117
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:
1. Describe the importance of control over inventory.
2. Describe three inventory cost flow assumptions and how they impact the income statement and
balance sheet.
3. Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and
weighted average cost methods.
4. Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and
weighted average cost methods.
5. Compare and contrast the use of the three inventory costing 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.
118 Chapter 7 Inventories
KEY TERMS
consigned inventory
consignee
consignor
first-in, first-out (FIFO) inventory cost flow method
gross profit method
inventory turnover
last-in, first-out (LIFO) inventory cost flow method
lower-of-cost-or-market (LCM) method
net realizable value
number of days’ sales in inventory
physical inventory
purchase order
receiving report
retail inventory method
specific identification inventory cost flow method
subsidiary inventory ledger
weighted average inventory cost flow method
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?
Chapter 7 Inventories 119
OBJECTIVE 1
Describe the importance of control over inventory.
SYNOPSIS
The chapter starts by describing how inventory control is achieved by safeguarding the inventory from
damage and theft and by the accurate reporting of inventory in the financial statements. Purchase orders
which authorize the acquisition of inventory must be matched with receiving reports to establish that
merchandise ordered is the same as what is received. The amount of inventory is always available when
using a perpetual inventory system. A physical inventory should be taken toward the end of the year.
After determining the inventory on hand, the cost of inventory is assigned for reporting on the balance
sheets.
Key Terms and Definitions
• Physical Inventory – A detailed listing of merchandise on hand.
• Purchase Order – The purchase order authorizes the purchase of the inventory from an approved
vendor.
• Receiving Report – The form or electronic transmission used by the receiving personnel to
indicate that materials have been received and inspected.
• Subsidiary Inventory Ledger – The subsidiary ledger containing individual accounts for items
of inventory.
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.
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
120 Chapter 7 Inventories
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.
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.
Chapter 7 Inventories 121
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.
SYNOPSIS
The physical purchase and sale of inventory may not follow the cost flow assumption used. The cost flow
assumption is just for accounting purposes. Three common cost flow assumptions are shown in Exhibit 1.
The first-in, first-out (FIFO) method assumes that items are sold in the same order they are purchased.
The last-in, first-out (LIFO) method assumes that the last item purchased is the first item sold. The
weighted average cost method assumes that the cost of all the items are added together, and then divided
by the number of items, resulting in an average cost per item. All items sold are assumed to have the same
cost, so it doesn’t matter in what order they are sold. One other cost flow method is discussed: the specific
identification method. Each item of inventory is uniquely identified and tracked with a specific purchase.
This method is not practical unless each inventory item can be specifically identified. Car dealers often
use this method because each car is identified with a vehicle identification number (VIN). Exhibit 2
demonstrates how each method affects the income statement and balance sheet.
Key Terms and Definitions
• First-In, First-Out (FIFO) Inventory Cost Flow Method – The method of inventory costing
based on the assumption that the costs of merchandise sold should be charged against revenue in
the order in which the costs were incurred.
• Last-In, First-Out (LIFO) Inventory Cost Flow Method – A method of inventory costing
based on the assumption that the most recent merchandise inventory costs should be charged
against revenue.
• Specific Identification Inventory Cost Flow Method – Inventory method in which the unit sold
is identified with a specific purchase.
• Weighted Average Inventory Cost Flow Method – A method of inventory costing in which the
cost of the units sold and in ending inventory is a weighted average of the purchase costs.
Relevant Example Exercises and Exhibits
• Example Exercise 7-1 Cost Flow Methods
• Exhibit 1 – Cost Flow Assumptions
• Exhibit 2 – Inventory Costing Methods
• Exhibit 3 – Use of Inventory Costing Methods
122 Chapter 7 Inventories
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
were on hand. What value should be shown for ending inventory on the year-end balance sheet? (Answer:
1,000 $7 = $7,000)
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
June 23 4,000 $7.25 29,000
Sept. 15 3,000 $7.40 22,200
Total 10,000 $73,300
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
First-in, first-out First items Last items
purchased purchased
Last-in, first-out Last items First items
purchased purchased
Chapter 7 Inventories 123
Some students find it helpful to attach a mental picture to each inventory method by associating it with a
product. The following are examples of products that would be sold in a FIFO, LIFO, or average cost
flow.
