Chapter 9

Inventories
Accounting, 21st Edition
Warren Reeve Fess

PowerPoint Presentation by Douglas Cloud

Professor Emeritus of Accounting Pepperdine University

Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

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Objectives
1. Summarize and provide examples of internal After studying this control procedures that apply to inventories. chapter, you should 2. Describe the effect of inventory errors on the financial statement. be able to: 3. Describe the three inventory cost flow assumptions and how they impact the income statement and balance sheet. 4. Compute the cost of inventory under the perpetual inventory system, using the following cost methods: first-in, first-out; lastin, first-out; average cost.

Objectives
5. Compute the cost of inventory under the periodic inventory system, using the following costing methods: first-in, first-out; last-in, first-out; average cost. 6. Compare and contrast the use of the three inventory costing methods. 7. Compute the proper valuation of inventory at other than cost, using the lower-of-cost-ormarket and net realization value concepts. 8. Prepare a balance sheet presentation of merchandise inventory.

Objectives
9. Estimate the cost of inventory, using the retail method and the gross profit method. 10. Compute the interpret the inventory turnover ratio and number of days sales in inventory.

Why is Inventory Control Important Important?

 Inventory is a significant asset and for many companies the largest asset.  Inventory is central to the main activity of merchandising and manufacturing companies.  Mistakes in determining inventory cost can cause critical errors in financial statements.  Inventory must be protected from external risks ( such as fire and theft) and internal fraud by employees.

Receiving report

AGREE

Purchase order

Invoice

JOURNAL
Date

Description
Accounts Payable--XYZ Co. Purchased merchandise on account.

Post. Ref.

Nov. 9 Inventory

1 222 00 1 222 00

Effect of Inventory Errors on Financial Statements

LIABILITIES

Merchandise Inventory Cost of Merchandise Sold

ASSETS

OWNERS EQUITY
Net Income

COSTS & EXPENSES

REVENUES

If merchandise inventory is . . . . . . . Cost of merchandise sold is . . . . . . Gross profit and net income are . . . Ending owners equity is . . . . . . . . .

overstated understated overstated overstated

Effect of Inventory Errors on Financial Statements

If merchandise inventory is . . . . . . . understated Cost of merchandise sold is . . . . . . Gross profit and net income are . . . overstated understated

Ending owners equity is . . . . . . . . . understated

Inventory Cost Flow Assumptions

Purchased goods

Sold goods

Inventory Cost Flow Assumptions

Sold Purchased goods goods

Inventory Cost Flow Assumptions

Purchased goods

Sold goods

Inventory Costing Methods

43%
40% 30% 20% 10% 0%

34%

19%

4% Fifo Lifo Average Other

Perpetual Inventory Costs

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

FIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. Unit Cost Total Cost Inventory Balance Qty. 10 Unit Total Cost Cost 20 200

The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

FIFO Perpetual Inventory Account

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

On January 4, 7 units of Item 127B are sold at $30 each.

FIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 Unit Total Cost Cost 20 20 200 60

The sale of 7 units leaves a balance of 3 units.

On January 4, 7 units of Item 127B are sold at $30 each.

FIFO Perpetual Inventory Account

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

On January 10, the firm purchased eight units at $21 each.

FIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 Unit Total Cost Cost 20 20 20 21 200 60 60 168

purchased eight units at $21 each.

Because the purchase price of $21 is different than the cost of the previous 3 units Onhand, the inventory balance of on January 10, the firm 11 units is accounted for separately.

FIFO Perpetual Inventory Account

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

On January 22, the firm sold four units for $31 each.

FIFO Perpetual Inventory Account

Item 127B

On January 22, the Unit Total firm sold four units Date Qty. Cost Cost Qty. for $31 each. Jan. 1
4 10 22 7 8 21 168 3 1

Purchases

Cost of Mdse. Sold Unit Cost 20 Total Cost 140

Inventory Balance Qty. 10 3 3 8 7 Unit Total Cost Cost 20 20 20 21 21 200 60 60 168 147

20 21

60 21

Of the four units sold, three are from the first units in (fifo) at a cost of $20.

