1. Chapter 15 Accounting for Merchandise Inventory

2. Learning Objectives
Journalize Transactions for a Perpetual and Periodic Inventory System
Explain Using Subsidiary Ledgers in Calculating Cost of Ending Inventory in a Perpetual System
Explain Inventory Methods to Calculate Ending Inventory in a Periodic System
Estimate Ending Inventory by the Retail and Gross Profit Methods

3. Accounting for Merchandise Inventory
Managers need to have current information.
The periodic system of inventory is checked and counted only at the end of the accounting period.
Today, with computers in so many businesses, the trend is toward perpetual inventory.
Perpetual inventory system is the inventory system of a company that keeps a continuous (perpetual) record of inventory on hand and of the cost of goods sold.

4. Learning Objective 1
Journalize Transactions for a Perpetual and Periodic Inventory System

5. Perpetual Inventory System
This system has two key accounts:
Merchandise Inventory
Is an asset
List the current balance of Inventory at all times
Entries are recorded for each purchase and each sale of Inventory
Cost of Goods Sold
Cumulative total cost of all merchandise sold to customers during accounting period

6. Perpetual Inventory System
Working through the transaction
Note that the asset account, Merchandise Inventory, has been increased by the cost of the new merchandise we have purchased.
Figure 15.1 Purchase of Inventory in a Perpetual System

7. Perpetual Inventory System
Now let’s look at a sales transaction.
In the perpetual inventory system we record both the retail value of the sale (three units at $50) in the Sales Revenue account and the cost of the sale (three units at $25) in the Cost of Goods Sold account
Figure 15.2
Matching Sales to Cost of Goods Sold

8. Perpetual Inventory System
What if the customer returns one of the packages?
Figure 15.3 Sales Return from Customer
We record the reduction in revenue of $50 and the increase in inventory

9. Perpetual Inventory System
What if the customer returns a damaged package?
Reduce what is owed the vendor by $25, the cost, and we reduced Merchandise Inventory—because we returned the item to the vendor
Figure 15.4 Return by Buyer of Merchandise

10. Perpetual Inventory System
Figure 15.5 General Ledger Accounts

11. Figure 15.6 Comparison of Perpetual and Periodic Systems

12. Perpetual and Periodic Inventory Systems
Sold merchandise that cost $8,000 on account for $20,000 Purchased $900 of merchandise on account

13. Perpetual and Periodic Inventory Systems
Paid $50 freight charges
Customer returned $200 of merchandise. Cost of merchandise was $100.

14. Perpetual and Periodic Inventory Systems
Returned $400 of merchandise previously bought on account due to defects

15. Learning Objective 2
Explain Using Subsidiary Ledgers in Calculating Cost of Ending Inventory in a Perpetual System

16. Inventory Subsidiary Ledger
Recall subsidiary ledgers to maintain the details of accounts receivable and payables
Merchandise Inventory account becomes a control account keeping track of the total balance of inventory
The details are kept in a subsidiary ledger

17. Inventory Subsidiary Ledger
Figure 15.7 Purchase of Inventory in a Perpetual System

18. Inventory Subsidiary Ledger
Let’s try another sales transaction
Figure 15.8 Matching Sales and Cost of Goods Sold

19. Computerized Accounting Systems
Handles a perpetual inventory system with ease
Local stores use a laser scanner or a bar code to enter your purchases
Will record the sale and update the cost of goods sold and inventory
Keeps track of inventory by many different methods

20. Different Inventory Methods
Average cost
Computed average is moved to cost of goods sold
First-in, first-out (FIFO)
Oldest inventory is sold first
Last-in, first-out (LIFO)
Newest inventory is sold first

21. First-in, first-out (FIFO)
Figure 15.9 An Inventory Record Using FIFO

22. Last-in, first-out (LIFO)
Figure An Inventory Record Using LIFO

23. Learning Objective 3
Explain Inventory Methods to Calculate Ending Inventory in a Periodic System

24. Inventory Valuation Methods: Periodic Inventory System
The ending inventory does in fact have a direct effect on the gross profit
Observe below, as the ending inventory value changes, so does cost of goods sold and gross profit

25. Inventory Valuation Methods: Periodic Inventory System
Four methods have been developed to assign a cost to ending inventory.
These methods are ways of tracing costs.
They are:
specific invoice (identification)
first-in, first-out
last-in, first-out
weighted average

26. Inventory Valuation Methods: Periodic Inventory System
Jones Hardware sells rakes.
Below is the inventory card for rakes:
Actual inventory on December 31 revealed that 12 rakes remained in stock.

