1. Principles of Financial Accounting, 11e7
Inventories
Principles of Financial Accounting, 11e
Reeve • Warren • Duchac

2. 1 2 3 Inventories Describe the importance of control over inventories.
After studying this chapter, you should be able to: 1
Describe the importance of control over inventories. 2
Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet. 3
Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods.
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3. Inventories (continued)
After studying this chapter, you should be able to: 4
Describe the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods. 5
Compare and contrast the use of the three inventory costing methods. 6
Describe and illustrate the reporting of merchandise inventory in the financial statements.
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4. Describe the importance of control over inventory.1
Describe the importance of control over inventory.
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5. Two primary objectives of control over inventory are:1
Two primary objectives of control over inventory are:
Safeguarding the inventory, and
Properly reporting it in the financial statements.

6. 1
The purchase order authorizes the purchase of the inventory from an approved vendor.
The receiving report establishes an initial record of the receipt of the inventory.
The amount of inventory is always available in the subsidiary inventory ledger.

7. 1
Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include the following:
Storing inventory in areas that are restricted to only authorized employees.

8. Locking high-priced inventory in cabinets.1
Locking high-priced inventory in cabinets.
Using two-way mirrors, cameras, security tags, and guards.

9. 1
A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate.

10. 2
Describe the three inventory cost flow assumptions and how they impact the income statement and balance sheet.
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11. Inventory Costing Methods2
Inventory Costing Methods

12. May 10 Purchase 1 $ 9 18 Purchase 1 13 24 Purchase 1 14 Total 3 $36 2
Average cost per unit $12 ($36 ÷ 3 units)

13. 2
Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 as shown below:

14. 2
Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase.
Not practical unless each inventory unit can be separately identified.

15. 2
Under the first-in, first out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold and the ending inventory is made up of the most recent purchases.

16. 2
Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold first and the ending inventory is made up of the first units purchased.

17. 2
Under the average inventory cost flow method, the cost of the units sold and in ending inventory is an average of the purchase costs.

18. 2 Effect of Inventory Costing Methods on Financial Statements
Exhibit 1
FIFO Method
Income Statement
Sales $20
Cost of merchan-
dise sold 9
Gross profit $11
(continued)

19. 2
Effect of Inventory Costing Methods on Financial Statements (continued)
Exhibit 1
LIFO Method
Income Statement
Sales $20
Cost of merchan-
dise sold 14
Gross profit $ 6
(continued)

20. 2
Effect of Inventory Costing Methods on Financial Statements (continued)
Exhibit 1
Average Cost Method
Income Statement
Sales $20
Cost of merchan-
dise sold 12
Gross profit $ 8
$36 ÷ 3 = $12
$12 × 2 = $24

21. 2 Exhibit 2 Inventory Costing Methods*
*Firms may be counted more than once for using multiple methods

22. 2 Example Exercise 7-1 7-22 Cost Flow Methods
The three identical units of Item QBM are purchased during February, as shown below.
Item QBM Units Cost
Feb. 8 Purchase 1 $ 45
15 Purchase 1 48
26 Purchase
Total 3 $144
Average cost per unit $48 ($144 ÷ 3 units)
Assume that one unit is sold on February 27 for $70.
Determine the gross profit for February and ending inventory on February 28 using (a) first-in, first-out (FIFO); (b) last-in, first-out (LIFO); and (c) average cost methods.
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23. 2 Follow My Example 7-1 Gross Profit Ending Inventory
Example Exercise 7-1 (continued) 2
Follow My Example 7-1
Gross Profit Ending Inventory
First-in, first-out (FIFO): $25 ($70 – $45) $99 ($48 + $51)
Last-in, first-out (LIFO): $19 ($70 – $51) $93 ($45 + $48)
Average cost: $22 ($70 – $48) $96 ($48 × 2)
For Practice: PE 7-1A, PE 7-1B
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24. 3
Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods.
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25. First-In, First-Out Method3
First-In, First-Out Method
On January 1, the firm had 100 units of Item 127B that cost $20 per unit.
Item 127B
Units Cost Jan. 1 Inventory 100 $20

26. First-In, First-Out Method3
First-In, First-Out Method
On January 4, the firm sold 70 units of 127B at $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70

27. 3
Exhibit 3
Entries and Perpetual Inventory Account (FIFO)

28. First-In, First-Out Method3
First-In, First-Out Method
On January 10, the firm purchased 80 units at $21 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21

29. 3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3
10 Merchandise Inventory 1,680
Accounts Payable 1,680
Date
Jan. 1