FIFO Perpetual Inventory Account

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

On January 28, the firm sold two units at $32.

FIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 28 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 3 1 2 20 21 21 60 21 42 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 7 5 Unit Total Cost Cost 20 20 20 21 21 21 200 60 60 168 147 105

On January 28, the firm sold two units at $32.

FIFO Perpetual Inventory Account

Inventory cost data to demonstrate FIFO and LIFO Perpetual Systems
Item 127B Jan. 1 Inventory 4 Sale Cost of 10 Mdse.Purchase Sold 22 Sale 28 Sale 30 Purchase Units 10 7 8 4 2 10 Cost $20 $30 21 31 32 22 Price

On January 30, purchased ten additional units of Item 127B at $22 each.

FIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 28 30 Totals Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. Unit Cost Total Cost 140 Inventory Balance Qty. 10 3 3 8 7 5 5 10 15 Unit Total Cost Cost 20 20 20 21 21 21 21 22 200 60 60 168 147 105 105 220 $325

On January 30, purchased 7 20 8ten additional units of Item 21 168 127B at $22 each.
3 1 2 20 21 21 10 18 22 220 $388 13

60 21 42

$263

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. Unit Cost Total Cost Inventory Balance Qty. 10 Unit Total Cost Cost 20 200

The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 Unit Total Cost Cost 20 20 200 60

On January 4, the firm sold 7 units at $30 each.

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 Unit Total Cost Cost 20 20 20 21 200 60 60 168

On January 10, the firm purchased eight units at $21 each.

Note that a new layer is formed.

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 4 21 84 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 3 4 Unit Total Cost Cost 20 20 20 21 20 21 200 60 60 168 60 84

On January 22,sold, all come Of the 4 units the firm sells four from the most recent purchase units at $31 each. each. at a cost of $21

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 28 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 4 2 21 21 84 42 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 3 4 3 2 Unit Total Cost Cost 20 20 20 21 20 21 20 21 200 60 60 168 60 84 60 42

On January 28, sold two units at $32 each.

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 28 30 10 22 220 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 4 2 21 21 84 42 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 3 4 3 2 3 2 10 Unit Total Cost Cost 20 20 20 21 20 21 20 21 20 21 22 200 60 60 168 60 84 60 42 60 42 220

On January 30, purchase 10 units at $22 each.

LIFO Perpetual Inventory Account

Item 127B Purchases Date Jan. 1 4 10 22 28 30 10 22 220 Qty. Unit Cost Total Cost Cost of Mdse. Sold Qty. 7 8 21 168 4 2 21 21 84 42 Unit Cost 20 Total Cost 140 Inventory Balance Qty. 10 3 3 8 3 4 3 2 3 2 10 15 Unit Total Cost Cost 20 20 20 21 20 21 20 21 20 21 22 200 60 60 168 60 84 60 42 60 42 220 $322

Totals

18

$388

13

$266

Fifo Periodic

Fifo Periodic
200 units @ $9 300 units @ $10 400 units @ $11 100 units @ $12 1,000 units available for sale during year Jan. 1 Beginning Inventory Mar. 10 Purchase Sept. 21 Purchase Nov. 18 Purchase

Fifo Periodic
200 units @ $9 300 units @ $10 400 units @ $11 100 units @ $12 = $1,800 = = = 3,000 4,400 1,200 Jan. 1 Mar. 10 Sept. 21 Nov. 18

1,000 units available $10,400 for sale during Cost of merchandise year
available for sale

Fifo Periodic
A physical count on December 31 reveals that 700 of the 1,000 units have been sold. Using fifo, the first units purchased are theoretically the first units sold. We begin the count with January 1.

