6 Inventories

Learning Objectives
After studying this chapter, you should be able to:
[1] Determine how to classify inventory and inventory quantities.
[2] Explain the accounting for inventories and apply the inventory cost flow
methods.
[3] Explain the financial effects of the inventory cost flow assumptions.
[4] Explain the lower-of-cost-or-market basis of accounting for inventories.
[5] Indicate the effects of inventory errors on the financial statements.
[6] Compute and interpret the inventory turnover.

6-1
Preview of Chapter 6

Accounting Principles
Weygandt Kimmel Kieso

6-2
Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials
 Work in Process
 Finished Goods
Helpful Hint Regardless of the
classification, companies report
all inventories under Current
Assets on the balance sheet.

6-3
(See page 324)

6-4
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
3. Determine the inventory on hand.
4. Determine the cost of goods sold for the period.

6-5 LO 1 Determine how to classify inventory and inventory quantities.

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 business is slow.
 at the end of the accounting period.

6-6 LO 1 Determine how to classify inventory and inventory quantities.

6-7
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.

6-8 LO 1 Determine how to classify inventory and inventory quantities.

Determining Inventory Quantities

Goods in Transit Illustration 6-2

Terms of sale

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.

6-9 LO 1 Determine how to classify inventory and inventory quantities.

Determining Inventory Quantities

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.

6-10 LO 1 Determine how to classify inventory and inventory quantities.

Determining Inventory Quantities

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, why?

6-11 LO 1 Determine how to classify inventory and inventory quantities.

Inventory Costing

Inventory is accounted for at cost.

 Cost includes all expenditures necessary to acquire goods
and place them in a condition ready for sale.
 Unit costs are applied to quantities to determine the total cost
of the inventory and the cost of goods sold using the following
costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Last-in, first-out (LIFO) Cost Flow
Assumptions
► Average-cost

LO 2 Explain the accounting for inventories and

6-12
apply the inventory cost flow methods.
Inventory Costing

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.

Illustration 6-3

LO 2 Explain the accounting for inventories and

6-13
apply the inventory cost flow methods.
Inventory Costing

Specific Identification
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 Explain the accounting for inventories and

6-14
apply the inventory cost flow methods.
Inventory Costing

Specific Identification
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

6-15
apply the inventory cost flow methods.
Inventory Costing

Cost Flow
Assumption
does not need to be
consistent with the
physical movement of
goods
Illustration 6-12
Use of cost flow methods in
major U.S. companies

LO 2 Explain the accounting for inventories and

6-16
apply the inventory cost flow methods.
Cost Flow Assumptions

Illustration: Data for Houston Electronics’ Astro condensers.

Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

LO 2 Explain the accounting for inventories and

6-17
apply the inventory cost flow methods.
Cost Flow Assumptions

First-In, First-Out (FIFO)

 Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.
 Often parallels actual physical flow of merchandise.
 Companies determine the cost of the ending inventory
by taking the unit cost of the most recent purchase and
working backward until all units of inventory have been
costed.

LO 2 Explain the accounting for inventories and

6-18
apply the inventory cost flow methods.
Cost Flow Assumptions

First-In, First-Out (FIFO)

Illustration 6-6

COST OF GOODS AVAILABLE FOR SALE

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

6-19
LO 2
Cost Flow Assumptions

First-In, First-Out (FIFO)

Illustration 6-6

Helpful Hint Another way of

thinking about the calculation
of FIFO ending inventory is the
LISH assumption—last in still here.

LO 2 Explain the accounting for inventories and

6-20
apply the inventory cost flow methods.
Cost Flow Assumptions

Last-In, First-Out (LIFO)

 Costs of the latest goods purchased are the 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 Explain the accounting for inventories and

6-21
apply the inventory cost flow methods.
Cost Flow Assumptions

Last-In, First-Out (LIFO)

Illustration 6-8

COST OF GOODS AVAILABLE FOR SALE

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

6-22 LO 2
Cost Flow Assumptions

Last-In, First-Out (LIFO)

Helpful Hint Another way of
thinking about the calculation
of LIFO ending inventory is the
FISH assumption—first in still here.

