Chapter 9 Inventories Accounting, 21st Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to: Objectives 1. Summarize and provide examples of internal control procedures that apply to inventories. 2. Describe the effect of inventory errors on the financial statement. 3. Describe the three inventory cost flow assumptions and how they impact the income statement and balance sheet. 4. Compute the cost of inventory under the perpetual inventory system, using the following cost methods: first-in, first-out; last-in, first-out; average cost. After studying this chapter, you should be able to:

Objectives 5. Compute the cost of inventory under the periodic inventory system, using the following costing methods: first-in, first-out; last-in, first-out; average cost. 6. Compare and contrast the use of the three inventory costing methods. 7. Compute the proper valuation of inventory at other than cost, using the lower-of-cost-or-market and net realization value concepts. 8. Prepare a balance sheet presentation of merchandise inventory.

Objectives 9. Estimate the cost of inventory, using the retail method and the gross profit method. 10. Compute the interpret the inventory turnover ratio and number of days’ sales in inventory.

Why is Inventory Control Important? Inventory is a significant asset and for many companies the largest asset. Inventory is central to the main activity of merchandising and manufacturing companies. Mistakes in determining inventory cost can cause critical errors in financial statements. Inventory must be protected from external risks ( such as fire and theft) and internal fraud by employees.

AGREE AGREE AGREE Receiving report Purchase order Invoice JOURNAL Date Description Post. Ref. Nov. 9 Inventory 1 222 00 Accounts Payable--XYZ Co. 1 222 00 Purchased merchandise on account.

Effect of Inventory Errors on Financial Statements LIABILITIES Merchandise Inventory ASSETS OWNER’S EQUITY Net Income Cost of Merchandise Sold COSTS & EXPENSES REVENUES If merchandise inventory is . . . . . . . Cost of merchandise sold is . . . . . . Gross profit and net income are . . . Ending owner’s equity is . . . . . . . . . overstated understated

Effect of Inventory Errors on Financial Statements If merchandise inventory is . . . . . . . Cost of merchandise sold is . . . . . . Gross profit and net income are . . . Ending owner’s equity is . . . . . . . . . understated overstated

Inventory Cost Flow Assumptions Purchased goods FIFO Sold goods

Inventory Cost Flow Assumptions Sold goods Purchased goods LIFO

Inventory Cost Flow Assumptions Purchased goods Sold goods Average Cost

Inventory Costing Methods 43% 40% 30% 20% 10% 0% 34% 19% 4% Fifo Lifo Average Other

Perpetual Inventory Costs Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold

Fifo Perpetual

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

FIFO Perpetual Inventory Account Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 4, 7 units of Item 127B are sold at $30 each.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 Jan. 1 10 20 200 4 7 20 140 3 20 60 The sale of 7 units leaves a balance of 3 units. On January 4, 7 units of Item 127B are sold at $30 each.

FIFO Perpetual Inventory Account Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 10, the firm purchased eight units at $21 each.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 Because the purchase price of $21 is different than the cost of the previous 3 units on hand, the inventory balance of 11 units is accounted for separately. On January 10, the firm purchased eight units at $21 each.

FIFO Perpetual Inventory Account Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Cost of Mdse. Sold Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 On January 22, the firm sold four units for $31 each.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance On January 22, the firm sold four units for $31 each. Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 Of the four units sold, three are from the first units in (fifo) at a cost of $20.

FIFO Perpetual Inventory Account Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Cost of Mdse. Sold Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 On January 28, the firm sold two units at $32.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 28 2 21 42 5 21 105 On January 28, the firm sold two units at $32.

