CH 06

REPORTING AND
ANALYZING
INVENTORY
6-1
Financial Accounting, Seventh Edition
Learning
Learning Objectives
Objectives
After studying this chapter, you should be able to:
6-2
1.
Determine how to classify inventory and inventory quantities.
2.
Explain the basis of accounting for inventories and apply the inventory
cost flow methods under a periodic inventory system.
3.
Explain the financial statement and tax effects of each of the inventory
cost flow assumptions.
4.
Explain the lower-of-cost-or-market basis of accounting for inventories.
5.
Compute and interpret the inventory turnover.
6.
Describe the LIFO reserve and explain its importance for comparing
results of different companies.
Preview of Chapter 6
6-3
Financial Accounting
Seventh Edition
Kimmel Weygandt Kieso
Classifying
Classifying and
and Determining
Determining Inventory
Inventory
Merchandising
Company
One Classification:
Merchandise
Inventory
Helpful Hint Regardless of the

classification, companies report
all inventories under Current
Assets on the balance sheet.
6-4
Manufacturing
Company
Three Classifications:
Raw Materials
Work in Process
Finished Goods
LO 1 Determine how to classify inventory and inventory quantities.
6-5
Determining
Inventory Quantities
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.
6-6
Determining
Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
6-7
when the business is closed or business is slow.
at the end of the accounting period.
6-8
Determining
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.
6-9
Determining
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.
6-10
Determining
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.
6-11
Determining
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?
6-12
Hasbeen Company completed its inventory count. It arrived at a

total inventory value of $200,000. 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 inventory that had been sold with a
cost of $12,000, which was in transit (terms: FOB shipping point).
Solution
1. Goods of $15,000 held on consignment should be deducted from the inventory
count.
2. The goods of $10,000 purchased FOB shipping point should be added to the
inventory count.
Inventory should be $195,000
3. Item 3 was treated correctly.
($200,000 - $15,000 + $10,000).
6-13
6-14
Inventory
Inventory Costing
Costing
Inventory is accounted for at cost.
6-15
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)
Average-cost
Cost Flow
Assumptions
LO 2 Explain the basis of accounting for inventories and apply the

inventory cost flow methods under a periodic inventory system.
Inventory
Inventory Costing
Costing
Illustration: Crivitz TV Company purchases three identical 50inch 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
6-16

Inventory
Inventory Costing
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
6-17

Inventory
Inventory Costing
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.
6-18
Practice is relatively rare.
Most companies make assumptions (cost flow assumptions)

about which units were sold.

Inventory
Inventory Costing
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
6-19

Cost
Cost Flow
Flow Assumptions
Assumptions
Illustration: Data for Houston Electronics Astro condensers.
Illustration 6-5
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

6-20

Cost
Cost Flow
Flow Assumptions
Assumptions
First-In, First-Out (FIFO)
6-21
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.

Cost
Cost Flow
Flow Assumptions
Assumptions
Illustration 6-6
6-22
LO 2
Cost
Cost Flow
Flow Assumptions
Assumptions
Illustration 6-6
Helpful Hint Another way of

thinking about the calculation
of FIFO ending inventory is the
LISH assumptionlast in still here.
6-23

Cost
Cost Flow
Flow Assumptions
Assumptions
Last-In, First-Out (LIFO)
6-24
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.

Cost
Cost Flow
Flow Assumptions
Assumptions
Illustration 6-8
6-25
LO 2
Cost
Cost Flow
Flow Assumptions
Assumptions
Helpful Hint Another way of
thinking about the calculation
of LIFO ending inventory is the
FISH assumptionfirst in still here.
Illustration 6-8
6-26

Cost
Cost Flow
Flow Assumptions
Assumptions
Average-Cost
6-27
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.

Cost
Cost Flow
Flow Assumptions
Assumptions
Average-Cost
Illustration 6-11
6-28

Cost
Cost Flow
Flow Assumptions
Assumptions
Average-Cost
Illustration 6-11
6-29

Financial
Financial Statement
Statement and
and Tax
Tax Effects
Effects
Comparative effects of cost flow methods
6-30
Illustration 6-13
LO 3 Explain the financial statement and tax effects of

each of the inventory cost flow assumptions.
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
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.
6-31

Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions
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.
6-32
Helpful Hint A tax rule,

often referred to as the LIFO
conformity rule, requires that
if companies use LIFO for tax
purposes, they must also use it
for financial reporting purposes.
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.

6-33
Inventory
Inventory Costing
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
6-34

Inventory
Inventory Costing
Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
6-35
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.
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

basis of accounting for inventories.
Inventory
Inventory Costing
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
6-36
LO 4 Explain the lower-of-cost-or-market

basis of accounting for inventories.
Analysis
Analysis of
of Inventory
Inventory
Inventory management is a critical task
1. High Inventory Levels - storage costs, interest cost (on
funds tied up in inventory), and costs associated with the

obsolescence of technical goods or shifts in fashion.
2. Low Inventory Levels may lead to lost sales.
6-37
LO 5 Compute and interpret the inventory turnover ratio.
Analysis
Analysis of
of Inventory
Inventory
Inventory Turnover Ratio
Illustration 6-17
6-38
Analysis
Analysis of
of Inventory
Inventory
Illustration: Data available for Wal-Mart.
Illustration 6-17
6-39
6-40
Analysis
Analysis of
of Inventory
Inventory
Analysts Adjustments for LIFO Reserve
Companies using LIFO are required to report the difference
between inventory reported using LIFO and Inventory using
FIFO. This amount is referred to as the LIFO reserve.
Illustration 6-18
6-41
LO 6 Describe the LIFO reserve and explain its importance