Fifo Periodic
Sold these 200 200 units @ $9 Sold these $10 300 units @300 Sold unitsof these 400 200 @ $11 200 100 units @ $12 = $1,800 $ 0 = = = 3,000 0 4,400 2,200 1,200 Jan. 1 Mar. 10 Sept. 21 Nov. 18

1,000 units available $10,400 $ 3,400 for sale during year Ending inventory

Fifo Periodic
Cost of merchandise available for sale $10,400 Less ending inventory 3,400 Cost of merchandise sold $ 7,000

Summary of Fifo Periodic

Purchases
Jan. 1 200 units at $9 Mar. 10 300 units at $10 Sep. 21 400 units at $11 Nov. 18 100 units at $12

Merchandise Available for Sale

$1,800 $3,000

Cost of Merchandise Sold

$1,800 $3,000 $2,200 $7,000 200 units at $9 300 units at $10 200 units at $11

$4,400 $1,200 $10,400

700 units

Merchandise Inventory
$2,200 $1,200 $3,400 200 units at $11 100 units at $12

1,000 units

300 units

Lifo Periodic

Lifo Periodic
200 units @ $9 300 units @ $10 400 units @ $11 100 units @ $12 Jan. 1 Beginning Inventory Mar. 10 Purchase Sept. 21 Purchase Nov. 18 Purchase

1,000 units lifo, the most recent batch Using available for sale during purchased is considered the first year of merchandise sold. batch

Lifo Periodic
200 units @ $9 300 units @ $10 400 units @ $11 100 units @ $12 1,000 units available for sale during year

700 units were sold Mar.during the year. 10 Purchase

Sept. 21 Purchase Nov. 18 Purchase

Jan. 1 Beginning Assume again that Inventory

Lifo Periodic
200 units @ $9 Sold unitsof these 100 200 @ $10 300 400 units @400 Sold these $11 100 units @100 Sold these $12 = $1,800 = = = 3,000 1,000 4,400 0 1,200 0 Jan. 1 Mar. 10 Sept. 21 Nov. 18

1,000 units available $10,400 $2,800 for sale during year Ending Inventory

Lifo Periodic
Cost of merchandise available for sale $10,400 Less ending inventory 2,800 Cost of merchandise sold $ 7,600

Summary of Lifo Periodic

Purchases
Jan. 1 200 units at $9 Mar. 10 300 units at $10 Sep. 21 400 units at $11 Nov. 18 100 units at $12

Cost of Merchandise Merchandise Sold Available 200 units at $9 for Sale $1,800
$1,800 $3,000 $1,800 $1,000 $2,800 Cost of Merchandise Sold $2,000 $4,400 $1,200 $7,600 200 units at $10 400 units at $11 100 units at $12 100 units at $10

300 units

$4,400 $1,200 $10,400

1,000 units

700 units

Average Cost Periodic

periodic method is based 300 units @ $10 Mar. 10 Purchase on the average cost of identicalSept. 21 Purchase units. 400 units @ $11
100 units @ $12 1,000 units available for sale during year Nov. 18 Purchase Jan. 1 200 units @ $9average cost Beginning The Inventory

Average Cost Periodic

200 units @ $9 300 units @ $10 400 units @ $11 100 units @ $11 1,000 units available for sale during year = $ 1,800 = $ 3,000 = $ 4,400 = $ 1,200 $10,400 Cost of merchandise available for sale

Average Cost Periodic

Cost of Merchandise Available for Sale = Average Unit Cost Units Available for Sale During Year $10,400 1,000 Units = $10.40 per Unit

Average Cost Periodic

Cost of merchandise available for sale $10,400 Less ending inventory ($10.40 x 300) 3,120 Cost of merchandise sold $ 7,280 To verify this amount, multiply 700 units sold times $10.40 to get the same $7,280.