Illustration 6-8

LO 2 Explain the accounting for inventories and

6-23
apply the inventory cost flow methods.
Cost Flow Assumptions

Average-Cost
 Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.
 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

6-24
apply the inventory cost flow methods.
Cost Flow Assumptions

Average-Cost
Illustration 6-11

COST OF GOODS AVAILABLE FOR SALE

STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

LO 2 Explain the accounting for inventories and

6-25
apply the inventory cost flow methods.
Cost Flow Assumptions

Average-Cost
Illustration 6-11

LO 2 Explain the accounting for inventories and

6-26
apply the inventory cost flow methods.
Financial Statement and Tax Effects
Comparative effects of cost flow methods Illustration 6-13

HOUSTON ELECTRONICS
Condensed Income Statements

6-27 LO 3 Explain the financial effects of inventory cost flow assumptions.

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 6-15
Disclosure of change in
cost flow method

6-28
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.

6-29 LO 3 Explain the financial effects of inventory cost flow assumptions.

Cost Flow Assumptions

Review Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method.
Helpful Hint A tax rule,
b. LIFO method. often referred to as the LIFO
conformity rule, requires that
if companies use LIFO for tax
c. average cost method. purposes, they must also use it
for financial reporting purposes.
d. gross profit method. This means that if a company
chooses the LIFO method to
reduce its tax bills, it will also
have to report lower net income
in its financial statements.

6-30 LO 3 Explain the financial effects of inventory cost flow assumptions.

(See page 324)

6-31
Inventory Costing

Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
 Companies “write down” the inventory to its market value in
the period in which the price decline occurs.
 Market value = Replacement Cost
 Example of conservatism. International Note Under
U.S. GAAP, companies cannot
reverse inventory write-downs
if inventory increases in
value in subsequent periods.
IFRS permits companies to
reverse write-downs in some
circumstances.

LO 4 Explain the lower-of-cost-or-market

6-32
basis of accounting for inventories.
Inventory Costing

Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following lines
of merchandise with costs and market values as indicated.

Illustration 6-16

LO 4 Explain the lower-of-cost-or-market

6-33
basis of accounting for inventories.
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.

6-34 LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Income Statement Effects

Inventory errors affect the computation of cost of goods sold
and net income.
Illustration 6-17

Illustration 6-18

6-35 LO 5 Indicate the effects of inventory errors on the financial statements.

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.
 Ending inventory depends entirely on the accuracy of taking
and costing the inventory.

6-36 LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
2013 2014
Illustration 6-19
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000

Combined income for ($3,000) $3,000

2-year period is correct. Net Income Net Income
understated overstated

6-37 LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.

6-38 LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:.
Illustration 6-17

Illustration 6-20

6-39 LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis

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 LCM), and

3) costing method (FIFO, LIFO, or average).

6-40
Statement Presentation and Analysis

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 stockouts and lost
sales.

6-41 LO 6 Compute and interpret the inventory turnover.

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

6-42 LO 6 Compute and interpret the inventory turnover.

Statement Presentation and Analysis

Illustration: Wal-Mart reported in its 2011 annual report a beginning

inventory of $32,713 million, an ending inventory of $36,318 million, and
cost of goods sold for the year ended January 31, 2011, of $315,287
million. The inventory turnover formula and computation for Wal-Mart are
shown below.
Illustration 6-22

Days in Inventory: Inventory turnover of 9.1 times divided into 365 is

approximately 40.1 days. This is the approximate time that it takes a
company to sell the inventory.

6-43 LO 6 Compute and interpret the inventory turnover.

Perpetual
APPENDIX 6A Cost Flow Methods Inventory
System
Illustration: Illustration 6A-1

HOUSTON ELECTRONICS
Astro Condensers

Assuming the Perpetual Inventory System, compute Cost of Goods Sold

and Ending Inventory under FIFO, LIFO, and Average cost.

