CHAPTER 6
INVENTORIES
LEARNING OBJECTIVES
1. DISCUSS HOW TO CLASSIFY AND DETERMINE
INVENTORY.
2. APPLY INVENTORY COST FLOW METHODS AND
DISCUSS THEIR FINANCIAL EFFECTS.
3. INDICATE THE EFFECTS OF INVENTORY ERRORS ON
THE FINANCIAL STATEMENTS.
4. EXPLAIN THE STATEMENT PRESENTATION AND
ANALYSIS OF INVENTORY.
*5. APPLY THE INVENTORY COST FLOW METHODS TO
PERPETUAL INVENTORY RECORDS.
*6. DESCRIBE THE TWO METHODS OF ESTIMATING
INVENTORIES.
*7. COMPARE THE ACCOUNTING FOR INVENTORIES
UNDER GAAP AND IFRS.
CHAPTER REVIEW
Classifying Inventory
1. (L.O. 1) Merchandise 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
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.
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-
average unit cost.
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.
Effects of Inventory Errors
15. (L.O. 3) The effects of inventory errors on the current year’s income statement are:
Presentation
17. (L. O. 4) In the financial statements:
a. Inventory is usually classified as a current asset after receivables in the balance sheet, and
for Sale at Retail
Lower-of-Cost-or-Market
18. The value of inventory for companies in certain industries can drop due to changes in technology
Inventory Turnover
20. The inventory turnover measures the number of times on average the inventory is sold during
the period.
*Applying Perpetual Inventory
*22. (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
goods sold.
Estimating Inventories
*23. (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
*24. The gross profit method is widely used to estimate the ending inventory. Two steps are involved
in using this method.
Retail Inventory Method
*25. 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
=
Compare the Accounting for Inventories Under GAAP and IFRS
*26. (L.O. 7) The similarities and differences under IFRS and GAAP are:
a. Similarities
(1) IFRS and GAAP account for inventory acquisitions at historical cost and evaluate
inventory for lower–of-cost-or-market subsequent to acquisition.
(2) Who owns the goods – goods in transit or consigned goods – as well as the costs to
LECTURE OUTLINE
A. Classifying and Determining Inventory.
1. Inventory of a merchandising company has two common characteristics:
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?
B. Determining Inventory Quantities.
1. 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 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:
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:
4. Cost of goods available for sale is allocated to either ending inventory or
to cost of goods sold.
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.
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.
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?
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).
2. Errors in ending inventory have no effect on liabilities and have the same
effect on total assets and total owners’ equity (overstatement of inventory
results in overstatement of total assets and owners’ equity).
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:
4. Companies apply LCM to the items in inventory after they have used
one of cost flow methods to determine cost. Under LCM, companies
recognize the loss in the period in which the price decline occurs.
a. LCM is an example of the accounting convention of conservatism,
which means that the approach adopted among accounting
5. Companies apply LCM to the items in inventory after they have used one
of the cost flow methods to determine cost.
6. Inventory turnover measures the number of times on average the inventory
is sold during the period.
*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:
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.
A Look at IFRS
The major IFRS requirements related to accounting and reporting for inventories
are the same as GAAP. The major differences are that IFRS prohibits the use of
the LIFO cost flow assumption and determines market in the lower–of-cost-or–
market inventory valuation differently.
KEY POINTS
SIMILARITIES
DIFFERENCES
• The requirements for accounting for and reporting inventories are more
principles-based under IFRS. That is, GAAP provides more detailed
guidelines in inventory accounting.
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.
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 LCM basis, market is defined as current replacement cost, not selling price.
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. 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
Multiple Choice