1. PRINCIPLES OF FINANCIAL ACCOUNTING
CHAPTER 6

2. INVENTORY SYSTEMS Periodic Inventory System Perpetual Inventory System
No attempt is made to account for the cost of the merchandise at the time of sale.
Cost of goods sold is computed only at period end.
Perpetual Inventory System
Cost of goods sold is accounted for every time a sale is recorded.

3. Periodic Inventory
Entry to record the purchase of an item that cost $500 on account
+ Purchases (dr)
+ Accounts Payable (cr) 500
Entry to record the sale of that item for $800.
+Accounts Receivable (dr) 800
+Sales (cr) 800
Note – no entry is made for the cost of goods sold at this time.

4. Periodic Inventory (cont)
To calculate the cost of goods sold for the period a physical inventory must be taken.
Calculation:
Beginning Merchandise Inventory
Plus Net Purchases
Plus Freight In
Minus Ending Merchandise Inventory
Refer to example on page 253

5. Perpetual Inventory
Entry to record the purchase of a item for $500 on account:
Merchandise Inventory (dr)
Accounts Payable (cr)
Entries to record the sale of the item for $800
Accounts Receivable (dr) 800
Sales (cr) 800
Cost of goods sold (dr) 500
Merchandise Inventory (cr) 500

6. Cost Flow Assumptions (Periodic)
FIFO (refer to example on page 256)
In times of steady price increases:
Net income will be higher than the other methods
Asset valuation on the balance sheet will be higher
LIFO (refer to example on page 257)
Net income will be lower than the other methods
Asset valuation on the balance sheet will be lower.

7. Cost Flow Assumptions (Cont) (Periodic)
Average cost (also called weighted average)
Refer to example on page 259
In times of steady rising or falling prices
Net income will fall between LIFO and FIFO
Asset valuation on the balance sheet will fall between LIFO and FIFO

8. Advantage of LIFO
Lower reported earnings means lower taxable income reported, hence lower taxes (temporarily).
Closer matching of current cost with current revenues.

9. Disadvantages of LIFO
Lower reported earnings – shareholder’s may be dissatisfied with management.
Lower asset valuation causes a lower current ratio and working capital.
LIFO layer erosion could cause earnings catch up at a bad time or can permit manipulation of income.

10. LOWER OF COST OR MARKET Departs from the Cost Principle.
The conservatism concept dictates that “when in doubt, avoid overstating assets and income.”
Therefore, if inventory has lost value below cost, then you must write down the inventory to the price you believe you can sell the item.

11. Inventory Ratios Inventory Turnover Ratio: Days in inventory
Cost of Goods sold/Average inventory
Days in inventory
365/Inventory turnover ratio

12. Appendix 6A Perpetual cost flow
FIFO the same whether using perpetual or periodic
LIFO
Must analyze the date of each sale and purchase
Refer example on page 273
Average cost (also called moving average)
Must recompute the average cost per item every time you have a purchase.
Refer to example on page 273