2. Accounting Principles, Eighth Edition
CHAPTER 6
INVENTORIES
Accounting Principles, Eighth Edition

3. Study Objectives
Describe the steps in determining inventory quantities.
Explain the accounting for inventories and apply the inventory cost flow methods.
Explain the financial effects of the inventory cost flow assumptions.
Explain the lower-of-cost-or-market basis of accounting for inventories.
Indicate the effects of inventory errors on the financial statements.
Compute and interpret the inventory turnover ratio.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Reporting and Analyzing Inventory
Classifying Inventory
Determining Inventory Quantities
Inventory Costing
Inventory Errors
Statement Presentation and Analysis
Finished goods
Work in process
Raw materials
Taking a physical inventory
Determining ownership of goods
Specific identification
Cost flow assumptions
Financial statement and tax effects
Consistent use
Lower-of-cost-or-market
Income statement effects
Balance sheet effects
Presentation
Analysis
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

5. Classifying Inventory
Merchandising Company
Manufacturing Company
One Classification:
Merchandise Inventory
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

6. Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
Check accuracy of inventory records.
Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft).
Periodic System
Determine the inventory on hand
Determine the cost of goods sold for the period.
LO 1 Describe the steps in determining inventory quantities.

7. Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of inventory on hand.
Taken,
when the business is closed or when business is slow.
at end of the accounting period.
LO 1 Describe the steps in determining inventory quantities.

8. Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale.
LO 1 Describe the steps in determining inventory quantities.

9. Determining Inventory Quantities
Terms of Sale
Illustration 6-1
Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
Ownership of the goods remains with the seller until the goods reach the buyer.
LO 1 Describe the steps in determining inventory quantities.

10. Determining Inventory Quantities
Review Question
Goods in transit should be included in the inventory of the buyer when the:
public carrier accepts the goods from the seller.
goods reach the buyer.
terms of sale are FOB destination.
terms of sale are FOB shipping point.
LO 1 Describe the steps in determining inventory quantities.

11. Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods.
These are called consigned goods.
LO 1 Describe the steps in determining inventory quantities.

12. Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average-cost
Cost Flow Assumptions
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

13. Inventory Costing Example
Young & Crazy Company makes the following purchases:
One item on 2/2/08 for $10
One item on 2/15/08 for $15
One item on 2/25/08 for $20
Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 28, 2008, assuming the company used the Specific Identification method to cost inventories and the item purchased on 2/15/08 is sold? Assume a tax rate of 30%.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

14. “Specific Identification”
Inventory Costing
“Specific Identification”
Inventory Balance = $ 30
Young & Crazy Company
Income Statement
For the Month of Feb
Sales $ 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income $ 29
Purchase on 2/25/08 for $20
Purchase on 2/15/08 for $15
Purchase on 2/2/08 for $10
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

15. Specific Identification Method
Inventory Costing
Specific Identification Method
An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory.
Practice is relatively rare.
Most companies make assumptions (Cost Flow Assumptions) about which units were sold.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

16. Inventory Costing – Cost Flow Assumptions
does not need to equal
Physical Movement of Goods
Illustration 6-11
Use of cost flow methods in major U.S. companies
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

17. Inventory Costing – Cost Flow Assumptions
Example
Young & Crazy Company makes the following purchases:
One item on 2/2/08 for $10
One item on 2/15/08 for $15
One item on 2/25/08 for $20
Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory, cost of goods sold, and net income for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, and Average-cost flow assumptions? Assume a tax rate of 30%.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

18. Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Earliest goods purchased are first to be sold.
Often parallels actual physical flow of merchandise.
Generally good business practice to sell oldest units first.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

19. Inventory Costing – Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Inventory Balance = $ 35
Young & Crazy Company
Income Statement
For the Month of Feb
Sales $ 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income $ 33
Purchase on 2/25/08 for $20
Purchase on 2/15/08 for $15
Purchase on 2/2/08 for $10
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

20. Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of merchandise.
Exceptions include goods stored in piles, such as coal or hay.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

21. Inventory Costing – Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Inventory Balance = $ 25
Young & Crazy Company
Income Statement
For the Month of Feb
Sales $ 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income $ 26
Purchase on 2/25/08 for $20
Purchase on 2/15/08 for $15
Purchase on 2/2/08 for $10
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

22. Inventory Costing – Cost Flow Assumptions
“Average-Cost”
Allocates cost of goods available for sale on the basis of weighted average unit cost incurred.
Assumes goods are similar in nature.
Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

23. Inventory Costing – Cost Flow Assumptions
“Average Cost”
Inventory Balance = $ 30
Young & Crazy Company
Income Statement
For the Month of Feb
Sales $ 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income $ 29
Purchase on 2/25/08 for $20
Purchase on 2/15/08 for $15
Purchase on 2/2/08 for $10
LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

24. Inventory Costing – Cost Flow Assumptions
Comparative Financial Statement Summary
FIFO
Average
LIFO
Sales $90 $90 $90
Cost of goods sold
Gross profit
Admin. & selling expense
Income before taxes
Income tax expense
Net income $33 $29 $26
Inventory balance $35 $30 $25
LO 3 Explain the financial effects of the inventory cost flow assumptions.

25. Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, FIFO Reports:
FIFO
Average
LIFO
Sales $90 $90 $90
Cost of goods sold
Gross profit
Admin. & selling expense
Income before taxes
Income tax expense
Net income $33 $29 $26
Inventory balance $35 $30 $25
Lowest
Highest
LO 3 Explain the financial effects of the inventory cost flow assumptions.

26. Inventory Costing – Cost Flow Assumptions
In Period of Rising Prices, LIFO Reports:
FIFO
Average
LIFO
Sales $90 $90 $90
Cost of goods sold
Gross profit
Admin. & selling expense
Income before taxes
Income tax expense
Net income $33 $29 $26
Inventory balance $35 $30 $25
Highest
Lowest
LO 3 Explain the financial effects of the inventory cost flow assumptions.

27. Inventory Costing – Cost Flow Assumptions
Review Question
The cost flow method that often parallels the actual physical flow of merchandise is the:
FIFO method.
LIFO method.
average cost method.
gross profit method.
LO 3 Explain the financial effects of the inventory cost flow assumptions.

28. Inventory Costing – Cost Flow Assumptions
Review Question
In a period of inflation, the cost flow method that results in the lowest income taxes is the:
FIFO method.
LIFO method.
average cost method.
gross profit method.
LO 3 Explain the financial effects of the inventory cost flow assumptions.

29. Inventory Costing – Cost Flow Assumptions
Discussion Question
Q6-12 Casey Company has been using the FIFO cost flow method during a prolonged period of rising prices. During the same time period, Casey has been paying out all of its net income as dividends. What adverse effects may result from this policy?
Question 6-12 (textbook)
Barto Company is using the FIFO method of inventory costing.
Cecil Company is using the LIFO method.
Under FIFO, the latest goods purchased remain in inventory. Thus, the inventory on the balance sheet should be close to current costs. The reverse is true of the LIFO method.
Barto Company will have the higher gross profit because cost of goods sold will include a higher proportion of goods purchased at earlier (lower) costs.
See notes page for discussion
LO 3 Explain the financial effects of the inventory cost flow assumptions.

30. Using Cost Flow Methods Consistently
Inventory Costing
Using Cost Flow Methods Consistently
Method should be used consistently, enhances comparability.
Although consistency is preferred, a company may change its inventory costing method.
Illustration 6-14
Disclosure of change in cost flow method
LO 3 Explain the financial effects of the inventory cost flow assumptions.

31. Lower-of-Cost-or-Market
Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
Companies can “write down” the inventory to its market value in the period in which the price decline occurs.
Market value = Replacement Cost
Example of conservatism.
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

32. Lower-of-Cost-or-Market
Inventory Costing
Lower-of-Cost-or-Market
BE6-7 Alou Appliance Center accumulates the following cost and market data at December 31.
$ 12,000
9,000
12,800
$ 33,800
Compute the lower-of-cost-or-market valuation for the company’s total inventory.
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.

33. Inventory Errors Common Cause:
Failure to count or price inventory correctly.
Not properly recognizing the transfer of legal title to goods in transit.
Errors affect both the income statement and balance sheet.
LO 5 Indicate the effects of inventory errors on the financial statements.

34. Income Statement Effects
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income.
Illustration 6-16
Illustration 6-17
LO 5 Indicate the effects of inventory errors on the financial statements.

35. Income Statement Effects
Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income in two periods.
An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.
Over the two years, the total net income is correct because the errors offset each other.
The ending inventory depends entirely on the accuracy of taking and costing the inventory.
LO 5 Indicate the effects of inventory errors on the financial statements.

36. Net Income understated
Inventory Errors
Illustration 6-18
Combined income for 2-year period is correct.
($3,000)
Net Income understated
$3,000
Net Income overstated
LO 5 Indicate the effects of inventory errors on the financial statements.

37. Review Question Inventory Errors
Understating ending inventory will overstate:
assets.
cost of goods sold.
net income.
owner's equity.
LO 5 Indicate the effects of inventory errors on the financial statements.

38. Inventory Errors Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-16
Illustration 6-19
LO 5 Indicate the effects of inventory errors on the financial statements.

39. Statement Presentation and Analysis
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from sales.
There also should be disclosure of
major inventory classifications,
basis of accounting (cost or LCM), and
costing method (FIFO, LIFO, or average).
LO 5 Indicate the effects of inventory errors on the financial statements.

40. Statement Presentation and Analysis
Inventory management is a double-edged sword
High Inventory Levels - may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage).
Low Inventory Levels – may lead to stockouts and lost sales.
LO 6 Compute and interpret the inventory turnover ratio.

41. Statement Presentation and Analysis
Inventory turnover measures the number of times on average the inventory is sold during the period.
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Days in inventory measures the average number of days inventory is held.
Days in Year (365)
Days in Inventory =
Inventory Turnover
LO 6 Compute and interpret the inventory turnover ratio.

42. Statement Presentation and Analysis
BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.
$270,000
Inventory Turnover
5.4 =
($60, ,000) / 2
365
Days in Inventory
67.59 days =
5.4
LO 6 Compute and interpret the inventory turnover ratio.

43. Inventory Cost Flow Methods in Perpetual Inventory Systems
The following data from Houston Electronics will be used to illustrate inventory costing under a perpetual system.
Illustration 6A-1
LO Apply the inventory cost flow methods to perpetual inventory records.

44. Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under FIFO for Houston Electronics.
Illustration 6A-2
Cost of goods sold
Ending inventory
LO Apply the inventory cost flow methods to perpetual inventory records.

45. Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under LIFO for Houston Electronics.
Illustration 6A-3
Cost of goods sold
Ending inventory
LO Apply the inventory cost flow methods to perpetual inventory records.

46. Inventory Cost Flow Methods in Perpetual Inventory Systems
Computation of cost of goods sold and ending inventory under moving average for Houston Electronics.
Illustration 6A-4
Cost of goods sold
Ending inventory
LO Apply the inventory cost flow methods to perpetual inventory records.

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