30. First-In, First-Out Method3
First-In, First-Out Method
On January 22, the firm sold 40 units for $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40

31. 3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3
Jan. 1
Date

32. First-In, First-Out Method3
First-In, First-Out Method
On January 28, the firm sold 20 units at $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40
28 Sale 20

33. 3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3
Date
Jan. 1

34. First-In, First-Out Method3
First-In, First-Out Method
On January 30, purchased one hundred additional units of Item 127B at $22 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40
28 Sale 20
30 Purchase

35. 3
Entries and Perpetual Inventory Account (FIFO) (continued)
Exhibit 3

36. Cost of merchandise sold3
Entries and Perpetual Inventory Account (FIFO) (concluded)
Exhibit 3
Cost of merchandise sold
January 31 inventory

37. 3 Example Exercise 7-2 Perpetual Inventory Using FIFO
Beginning inventory, purchases, and sales for Item ER27 are as follows:
Nov. 1 Inventory 40 units at $5
5 Sale 32 units
11 Purchase 60 units at $7
21 Sale 45 units
Assuming a perpetual inventory system and the first-in, first-out (FIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30.
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38. 3 Follow My Example 7-2 Cost of merchandise sold (November 21):
Example Exercise 7-2 (continued) 3
Follow My Example 7-2
Cost of merchandise sold (November 21):
8 $5 $40
37 $
45 units $299
Inventory, November 30:
$161 = (23 units × $7)
For Practice: PE 7-2A, PE 7-2B
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39. Last-In, First-Out Method3
Last-In, First-Out Method
On January 1, the firm had 100 units of Item 127B that cost $20 per unit.
Item 127B
Units Cost Jan. 1 Inventory 100 $20

40. Last-In, First-Out Method3
Last-In, First-Out Method
On January 4, the firm sold 70 units of 127B at $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70

41. 3
Exhibit 4
Entries and Perpetual Inventory Account (LIFO)

42. Last-In, First-Out Method3
Last-In, First-Out Method
On January 10, the firm purchased 80 units at $21 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21

43. 3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4
10 Merchandise Inventory 1,680
Accounts Payable 1,680
Date
Jan. 1 4

44. Last-In, First-Out Method3
Last-In, First-Out Method
On January 22, the firm sold 40 units for $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40

45. 3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4
Date
Jan. 1 4

46. Last-In, First-Out Method3
Last-In, First-Out Method
On January 28, the firm sold 20 units at $30 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40
28 Sale 20

47. 3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4
Date
Jan. 1 4

48. Last-In, First-Out Method3
Last-In, First-Out Method
On January 30, the firm purchased one hundred additional units of Item 127B at $22 each.
Item 127B
Units Cost Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40
28 Sale 20
30 Purchase

49. 3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4
Date
Jan. 1 4 10

50. Cost of Merchandise Sold3
Entries and Perpetual Inventory Account (LIFO) (concluded)
Exhibit 4
Cost of Merchandise Sold
January 31 Inventory

51. 3 Example Exercise 7-3 Perpetual Inventory Using LIFO
Beginning inventory, purchases, and sales for Item ER27 are as follows:
Nov. 1 Inventory 40 units at $5
5 Sale 32 units
11 Purchase 60 units at $7
21 Sale 45 units
Assuming a perpetual inventory system and the last-in, first-out (LIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30.
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52. 3 Follow My Example 7-3 Cost of merchandise sold:
Example Exercise 7-3 (continued) 3
Follow My Example 7-3
Cost of merchandise sold:
$315 = (45 units × $7)
Inventory, November 30:
8 $5 $ 40
15 $
23 $145
For Practice: PE 7-3A, PE 7-3B
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53. 3
Moving Average
When the average cost is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. The unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average.

54. 4
Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods.
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55. First-In, First-Out Method4
First-In, First-Out Method
Using FIFO, the earliest batch purchased is considered the first batch of merchandise sold. The physical flow does not have to match the accounting method chosen.