for comparing results of different companies.
Analysis
Analysis of
of Inventory
Inventory
Analysts Adjustments for LIFO Reserve
The LIFO reserve can have a significant effect on ratios analysts
commonly use.
Illustration 6-20
6-42
LO 6 Describe the LIFO reserve and explain its importance

for comparing results of different companies.
Appendix
Appendix 6A
6A
Illustration:
Perpetual
Inventory
System
Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods Sold

and Ending Inventory under FIFO, LIFO, and Average cost.
6-43
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
Appendix
Appendix 6A
6A
Cost of Goods
Sold
6-44
Perpetual
Inventory
System
Illustration 6A-2
Ending Inventory
Appendix
Appendix 6A
6A
Cost of Goods
Sold
6-45
Perpetual
Inventory
System
Illustration 6A-3
Ending Inventory
Appendix
Appendix 6A
6A
Average-Cost
Cost of Goods
Sold
6-46
Perpetual
Inventory
System
Illustration 6A-4
Ending Inventory
Appendix
Appendix 6B
6B
Inventory
Errors
Inventory Errors
Common Cause:
6-47
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 8 Indicate the effects of inventory errors on the financial statements.
Appendix
Appendix 6B
6B
Inventory
Errors
Income Statement Effects

Inventory errors affect the computation of cost of goods sold and
net income.
Illustration 6-B1
Illustration 6-B2
6-48
Appendix
Appendix 6B
6B
Inventory
Errors
Income Statement Effects

Inventory errors affect the computation of cost of goods sold
and net income in two periods.
6-49
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.
Inventory
Errors
Appendix
Appendix 6B
6B
Illustration 6-B3
Combined income for 2year period is correct.

6-50
($3,000)
Net Income
understated
$3,000
Net Income
overstated
Appendix
Appendix 6B
6B
Inventory
Errors
Review Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
6-51
Appendix
Appendix 6B
6B
Inventory
Errors
Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined by
using the basic accounting equation:
Illustration 6-B1
Illustration 6-B4
6-52
Key Points
6-53
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).
LO 9 Compare the procedures for the merchandising under GAAP and IFRS.
Key Points
6-54
Who owns the goodsgoods in transit or consigned goodsas

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.
Key Points
6-55
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 averagecost 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.
Key Points
6-56
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.
Key Points
6-57
Under GAAP, if inventory is written down under the lower-ofcost-or-market valuation, the new value becomes its cost
basis. As a result, the inventory may not be written back up to
its original cost in a subsequent period. Under IFRS, the writedown 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.
Key Points
6-58
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.
Looking to the Future

IFRS specifically prohibits the use of the LIFO cost flow assumption.
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. With a new
conceptual framework being developed, it is highly probable that the
use of the concept of conservatism will be eliminated. Similarly, the
concept of prudence in the IASB literature will also be eliminated.
This may ultimately have implications for the application of the lowerof-cost-or-net realizable value.
6-59
IFRS Practice
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.
6-60
IFRS Practice
Which method of inventory costing is prohibited under IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
6-61
IFRS Practice
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.
6-62
Copyright
Copyright
Copyright 2013 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
6-63

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REPORTING AND

Financial Accounting, Seventh Edition

Determine how to classify inventory and inventory quantities.

Explain the lower-of-cost-or-market basis of accounting for inventories.

Compute and interpret the inventory turnover.

Helpful Hint Regardless of the

LO 1 Determine how to classify inventory and inventory quantities.

LO 1 Determine how to classify inventory and inventory quantities.

when the business is closed or business is slow.

at the end of the accounting period.

LO 1 Determine how to classify inventory and inventory quantities.

Purchased goods not yet received.

Sold goods not yet delivered.

Goods in transit should be included in the inventory of the company

LO 1 Determine how to classify inventory and inventory quantities.

Ownership of the goods

Ownership of the goods

LO 1 Determine how to classify inventory and inventory quantities.

LO 1 Determine how to classify inventory and inventory quantities.

LO 1 Determine how to classify inventory and inventory quantities.

Hasbeen Company completed its inventory count. It arrived at a

LO 1 Determine how to classify inventory and inventory quantities.

LO 1 Determine how to classify inventory and inventory quantities.

Cost includes all expenditures necessary to acquire goods

Unit costs are applied to quantities to determine the total cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

Practice is relatively rare.

Most companies make assumptions (cost flow assumptions)

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

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

LO 2 Explain the basis of accounting for inventories and apply the

Costs of the earliest goods purchased are the first to

Often parallels actual physical flow of merchandise.

Companies determine the cost of the ending inventory

LO 2 Explain the basis of accounting for inventories and apply the

Helpful Hint Another way of

LO 2 Explain the basis of accounting for inventories and apply the

Costs of the latest goods purchased are the first to be

Seldom coincides with actual physical flow of

Exceptions include goods stored in piles, such as coal or

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

Allocates cost of goods available for sale on the basis of

Applies weighted-average unit cost to the units on

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

LO 2 Explain the basis of accounting for inventories and apply the

LO 3 Explain the financial statement and tax effects of

LO 3 Explain the financial statement and tax effects of

Helpful Hint A tax rule,

LO 3 Explain the financial statement and tax effects of

Method should be used consistently, enhances

Although consistency is preferred, a company may change

LO 3 Explain the financial statement and tax effects of

Companies can write down the inventory to its market

Market value = Replacement Cost

International Note Under

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