FIFO Perpetual Inventory Account Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems Cost of Mdse. Sold Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 On January 30, purchased ten additional units of Item 127B at $22 each.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 On January 30, purchased ten additional units of Item 127B at $22 each. 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 28 2 21 42 5 21 105 30 10 22 220 5 21 105 10 22 220 Totals 18 $388 13 $263 15 $325

Lifo Perpetual

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 On January 4, the firm sold 7 units at $30 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 Note that a new layer is formed. On January 10, the firm purchased eight units at $21 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 Of the 4 units sold, all come from the most recent purchase at a cost of $21 each. On January 22, the firm sells four units at $31 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 28 2 21 42 3 20 60 2 21 42 On January 28, sold two units at $32 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 28 2 21 42 3 20 60 2 21 42 30 10 22 220 3 20 60 2 21 42 10 22 220 On January 30, purchase 10 units at $22 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 28 2 21 42 3 20 60 2 21 42 30 10 22 220 3 20 60 2 21 42 10 22 220 Totals 18 $388 13 $266 15 $322

Fifo Periodic

Fifo Periodic Jan. 1 Beginning Inventory 200 units @ $9 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year

Cost of merchandise available for sale Fifo Periodic 200 units @ $9 = $1,800 Jan. 1 = 3,000 Mar. 10 = 4,400 Sept. 21 = 1,200 Nov. 18 300 units @ $10 400 units @ $11 100 units @ $12 1,000 units available for sale during year $10,400 Cost of merchandise available for sale

Fifo Periodic A physical count on December 31 reveals that 700 of the 1,000 units have been sold. Using fifo, the first units purchased are theoretically the first units sold. We begin the count with January 1.

Fifo Periodic 200 units @ $9 Sold these 200 = $1,800 Jan. 1 = 0 Mar. 10 = 3,000 Mar. 10 Sold 200 of these 200 units @ $11 400 units @ $11 = 2,200 Sept. 21 = 4,400 Sept. 21 100 units @ $12 = 1,200 Nov. 18 1,000 units available for sale during year $10,400 $ 3,400 Ending inventory

Fifo Periodic Cost of merchandise available for sale $10,400 Less ending inventory 3,400 Cost of merchandise sold $ 7,000

Summary of Fifo Periodic Cost of Merchandise Sold Merchandise Available for Sale Purchases $1,800 200 units at $9 Jan. 1 200 units at $9 $1,800 $3,000 300 units at $10 Mar. 10 300 units at $10 $3,000 $2,200 200 units at $11 Sep. 21 400 units at $11 $7,000 700 units $4,400 Merchandise Inventory Nov. 18 100 units at $12 $1,200 $2,200 200 units at $11 1,000 units $10,400 $1,200 100 units at $12 $3,400 300 units

Lifo Periodic

Lifo Periodic 200 units @ $9 Jan. 1 Beginning Inventory 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year Using lifo, the most recent batch purchased is considered the first batch of merchandise sold.

Assume again that 700 units were sold during the year. Lifo Periodic 200 units @ $9 Jan. 1 Beginning Inventory Assume again that 700 units were sold during the year. 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year

Lifo Periodic 200 units @ $9 = $1,800 Jan. 1 = 3,000 Mar. 10 = 4,400 Sept. 21 = 1,200 Nov. 18 Sold 200 of these 300 units @ $10 100 units @ $10 1,000 Sold these 400 400 units @ $11 Sold these 100 100 units @ $12 1,000 units available for sale during year Ending Inventory $2,800 $10,400

Lifo Periodic Cost of merchandise available for sale $10,400 Less ending inventory 2,800 Cost of merchandise sold $ 7,600

Cost of Merchandise Sold Summary of Lifo Periodic Cost of Merchandise Sold Merchandise Available for Sale Purchases $1,800 200 units at $9 $1,800 Jan. 1 200 units at $9 $1,000 100 units at $10 $1,800 $2,800 300 units Mar. 10 300 units at $10 $3,000 Cost of Merchandise Sold Sep. 21 400 units at $11 $4,400 $2,000 200 units at $10 Nov. 18 100 units at $12 $1,200 $4,400 400 units at $11 1,000 units $10,400 $1,200 100 units at $12 $7,600 700 units

Average Cost Periodic 200 units @ $9 Jan. 1 Beginning Inventory The average cost periodic method is based on the average cost of identical units. 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year

Average Cost Periodic 200 units @ $9 = $ 1,800 1,000 units available for sale during year $10,400 Cost of merchandise available for sale

Average Cost Periodic Cost of Merchandise Available for Sale = Average Unit Cost Units Available for Sale During Year $10,400 1,000 Units = $10.40 per Unit

Average Cost Periodic Cost of merchandise available for sale $10,400 Less ending inventory ($10.40 x 300) 3,120 Cost of merchandise sold $ 7,280 To verify this amount, multiply 700 units sold times $10.40 to get the same $7,280.

