CHAPTER

6 Inventories
CHAPTER 6 LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Discuss how to classify and determine inventory.

Inventories
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-net realizable value basis of accounting for inventories.
5. Indicate the effects of inventory errors on the financial statements.
6. Discuss the presentation and analysis of inventory.

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Classifying and Determining Inventory

PREVIEW OF CHAPTER 6 Learning Objective 1
Discuss how to classify and determine
Classifying Inventory inventory.

Merchandising Company Manufacturing Company

One Classification: Three Classifications:

 Inventory  Raw Materials

 Work in Process
• HELPFUL HINT  Finished Goods
Regardless of the classification, companies report
all inventories under Current Assets on the
statement of financial position.

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 Determining Inventory Quantities Determining Inventory Quantities

Physical Inventory taken for two reasons: TAKING A PHYSICAL INVENTORY

Perpetual System Involves counting, weighing, or measuring each kind of inventory on hand.

1. Check accuracy of inventory records. Companies often “take inventory”

2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee  when the business is closed or
theft. business is slow.

Periodic System  at the end of the accounting period.

1. Determine the inventory on hand.

2. Determine the cost of goods sold for the period.

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Determining Inventory Quantities DETERMINING OWNERSHIP OF GOODS

DETERMINING OWNERSHIP OF GOODS GOODS IN TRANSIT Illustration 6-2 Terms

of sale
GOODS IN TRANSIT
Ownership of the goods passes to the buyer
 Purchased goods not yet received.
when the public carrier accepts the goods from
the seller.
 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. Ownership of the goods remains with the seller
until the goods reach the buyer.

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 Determining Ownership of Goods Determining Ownership of Goods

Question CONSIGNED GOODS

Goods in transit should be included in the inventory of the buyer when the: 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.
a. public carrier accepts the goods from the seller.
Many car, boat, and antique dealers sell goods on consignment, why?
b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

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> DO IT! E6-1/p.309

Deng Yaping Company completed its inventory count. It arrived at a total inventory value of ¥200,000. You have been given the Premier Bank and Trust is considering giving Alou Company a
information listed below. Discuss how this information affects the reported cost of inventory. loan. Before doing so, management decides that further
1. Deng Yaping included in the inventory goods held on consignment for Falls Co., costing ¥15,000. discussions with Alou’s accountant may be desirable. One area of
2. The company did not include in the count purchased goods of ¥10,000, which were in transit (terms: FOB shipping particular concern is the inventory account, which has a year-end
point). balance of £297,000. Discussions with the accountant reveal the
3. The company did not include in the count inventory that had been sold with a cost of ¥12,000, which was in transit following.
(terms: FOB shipping point). 1. Alou sold goods costing £38,000 to Comerico Company, FOB
shipping point, on December 28. The goods are not expected to
arrive at Comerico until January 12. The goods were not included
Solution in the physical inventory because they were not in the warehouse.
2. The physical count of the inventory did not include goods
costing £91,000 that were shipped to Alou FOB destination on
December 27 and were still in transit at year-end.

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 E6-1/p.309 Classifying and Determining Inventory
Learning Objective 2
3. Alou received goods costing £25,000 on January 2. The goods Explain the accounting for
were shipped FOB shipping point on December 26 by Grant Co. Inventory is accounted for at cost. inventories and apply the inventory cost
flow methods.
The goods were not included in the physical count.  Cost includes all expenditures necessary
4. Alou sold goods costing £35,000 to Emerick Co., FOB to acquire goods and place them in a condition ready for sale.
destination, on December 30. The goods were received at
Emerick on January 8. They were not included in Alou’s physical  Unit costs are applied to quantities to compute the total cost of the inventory and the cost
inventory. of goods sold using the following costing methods:
5. Alou received goods costing £44,000 on January 2 that were ► Specific identification Cost Flow
shipped FOB shipping point on December 29. The shipment was
► First-in, first-out (FIFO) Assumptions
a rush order that was supposed to arrive December 31. This
purchase was included in the ending inventory of £297,000. ► Average-cost
Instructions
Determine the correct inventory amount on December 31.

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Inventory Costing Specific Identification

Illustration: Crivitz TV Company purchases three identical 50-inch TVs on different dates at If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is
costs of £700, £750, and £800. During the year Crivitz sold two sets at £1,200 each. These £1,500 (£700 + £800), and its ending inventory is £750.
facts are summarized below.

Illustration 6-3
Data for inventory costing example
Illustration 6-4
Specific identification method

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 Specific Identification Cost Flow Assumptions

Actual physical flow costing method in which items still in inventory are specifically costed to There are two assumed cost flow methods:
arrive at the total cost of the ending inventory.
1. First-in, first-out (FIFO)

 Practice is relatively rare. 2. Average-cost

 Most companies make assumptions (cost flow Cost flow does not need be consistent with the physical movement of the goods.
assumptions) about which units were sold.

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Cost Flow Assumptions Cost Flow Assumptions

Data for Lin Electronics’ Astro condensers. Illustration 6-5

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 obtain 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.

