1. Financial Accounting: Tools for Business Decision Making, 2nd Ed.
Kimmel, Weygandt, Kieso
ELS 1

2. Chapter 6

3. Chapter 6 Reporting and Analyzing Inventory
After studying Chapter 6, you should be able to:
Explain the recording of purchases and sales of inventory under a periodic inventory system.
Explain how to determine cost of goods sold under a periodic inventory system.
Describe the steps in determining inventory quantities.
Identify the unique features of the income statement for a merchandising company under a periodic inventory system. 3

4. Chapter 6 Reporting and Analyzing Inventory
After studying Chapter 6, you should be able to:
Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system.
Explain the financial statement and tax effects of each of the inventory cost flow assumptions.
Explain the lower of cost or market basis of accounting for inventories.
Compute and interpret the inventory turnover ratio.
Describe the LIFO reserve and explain its importance for comparing results of different companies. 4

5. Merchandise Inventory
owned by the company
in form ready to sale to customers 5

6. Manufacturing Inventory
Finished goods inventory
Work in process
Raw materials 6

7. Finished Goods Inventory
Manufactured items that are complete and ready for sale. 7

8. Work in Process
Manufactured inventory that has been placed into production but is not yet complete. 8

9. Raw Materials
The basic goods that will be used in production, but have not been placed in production. 9

10. Key difference between periodic and perpetual inventory…
is the point at which the costs of goods sold is computed.

11. Periodic Inventory
No attempt is made on date of sale to record the cost of merchandise sold...
A physical count of inventory is taken at end of period to determine:
Cost of merchandise on hand;
Cost of goods sold.

12. Comparing Periodic and Perpetual Inventory Systems
Inventory Purchased
Item Sold
End of Period
Perpetual
Perpetual
No Entry
Record Purchase of Inventory
Record Revenue and Cost of Goods Sold
End of Period
Inventory Purchased
Item Sold
Periodic
Record Purchase of Inventory
Record Revenue Only
Compute Cost of Goods Sold

13. Businesses that use the periodic method generally do not have sophisticated computer systems required to compute cost of goods sold when sale is made.

14. Merchandise Purchases
On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc.
Task:Record the purchase by getting information from the Purchase Invoice.
The Purchase Invoice is just a copy of the sales invoice. 14

15. 7.Goods sold: catalog no.,description,quantity, price per unit
1. Seller
2.Invoice Date
3.Purchaser
4.Salesperson
5.Credit terms
6.Freight terms
7.Goods sold: catalog no.,description,quantity, price per unit
8.Total invoice price
Invoice No. 731
Illustration 5-4
Firm Name: Sauk Stero
City Chelsea State Illinois Zip 60915
Attention o f James Hoover, Purchasing Agent
Address 125 Main Street
Date 5/4/01 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer
Catalog No. Description QTY Price Amount
IMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,800
1,500
300 8
Production Model
Circuits
A2547Z48

16. Merchandise Purchases-Periodic
On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc.
Purchases
Purchase Returns & All.
Purchase Discounts
May
Accounts Payable
Freight-In
Cash
May 4 3,800

17. Purchases Returns and Allowances - Periodic
On May 8 the company returned $300 worth of merchandise to PW Audio Supply, Inc.
Purchases
Purchase Returns & All.
Purchase Discounts
May
May
Accounts Payable
Freight-In
Cash
May 4 3,800

18. Freight Costs -
On Incoming Inventory 18

19. Freight - In Periodic
On May 9 the company paid $ 150 to have the merchandise inventory delivered to them.
Purchase Returns & All.
Purchase Discounts
Purchases
May
May
Accounts Payable
Freight-In
Cash
May
May
May 4 3,800

20. Purchase Discounts
Credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment.
Credit terms specify the amount of cash discounts and the time period during which it is offered.
2/10,n/30
1/10 EOM 20

21. Purchase Discounts
On May 14, the company pays the balance due on the account within the discount period
Purchases
Purchase Returns & All.
Purchase Discounts
Cash
Accounts Payable
Freight-In
May
May 4 3,800
May
May

