1. Inventories – Chapter 6
Financial & Managerial Accounting, 8th Edition by Needles, Powers, Crosson

2. Accounting for Inventories

3. Key Concepts / Terms Evaluating inventories:
Inventory turnover = Cost of Goods Sold ÷ Average Inventory. The average number of times a company sells its inventory during an accounting period.
Days’ Inventory on Hand = 365 ÷ Inventory Turnover. The average number of days it takes a company to sell the inventory it has in stock.

4. Key Concepts / Terms
Inventory affects both the balance sheet and the income statement. Therefore, the value of the ending inventory and the cost of goods sold as reported are EXTREMELY important.
The higher the value of ending inventory, the lower the cost of goods sold and the higher the gross margin.
The lower the value of ending inventory, the higher the cost of goods sold and the lower the gross margin.
Misstatements affect the current and subsequent periods.

5. Effects of Inventory Misstatements on Income Measurement
If ending inventory is overstated…
Cost of goods sold is understated
Gross margin is overstated
If ending inventory is understated…
Cost of goods sold is overstated
Gross margin is understated
Important: Errors not only affect the current year, but also the following year.

6. Inventory Errors: Examples
Column 1
Ending Inventory Correctly Stated
Net Sales
$100,000
Beg. Inv.
$12,000
Net cost of purchases
58,000
Cost of goods available for sale
$70,000
End. Inv.
10,000
Cost of goods sold
60,000
Gross margin
$ 40,000
Operating expenses
32,000
Income before income taxes
$ 8,000
Column 2
Ending Inventory Overstated
Column 3
Ending Inventory Understated
$100,000
$12,000
58,000
$70,000
16,000
4,000
54,000
66,000
$ 46,000
$ 34,000
32,000
$ 14,000
$ 2,000

7. Merchandise in Transit

8. Key Concepts / Terms
Inventory cost: includes the purchase price less purchase discounts + freight-in, including insurance in transit + applicable taxes and tariffs.
Lower-of-cost-or-market (LCM) rule: a valuation method; requires that inventory be written down to the lower of cost or market value and that a loss be recorded. This occurs because of physical deterioration, obsolescence, or decline in price level.

9. Key Concepts / Terms Periodic inventory system – four costing methods.
Specific identification
Average-cost
First-in, first-out (FIFO) method
Last-in, first-out (LIFO) method
Choice of method depends on the nature of the business, the financial effects of the method, and the cost of implementing the method.

10. Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 25
200 units
@ $14.00
2,800
Goods available for sale
500 units
$6,350
Sales
280 units
On hand June 30
Specific Identification Method
Specific Identification Method
980
70 $14.00
1,250
100 $12.50
$2,730
220 units at cost of
$ 500
50 $10.00
$3,620
Cost of goods sold
2,730
Less June 30 inventory
$6,350
Cost of goods avail. for sale

11. Average-Cost Method
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 25
200 units
@ $14.00
2,800
Goods available for sale
500 units
$6,350
Sales
280 units
On hand June 30
Inventory is priced at the average cost of the goods available for sale during the period.
Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost
$6,350 ÷ 500 units = $12.70
Ending Inventory = 220 $ = $2,794
Average Cost Method .
$3,556
Cost of goods sold
2,794
Less June 30 inventory
$6,350
Cost of goods avail. for sale

12. Key Concepts / Terms FIFO Method (Balance Sheet)
Assumes that the costs of the first items acquired should be to the first items sold.
Inventory is valued at the most recent costs and includes earlier costs in cost of goods sold.
In periods of rising prices, FIFO yields the highest inventory valuation, the lowest cost of goods sold, and hence a higher net income.

13. First-In, First-Out (FIFO) Method
Assumes that the first units purchased will be the first units sold; ending inventory is priced using the most recent purchases.
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 25
200 units
@ $14.00
2,800
Goods available for sale
500 units
$6,350
Sales
280 units
On hand June 30
First-In, First-Out (FIFO) Method
200 $14.00 from purchase of June 25 $2,800
20 $12.50 from purchase of June
220 units at a cost of $3,050
$3,300
Cost of goods sold
3,050
Less June 30 inventory
$6,350
Cost of goods avail. for sale

14. Key Concepts / Terms LIFO Method (Income Statement)
Assumes that the cost of the last items purchased should be assigned to the first items sold and that the cost of ending inventory should reflect the cost of the goods purchased earliest.
In periods of rising prices, LIFO yields the lowest inventory valuation, the highest cost of goods sold, and thus a lower net income.

15. Last-In, First-Out (LIFO) Method
Ending inventory is priced using the earliest purchases.
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 25
200 units
@ $14.00
2,800
Goods available for sale
500 units
$6,350
Sales
280 units
On hand June 30
Last-In, First-Out (LIFO) Method
80 $10.00 from June 1 inventory $ 800
140 $12.50 from purchase of June ,750
220 units at a cost of $2,550
$3,800
Cost of goods sold
2,550
Less June 30 inventory
$6,350
Cost of goods avail. for sale

16. Key Concepts / Terms
Perpetual inventory system – three costing methods.
Average cost
First-in, first-out (FIFO) method
Last-in, first-out (LIFO) method
Average cost: under the periodic system, average cost is computed for ALL goods available for sale during the period; under the perpetual system, an average is computed after each purchase or series of purchases.

17. Average-Cost Under the Perpetual Inventory System: Example
An average is computed after each purchase or series of purchases
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750
Balance
300 units
@ $11.83*
$3,550 10
Sale
280 units
@ $11.83
3,313
Balance
20 units
@ $11.88
$ 237 25
200 units
@ $14.00
2,800 30
@ $13.80*
$3,037
Cost of goods sold
$3,313
*Rounded

18. FIFO Under the Perpetual Inventory System: Example
Keep track of inventory costs and amounts in date order as purchases and sales are made
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 10
Sale
($ 800)
200 units
(2,500)
(3,300)
Balance
20 units
$ 250 25
@ $14.00
2,800 30
$250
$3,050
Cost of goods sold
$3,300
Cost of goods sold is the total of sales on June 10

19. LIFO Under the Perpetual Inventory System: Example
Keep track of inventory costs and amounts in date order as purchases and sales are made
Inventory Data
June 1
Inventory
80 units
@ $10.00
$ 800 6
Purchase
220 units
@ $12.50
2,750 10
Sale
($2,750)
60 units
(600)
(3,350)
Balance
20 units
$ 200 25
200 units
@ $14.00
2,800
$200
$2,800
$3,000
Cost of goods sold
$3,350
Cost of goods sold is the total of sales on June 10

20. Key Concepts / Terms
When costing using the FIFO or LIFO methods, it is necessary to keep track of components of inventory at each step of the way because as sales are made, the costs must be assigned in proper order.
The value of ending inventory when using the FIFO method yields the same result whether using the periodic or perpetual inventory system.
See slides 12 and 14 for detailed information on the FIFO and LIFO methods.