56. Cost of merchandise available for sale4
FIFO Method
100 $20
= $2,000
Jan. 1
80 $21
Jan. 10
= 1,680
100 $22
Jan. 30
= 2,200
280 units available for sale during year
$5,880
Cost of merchandise available for sale

57. 4
The physical count on January 31 shows that 150 units are on hand (conclusion: 130 units were sold). What is the cost of the ending inventory?
100 $20
80 $21
100 $22
Jan. 1
Jan. 10
Jan. 30
Sold these
= $ 0
Sold 30 of the 80
= 1,050
50 $21
100 $22
= 2,200
Ending inventory $3,250

58. Now we can calculate the cost of goods sold as follows:4
Now we can calculate the cost of goods sold as follows:
Beginning inventory, January 1 (Slide 55) $2,000
Purchases ($1,680 + $2,200) 3,880
Cost of merchandise available for sale $5,880
Ending inventory, January 31(Slide 56) 3,250
Cost of merchandise sold $2,630

59. 4
Exhibit 5
First-In, First-Out Flow of Costs

60. Last-In, First-Out Method4
Last-In, First-Out Method
Using LIFO, the most recent batch purchased is considered the first batch of merchandise sold. The actual flow of goods does not have to be LIFO. For example, a store selling fresh fish would want to sell the oldest fish first (which is FIFO) even though LIFO is used for accounting purposes.

61. Cost of merchandise available for sale4
LIFO Method
= $2,000
= 1,680
= 2,200
Cost of merchandise available for sale
100 $20
80 $21
100 $22
280 units available for sale during year
Jan. 1
Jan. 10
Jan. 30
$5,880

62. 4
Assume again that the physical count on January 31 is 150 units (and that 130 units were sold). What is the cost of the ending inventory?
100 $20
80 $21
100 $22
Jan. 1
Jan. 10
Jan. 30
= $2,000
50 $21
= 1, 680
= 1,050
Sold 30 of the 80
Sold these
= 2,200
= 0
Ending inventory $3,050

63. Now we can calculate the cost of goods sold as follows:4
Now we can calculate the cost of goods sold as follows:
Beginning inventory, January 1 (Slide 60) $2,000
Purchases ($1,680 + $2,200) 3,880
Cost of merchandise available for sale $5,880
Ending inventory, January 31(Slide 61) 3,050
Cost of merchandise sold $2,830

64. 4
Exhibit 5
Last-In, First-Out Flow of Costs

65. 4
Average Cost Method
The average cost method is sometimes called the weighted average method. It uses the average unit cost for determining cost of merchandise sold and the ending merchandise inventory.

66. Total Cost of Units Available for Sale Units Available for Sale4
The weighted average unit cost is determined as follows:
Total Cost of Units Available for Sale
Units Available for Sale
Average Unit Cost =

67. 4
$5,880
= $2,000
= 1,680
= 2,200
100 $20
80 $21
100 $22
280
Jan. 1
Jan. 10
Jan. 30
100 $22
Average unit cost: $5,880 ÷ 280 = $21
Cost of merchandise sold: 130 units at $21 = $2,730
Ending merchandise inventory: 150 units at $21= $3,150

68. Now we can calculate the cost of goods sold as follows:4
Now we can calculate the cost of goods sold as follows:
Beginning inventory, January 1 (Slide 66) $2,000
Purchases ($1,680 + $2,200) 3,880
Cost of merchandise available for sale $5,880
Ending inventory, January 31(Slide 66) 3,150
Cost of merchandise sold $2,730

69. 4
Example Exercise 7-4
Periodic Inventory Using FIFO, LIFO, Average Cost Methods
The units of an item available for sale during the year were as follows:
Jan. 1 Inventory 6 $50 $ 300
Mar Purchase 14 $55 770
Oct. 30 Purchase 20 $62 1,240
Available for sale 40 units $2,310
There are 16 units of the item in the physical inventory at December 31. The periodic inventory system is used. Determine the inventory cost by (a) the first-in, first-out (FIFO) method, (b) the last-in, first-out (LIFO) method, and (c) the average cost method.
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70. Example Exercise 7-4 (continued)
Follow My Example 7-4
First-in, first-out (FIFO) method: $992 (16 units × $62)
Last-in, first-out (LIFO) method: $850 (6 units × $50) + (10 units × $55)
Average method: $924 (16 units × $57.75) where average cost = $57.75 ($2,310 ÷ 40 units)
For Practice: PE 7-4A, PE 7-4B
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71. Compare and contrast the use of the three inventory costing methods.5
Compare and contrast the use of the three inventory costing methods.
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72. Partial Income Statements5
Partial Income Statements
First-In, First-Out
Net sales $3,900
Cost of merchandise sold:
Beginning inventory $2,000
Purchases 3,880
Merchandise available for sale $5,880
Less ending inventory 3,250
Cost of merchandise sold 2,630
Gross profit $1,270

