1. 8
C H A P T E R
Inventory

2. Learning Objective 1
Identify what items and costs should be included in inventory and cost of goods sold.

3. Define Inventory and COGS. What are some of their characteristics?

4. Describe the Time Line of Business.

5. Defined according to type and nature of the company.
What is Inventory?
Defined according to type and nature of the company.
Merchandising:
Manufacturing:

6. Define Each Manufacturing Inventory
Raw materials
Work in process
Finished goods

7. What Costs are Included in Inventory?

8. Who Owns the Inventory? When goods are in transit?
Q: Who owns inventory on a truck or railroad car?
When goods are on consignment?
Q: Who owns inventory stocked in a warehouse?

9. Ending Inventory & COGS
Cost of goods available for sale
Beginning inventory
Net purchases = +
The question is where is the inventory that could have been sold this period? Only two choices:
At period’s end, allocated between
inventory is still remaining (an asset), and
inventory sold during the period (an expense, Cost of Goods Sold).

10. Learning Objective 2
Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

11. What are the Two Methods for Accounting for Inventory?

12. Example: Accounting for Inventory Purchases and Sales
Harper’s Hats recorded the following transactions for 2006:
Beginning inventory 10 $10 each = $100
March 1 Purchase 15 $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 $15 each = $ 45
May 2 Purchase 10 $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats $10, $15)
July 3 Sales return 1 $15 = $ 15
Ending inventory 13 hats 18

13. Example: 2006 Inventory Purchase Sale Balance `
Date Units Total Units Total Units Cost Total
Jan $10 $100
Mar $ $10 $ $15 $225 (3) ($45) 12 $15 $180
May 2 10 $ $10 $ $15 $ $20 $200
June $ $ $15 $ $20 $200
July 3 (1) ($15) 3 $15 $ $20 $200 19

14. Perpetual & Periodic Journal Entries
All purchases are added directly to the inventory account.
Periodic
At end of period,
Inventory balance is updated using inventory count.
Temporary purchases account balance is closed to Inventory to compute COGS.
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS

15. Example: Journal Entries for Purchases
Harper purchased 10 hats at $10 each on January 1. Record the entries for both perpetual and periodic systems.
PERPETUAL
PERIODIC 22

16. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
All costs are added directly to the inventory balance.
Periodic
At end of period, temporary freight in account balance is closed to Inventory to compute COGS.

17. Example: Journal Entries for Transportation Cost
Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10. Record the entries for both the perpetual and the periodic systems.
PERPETUAL
PERIODIC 22

18. Perpetual & Periodic Journal Entries
Inventory is decreased.
Accounts Payable is decreased by same amount.
Periodic
If merchandise has been paid for, the supplier will reimburse (debit Cash).
At end of period, temporary purchase returns account balance is closed to Inventory to compute COGS.
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS

19. Example: Journal Entries for Purchase Returns
Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day. Record the entries for both the perpetual and the periodic inventory systems.
PERPETUAL
PERIODIC 22

20. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Subtract the discount amount from the inventory account.
Periodic
At end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS.

21. Example: Journal Entries for Purchase Discounts
On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems.
PERPETUAL
PERIODIC 22

22. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Perpetual
All adjustments are entered directly in the Inventory account.
Periodic
All adjustments are accumulated in an array of temporary holding accounts:
Purchases
Freight In
Purchase Returns
Purchase Discounts
The difference in terms of journal entries:

23. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Recognize sales and COGS on a transaction-by-transaction basis.
Periodic
Only total sales are known.

24. Example: Journal Entries for Sales
In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first). Record the entries for both the perpetual and the periodic systems.
PERPETUAL
PERIODIC 22

25. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Sales for returned items are canceled.
Cost of returned inventory is removed from COGS and restored to the inventory account.
Periodic
Sales for returned items are canceled.
No entry is made to adjust COGS.

26. Example: Journal Entries for Sales Returns
On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems.
PERPETUAL
PERIODIC 22

27. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
All journal entries are posted to the ledger.
Results in new balances for Inventory and COGS.
Numbers are verified by physical count.
Periodic
Temporary holding accounts are accumulated and added to Inventory.
Inventory account balance is reduced by the amount of COGS.

28. Accounting for Inventory Purchases and Sales
Harper’s Hats recorded the following transactions for 2006:
Beginning inventory 10 $10 each = $100
March 1 Purchase 15 $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 $15 each = $ 45
May 2 Purchase 10 $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats $10, $15)
July 3 Sales return 1 $15 = $ 15
Ending inventory 13 hats 18

29. Closing Entries for Cost of Goods Sold
Perpetual: the inventory account will have an ending balance of $255.
Inventory
COGS
1/1 100
3/ /1 45
3/1 10
5/2 200
6/30 250
7/3 15
Bal. 255
6/30 250
7/3 15
Bal. 235

30. Closing Entries for Cost of Goods Sold
Periodic: the inventory account will be debited by $386, which represents the net purchases for the year.
Jul. 31 Inventory
Purchase Returns
Purchase Discounts
Freight In
Purchases

31. Periodic Inventory
With a periodic system, a physical count is the only way to get the information necessary to compute COGS:
Beginning Inventory, January 1, 2006
+ Purchases for the year
= Cost of goods available for sale during 2006
– Ending Inventory, December 31, 2006
= Cost of Goods Sold for 2006 30

32. Learning Objective 3
Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.

33. Physical Count of Inventory
Essential to maintaining reliable inventory accounting records.
Perpetual
Physical count either confirms records are accurate or highlights shortages and clerical errors.
Periodic
The only way to get information necessary to compute COGS:
Quantity count.
Inventory costing (assigning a unit cost to each type of merchandise).
Ending inventory = quantity of each type x its unit cost.

