger
SUGGESTED APPROACH
Internal controls for inventory exist to (1) protect inventory from theft and damage and (2) ensure that
inventory is reported accurately in the financial statements. Ask your students to give examples of how
retail stores safeguard inventories. Examples might include security cameras, locked show cases, and
inventory control tags. The Group Activity below will facilitate further discussion of inventory controls.
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GROUP LEARNING ACTIVITY — Internal Controls over Inventory
Transparency Master (TM) 7-1 presents a case of poor internal controls over inventory. Divide the class
into small groups. Ask your students to read the case, identify the control problems, and suggest how to
correct the inappropriate inventory procedures.
The City of Milford Parks and Recreation department operates three community swimming pools.
Each pool has a concession stand that sells candy. Each concession stand is staffed with two
workers.
To be eligible for volume discounts, the Parks and Recreation department orders the candy for all
three pools. Sandy Wells is responsible for ordering the concession stand goodies. Sandy uses a
locked closet down the hall from her office at the Parks and Recreation headquarters to store the
candy. She checks the closet periodically and, when supplies seem low, she orders more.
Whenever a concession stand needs to restock inventory, a worker goes to the Parks and
Recreation headquarters to get the needed candy. Because Sandy knows all of the concession
workers, she usually just hands the worker the key to the candy closet so the worker can get
whatever is needed. Sandy has attached a chart to the closet door to keep track of candy
withdrawals. On that chart, each worker records the number of boxes of candy that he or she is
taking and the pool to which it is going.
By the end of the summer, Sandy becomes worried that someone else has a key to the candy
closet. The candy seems to be disappearing more quickly than it did at the beginning of the
summer. For the last month or so, she hasn’t found time to compare the withdrawals on her chart
with candy purchases, but something just doesn’t seem right.
Possible response: Even though Sandy knows all the concession stand workers, just providing the key
and assuming everyone will adhere to the honor system is a bad idea. Temptation can cause the strongest-
willed individuals to succumb. The enticement to just take one leads to more and more; and before you
know it, someone who under normal circumstance would not consider stealing, does so when internal
controls to prevent them do not exist. The lack of knowledge of inventory balance adds to this problem.
If you don’t know what you have (or should have), you don’t know what is missing and how much. You
can only speculate. Proper procedures would compare inventory to sales to determine if all inventory is
actually being sold. The chart on the door is a start for tracking inventory, but allowing the concession
stand workers to record inventory withdrawals makes the record unreliable. Sandy should take the needed
inventory from the storeroom, record the withdrawal on the chart, and personally provide the inventory to
the concession stand workers. Knowing inventory at each location and comparing that with sales at each
location should provide additional assurance that all of the inventory is being used for the designated
purpose of sales to generate revenue for the parks and recreation department.
This objective also covers the procedures for taking a physical inventory. To stimulate interest in this
topic, ask your class for real-world examples of how a physical inventory is taken, using the Class
Discussion ideas that follow. As part of this discussion, be sure to remind students of the special attention
that must be devoted to merchandise in transit and on consignment to ensure that all valid inventory items
are counted.
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CLASS DISCUSSION — Procedures for a Physical Inventory Count
Ask your students to indicate, by a show of hands, whether they have participated in taking a physical
inventory count. Next, ask who has participated in an inventory count recently. Call on one or two
students to describe the procedures that were used during the inventory count. This will supplement the
procedures described in the text with additional, real-world examples. If you have participated in a
physical inventory count, you may also want to describe the procedures used.
The following question can be used to stimulate further class discussion: Should warehouse employees be
members of the inventory count team? Point out that a warehouse employee could steal inventory and
cover up the theft by inflating the physical inventory count if he/she were on the count team.
LECTURE AID — Items Included in Ending Inventory
Remind students that all merchandise owned by the business on the physical inventory date should be
included in the inventory amount shown on the financial statements. TM 7-2 outlines the items included
in inventory.