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

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 FIRST-IN, FIRST-OUT (FIFO) FIRST-IN, FIRST-OUT (FIFO)

• HELPFUL HINT
Another way of thinking about the calculation of
FIFO ending inventory is the LISH assumption—
last in still here.
Illustration 6-6
Allocation of costs—FIFO method
Illustration 6-6
Allocation of costs—FIFO method
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Cost Flow Assumptions AVERAGE-COST

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.

Illustration 6-8
Formula for weighted-average unit cost
Illustration 6-9
Allocation of costs—average-cost method

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 AVERAGE-COST > DO IT!

Illustration 6-11
The accounting records of Shumway Ag Implement show the following.
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 and (b) the average-cost method.

Illustration 6-9
Allocation of costs—average-cost method

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E6-4/p.310 E6-4/p.310

Zhu Boards sells a snowboard, Xpert, that is Instructions

popular with snowboard enthusiasts. Information
relating to Zhu’s purchases of Xpert snowboards
during September is shown on the next page.
During the same month, 121 Xpert snowboards
were sold. Zhu’s uses a periodic inventory system.
(a) Compute the ending inventory at September 30
and cost of goods sold using the FIFO and
average-cost methods. Prove the amount allocated
to cost of goods sold under each method.
(b) For both FIFO and average-cost, calculate the
sum of ending inventory and cost of goods sold.
What do you notice about the answers you found
for each method?

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 Financial Statement and Tax Effects of Cost Flow INCOME STATEMENT EFFECTS
Methods
Learning Objective 3
Explain the financial effects of the
Either of the two cost flow assumptions inventory cost flow assumptions.

is acceptable for use. For example,

 adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas
 Syngenta Group (CHE) and Nokia (FIN) use FIFO.

A recent survey of IFRS companies, approximately

► 60% use the average-cost method,

► 40% use FIFO, and
► 23% use both for different parts of their inventory.

Illustration 6-10
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STATEMENT OF FINANCIAL POSITION EFFECTS TAX EFFECTS

 Both inventory and net income are higher when companies use FIFO in a period of inflation.
 A major advantage of the FIFO method is that in a period of inflation, the costs
 Average-cost results in the lower income taxes (because of lower net income) during
allocated to ending inventory will approximate their current cost.
times of rising prices.
 A major shortcoming of the average-cost method is that in a period of inflation, the
costs allocated to ending inventory may be understated in terms of current cost.

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 Using Cost Flow Methods Consistently Cost Flow Assumptions

 Method should be used consistently, enhances comparability. Question

 Although consistency is preferred, a company may change its inventory costing method. In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. net income equal to the specific identification method.

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Cost Flow Assumptions E6-6/p.311

Howsham Company, Ltd. reports the following for the month
Question of June.
Factors that affect the selection of an inventory costing method do not include:
a. tax effects.
b. statement of financial position effects.
c. income statement effects. Instructions
d. perpetual vs. periodic inventory system. (a) Compute the cost of the ending inventory and the cost
of goods sold under (1) FIFO and (2) average-cost.
(b) Which costing method gives the higher ending
inventory? Why?
(c) Which method results in the higher cost of goods
sold? Why?
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 Lower-of-Cost-or-Net Realizable Value Lower-of-Cost-or-Net Realizable Value
Learning Objective 4
Explain the lower-of-cost-or-net
When the value of inventory is lower realizable value Illustration: Assume that Gao TV has the following lines of merchandise with costs and
basis of accounting for
than its cost inventories.
market values as indicated.

 companies must “write down” the inventory to its net realizable value.

Net realizable value: Amount that a company expects to realize (receive from the sale of
inventory).

Illustration 6-11
Computation of lower-of-cost-or-net realizable value

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Inventory Errors Income Statement Effects

Learning Objective 5
Indicate the effects of inventory errors on
Common Causes: the financial statements. Inventory errors affect the computation of cost of goods sold and net income in two
periods. Illustration 6-12
 Failure to count or price inventory correctly. Formula for cost of goods sold

 Not properly recognizing the transfer of legal title to goods in transit.

 Errors affect both the income statement and statement of financial position.

Illustration 6-13
Effects of inventory errors on current year’s income statement
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 Income Statement Effects Income Statement Effects Illustration 6-14
Effects of inventory errors on two years’
income statements

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.

Combined income for (€3,000) €3,000

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

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Income Statement Effects Statement of Financial Position Effects

Question Effect of inventory errors on the statement of financial position is determined by using the basic
accounting equation: Assets = Liabilities + Equity.
Atlantis Company’s ending inventory is understated NT$122,000. The effects of this
error on the current year’s cost of goods sold and net income, respectively, are: Errors in the ending inventory have the following effects.

a. understated, overstated.

b. overstated, understated.

c. overstated, overstated.

d. understated, understated. Illustration 6-15

Effects of ending inventory errors on statement of financial position

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 > DO IT! > DO IT!

