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					Chapter 6-1

CHAPTER 6

INVENTORIES

Accounting Principles, Eighth Edition
Chapter 6-2

Study Objectives
1. Describe the steps in determining inventory quantities.

2. Explain the accounting for inventories and apply the inventory cost flow methods.

3. Explain the financial effects of the inventory cost flow assumptions. 4. Explain the lower-of-cost-or-market basis of accounting for inventories. 5. Indicate the effects of inventory errors on the financial statements. 6. Compute and interpret the inventory turnover ratio.
Chapter 6-3

Reporting and Analyzing Inventory

Classifying Inventory

Determining Inventory Quantities
Taking a physical inventory Determining ownership of goods

Inventory Costing

Inventory Errors

Statement Presentation and Analysis
Presentation
Analysis

Finished goods Work in process Raw materials

Specific identification Cost flow assumptions Financial statement and tax effects Consistent use

Income statement effects Balance sheet effects

Chapter 6-4

Lower-ofcost-ormarket

Classifying Inventory
Merchandising Company
One Classification: Merchandise Inventory

Manufacturing Company
Three Classifications: Raw Materials

Work in Process Finished Goods

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
Chapter 6-5

Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records. 2. Determine amount of inventory lost (wasted raw

materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand 2. Determine the cost of goods sold for the period.

Chapter 6-6

LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory on hand. Taken,
when the business is closed or when business is slow.

at end of the accounting period.

Chapter 6-7

LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit Purchased goods not yet received. Sold goods not yet delivered.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale.
Chapter 6-8

LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Terms of Sale
Illustration 6-1

Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

Ownership of the goods remains with the seller until the goods reach the buyer.
Chapter 6-9

LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities

Review Question
Goods in transit should be included in the inventory of the buyer when the:

a. public carrier accepts the goods from the seller.
b. goods reach the buyer. c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

Chapter 6-10

LO 1 Describe the steps in determining inventory quantities.

Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
•In

some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods.
•These

are called consigned goods.

Chapter 6-11

LO 1 Describe the steps in determining inventory quantities.

Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
Specific Identification

First-in, first-out (FIFO) Last-in, first-out (LIFO)
Average-cost

Cost Flow Assumptions

Chapter 6-12

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Example
Young & Crazy Company makes the following purchases:
1. 2. 3.

One item on 2/2/08 for $10 One item on 2/15/08 for $15 One item on 2/25/08 for $20

Chapter 6-13

Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2008, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of 30%. LO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.

Inventory Costing
“Specific Identification”
Inventory Balance = $ 30
Purchase on 2/25/08 for $20
Purchase on 2/15/08 for $15
Young & Crazy Company Income Statement For the Month of Feb. 2008
Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 15 75

Purchase on 2/2/08 for $10
Chapter 6-14

14 12 7 33 42 13 $ 29

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Specific Identification Method
An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. Practice is relatively rare. Most companies make assumptions (Cost Flow Assumptions) about which units were sold.

Chapter 6-15

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Cost Flow Assumption
does not need to equal Physical Movement of
Goods
Illustration 6-11 Use of cost flow methods in major U.S. companies
Chapter 6-16

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Example
Young & Crazy Company makes the following purchases:
1. 2. 3.

One item on 2/2/08 for $10 One item on 2/15/08 for $15 One item on 2/25/08 for $20

Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, and Average-cost flow assumptions? Assume a tax rate of 30%.
Chapter 6-17

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise. Generally good business practice to sell oldest units first.

Chapter 6-18

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Inventory Balance = $ 35
Purchase on 2/25/08 for $20
Young & Crazy Company Income Statement For the Month of Feb. 2008
Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 10 80

Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10
Chapter 6-19

14 12 7 33 47 14 $ 33

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Latest goods purchased are first to be sold. Seldom coincides with actual physical flow of merchandise. Exceptions include goods stored in piles, such as coal or hay.

Chapter 6-20

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Inventory Balance = $ 25
Purchase on 2/25/08 for $20
Young & Crazy Company Income Statement For the Month of Feb. 2008
Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 20 70

Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10
Chapter 6-21

14 12 7 33 37 11 $ 26

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“Average-Cost”
Allocates cost of goods available for sale on the basis of weighted average unit cost incurred. Assumes goods are similar in nature. Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.
Chapter 6-22

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
“Average Cost”
Inventory Balance = $ 30
Purchase on 2/25/08 for $20
Young & Crazy Company Income Statement For the Month of Feb. 2008
Sales Cost of goods sold Gross profit Expenses: Administrative Selling Interest Total expenses Income before tax Taxes Net Income $ 90 15 75

Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10
Chapter 6-23

14 12 7 33 42 13 $ 29

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing – Cost Flow Assumptions
Comparative Financial Statement Summary
FIFO Average LIFO