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.
Average — Gasoline. When new gasoline is delivered to a gas station, it is dumped into the tank with any
old gas that has not been sold. Therefore, the customer is buying a mixture of old and new gas.
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):
FIFO: ending inventory value – $7,400
LIFO: ending inventory value – $7,100 = (800 × 7) + (200 × 7.5)
Average Cost: ending inventory value – $7,330 = (73300/10000) × 1000
OBJECTIVE 3
Determine the cost of inventory under the perpetual inventory system, using the FIFO,
LIFO, and weighted average cost methods.
SYNOPSIS
Using a perpetual inventory system, the FIFO method results in the merchandise being sold in the order in
which it was purchased. This often provides results similar to the specific identification method, if the
inventory is stocked with the oldest merchandise to the front of the shelf. Exhibit 4 shows the flow of
costs along with the associated journal entries using FIFO and a perpetual inventory system. The LIFO
method results in the costs of the units sold being the cost of the most recent purchases. LIFO is normally
used, not because it follows the physical flow of goods, but because of the impact it has on taxes. Exhibit
5 shows the cost flows along with the associated journal entries. When the weighted average cost method
is used with a perpetual inventory system, an average price is calculated using the available merchandise
and the prices paid for that merchandise. This average is used until another purchase is made and then a
new weighted average price is calculated. Because the price is constantly changing, this technique is
called a moving average. Exhibit 6 shows the flow of costs along with the journal entries.
124 Chapter 7 Inventories
Relevant Example Exercises and Exhibits
• Example Exercise 7-2 Perpetual Inventory Using FIFO
• Example Exercise 7-3 Perpetual Inventory Using LIFO
• Example Exercise 7-4 Perpetual Inventory Using Weighted Average
• Exhibit 4 – Entries and Perpetual Inventory Account (FIFO)
• Exhibit 5 – Entries and Perpetual Inventory Account (LIFO)
• Exhibit 6 – Entries and Perpetual Inventory Account (Weighted Average)
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
cannot be passed on to the consumer. After checking each entry, it is helpful to compute the current
inventory balance for your students.
Use tape to attach the four $0.10 inventory items (blue sheets) to the board. Tell your students that these
items were purchased on account on April 1. Ask them to record the journal entry for this purchase. At
this point, the inventory on hand is valued at $0.40 (4 $0.10).
Tell your students that a customer purchased two items for cash on April 3. Ask them to record this sale.
Remind them that the perpetual inventory system requires two entries for a sales transaction: one to
record sales revenue and one to record the cost of merchandise sold. After the students have completed
their entries, remove two of the blue sheets from the board. At this point, the inventory on hand is valued
at $0.20 (2 $0.10).
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
valued at $0.68 [(2 $0.10) + (4 $0.12)].
Tell your students that a customer purchased three items for cash on April 12. Ask them to record this
sale. Remind them that the company uses the FIFO costing method. After the students have completed
Chapter 7 Inventories 125
their entries, remove the two blue sheets and one green sheet from the board. At this point, the inventory
on hand is valued at $0.36 (3 $0.12).
Tape the four $0.15 inventory items (yellow sheets) to the board. These items were purchased on account
on April 20. Ask your students to record the purchase. At this point, the inventory on hand is valued at
$0.96 [(3 $0.12) + (4 $0.15)].
Inform your students that a customer purchased five items for cash on April 27. Ask them to record this
sale. After they have completed their entries, remove three green sheets and two yellow sheets from the
board.
Ask your students to compute the ending inventory value at the end of April. The correct answer is $0.30
(2 units at $0.15 each).
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
that IFRS permits FIFO and average cost methods but prohibits the LIFO costing method. Since many
U.S. companies use LIFO, adoption of IFRS could have a significant impact on those companies.
Example #3: Weighted Average Cost Inventory
Repeat the same transactions a third time, using the average cost method. You will need to remind
students that a new average cost must be computed after each purchase. To reinforce this, ask them to
compute the new average cost after each purchase is recorded. The correct journal entries are listed on
TM 7-11. The correct ending inventory value is $0.27 (2 units at $0.134 each).