22. Amount due before discount $3,500
Purchases Discounts
Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period.
Original Invoice $3,800
-Returns
Amount due before discount $3,500
2% discount
Net due $3,430

23. Purchase Discounts
On May 14, the company pays the balance due on the account within the discount period
Purchases
Purchase Returns & All.
Cash
Accounts Payable
Freight-In
May
May 4 3,800
May
May
May
May 14 3,500
May
May 14 3,430

24. Under a Periodic System
Sales Revenues -
Under a Periodic System
are recorded when earned-revenue recognition principle
must be supported by a business document-written evidence
ONLY 1 entry is made for each sale
one to record sale 24

25. Sales Returns and Allowances
Flip side of purchase returns and allowance
On buyer’s books
GENERAL JOURNAL Debit Credit
May 8 Accounts Payable Purchase Returns and Allowances
To record goods returned that were purchased on account
On seller’s books
GENERAL JOURNAL Debit Credit
May 8 Sales Returns and Allowance Accounts Receivable
To record return of goods delivered to Sauk Stero 25

26. Merchandise Inventory Sales Returns & Allowances
Sales - Under a Periodic System
Assume a sale of $ 3,800 on Account
Cash
Accounts Receivable
Merchandise Inventory
May 4 3,800
Cost of Goods Sold
Sales Returns & Allowances
Sales
May 4 3,800

27. What is the Sales Returns and Allowances Account?
Contra Revenue Account to sales
Used to show how much came in on returns and allowances
Excessive returns and allowances suggest:
inferior merchandise
inefficiencies in filing orders
errors in billing customers
mistakes in delivery or shipment of goods 27

28. What Is the Sales Discount Account?
Contra Revenue Account to sales
Used to disclose amount of cash discounts taken by customers 28

29. Flip side of purchase discounts
Sales Discounts
Flip side of purchase discounts
On buyer’s books
GENERAL JOURNAL Debit Credit
May 14 Accounts Payable , Cash ,430 Merchandise Inventory
To record payment within discount period
On seller’s books
GENERAL JOURNAL Debit Credit
May 14 Cash , Sales Discounts Accounts Receivable
To record collection within discount period 29

30. Net Purchases
Purchases $ 325,000
Less: Purchase returns and allowances $ 10,400
Purchase discounts 6, ,200
Net purchases 307,800
Net Purchases are gross purchases adjusted for returns and discounts. 30

31. Cost of Goods Purchased
Illustration 6-3
Cost of Goods Purchased
Purchases $ 325,000
Less: Purchase returns and allowances $ 10,400
Purchase discounts 6, ,200
Net purchases 307,800
Add: Freight-in 12,200
Cost of goods purchased 320,000
Cost of goods purchased is net purchases plus freight-in. 31

32. Companies that use periodic inventory take a physical count to...
determine ending inventory
compute cost of goods sold
Companies that use perpetual inventory must take a physical inventory to check accuracy of “book inventory” to actual inventory. 32

33. Taking a Physical Inventory
Determining inventory quantities by counting, weighting or measuring each type of inventory.
Determining ownership of goods, including goods in transit,consigned goods.
Quantity of each kind of inventory is listed on inventory summary sheets where unit costs are applied. 33

34. Questions Concerning Ownership
Do all the goods included in the count belong to the company?
Does the company own any goods not included in the count? 34

35. Goods in Transit
These are goods on board a truck, train, ship, or plane at the end of the period. 35

36. The Company with Legal Title
Goods in Transit
Who includes these in inventory?
Buyer?
Seller?
The Company with Legal Title 36

37. Shipping Terms
FOB (free on board) shipping point- ownership of goods passes to buyer when public carrier accepts the goods
FOB (free on board) destination- ownership of goods remains with the seller until the goods reach the buyer 38