27. Specific Invoice Method
Valuing of inventory where each item is identified with a specific invoice.

28. Specific Invoice Method
Pros
Simple to use if company has small amount of high-cost goods, such as autos, jewels, boats, or antiques.
Flow of goods and flow of cost are the same.
Costs are matched with the sales they helped to produce.

29. Specific Invoice Method
Cons
Difficult to use for goods with large unit volume and small unit prices, such as nails at a hardware store or packages of toothpaste at a drug store.
Difficult to use for decision-making purposes; ordinarily an impractical approach because companies usually deal with high-cost unique items.

30. First-In, First-Out Method (FIFO)
The assumption that the oldest goods are sold first

31. First-In, First-Out Method (FIFO)
Pros
The cost flow tends to follow the physical flow; most businesses try to sell the old goods first (e.g. perishables such as fruit or vegetables).
The figure for ending inventory is made up of current costs on the balance sheet (because inventory left over is assumed to be from goods last brought into the store).

32. First-In, First-Out Method (FIFO)
Cons
During periods of inflation, this method will produce higher income on the income statement and thus more taxes to be paid (discussed later in the chapter).
Recent sales are not matched with recent cost, because we assume old goods at old prices are sold first.

33. Last-In, First-Out Method (LIFO)
The assumption that the goods most recently acquired are sold first

34. Last-In, First-Out Method (LIFO)
Pros
Cost of goods sold is recorded at or near current costs, because costs of latest goods acquired are used.
Matches current costs with current sales revenue
During periods of inflation, this method produces the lowest net income, which is a tax advantage.
(The lower cost of ending inventory means a higher cost of goods sold; thus, gross profit and ultimately net income are smaller and taxes are lower.)

35. Last-In, First-Out Method (LIFO)
Cons
Ending inventory is valued at very old prices.
Doesn’t match physical flow of goods (but can still be used to calculate flow of costs).

36. Weighted-Average Method
Calculates an average unit cost by dividing the total cost of goods available for sale by the total units of goods available for sale.

37. Weighted-Average Method
Pros
Weighted average takes into account the number of units purchased at each amount, not a simple average cost.
Good for products sold in large volume, such as grains and fuels.
Accountant assigns an equal unit cost to each unit of inventory; thus, when the income statement is prepared, net income will not fluctuate as much as with other methods.

38. Weighted-Average Method
Cons
Current prices have no more significance than prices of goods bought a month earlier.
Compared with other methods, the most recent costs are not matched with current sales.
Important in financial reporting so as to provide an accurate picture of the company.
Cost of ending inventory is not as up-to-date as it could be using another method.

39. When Can an Inventory Method Be Changed?
Consistency means that once a business selects a particular accounting method, it should follow it from one year to the next without switching to another method
Doesn’t mean that a company can never change from one method of inventory valuation to another
Full disclosure principle - Should fully disclose the change, the effects of the change on profit and inventory valuation, and the justification for change

40. Items That Should Be Included in the Cost of Inventory
Goods in Transit
should be added to inventory if the ownership has been transferred to the buyer
Merchandise on Consignment
belongs to the consignor and should not be included in the consignee’s inventory cost.
Damaged or Obsolete Merchandise
if not saleable, it should not be added to the cost of the inventory.

42. Learning Objective 4
Estimate Ending Inventory by the Retail and Gross Profit Methods

43. Estimating the Inventory
Taking of a physical inventory is time consuming and expensive.
Some firms need inventory figures more often than once a year.
Sometimes estimating the inventory rather than taking a physical count is accurate enough.
May need to estimate the ending inventory is in case of a fire or other disaster

44. Methods of Estimating Ending Inventory
Two Methods
Retail Method
Used to determine the value of the ending inventory using a cost-to-retail ratio.
Gross Profit Method
Used to determine the value of the ending inventory using a predetermined gross profit rate.