6-44 LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
APPENDIX 6A Cost Flow Methods Inventory
System
First-In, First-Out (FIFO) Illustration 6A-2

Cost of Goods
Ending Inventory
Sold
6-45
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
APPENDIX 6A Cost Flow Methods Inventory
System
Last-In, First-Out (LIFO) Illustration 6A-3

Cost of Goods
Ending Inventory
Sold
6-46
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Perpetual
APPENDIX 6A Cost Flow Methods Inventory
System
Average-Cost
Illustration 6A-4

Cost of Goods Ending Inventory

Sold

6-47 LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6B Estimating Inventories

Gross Profit Method

A method of estimating the cost of ending inventory by applying a
gross profit rate to net sales. A company needs to know
► its net sales, cost of goods available for sale, and gross profit
rate.
Illustration 6B-1

6-48 LO 8 Describe the two methods of estimating inventories.

APPENDIX 6B Estimating Inventories

Illustration: Kishwaukee Company records show net sales of

$200,000, beginning inventory $40,000, and cost of goods purchased
$120,000. In the preceding year, the company realized a 30% gross
profit rate. It expects to earn the same rate this year. Compute the
estimated cost of the ending inventory at January 31 under the gross
profit method.
Illustration 6B-1

Illustration 6B-2
6-49
APPENDIX 6B Estimating Inventories

Retail Inventory Method

► Retail companies establish a relationship between cost and sales
price.
► Company applies cost-to-retail percentage to ending inventory at
retail prices to determine inventory at cost.
Illustration 6B-3

6-50 LO 8
APPENDIX 6B Estimating Inventories

Illustration: Note that it is not necessary to take a physical inventory

to determine the estimated cost of goods on hand at any given time.
Illustration 6B-4

Illustration 6B-1

The major disadvantage of the retail method is that it is an averaging technique.

It may produce an incorrect inventory valuation if the mix of the ending inventory
is not representative of the mix in the goods available for sale.
6-51 LO 8
A Look at IFRS

Key Points
 The requirements for accounting for and reporting inventories
are more principles-based under IFRS. That is, GAAP provides
more detailed guidelines in inventory accounting.
 The definitions for inventory are essentially similar under IFRS
and GAAP. Both define inventory as assets held-for-sale in the
ordinary course of business, in the process of production for
sale (work in process), or to be consumed in the production of
goods or services (e.g., raw materials).

6-52 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Key Points
 Who owns the goods—goods in transit or consigned goods—
as well as the costs to include in inventory, are accounted for
the same under IFRS and GAAP.
 Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in which
specific identification must be used.

6-53 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Key Points
 A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO for
inventory valuation. IFRS prohibits its use. FIFO and average-
cost are the only two acceptable cost flow assumptions
permitted under IFRS.
 IFRS requires companies to use the same cost flow
assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.

6-54 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Key Points
 In the lower-of-cost-or-market test for inventory valuation, IFRS
defines market as net realizable value. Net realizable value is
the estimated selling price in the ordinary course of business,
less the estimated costs of completion and estimated selling
expenses. GAAP, on the other hand, defines market as
essentially replacement cost.

6-55 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Key Points
 Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new basis is now considered its
cost. As a result, the inventory may not be written back up to its
original cost in a subsequent period. Under IFRS, the write-
down may be reversed in a subsequent period up to the
amount of the previous write-down. Both the write-down and
any subsequent reversal should be reported on the income
statement as an expense. An item-by-item approach is
generally followed under IFRS.

6-56 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Key Points
 Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.
 Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.
 IFRS allows companies to report inventory at standard cost if it
does not differ significantly from actual cost. Standard cost is
addressed in managerial accounting courses.

6-57 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

Looking to the Future

One convergence issue that will be difficult to resolve relates to the use
of the LIFO cost flow assumption. As indicated, IFRS specifically
prohibits its use. Conversely, the LIFO cost flow assumption is widely
used in the United States because of its favorable tax advantages. In
addition, many argue that LIFO from a financial reporting point of view
provides a better matching of current costs against revenue and,
therefore, enables companies to compute a more realistic income.

6-58 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

IFRS Self-Test Questions

Which of the following should not be included in the inventory of a

company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping
point.
d) None of the above.

6-59 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

IFRS Self-Test Questions

Which method of inventory costing is prohibited under IFRS?

a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.

6-60 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.
A Look at IFRS

IFRS Self-Test Questions

Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.

6-61 LO 9 Compare the accounting procedures for inventories under GAAP and IFRS.