1. Chapter 6
Inventories

2. Objectives: Discuss inventory cost flow assumptions.
Apply cost flow assumptions to determine the CGS and the value of ending inventory.
Explain the lower-of-cost-or-market (LCM) rule for inventory reporting.
Discuss the financial effects of the inventory cost flow assumptions.
Learn the effects of inventory errors on financial statements.
Discuss the inventory turnover rate and the gross margin ratio.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

3. Defining Inventory
1. Assets held for resale purpose in a normal course of business.
2. Assets used to produce products for resale purpose.
Merchandising Firms: merchandise
Manufacturing Firms: raw materials
Work-in-process
Finished Goods
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

4. How to Account for Inventory Purchases, Sales and Reporting?
Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories.
Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory count.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

5. Inventory Systems A. Perpetual Inventory System.
B. Periodic Inventory System.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

6. Perpetual vs. Periodic Inventory System
Perpetual system Periodic System
At purchase
Inventory xxx Purchases xxx
A/P xxx A/P xxx
At sale:
CGS xxx None
Inventory xxx
A/R xxx A/R xxx
Sales xxx Sales xxx
Inventories

7. Perpetual Inventory System
Inventory account is used for the purchase and sale.
The balance of inventory is available at all time.
A physical count is needed at the end of a period.
Any discrepancy of book balance with physical count should be adjusted to a loss or gain account.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

8. Perpetual Inventory System (contd.)
CGS account is used to record the CGS of a sale.
Therefore, the CGS is also known at all time.
CGS is determined by selecting a cost flow assumption.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

9. Cost Flow Assumptions
In order to apply these assumptions, companies must keep a record of the cost of each inventory unit purchased.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

10. Cost Flow Assumptions (contd.)
1. First-In, First Out (FIFO) method.
2. Last-in, First-Out (LIFO) method.
3. Weighted-Average Cost method.
4. Specific Identification method.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

11. Perpetual Inventory System Example
The following inventory information is available for March:
Beginning balance of inventory on
3/1: Beginning balance of 100 units at $5 per unit
3/5: Purchased 150 units at $6
3/7: Sold 200 units at $10
3/14: Purchased 100 units at $7
3/28: Sold 30 units at $11
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

12. Perpetual Inventory System Example (contd.)
The following is a perpetual record using different cost flow assumptions:
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

13. Perpetual Inventory System Example (contd.)
Inventory (FIFO)
700
820
Inventory (LIFO)
700
740
Inventory (WA)
700
784.1
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

14. J. E. for Perpetual (FIFO)
3/5 Inventory 900
Cash 900
3/7 Cash 2,000
Sales Rev. 2,000
Cost of Goods Sold 1,100*
Inventory 1,100
3/14 Inventory 700
Cash 700
3/28 Cash 330
Sales Rev. 330
Cost of Good Sold 180**
Inventory
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

15. J. E. for Perpetual (FIFO) (contd.)
Notes:
* Cost of goods sold of 200 units on 3/7 is based on a FIFO assumption:
Balance before the sale
of 200 units on 3/7
$100 x x 6 = $1100
100 $5
150 $6
** Balance before the sale $6
of 30 units on 3/ $7
30 x $6 = $180
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

16. If the CGS Is Based on LIFO:
3/7 Cost of good sold* 1,150
Inventory 1,150
* Balance before the sale: 100 $5
150 $6
$150 x $ x $5 = $1,150
3/28 Cost of goods sold** 210
Inventory 210
** Balance before the sale: $5
100 $7
30 x $7 = $210
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

17. If the CGS Is Based on Weighted-Average Method:
3/7 Cost of good sold* 1,120
Inventory 1,120
* 200 x $5.6 = $1,120
3/28 Cost of goods sold**
Inventory
** 30 x 6.53 = $195.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