Valuation of Inventory at Lower-of-Cost-orLower-of-Cost-or-Market

Inventory Item Quantity A B C D Total 400 120 600 280 Unit Cost Price $10.25 22.50 8.00 14.00 Unit Market Price $ 9.50 24.10 7.75 14.75 Total Cost $ 4,100 2,700 4,800 3,920 $15,520 Total Market $ 3,800 2,892 4,650 4,130 $15,472 Lower C or M $ 3,800 2,700 4,650 3,920 $15,070

The market decline based on individual items ($15,520 $15,070) = $450

Presentation of Merchandise Inventory on the Balance Sheet

Metro-Arts Balance Sheet December 31, 2007 Assets Current assets: Cash $ 19 400 00 Accounts receivable $80 000 00 Less allowance for doubtful accounts 3 000 00 77 000 00 Merchandise inventory at lower of cost (first-in, first-out method) or market 216 300 00

Estimating Inventory Cost

Retail Method of Estimating Inventory Cost

 Retail method is based on relationship between cost of merchandise available for sale and the retail price.  Retail prices of all merchandise must be accumulated and totaled.  Inventory at retail is calculated at retail price of merchandise available for sale less net sales at retail.  Ratio is calculated as cost divided by retail price.  Inventory at retail price times cost ratio equals estimated cost of inventory.

Retail Inventory Method

Merchandise inventory, Jan. 1 Purchases in January (net) Merchandise available for sale Cost $19,400 42,600 $62,000 Retail $ 36,000 64,000 $100,000

$62,000 = 62% Ratio of cost to retail price = $100,000

Step 1: Determine the ratio of cost to the retail price.

Retail Inventory Method

Retail Merchandise inventory, Jan. 1 $ 36,000 64,000 Purchases in January (net) Merchandise available for sale $100,000 Sales for January (net) 70,000 Merchandise inventory, January 31, at retail $ 30,000 Cost $19,400 42,600 $62,000

Step 2: Determine the ending inventory at retail.

Retail Inventory Method

Retail Merchandise inventory, Jan. 1 $ 36,000 64,000 Purchases in January (net) Merchandise available for sale $100,000 Sales for January (net) 70,000 Merchandise inventory, January 31, at retail $ 30,000 Merchandise inventory, January 31, at cost ($30,000 x 62%) $18,600 Cost $19,400 42,600 $62,000

Step 3: Calculate the estimated inventory at cost.

Gross Profit Method of Estimating Inventory Cost

1. A gross profit percentage rate is estimated based on previous experience adjusted for known changes. 2. Estimated gross profit is calculated by multiplying the estimated gross profit rate times the actual net sales. 3. Estimated cost of merchandise sold is calculated by subtracting the gross profit from actual sales. 4. The cost of merchandise sold estimate is deducted from actual merchandise available for sale to determine the estimated cost of merchandise inventory.

Gross Profit Method

Merchandise inventory, January 1 Purchases in January (net) Merchandise available for sale Sales in January (net) Less: Estimated gross profit ($250,000 x 30%) $ 57,000 180,000 $237,000 $250,000 75,000 175,000 $ 62,000

Estimated cost of merchandise sold Estimated merchandise inventory, January 31

The gross profit method is useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system.

Inventory Turnover
SUPERVALU
Cost of merchandise sold Inventories: Beginning of year End of year Total Average $15,620,127,000 $1,115,529,000 1,067,837,000 $2,183,366,000 $1,091,683,000

Zale
$ 737,188,000 $478,467,000 571,669,000 $1,050,136,000 $525,068,000

Inventory turnover

14.3 times

1.4 times

Use: Inventory turnover measures the relationship between the volume of goods sold and the amount of inventory carried during the period.

Number of Days Sales in Inventory

SUPERVALU
Average daily cost of merchandise sold: $15,620,127,000/365 $737,188,000/365 Ending inventory

Zale

$42,794,868 $1,067,837,000 $2,019,693 $571,669,000

Average selling period

25 days

283 days

Use: To assess the efficiency in the management of inventory

Chapter 9 The End