LCNRV Basis; Inventory Errors LCNRV Basis; Inventory Errors

(a) Tracy Company sells three different types of home heating stoves (wood, gas, and pellet). The (b) Visual Company overstated its 2016 ending inventory by NT$22,000. Determine the impact
cost and net realizable value of its inventory of stoves are as follows. this error has on ending inventory, cost of goods sold, and equity in 2016 and 2017.

2016 2017
Ending inventory NT$22,000 overstated No effect
Cost of goods sold NT$22,000 understated NT$22,000 overstated
Equity NT$22,000 overstated No effect
Determine the value of the company’s inventory under the lower-of-cost-or-net realizable value
approach.
Total inventory value is the sum of these amounts, NT$430,000.
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E6-11/p.312 E6-11/p.312

Wu Watch Company, Ltd. reported the following Wu uses a periodic inventory system. The inventories at
income statement data for a 2-year period. January 1, 2016, and December 31, 2017, are correct.
However, the ending inventory at December 31, 2016, was
understated HK$60,000.
Instructions
(a) Prepare correct income statement data for the 2 years.
(b) What is the cumulative effect of the inventory error on
total gross profit for the 2 years?
(c) Explain in a letter to the president of Wu Watch
Company, Ltd. what has happened, i.e., the nature of the
error and its effect on the financial statements.

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 Statement Presentation and Analysis Statement Presentation and Analysis
Learning Objective 6
Discuss the presentation and analysis of
Presentation inventory. Analysis
Statement of Financial Position - Inventory classified as current asset. Inventory management is a double-edged sword

Income Statement - Cost of goods sold is subtracted from sales. 1. High Inventory Levels - may incur high carrying costs (e.g., investment, storage,
insurance, obsolescence, and damage).
There also should be disclosure of the
2. Low Inventory Levels – may lead to stock-outs and lost sales.
1) major inventory classifications,

2) basis of accounting (cost or LCNRV), and

3) costing method (specific identification, FIFO, or average-cost).

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Analysis Analysis

Inventory turnover measures the number of times on average the inventory is sold during Illustration: Esprit Holdings (HKG) reported in a recent annual report a beginning inventory of HK$3,209
million, an ending inventory of HK$3,254 million, and cost of goods sold for the year ended of HK$12,071
the period.
million. The inventory turnover formula and computation for Esprit Holdings are shown below.
Cost of Goods Sold
Inventory Turnover
=
Average Inventory

Days in inventory measures the average number of days inventory is held.

Illustration 6-17
Days in Year (365) Inventory turnover formula and computation Days in Inventory: Inventory turnover of 3.7 times divided into 365 is
Days in Inventory for Esprit Holdings (in millions)
= approximately 99 days. This is the approximate time that it takes a company
Inventory Turnover to sell the inventory.

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 > DO IT! APPENDIX 6A Perpetual Inventory System
Early in 2017, Seoul Company switched to a just-in-time inventory system. Its sales, cost of goods sold, Learning Objective 7
Apply the inventory cost
and inventory amounts for 2016 and 2017 are shown below. Illustration 6A-1 flow methods to perpetual
inventory records.
2016 2017 Inventoriable units and costs

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 2016 and 2017.

2016 2017

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO
and average-cost.
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First-In-First-Out (FIFO) Average-Cost

Illustration 6A-3
Perpetual system— Cost of Goods Sold Ending Inventory
average-cost method

Illustration 6A-2
Perpetual system—FIFO Cost of Goods Sold
Ending Inventory

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APPENDIX 6B Estimating Inventories Gross Profit Method
Learning Objective 8
Describe the two methods of estimating Illustration: Kishwaukee Company’s records for January show net sales of $200,000, beginning inventory
Gross Profit Method inventories. $40,000, and cost of goods purchased $120,000. The company expects to earn a 30% gross profit rate.
Compute the estimated cost of the ending inventory at January 31 under the gross profit method.
Estimates the cost of ending inventory by applying a gross profit rate to net sales.
Illustration 6B-2
Example of gross profit method

Illustration 6B-1
Gross profit method formulas

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Retail Inventory Method Retail Inventory Method

Company applies the cost-to-retail percentage to ending inventory at retail prices to determine Illustration: Illustration 6B-4
Application of retail inventory method

inventory at cost.

Note that it is not necessary to take a physical inventory to estimate the cost of goods on hand at any
given time.

Illustration 6B-3
Retail inventory method formulas
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APPENDIX 6C LIFO Inventory Method Last-In-First-Out (LIFO)
Illustration 6C-1
Allocation of costs—LIFO method
Learning Objective 9
Apply the LIFO inventory costing
Last-In-First-Out (LIFO) method.

 Under IFRS, LIFO is not permitted for financial reporting purposes.

 Assumes latest goods purchased are first to be sold.

 Seldom coincides with actual physical flow of merchandise, except for goods
stored in piles, such as coal or hay.

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Last-In-First-Out (LIFO)

Illustration 6C-1
Allocation of costs—LIFO method

Illustration 6C-2
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