18. The T Accounts of CGS at the End of Period (3/31):
CGS (FIFO)
1,100
180
1,280
CGS (LIFO)
1,150
200
1,360
CGS (WA)
1,120
195.90
1,315.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

19. End of Period Adjustments
1. Adjustment for lost units
2. Adjustments for LCM (Lower-of-Cost-or-market) valuation
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

20. Adjustment for Lost Units
Assuming ending units = 110 units on 3/31.
The lost units on 3/31 are 10.
Cost of 10 lost units (under FIFO)
=> $6  10 = $60
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

21. Adjustment for Lost Units (contd.)
Adjusting Ending:
3/31 Loss from Declining
in inventory units 60
Inventory 60
Inventory (FIFO)
760
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

22. Adjustments for LCM Valuation
LCM rule requires that inventory be reported in the statements at the lower of cost or market value (an application of conservatism)
Inventory (FIFO) B.B ,100
700
/31
760
Cost (on 3/31, FIFO)
= $760
Assuming market price
= $600
LCM = $600.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

23. 2. Adjustments for LCM Valuation (contd.)
Adjusting entry ==>Given Allowance for declining in market value of inventory with a beginning balance of zero.
Allowance
0 -- 3/1
160
/31
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

24. I/S (for the period ended 3/31)
B/S (3/31)
Inventory 760
Allowance (160)
Inv. At LCM
3/31 Loss Due to Market
Decline of Inventory 160
Allowance to reduce
Inventory to market 160
I/S (for the period ended 3/31)
Loss(from declining in units) $ 60
Loss (or CGS) $160
CGS $1,280
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 24

25. Periodic Inventory System
Using the example on page 11, the following entries will be recorded under the periodic inventory system:
3/5 Purchases 900
Cash 900
3/7 Cash 2,000
Sales Revenue 2,000
3/14 Purchases 700
Cash 700
3/28 Cash 330
Sales Revenue 330
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

26. Periodic Inventory System (contd.)
At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and for the cost of goods sold:
1. Do an inventory count.
2. Apply a cost flow assumption to determine the cost of ending inventory.
3. Determine the cost of goods sold using:
CGS = Beg. Inv. + Net Pur. - Ending Inv.*
* No adjusting entries are required for lost units.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

27. Periodic Inventory System Example
Using the example on Page 11 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption):
$7  $6  5 = $730
Inventory Data:
Units Cost
3/1 (B.B) 100 $5
3/ 5 Pur 150 $6
3/ 7 Pur 100 $7
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

28. Periodic Inventory System Example (contd.)
The cost of goods sold (based on a FIFO cost flow) equals:
Beg. Inv. + Pur - Ending Inv.
= ,
= 1,370
If a LIFO cost assumption is used, the cost of ending inventory equals:
The CGS = , * = 1,570
* Cost of Ending Inv. = $5 x x 5 = 530
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

29. Periodic Inventory System Example (contd.)
A weighted-average cost flow assumption:
WAUC = 100 x x x 7
350
= 6
Cost of ending inventory: 6 x 105 = 630
Cost of goods sold = = 1470
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

30. Periodic Inventory System End of Period Adjustments
1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS).
2. Adjustment for the LCM valuation assuming FIFO,
cost = $730
Assuming the market price = $600
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

31. Periodic Inventory System End of Period Adjustments (contd.)
Adjusting entry:
Loss Due to Market Value
Decline of Inventory (or CGS) 130
Allowance to Reduce
Inventory to Market Value 130
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

32. I/S (for the period ended 3/31)
B/S (3/31)
Inventory 730
Allowance (130)
Inv. At LCM
I/S (for the period ended 3/31)
Loss Due to Market Value
Decline of Inv. (or CGS) 130
Cost of Good Sold:
Beginning Inventory $ 500
Net Purchase 1,600
Total Goods Available for Sale $2,100
Ending Inventory (730)
1,370
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 32