Sales Cost of goods sold Gross profit

$90 10 80

$90 15 75

$90 20 70

Admin. & selling expense Income before taxes Income tax expense Net income Inventory balance
Chapter 6-24

33 47 14 $33 $35

33 42 13 $29 $30

33 37 11 $26 $25

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, FIFO Reports:
FIFO Average LIFO

Lowest

Sales Cost of goods sold Gross profit

$90 10 80

$90 15 75

$90 20 70

Admin. & selling expense Income before taxes Income tax expense

33 47 14 $33 $35

33 42 13 $29 $30

33 37 11 $26 $25

Highest

Net income Inventory balance

Chapter 6-25

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, LIFO Reports:
FIFO Average LIFO

Highest

Sales Cost of goods sold Gross profit

$90 10 80

$90 15 75

$90 20 70

Admin. & selling expense Income before taxes Income tax expense

33 47 14 $33 $35

33 42 13 $29 $30

33 37 11 $26 $25

Lowest

Net income Inventory balance

Chapter 6-26

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions

Review Question
The cost flow method that often parallels the actual physical flow of merchandise is the:

a. FIFO method.
b. LIFO method.

c. average cost method. d. gross profit method.

Chapter 6-27

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions

Review Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:

a. FIFO method.
b. LIFO method.

c. average cost method. d. gross profit method.

Chapter 6-28

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing – Cost Flow Assumptions

Discussion Question
Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period,
Casey has been paying out all of its net income

as dividends. What adverse effects may result from this policy?
See notes page for discussion
Chapter 6-29

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing
Using Cost Flow Methods Consistently
Method should be used consistently, enhances comparability. Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14 Disclosure of change in cost flow method

Chapter 6-30

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost Companies can “write down” the inventory to its market value in the period in which the price decline occurs.
Market value = Replacement Cost

Example of conservatism.

Chapter 6-31

LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Costing
Lower-of-Cost-or-Market
BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31.
Inventory Categories Cameras Camcorders VCRs Cost Data $ 12,000 9,500 14,000 $ Market Data 12,100 9,700 12,800 Lower of Cost or Market

$ 12,000 9,000 12,800 $ 33,800

Compute the lower-of-cost-or-market valuation for the company’s total inventory.
Chapter 6-32

LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

Inventory Errors
Common Cause:
Failure to count or price inventory correctly.

Not properly recognizing the transfer of legal title to goods in transit.
Errors affect both the income statement and balance sheet.

Chapter 6-33

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-16

Illustration 6-17

Chapter 6-34

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income in two periods.

An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.
Over the two years, the total net income is correct because the errors offset each other. The ending inventory depends entirely on the accuracy of taking and costing the inventory.
Chapter 6-35

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Illustration 6-18

2008 Incorrect $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000 Correct $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 $ 25,000

2009 Incorrect $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 Correct $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 $ 10,000

Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income

Combined income for 2-year period is correct.
Chapter 6-36

($3,000) Net Income understated

$3,000 Net Income overstated

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Review Question
Understating ending inventory will overstate: a. assets. b. cost of goods sold.

c. net income. d. owner's equity.

Chapter 6-37

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-16

Illustration 6-19

Chapter 6-38

LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis
Presentation
Balance Sheet - Inventory classified as current asset. Income Statement - Cost of goods sold subtracted from sales. There also should be disclosure of
1) major inventory classifications,

2) basis of accounting (cost or LCM), and 3) costing method (FIFO, LIFO, or average).
Chapter 6-39

LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying

costs (e.g., investment, storage, insurance, obsolescence, and damage).
lost sales.

2. Low Inventory Levels – may lead to stockouts and

Chapter 6-40

LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period.

Inventory Turnover

=

Cost of Goods Sold

Average Inventory

Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in = Inventory Inventory Turnover
Chapter 6-41

LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis
BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.

Inventory Turnover Days in Inventory
Chapter 6-42

$270,000

($60,000 + 40,000) / 2
365

=

5.4

5.4

=

67.59 days

LO 6 Compute and interpret the inventory turnover ratio.

Inventory Cost Flow Methods in Perpetual Inventory Systems
The following data from Houston Electronics will be used to illustrate inventory costing under a perpetual system.

Illustration 6A-1

Chapter 6-43

LO 7

Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under FIFO for Houston Electronics.
Illustration 6A-2

Cost of goods sold

Chapter 6-44

LO 7

Apply the inventory cost flow methods to perpetual inventory records.

Ending inventory

Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under LIFO for Houston Electronics.
Illustration 6A-3

Cost of goods sold

Ending inventory
Chapter 6-45

LO 7

Apply the inventory cost flow methods to perpetual inventory records.

Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under moving average for Houston Electronics.
Illustration 6A-4

Cost of goods sold

Ending inventory

Chapter 6-46

LO 7

Apply the inventory cost flow methods to perpetual inventory records.

Copyright
“Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”

Chapter 6-47


				
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