Valuation of Inventory at Lower-of-Cost-or-Market Unit Unit Inventory Cost Market Total Total Lower Item Quantity Price Price Cost Market C or M $ 3,800 2,700 4,650 3,920 Total $15,520 $15,472 $15,070 A 400 $10.25 $ 9.50 $ 4,100 $ 3,800 B 120 22.50 24.10 2,700 2,892 C 600 8.00 7.75 4,800 4,650 D 280 14.00 14.75 3,920 4,130 The market decline based on individual items ($15,520 – $15,070) = $450

Metro-Arts Balance Sheet December 31, 2007 Presentation of Merchandise Inventory on the Balance Sheet Metro-Arts Balance Sheet December 31, 2007 Assets Current assets: Cash $ 19 400 00 Accounts receivable $80 000 00 Less allowance for doubtful accounts 3 000 00 77 000 00 Merchandise inventory at lower of cost (first-in, first-out method) or market 216 300 00

Estimating Inventory Cost

Retail Method of Estimating Inventory Cost Retail method is based on relationship between cost of merchandise available for sale and the retail price. Retail prices of all merchandise must be accumulated and totaled. Inventory at retail is calculated at retail price of merchandise available for sale less net sales at retail. Ratio is calculated as cost divided by retail price. Inventory at retail price times cost ratio equals estimated cost of inventory.

Retail Inventory Method Cost Retail Merchandise inventory, Jan. 1 $19,400 $ 36,000 Purchases in January (net) 42,600 64,000 Merchandise available for sale $62,000 $100,000 $62,000 $100,000 Ratio of cost to retail price = = 62% Step 1: Determine the ratio of cost to the retail price.

Retail Inventory Method Cost Retail Merchandise inventory, Jan. 1 $19,400 $ 36,000 Purchases in January (net) 42,600 64,000 Merchandise available for sale $62,000 $100,000 Sales for January (net) 70,000 Merchandise inventory, January 31, at retail $ 30,000 Step 2: Determine the ending inventory at retail.

Retail Inventory Method Sales for January (net) 70,000 Merchandise inventory, January 31, at retail $ 30,000 Cost Retail Merchandise inventory, Jan. 1 $19,400 $ 36,000 Purchases in January (net) 42,600 64,000 Merchandise available for sale $62,000 $100,000 Merchandise inventory, January 31, at cost ($30,000 x 62%) $18,600 Step 3: Calculate the estimated inventory at cost.

Gross Profit Method of Estimating Inventory Cost 1. A gross profit percentage rate is estimated based on previous experience adjusted for known changes. 2. Estimated gross profit is calculated by multiplying the estimated gross profit rate times the actual net sales. 3. Estimated cost of merchandise sold is calculated by subtracting the gross profit from actual sales. 4. The cost of merchandise sold estimate is deducted from actual merchandise available for sale to determine the estimated cost of merchandise inventory.

Gross Profit Method Merchandise inventory, January 1 $ 57,000 Purchases in January (net) 180,000 Merchandise available for sale Sales in January (net) $250,000 Less: Estimated gross profit Estimated cost of merchandise sold Estimated merchandise inventory, January 31 $237,000 ($250,000 x 30%) 75,000 175,000 $ 62,000 The gross profit method is useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system.

Inventory Turnover SUPERVALU Zale Cost of merchandise sold $15,620,127,000 $ 737,188,000 Inventories: Beginning of year $1,115,529,000 $478,467,000 End of year 1,067,837,000 571,669,000 Total $2,183,366,000 $1,050,136,000 Average $1,091,683,000 $525,068,000 Inventory turnover 14.3 times 1.4 times Use: Inventory turnover measures the relationship between the volume of goods sold and the amount of inventory carried during the period.

Number of Days’ Sales in Inventory SUPERVALU Zale Average daily cost of merchandise sold: $15,620,127,000/365 $42,794,868 $737,188,000/365 $2,019,693 Ending inventory $1,067,837,000 $571,669,000 Average selling period 25 days 283 days Use: To assess the efficiency in the management of inventory

Chapter 9 The End