33. Periodic Inventory System
End of period entries to update inventory and related cost of goods sold accounts based on a FIFO cost-flow assumption:
a. Transfer the cost of beginning inventory to the CGS account:
CGS 500
Inventory (Beg. Balance) 500
b. Transfer the cost of purchase to CGS:
CGS 1,600
Purchase 1,600
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

34. Periodic Inventory System (contd.)
c. Record the cost of ending inventory based on a physical count of 105 units and a FIFO cost-flow assumption:
Inventory (ending balance) 730
CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

35. Periodic Inventory System (contd.)
T- accounts:
Inventory
B.B a. 500 c
Purchase
3/ b. 1,600 3/
CGS
a c. 730
b. 1,600
1,370
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

36. Comparison of FIFO vs. LIFO
During an Inflation Period
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

37. Inventories: Measurement
4/19/2017
Survey: (Source: Accounting Trends & Techniques and KWW Textbook) a, b,c
Yearl
Firms
LIF1O
FIFO
W-A
Others
1984 %
408 38%
366 30%
225 22% %
1988 % %
396 38% % %
1991 %
361 35%
421 41%
200 19% 50 5%
2000 %
283 32%
386 44%
180 20% 38 4%
2006
802
100%
228
28%
385
48%
159
20% 30
2010
666d
176
26.4%
325
49%
147
22% 18
2.6%
Inventories: Measurement

38. Survey: (Source: Accounting Trends & Techniques ) (contd.)
4/19/2017
Survey: (Source: Accounting Trends & Techniques ) (contd.)
Sample firms are 600 firms. Most companies adopt more than one inventory method.
Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s.
IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries.
The number of disclosures.
Inventories: Measurement

39. Items to Be Included in Inventory Count
Any goods with the legal title transferred to the buyer should be included in the inventory count of the buyer (including goods in transit with a FOB shipping point term).
Consigned Goods: Legal title remained with the consignor (i.e., the manufacturers).
Inventory shipped for an “on approval” sale.
Note: FOB shipping point – the ownership transfers to the buyer at the shipping point. FOB destination – the ownership transfers to the buyer at the destination.
Inventories: Measurement

40. Reason of Switching to LIFO
1. Tax savings.
2. Income Manipulation.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

41. Reason of Switching to LIFO Income Manipulation
When LIFO cost flows assumption is used and price is rising, income maybe subject to management manipulation as follows:
a. Liquidation LIFO (to reduce CGS and therefore increase income)
b. To decrease income by increasing CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

42. Income Manipulation a. Liquidation LIFO
When the inventory is depleted to the early layers, the CGS would be low and the income would be high.
Strategy: to delay the purchase of inventory so that the cost of inventory would be depleted to the cost of early layers.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

43. Income Manipulation b. To Decrease Income by Increasing CGS
Strategy: order more inventory at the end of period so that CGS would be high (under LIFO) and income would be low.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

44. Advantages of FIFO
a. Less likely to be subject to management manipulation;
b. Produce higher income during an inflation period;
c. Inventory cost reported on the B/S is close to the replacement cost.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

45. Disadvantage of FIFO
a. Bad match of sales revenue with CGS; match current sales revenue with old costs;
b. Producing higher income during an inflation period results in paying more income tax.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

46. Advantages of LIFO
a. Good match of sales revenue with CGS; match the most recent inventory cost against sales revenue;
b. Produce lower income during an inflation period; result in tax savings (defer income tax).
(This is only true when the inventory level is not decreasing. If inventory is decreasing, there would be liquidation profits).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

47. Disadvantages of LIFO
a. Inventory cost presented on the B/S is not fair.
b. Subject to management.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

48. IRS 1. Does not allow firms to use LCM if firms are using LIFO.
2. If firms are using LIFO for income tax filing purposes, firms must also use LIFO for financial reporting purposes (referred to as LIFO conformity rule).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