45. Retail Method Must know
Beginning inventory at cost and at retail (selling price)
Cost of net purchases at both cost and at retail
The net sales at retail

46. Retail Method Steps
STEP 1: Calculate cost of merchandise available for sale at cost and retail. STEP 2: Calculate the cost ratio (cost of goods available for sale at cost divided by cost of goods available for sale at retail). STEP 3: Deduct net sales from retail value of merchandise available for sale to arrive at an estimated ending inventory at retail. STEP 4: Multiply cost ratio by ending inventory at retail to arrive at ending inventory at cost.

47. Retail Method Steps

48. Gross Profit Method
Develops relationship among Sales, Cost of Goods Sold, and gross profit
Must track
Average gross profit rate ( = gross profit/net sales)
Net sales, beginning inventory, and net purchases

49. Gross Profit Method
Assume an average gross profit rate of 30% of net sales. If 30 cents of each dollar in net sales is profit, 70 cents on a dollar is cost.

50. Effects of Inventory Errors
Errors have an effect on:
cost of goods sold
gross profit
net income
current assets
owner’s capital

51. Effects of Inventory Errors

52. Effects of Inventory Errors
Summary:
Any mistake will cause the balance sheet assets to be under- or overstated
Statement of owner’s equity will also be affected, with net income over- and understated

53. Summary of the chapter
Understanding and journalizing transactions using the perpetual inventory system and explaining the difference between perpetual and periodic inventory systems:
In the perpetual inventory system, two key accounts are kept up-to-date at all times: Merchandise Inventory and Cost of Goods Sold.
Each purchase of merchandise is recorded by a debit to the Merchandise Inventory account.

54. Summary of the chapter
Each sale requires two entries: one entry records the revenue or selling price of the merchandise, and the other transfers the cost of the items sold from the Merchandise Inventory account to the Cost of Goods Sold account.
Sales returns also require two entries: one entry is to record the reduction in revenue in a Sales Returns and Allowance account, and the other is to move the cost of the items returned back to the Merchandise Inventory account from the Cost of Goods Sold account.

55. Summary of the chapter
When the business returns merchandise to the vendor because of damage or some other reason, the Merchandise Inventory account is credited because the merchandise is no longer available to sell.
The comparison of the perpetual inventory system and the periodic inventory system reveals that the Purchases, Purchases Returns and Allowances, and Freight accounts do not exist in the perpetual inventory system.
The accounts Merchandise Inventory and Cost of Goods Sold become a very important part of the perpetual system.

56. Summary of the chapter
Maintaining a subsidiary ledger for inventory and calculating cost of ending inventory for perpetual inventory:
If an inventory includes many items, a subsidiary inventory ledger will be used to keep track of the details of quantities and cost for each item in inventory.
An inventory record form will be used for each item in the inventory. This form has columns for recording the quantities and cost of units purchased and units sold, and it provides a running balance of inventory on hand.

57. Summary of the chapter
When selling an item, the inventory record form provides the cost information for the debit to Cost of Goods sold and the credit to Merchandise Inventory.
Understanding periodic methods of determining the value of the ending inventory:
In assigning a cost to ending inventory, the flow of goods may not follow the actual flow of costs.
The specific invoice method identifies each item in inventory with a specific invoice in assigning a cost of ending inventory. It matches costs exactly with revenues.

58. Summary of the chapter
FIFO assumes that the old goods are sold first. Because ending inventory is valued at most recent costs, FIFO provides the most realistic figure for ending merchandise inventory.
LIFO assumes that the newest goods are sold first. It provides the most realistic figure for cost of goods sold. LIFO may also reduce income taxes in times when prices are rising.
Accounting principles require consistency in the use of the inventory method that is adopted.

59. Summary of the chapter
The weighted-average method provides an average unit cost of all inventory.
Weighted-average inventory value generally falls somewhere between LIFO and FIFO.
Goods in transit should be added to the value of the inventory if they are purchased F.O.B. shipping point.
Merchandise on consignment and damaged or obsolete merchandise should not be included in the value of the inventory.

60. Summary of the chapter
Estimating ending inventory using the retail method and gross profit method and understanding how the ending inventory amount affects financial reports:
Taking a physical inventory is costly and time consuming.
If a business needs to take an inventory more often than once a year, the retail method or gross profit method may be used to prepare interim financial statements or to submit a claim for insurance purposes.

61. Summary of the chapter
The ending inventory amount has an effect on the financial reports, and a mistake will cause the assets to be understated or overstated.
Net income will also be understated or overstated by this mistake.

62. Questions?