38. Ownership passes to owner here
Illustration 6-4
FOB Shipping Point
Public
Carrier Co
Seller
Buyer
Ownership
passes to
buyer here
FOB Destination Point
Public
Carrier Co
Seller
Buyer

39. Consigned Goods
Goods in your store that you don’t pay for until they sell…
the company does not take ownership. 39

40. Income Statement Presentation
The income statement for a merchandising company is the same whether a periodic or perpetual inventory system is used, except for the
cost of goods sold section. 40

41. Select Buy, INC. Income Statement (Perpetual) For the Year Ended December 31, 2001
Illustration 5-3
Sales revenues
Sales $ 480,000 Less: Sales returns and allowance $12,000
Sales discounts , ,000
Net sales ,000
Cost of goods sold ,000
Gross profit $ 144,000 Operating expenses
Selling expenses:
Store salaries expense $45,000
Advertising expense ,000
Depreciation expense ,000
Freight-out ,000
Total selling expenses $76,000
Administrative expenses
Salaries expense $19,000
Utilities expense ,000
Insurance Expense ,000
Total administrative expenses ,000
Total operating expenses ,000
Income from operations $ 30,000

42. Income Statement (Periodic)
Illustration 6-6
Sales revenues
Sale $ 480,000
Less: Sales returns and allowance $12,000
Sales discounts , ,000
Net sales ,000
Cost of goods sold
Inventory, January ,000
Purchases $ 325,000
Less: Purchase returns and
allowances $10,400
Purchase discounts , , Net Purchases ,800
Add: Freight-in ,200
Cost of goods purchased 320,000
Cost of goods available for sale ,000
Inventory, December ,000
Cost of goods sold ,000
Gross profit ,000
Operating expenses ,000
Net Income $ 30,000

43. Specific Identification
Illustration 6-7
Specific Identification
Cost of goods sold = $700 + $800
An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of ending inventory.

44. Inventory Costing Specific Identification method Cost Flow Assumptions
FIFO- First-in, First-Out- earliest goods purchased first to be sold
LIFO- Last-in,First-Out- latest goods purchased the first to be sold
Average Cost Method- costs are charged on the basis of weighted average unit cost 44

45. What Makes Cost Flow Assumptions Necessary?
Changing Prices 45

46. Illustration 6-9
The FIFO method assumes the earliest goods purchased are the first to be sold.

47. Illustration 6-11
The LIFO method assumes the latest goods purchased are the first to be sold.

48. Illustration 6-13
The average cost method assumes that goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

49. Illustration 6-14
The average cost method assumes that goods available for sale are homogeneous.

50. Factors Used in Selecting an Inventory Cost Method
Income statement effects
Balance sheet effects
Tax Effects 51

51. Income Statement Effects
In periods of increasing prices
FIFO reports the highest net income
LIFO the lowest
average cost falls in the middle.
In periods of decreasing prices
FIFO will report the lowest net income
LIFO the highest
average cost in the middle. 52

52. Balance Sheet Effects
In a period of increasing prices costs allocated to ending inventory using:
FIFO will approximate current costs
LIFO will be understated 53

53. Why Do Companies Use Lifo?
Higher cost of goods sold
Lower net income
Lower Income Taxes 54

54. The Lower of Cost or Market Basis of Accounting for Inventories
When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs. 55

55. Lower of Cost or Market (LCM)
departure from cost principle
follows conservatism concept
can be used only after one of the cost flow methods ( Specific Identification FIFO, LIFO, or Average Cost) 56

56. CURRENT REPLACEMENT COST
Market Is...
CURRENT REPLACEMENT COST 57

57. How Much Inventory Should a Company Have?
Only enough for sales needs
Excess inventory costs:
storage costs
interest costs
obsolescence - technology, fashion 58

58. Inventory Turnover Ratio =
Cost of Goods Sold
Average Inventory

59. Inventory Turnover Ratio
Days in Inventory =
365 days
Inventory Turnover Ratio

60. Lifo Reserve And Its Importance For Comparing Results Of Different Companies
Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO.
This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods. 61

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