49. IRS (contd.) 3. LIFO is not acceptable by the IRS until late 1930’s.
Switch from FIFO to LIFO, firms do not need the approval of the IRS. However, switch from LIFO to FIFO, firms need to receive the approval of the IRS and need to pay back taxes (the cumulative effect).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

50. International Perspective
Many countries do not permit the use of LIFO.
For example, Australia, Singapore, and United Kingdom do not permit the use of LIFO.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

51. Accounting Principles and Theory Related to Inventories
1. Consistency Principle
2. Disclosure Principle
3. Materiality
4. Conservatism
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

52. The Impact of Inventory Errors on the Financial Statements
Year 1:
Income CGS Gross Margin = Beg Inv + Net Pur - End Inv
under over under under *
over under over over **
Year 2:
over under over under
under over under over
* either understating the units or understating the value
** either overstating the units or the value
*** Gross Margin = Sales Revenue - CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

53. Ethical Issues To artificially inflate the net income, a company may
1. Overstating the ending inventory to decrease the cost of goods sold.
2. Ship the goods to distributors at the end of a period (i.e., 12/20/x1). The goods are later returned but in the next period (I.e., 1/3/x2) (Parking transactions).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

54. Estimating Inventory: Gross Margin Method
Reasons: For some companies, inventory information is needed between accounting periods. Companies cannot afford to do physical inventory count every quarter.
Thus, a gross margin method (gross profit method) can be used to estimate value of ending inventory for interim reports.
No physical count of inventory is needed for this method. The value of inventory is based on estimation.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

55. Estimating Inventory: Gross Margin Method (contd.)
This method is not acceptable for annual financial reporting purposes.
This method is acceptable for interim reporting
The insurance companies may use this method to estimate the loss of inventory in case of fire or flood.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

56. Gross Profit Method (Gross margin Method) Data Required
Beginning Inventory (at cost)
Purchase (net) (at Cost)
Sales Price
Gross margin ratio (Gross margin/sales price)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

57. Example Beginning Inv. = $60,000 Purchase (net) = $200,000
Sales = $280,000
Gross margin ratio* = 30%
* gross marking ratio is obtained from past years’ experience (assuming the ratio is stable over years)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

58. Using Gross Profit Method to Estimate the Cost of Ending Inventory
Selling Price Cost
Beg, Inv. $60,000
Purchase (net) 200,000
Goods Avai. For Sale 260,000
Sales 280,000
Less: gross margin* (84,000)
Sales (at cost) 196,000 **
Estimated Inv. (at cost) 64,000
* gross margin = 280,000 x 30%
** also equals 280,000 x (1-30%) = 196,000
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

59. Comments for Gross Profit Method
If the relationship between the gross profit and shelling price has been changed, the ratio should be adjusted accordingly.
A separate gross profit ratio should be applied to different type of inventory with different relationship between the gross profit and selling price.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

60. Analyzing Financial Statements
1. Inventory turnover rate
2. Gross margin percentage
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

61. 1. Inventory Turnover Rate
Cost of Goods Sold
= ___________________________
Average Inventory
This ratio measures how fast inventory is sold.
Average Inventory = (Beg. Inv. + End Inv.)/2
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

62. 2. Gross Margin Percentage
= _______________________________
Net Sales Revenue
This percentage is an indication of profitability. A 40% gross margin means that each dollar of sales generate 40 cents of gross profit.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

63. 2. Gross Margin Percentage (contd.)
This percentage varies among industries. In general, the average gross profit is 14.1% for automobile dealers, 22.8% for grocery stores and 55.7% for restaurants.
Sources: Robert Morris Associates’ Annual Statement Studies).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

64. Inventory Control
1. Keeping inventory handles away from the accounting.
2. Physical count of inventory. ( At lease once a year)
3. Keeping perpetual inventory system for high-cost inventory.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit

65. Inventory Transaction on the Cash Flow Statement
Cash Flows from Operating Activities:
Collection from Customers $xxx
Cash Payments to Suppliers ($xxx)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit