Accounting Principles

Fourteenth Edition
Weygandt Kimmel Mitchell

Chapter 6
Inventories

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Copyright ©2021 John Wiley & Sons, Inc.

Chapter Outline
Learning Objectives
LO 1 Discuss how to classify and determine inventory.
LO 2 Apply inventory cost flow methods and discuss
their financial effects.
LO 3 Indicate the effects of inventory errors on the
financial statements.
LO 4 Explain the statement presentation and analysis of
inventory.
Copyright ©2021 John Wiley & Sons, Inc. 2
Classifying and Determining Inventory
LEARNING OBJECTIVE 1
Discuss how to classify and determine inventory.

Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
• Inventory • Raw Materials
• Work in Process
• Finished Goods

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 3

Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted
raw materials, shoplifting, or employee theft.
Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 4

Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand.
Companies often “take inventory”
• when business is closed or business is slow
• at the end of accounting period

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 5

Determining Ownership of Goods
Goods in Transit
• Purchased goods not yet received
• Sold goods not yet delivered
• Included in inventory of company that has legal title to
goods

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 6

Goods in Transit
Terms of Sale

ILLUSTRATION 6.2

Freight costs incurred by the seller are an operating expense.

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 7

Goods in Transit
Review Question
Goods in transit should be included in the inventory of
the buyer when the:
a. public carrier accepts the goods from the seller
b. goods reach the buyer
c. terms of sale are FOB destination
d. terms of sale are FOB shipping point

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 8

Goods in Transit
Review Answer
Goods in transit should be included in the inventory of
the buyer when the:
a. public carrier accepts the goods from the seller
b. goods reach the buyer
c. terms of sale are FOB destination
d. Answer: terms of sale are FOB shipping point

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 9

Determining Ownership of Goods
Consigned Goods
To hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of
the goods.
Many car, boat, and antique dealers sell goods on
consignment to keep their inventory costs down and to
avoid the risk of purchasing an item that they will not be
able to sell.

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 10

DO IT! 1: Rules of Ownership

Hasbeen Company completed its inventory count. It arrived at a total

inventory value of $200,000. As a new member of Hasbeen’s accounting
department, you have been given the information listed below. Discuss
how this information affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for
Falls Co., costing $15,000.
2. The company did not include in the count purchased goods of
$10,000 which were in transit (terms: FOB shipping point).
3. The company did not include in the count sold inventory with a cost
of $12,000 which was in transit (terms: FOB shipping point).
Inventory = $200,000 − $15,000 + $10,000 = $195,000

LO 1 Copyright ©2021 John Wiley & Sons, Inc. 11

Inventory Methods and Financial Effects
LEARNING OBJECTIVE 2
Apply inventory cost flow methods and discuss their
financial effects.
Inventory is accounted for at cost
• Includes all expenditures necessary to acquire goods and
place them in a condition ready for sale
• Unit costs are applied to quantities to compute total cost
of inventory and cost of goods sold using the following
costing methods:
§ Specific identification
§ First-in, first-out (FIFO)
§ Last-in, first-out (LIFO) Cost Flow
§ Average-cost
Assumptions

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 12

Inventory Methods and Financial Effects
Illustration: Crivitz TV Company purchases three identical 50-
inch TVs on different dates at costs of $700, $750, and $800.
During the year Crivitz sold two sets at $1,200 each. These
facts are summarized below.
Purchases
February 3 1 TV at $700
March 5 1 TV at $750
May 22 1 TV at $800
Sales
June 1 2 TVs for $2,400 ($1,200 × 2)
ILLUSTRATION 6.3
LO 2 Copyright ©2021 John Wiley & Sons, Inc. 13
Specific Identification Method

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 Copyright ©2021 John Wiley & Sons, Inc. 14

Specific Identification Method Example
If Crivitz sold the TVs it purchased on February 3 and May
22, then its cost of goods sold is $1,500 ($700 + $800),
and its ending inventory is $750.

ILLUSTRATION 6.4

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 15

Cost Flow Assumptions
Illustration: Data for Houston Electronics’ Astro condensers.
Date Explanation Units Unit Cost Total Cost
Jan. 1 Beginning inventory 100 $10 $1,000
Apr. 15 Purchase 200 11 2,200
Aug. 24 Purchase 300 12 3,600
Nov. 27 Purchase 400 13 5,200
Total units available for sale 1,000 $12,000
Units in ending inventory (450)

Units sold 550

ILLUSTRATION 6.5
Beginning Inventory + Purchases − Ending Inventory = Cost of Goods Sold
LO 2 Copyright ©2021 John Wiley & Sons, Inc. 16
Cost Flow Assumptions
First-In, First-Out (FIFO)
• Costs of earliest goods purchased are first to be
recognized in determining cost of goods sold
• Often parallels actual physical flow of merchandise
• Companies determine cost of ending inventory by
taking unit cost of most recent purchase and working
backward until all units of inventory have been costed

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 17

First-In, First-Out (FIFO)
ILLUSTRATION 6.6

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 18

Cost Flow Assumptions
Last-In, First-Out (LIFO)

• Costs of latest goods purchased are first to be

recognized in determining cost of goods sold
• Seldom coincides with actual physical flow of
merchandise
• Exceptions include goods stored in piles, such as
coal or hay

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 19

Last-In, First-Out (LIFO)

ILLUSTRATION 6.8

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 20

Cost Flow Assumptions
Average-Cost

• Allocates cost of goods available for sale on basis

of weighted-average unit cost incurred
• Applies weighted-average unit cost to units on
hand to determine cost of ending inventory

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 21

Average-Cost

ILLUSTRATION 6.11

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 22

Financial Statement and Tax Effects
of Cost Flow Methods
Each of the three cost flow methods is acceptable for use.
• Under Armour, Inc. and Wendy’s International
currently use the FIFO method
• Target Corporation, Kroger, and Walgreens use LIFO
for part or all of their inventory
• Bristol-Myers Squibb, Starbucks, and Microsoft use
the average-cost method
• Stanley Black & Decker Manufacturing Company uses
LIFO for domestic inventories and FIFO for foreign
inventories

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 23

Use of Cost Flow Methods in Major
U.S. Companies

Cost flow assumptions

DO NOT need to be
consistent with the
physical movement of
the goods

ILLUSTRATION 6.12

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 24

Income Statement Effects

ILLUSTRATION 6.13

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 25

Balance Sheet Effects
• A major advantage of the FIFO method is that in a
period of inflation, costs allocated to ending
inventory will approximate their current cost
• A major shortcoming of the LIFO method is that in
a period of inflation, costs allocated to ending
inventory may be significantly understated in
terms of current cost

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 26

Tax Effects
• Both inventory and net income are higher when
companies use FIFO in a period of inflation
• LIFO results in the lowest income taxes (because of
lower net income) during times of rising prices
• A tax rule requires that if companies use LIFO for
tax purposes they must also use it for financial
reporting purposes (LIFO conformity rule)

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 27

Using Inventory 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

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 28

Cost Flow Assumptions
Review Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method
b. LIFO method
c. average cost method
d. gross profit method

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 29

Cost Flow Assumptions
Review Answer
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. Answer: FIFO method
b. LIFO method
c. average cost method
d. gross profit method

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 30

Cost Flow Assumptions
Another Review Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method
b. LIFO method
c. average cost method
d. gross profit method

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 31

Cost Flow Assumptions
Another Review Answer
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method
b. Answer: LIFO method
c. average cost method
d. gross profit method

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 32

DO IT! 2: Cost Flow Methods

The accounting records of Shumway Ag Implements show the

following data.

Beginning inventory 4,000 units at $ 3

Purchases 6,000 units at $ 4
Sales 7,000 units at $12

Determine the cost of goods sold during the period under a

periodic inventory system using (a) the FIFO method, (b) the
LIFO method, and (c) the average-cost method.

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 33

DO IT! 2: FIFO Method

Determine cost of goods sold under a periodic inventory.

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 34

DO IT! 2: LIFO Method

Determine cost of goods sold under a periodic inventory.

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 35

DO IT! 2: Average-Cost Method
Determine cost of goods sold under a periodic inventory.

LO 2 Copyright ©2021 John Wiley & Sons, Inc. 36

Effects of Inventory Errors

LEARNING OBJECTIVE 3
Indicate the effects of inventory errors on the financial
statements.

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 3 Copyright ©2021 John Wiley & Sons, Inc. 37

Effects of Inventory Errors
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
Formula for cost of goods sold
Beginning Inventory + Cost of Goods Purchased − Ending
Inventory = Cost of Goods Sold
ILLUSTRATION 6.15
When Inventory Error: Cost of Goods Sold Is: Net Income Is:
Understates beginning inventory Understated Overstated
Overstates beginning inventory Overstated Understated
Understates ending inventory Overstated Understated
Overstates ending inventory Understated Overstated
ILLUSTRATION 6.16
LO 3 Copyright ©2021 John Wiley & Sons, Inc. 38
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 current period will
have a reverse effect on net income of next
accounting period
• Over two years, total net income is correct because
errors offset each other
• Ending inventory depends entirely on accuracy of
taking and costing inventory

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 39

Effects of Inventory Errors on Two
Years’ Income Statements

ILLUSTRATION 6.17

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 40

Income Statement Effects
Review Question
Understating ending inventory will overstate:
a. assets
b. cost of goods sold
c. net income
d. stockholders’ equity

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 41

Income Statement Effects
Review Answer
Understating ending inventory will overstate:
a. assets
b. Answer: cost of goods sold
c. net income
d. stockholders’ equity

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 42

Balance Sheet Effects
Effect of inventory errors on the balance sheet is
determined by using the basic accounting equation:
Assets = Liabilities + Stockholders’ Equity.
Errors in the ending inventory have the following effects.

Ending Inventory Error Assets Liabilities Stockholders’ Equity

Overstated Overstated No effect Overstated
Understated Understated No effect Understated

ILLUSTRATION 6.18

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 43

DO IT! 3: Inventory Errors
Visual Company overstated its 2021 ending inventory by
$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and owner’s equity in 2021
and 2022.
Solution
2021 2022
Ending inventory $22,000 overstated No effect
Cost of goods sold $22,000 understated $22,000 overstated
Owner’s equity $22,000 overstated No effect

LO 3 Copyright ©2021 John Wiley & Sons, Inc. 44

Inventory Presentation and Analysis

LEARNING OBJECTIVE 4
Explain the statement presentation and analysis of
inventory.
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
sales.
There also should be disclosure of
1. major inventory classifications
2. basis of accounting (cost or LCNRV)
3. costing method (FIFO, LIFO, or average-cost)

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 45

Lower-of-Cost-or-Net Realizable Value

When the value of inventory is lower than its cost

• Companies must “write down” inventory to its net
realizable value
• Net realizable value: Amount that company expects to
realize (receive from the sale of inventory)
• Example of conservatism

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 46

Computation of Lower-of-Cost-or-Net
Realizable Value
Illustration: Assume that Ken Tuckie Electronics has the
following lines of merchandise with costs and net realizable
values as indicated.
Cost Net Realizable Lower-of-Cost-or-Net
Units per Unit Value per Unit Realizable Value
Flat-screen TVs 100 $600 $550 $ 55,000 ($550 × 100)
Satellite radios 500 90 104 45,000 ($90 × 500)
DVD recorders 850 50 48 40,800 ($48 × 850)
DVDs 3,000 5 6 15,000 ($5 × 3,000)
Total inventory $155,800

ILLUSTRATION 6.20
LO 4 Copyright ©2021 John Wiley & Sons, Inc. 47
DO IT! 4a: LCNRV
Tracy company sells three different types of home heating stoves (gas,
wood, and pellet). The cost and net realizable value of its inventory of
stoves are as follows.
Cost Net Realizable Value
Gas $ 84,000 $ 79,000
Wood 250,000 280,000
Pellet 112,000 101,000

Determine the value of the company’s inventory under the lower-of-cost-

or-net realizable value approach.
Solution: The lowest value for each inventory type is gas $79,000, wood
$250,000, and pellet $101,000. The total inventory value is the sum of
these amounts, $430,000.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 48

Analysis

Inventory management is a double-edged sword

1. High Inventory Levels - may incur high carrying
costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stock-outs and
lost sales.

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 49

Inventory Turnover and Days in
Inventory
Inventory turnover measures the number of times on
average the inventory is sold during the period.
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Days in inventory measures the average number of days

inventory is held.
Days in Days in Year (365)
=
Inventory Inventory Turnover
LO 4
Inventory Turnover Formula and
Computation for Walmart
Illustration: Walmart reported in a recent annual report a
beginning inventory of $45,141 million, an ending
inventory of $44,469 million, and cost of goods sold for
the year of $360,984 million. The inventory turnover
formula and computation for Walmart are shown below.
Cost of Average
÷ = Inventory Turnover
Goods Sale Inventory
$45,141 + $44,469
$360,984 ÷ = 8.1 times
2

ILLUSTRATION 6.21

Days in inventory = 365 ÷ 8.1 = 45.1 Days

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 51
DO IT! 4b: Inventory Turnover

Early in 2022, Westmoreland Company switched to a just-in-time

inventory system. Its sales revenue, cost of goods sold, and
inventory amounts for 2021 and 2022 are shown below.
2021 2022
Sales revenue $2,000,000 $1,800,000
Cost of goods sold 1,000,000 910,000
Beginning inventory 290,000 210,000
Ending inventory 210,000 50,000
Determine the inventory turnover and days in inventory for 2021
and 2022.
LO 4 Copyright ©2021 John Wiley & Sons, Inc. 52
DO IT! 4b: Inventory Turnover Solution

2021 2022
Sales revenue $2,000,000 $1,800,000
Cost of goods sold 1,000,000 910,000
Beginning inventory 290,000 210,000
Ending inventory 210,000 50,000

2021 2022
$1,000,000 $910,000
Inventory turnover =4 =7
($290,000 + $210,000) ÷ 2 ($210,000 + $50,000) ÷ 2
Days in inventory 365 ÷ 4 = 91.3 days 365 ÷ 7 = 52.1 days

LO 4 Copyright ©2021 John Wiley & Sons, Inc. 53