These simple demonstrations point out how time consuming and costly it would be to maintain a
perpetual inventory system without the use of computers. You can also emphasize that, in practice,
perpetual inventories are often maintained only in units and then converted to dollars for preparing
financial statements at the end of the period.
OBJECTIVE 4
Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO,
and weighted average cost methods.
SYNOPSIS
Using the periodic inventory system, only revenue is recorded with a sale. Physical inventory is taken at
the end of the accounting period to determine the cost of the merchandise sold and the cost of the ending
126 Chapter 7 Inventories
inventory. Exhibit 7 shows the FIFO flow of costs in the periodic system. If you compare that exhibit
with Exhibit 4, you can see that the costs are the same as when you use FIFO with a perpetual system.
Using LIFO, the cost of ending inventory is made up of the earliest cost. It may not be same number as
perpetual inventory: compare Exhibit 8 with Exhibit 5 to see the differences. The weighted average cost
method uses the formula: weighted average cost = total costs of units available for sale/units available for
sale. Compare Exhibit 6 with the calculations on page 333 to see the differences.
Relevant Example Exercises and Exhibits
• Example Exercise 7-5 Periodic Inventory Using FIFO, LIFO, and Weighted Average Cost
Methods
• Exhibit 7 – First-In, First-Out Flow of Costs
• Exhibit 8 – Last-In, First-Out Flow of Costs
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
Chapter 7 Inventories 127
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)
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?
(Answers: Cost of Merchandise Purchases = $116,000
Cost of Merchandise Sold = $111,000)
Use TM 7-13 to illustrate that cost of merchandise purchased is simply one part of calculating cost of
merchandise sold. This amount is also called “net purchases.”
This Demonstration Problem provides calculations for cost of merchandise sold or ending inventory when
the totals are given. Calculating cost of merchandise sold or ending inventory value numbers requires a
demonstration problem where different purchases are made at different times and different cost. Problem
7-5A from the text will provide a demonstration for student to actually use the three different inventory
costing methods described in the objective. Work the problem for your students to show how the ending
inventory value is impacted, depending on which method of inventory costing the company decides to
use. One confusing point for students is to determine what is being asked: Are we calculating ending
inventory value (those items left in inventory) or cost of merchandise sold (the value of those items that
have been 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.
128 Chapter 7 Inventories
OBJECTIVE 5
Compare and contrast the use of the three inventory costing methods.
SYNOPSIS
The use of different cost methods will result in differing amounts for cost of merchandise sold and ending
inventory. The inventory cost method will then impact the income statement with a gross profit varying
between each method used. The balance sheet will also be affected since the cost of ending inventory is
an asset listed on the balance sheet. Exhibit 9 demonstrates how the cost of merchandise sold, gross profit,
net income, and ending merchandise inventory will be affected.
Relevant Example Exercises and Exhibits
• Exhibit 9 – Effects of Changing Costs (Prices): FIFO and LIFO Cost 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.
Point out to students that in times of rising prices, FIFO will always result in the lowest cost of
merchandise sold (highest ending inventory value), LIFO will always produce the highest cost of
merchandise sold (lowest ending inventory value), and average cost will fall between these results.
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.
SYNOPSIS
Cost is the primary way to report the value of merchandise inventory in the financial statements. If the
cost to replace the inventory is lower than the recorded purchase price, the lower-of-cost-or-market
method may be used. The amount of the price decline is included in the cost of merchandise; this
transaction will also reduce gross profit and net income. Inventory is reported in the current assets section
of the balance sheet. The balance sheet must also state what method was used to determine the cost of the
inventory (FIFO, LIFO, or weighted average) and the method of valuing the inventory (cost or lower of
cost or market). Inventory errors can also have an effect on the financial statements. The errors usually
fall into one of four categories: physical miscounts, incorrectly assigned costs, inventory in transit, and
consigned inventory incorrectly included. Exhibits 11 and 12 show the effects of the errors on the income