73. Partial Income Statements5
Partial Income Statements
Average Cost
Net sales $3,900
Cost of merchandise sold:
Beginning inventory $2,000
Purchases 3,880
Merchandise available for sale $5,880
Less ending inventory 3,150
Cost of merchandise sold 2,730
Gross profit $1,170

74. Partial Income Statements5
Partial Income Statements
Last-In, First-Out
Net sales $3,900
Cost of merchandise sold:
Beginning inventory $2,000
Purchases 3,880
Merchandise available for sale $5,880
Less ending inventory 3,050
Cost of merchandise sold 2,830
Gross profit $1,070

75. 5 Effects of Changing Costs (Prices): FIFO and LIFO Cost Methods
Exhibit 7

76. Cost of merchandise sold $2,630 $2,730 $2,830 5
Recap
Weighted
FIFO Average LIFO
Ending inventory $3,250 $3,150 $3,050
Cost of merchandise sold $2,630 $2,730 $2,830
Gross profit $1,270 $1,170 $1,070

77. 6
Describe and illustrate the reporting of merchandise inventory in the financial statements.
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78. 6
Cost
Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases:
(continued)

79. The cost of replacing items in inventory is below the recorded cost.6
The cost of replacing items in inventory is below the recorded cost.
The inventory cannot be sold at normal prices due to imperfections, style changes, or other causes.

80. 6
Market
Market, as used in lower of cost or market, is the cost to replace the merchandise on the inventory date.

81. Cost and replacement cost can be determined for the following:6
Cost and replacement cost can be determined for the following:
Each item in the inventory.
Each major class or category of inventory.
Total inventory as a whole.

82. 6
Determining Inventory at Lower of Cost or Market
Exhibit 8

83. 6 Example Exercise 7-5 Lower-of-Cost-or-Market Method
On the basis of the following data, determine the value of the inventory at the lower of cost or market. Apply lower of cost or market to each inventory item as shown in Exhibit 8.
Inventory Unit Unit
Commodity Quantity Cost Price Market Price
C17Y 10 $ 39 $40 B
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84. 6 Follow My Example 7-5 For Practice: PE 7-5A, PE 7-5B 7-84
Example Exercise 7-5 (continued) 6
Follow My Example 7-5
For Practice: PE 7-5A, PE 7-5B
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85. 6
Net Realizable Value
Merchandise that is out of date, spoiled, or damaged should be written down to its net realizable value. This is the estimated selling price less any direct cost of disposal, such as sales commissions.

86. Merchandise Inventory on the Balance Sheet6
Merchandise Inventory on the Balance Sheet
Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following receivables.

87. Merchandise Inventory on the Balance Sheet6
Merchandise Inventory on the Balance Sheet
The method of determining the cost of inventory (FIFO, LIFO, or weighted average) and the method of valuing the inventory (cost or the lower of cost or market) should be shown.

88. 6

89. Effect of Inventory Errors on the Financial Statements6
Effect of Inventory Errors on the Financial Statements
Some reasons causing inventory errors to occur include the following:
Physical inventory on hand was miscounted.
Costs were incorrectly assigned to inventory.
Inventory in transit was incorrectly included or excluded from inventory.
Consigned inventory was incorrectly included or excluded from inventory.

90. 6 Effect of Inventory Errors on Current Period’s Income Statement
Exhibit 9

91. 6 Effect of Inventory Errors on Two Years’ Income Statements
Exhibit 10
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92. 6 Effect of Inventory Errors on Current Period’s Balance Sheet
Exhibit 11

93. 6 Example Exercise 7-6 Effect of Inventory Errors
Zula Repair Shop incorrectly counted its December 31, 2010 inventory as $250,000 instead of the correct amount of $220,000. Indicate the effect of the misstatement on Zula’s December 31, 2010 balance sheet and income statement for the year ended December 31, 2010.
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94. Amount of Misstatement Overstatement (Understatement)
Example Exercise 7-6 (continued) 6
Follow My Example 7-6
Amount of Misstatement Overstatement (Understatement)
Balance Sheet:
Merchandise inventory overstated $30,000
Current assets overstated 30,000
Total assets overstated 30,000
Owner’s equity overstated 30,000
Income Statement:
Cost of merchandise sold understated $(30,000)
Gross profit overstated 30,000
Net income overstated 30,000
For Practice: PE 7-6A, PE 7-6B
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95. Estimating Inventory Cost
Appendix:
Estimating Inventory Cost
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96. Exhibit 12
Determining Inventory by the Retail Method

97. Estimating Inventory by the Gross Profit Method
Exhibit 13