OBJECTIVE 2
Describe three inventory cost flow assumptions and how they impact the income statement
and balance sheet.
KEY TERMS
First-in, First-out (FIFO) Specific Identification Inventory Cost Flow Method
Inventory Cost Flow Method Weighted Average Inventory Cost Flow Method
Last-in, First-out (LIFO)
Inventory Cost Flow Method
SUGGESTED APPROACH
This objective opens with a quick description of the specific identification inventory cost flow method
and an explanation of why this method is impractical for most businesses. Next, the text illustrates the
FIFO, LIFO, and average cost methods. Use the lecture aids below to supplement the text’s presentation.
LECTURE AID — Inventory Costing Methods
Remind your class that inventory is shown on the balance sheet at an amount equal to what the
merchandise cost. Next, establish the need for inventory costing methods by presenting the following
scenario to your class (TM 7-7).
At the beginning of the current year, John Bach opened a music store that sells compact discs of classical
music. The store is called Strictly Classical. During the year, Strictly Classical purchased 10,000 compact
discs for $7 each. At the end of the year, a physical inventory count revealed that 1,000 of those discs
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Next, pose the following question: How realistic is it that every item of merchandise that a business
purchases during a year has the same cost?
TM 7-8 presents the following scenario:
Assume instead that Strictly Classical purchased 10,000 compact discs as follows:
Date No. of Discs Purchased Cost/Unit Total Cost
Jan. 1 800 $7.00 $ 5,600
Mar. 8 2,200 $7.50 16,500
If the year-end inventory reveals 1,000 discs on hand, what is the inventory value on the balance sheet?
What is the store’s cost of merchandise sold?
Explain that you must make an assumption about which discs are the ones in ending inventory and which
discs were sold. At this point, introduce the three commonly used inventory methods. Remind your
students that the name of the LIFO and FIFO methods describes which inventory items have been sold.
Items Sold Items in
Method (out the door) Ending Inventory
FIFO — Milk (or any perishable item). When shelves are restocked, the “older” milk is moved to the
front, and the “newer” milk is placed in back to encourage customers to buy the older milk first.
LIFO — Packages of nails or screws at a hardware store. When shelves are restocked, the older packages
are slid to the back of the shelf or rack and the newer packages placed in front. Customers buy the newest
hardware first.
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If you do mention these examples, point out that a company’s inventory costing method does not have to
match how the products are actually sold.
Solution to Strictly Classical (assuming periodic inventory):
OBJECTIVE 3
Determine the cost of inventory under the perpetual inventory system, using the FIFO,
LIFO, and weighted average cost methods.
SUGGESTED APPROACH
You can use this objective to review the journal entries under a perpetual inventory system as well as
teach the inventory costing methods. It is helpful to present a simple demonstration of each method.
DEMONSTRATION PROBLEM — Perpetual Inventory Methods
Obtain two sheets each of blue, green, and yellow 8-1/2-inch 11-inch paper (or any three different
colors available). Divide each sheet in half. These half-sheets of paper will serve as inventory items, with
each color representing a different cost. On each half-sheet of blue paper, write $0.10. Write $0.12 on
each green sheet and $0.15 on each yellow sheet.
Example #1: FIFO Inventory
Inform your students that they will be recording journal entries for a merchandiser who uses a perpetual
inventory system and the FIFO inventory method. For each transaction you cover, they will be given
approximately one minute to record the entry. After that time, you will show them the correct entry (using
TM 7-9). Ask your students to assume that all inventory items are sold for $1.00 each—price increases
Chapter 7 Inventories 111
Next, tape the four $0.12 inventory items (green sheets) to the board. These items were purchased on
account on April 6. Ask your students to record the purchase. At this point, the inventory on hand is
Example #2: LIFO Inventory
Repeat the previous transactions. Ask your students to record them using the LIFO method. The correct
journal entries are listed on TM 7-10. The correct ending inventory value is $0.20 (2 units at $0.10 each).
Optional discussion: International Financial Reporting Standards (IFRSs). You may want to mention
Example #3: Weighted Average Cost Inventory
Repeat the same transactions a third time, using the average cost method. You will need to remind
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OBJECTIVE 4
Determine the cost of inventory under a periodic inventory system, using the FIFO, LIFO,
and weighted average cost methods.
SUGGESTED APPROACH
Although your students were introduced to the periodic inventory system in the Chapter 6 Appendix, you
will find it worthwhile to review some basic information. Use TM 7-12 to overview the accounting
procedures in a periodic inventory system.
After an introduction to the periodic inventory system, ask your students to practice calculating ending
inventory and cost of merchandise sold under the LIFO, FIFO, and average cost methods with the Group
Learning Activity below.
LECTURE AID — Cost of Merchandise Sold
In Chapter 6, the lecture aids gave you a “Twinkies” story to present the calculation of cost of
merchandise sold. Here is a shorter version of this silly story for a quick review:
Assume your favorite snack to eat while studying is Twinkies. One evening, before a night of heavy
studying for an accounting test, you notice that you have only three Twinkies in your cupboard. Knowing
this will never get you through your intense study session, you go to the grocery and buy a box of twelve
Twinkies. The next morning, you wonder how many Twinkies you ate. Since you didn’t keep track of the
number of Twinkies consumed as you were eating them, how could you determine the number eaten?
(Answer: Count the Twinkies left. If you have only five Twinkies left, you ate ten [3 + 12 = 15 – 5 =10].)
This is the same methodology a merchandiser uses to calculate the cost of merchandise sold:
Beginning Inventory
+ Cost of Merchandise Purchased
Merchandise Available for Sale
– Ending Inventory
Cost of Merchandise Sold
DEMONSTRATION PROBLEM — Cost of Merchandise Sold
To reinforce this concept, you may want to ask your students to calculate a company’s cost of
merchandise sold, using the following information:
Beginning Inventory = $5,000
Purchases = $120,000
Ending Inventory = $10,000
Cost of Merchandise Sold = ? (Answer: $115,000)
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Next, give the class the following additional information:
The same company had purchase returns of $2,000, purchase discounts of $3,500, and transportation costs
of $1,500. What did it cost the company to purchase its merchandise, and what is the cost of merchandise
sold?
GROUP LEARNING ACTIVITY — Inventory Costing Methods
Display the information on inventory purchases made by Strictly Classical (TM 7-8). Divide the class into
small groups and ask them to determine the value of Strictly Classical’s ending inventory and cost of
merchandise sold under each of the three inventory costing methods. Emphasize that assumptions
concerning which items were sold are not made until the end of the year. TM 7-14 provides the solution
to this exercise.
OBJECTIVE 5
Compare and contrast the use of the three inventory costing methods.
SUGGESTED APPROACH
TM 7-15 presents information to allow you to compare the advantages and disadvantages of the three
inventory methods. Point out that if all units of inventory on hand during a year had the same cost, all
three inventory methods would yield the same results.
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LIFO, although not supported by the IFRS, is popular with U.S. companies due to high cost of
merchandise sold results that equate to lower income tax obligations.
OBJECTIVE 6
Describe and illustrate the reporting of merchandise inventory in the financial statements.
KEY TERMS
Consigned Inventory Lower-of-Cost-or-Market (LCM) Method
Consignee Net Realizable Value
Consignor
SUGGESTED APPROACH
Inventory is carried on the financial statements at its cost unless one of the following conditions has
occurred:
1. If the current cost to purchase inventory items is lower than the cost recorded in the accounting
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 7-16 presents three inventory items. Divide your class into small groups and ask them to determine
the value that each item should carry.
The solutions to this exercise are as follows:
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):
Chapter 7 Inventories 115
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
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:
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.
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.