34. COGS Computation Perpetual
The accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count.
The difference between the records and actual count = inventory lost, stolen, or spoiled.
Periodic
Company does not know what ending inventory should be.
Assumes physical count is the difference between cost of goods available for sale and ending inventory.
Cannot tell whether goods were sold, lost, stolen, or spoiled.

35. What is the Income Effect of an Error in Ending Inventory?8

36. Complete Table of Effects of Inventory Errors
Understate Ending
Inventory
Sales OK
Beginning inventory OK
Net purchases OK
Goods available OK
Ending inventory LOW
Cost of goods sold HIGH
Gross margin LOW
Expenses OK
Net income LOW
Understate
Purchases
Beginning
Understate Sales 12

37. Learning Objective 4
Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

38. Inventory Cost Flow
Kernel King buys and sells corn and had the following transactions for 2002:
June 10 Purchased 10 tons at $6 per ton.
July 28 Purchased 10 tons at $9 per ton.
October 10 Sold 10 tons at $11 per ton.
How much did Kernel King make in 2002?
Case #1 Case #2 Case #3
Sold Sold Sold
Old Corn New Corn Mixed Corn
Sales ($11 x 10 tons)
COGS (10 tons)
Gross margin

39. Specific Identification Cost Flow
Specifically identify the cost of each unit sold.
The individual cost of each unit is charged against revenue as COGS.
To compute COGS and ending inventory, a firm must know each unit sold and its cost.

40. Inventory Cost Flow Methods
FIFO
The oldest units are sold and the newest units remain in inventory.
The cost of the oldest units purchased is transferred to COGS.
LIFO
The newest units are sold and the oldest units remain in inventory.
The cost of the most recent units purchased is transferred to COGS.
Average Cost
An average cost is computed for all inventory available for sale during the period.
COGS is computed by multiplying the number of units sold by the average cost per unit.

41. Compare Inventory Methods
LIFO gives a better reflection of COGS in the income statement.
Therefore, LIFO is a better measure of income.
FIFO gives a better measure of inventory on the balance sheet.
Therefore, FIFO is a better measure of inventory value.

42. Learning Objective 5
Use financial ratios to evaluate a company’s inventory level.

43. Why Use JIT Inventory Management?

44. Evaluating Inventory Levels
Cost of goods sold
Average inventory
Inventory Turnover
Measures how many times a company turns over (or replenishes) its inventory.
Average inventory = average of the beginning and ending inventory balances.
Number of Days’ Sales in Inventory
365 days
Inventory turnover 58

45. Evaluating Inventory Management
Buster Boots had cost of goods sold of $60,000 during The inventory account decreased by $1,000 to $4,000 during the same time. Calculate the inventory turnover ratio and number of days’ sales in inventory.
Inventory turnover ratio
Number of days’ sales in inventory 22

46. Expanded Material Learning Objective 6
Analyze the impact of inventory errors on reported cost of goods sold. ? ?

47. What Is the Effect of These Inventory Errors?
If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory,
If a sale is not recorded, but inventory is shipped and not counted in ending inventory,

48. Expanded Material Learning Objective 7
Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.

49. Using Average Cost or LIFO with a Perpetual System
Using average cost or LIFO with perpetual leads to complications.
The average cost of units available for sale changes every time a purchase is made.
The identification of the “last in” units
also changes with every purchase.
With periodic,
One overall average cost is used for all goods available for sale during the period.
The “last in” units are identified at the end of the period.

50. Describe the Similarities of Using FIFO for Perpetual and Periodic Systems.

51. Expanded Material Learning Objective 8
Apply the lower-of-cost-or-market method of accounting for inventory.

52. When Do You Report Inventory Below Cost?

53. When Do You Report Inventory at Net Realizable Value (NRV)?

54. Lower of Cost or Market (LCM)
Ceiling: the maximum market amount at which inventory can be carried on the books; equal to net realizable value (selling price less estimated selling costs).
LCM: A basis for valuing inventory at the lower of original cost or current market value.
Floor: the minimum market amount at which inventory can be carried on the books; equal to net realizable value less a normal profit.

55. Example: LCM
Market
Inventory Replacement NRV
Item Cost Floor Cost Ceiling A B C D
Define market value as:
replacement cost, if it falls between the ceiling and the floor.
the floor, if the replacement cost is less than the floor.
the ceiling, if the replacement cost is higher than the ceiling.
When replacement cost, ceiling, and floor are compared, market is always the middle value.
Compare the defined market value with the original cost and choose the lower amount.
110

56. Expanded Material Learning Objective 9
Explain the gross margin method of estimating inventories.

57. Gross Margin Method
There are times when a physical count of inventory is either impossible or impractical.
If perpetual is used, the inventory account balance is assumed to be correct.
If periodic is used, an estimate of the inventory balance must be made.
Gross margin method.
COGS and ending inventory are
estimated using available information:
beginning inventory
purchases
historical gross margin percentage

58. Gross Margin Method Example
Payson Brick has net sales for 1/1 to 3/31 of $100,000 and net purchases of $65,000. Inventory on 1/1 was $15,000 and a historic gross profit percentage of 40%.
Dollars % of sales
Net sales revenue $100, %
Cost of goods sold:
Beginning inventory $15,000
Purchases ,000
Total available for sale $80,000
Ending Inventory (3) 20,000
Cost of goods sold (2) , %
Gross margin (1) $ 40, %
$100,000 X .40 (2) $100,000 - $40, (3) $80,000 - $40,000

59. Everything Should Be Made as Simple as Possible and Not
Chapter 8 is Finished
Everything Should Be Made as
Simple as Possible and Not
One Bit Simplier
Albert Einstein