Chapter 6

Chapter 6

Inventories

Merchandise inventory: includes all goods that a company owns and holds for
sale, regardless of where the goods are located when
inventory is counted.

Inventory systems

Perpetual Periodic
Inventory Inventory
System System

Note that :

1- In perpetual inventory system we use one account which is called

"merchandise inventory" for all inventory accounts.

2 - In periodic inventory system we use a lot of accounts like "purchases,

freight, purchase return and allowances".

3- Every organization use periodic inventory system must make a physical

count to determine the inventory on hand at the balance sheet date.

4- Unlike, perpetual inventory system which computes the cost of goods sold
and ending inventory balance after each transaction.

2 Mr. Kareem Abozeed

--1
 Chapter 6

Determining ownership of goods:

A ) Goods in transit : goods are considered in transit when they are in

the hand of public carrier such as
"rail road, trucking, or Airline Company"
at the statement date.

1- FOB (free on board) shipping point ownership of the goods passes

to the buyer when the public
carrier accepts the goods from
the seller.

2- FOB destination legal title to the goods remains with the seller
until the goods reach the buyer.

FOB shipping FOB destination

pon
Seller Public Buyer
carrier

Example : Assume that Hargrove company has 20,000 units of inventory on

hand on December 31 .
It also has the following goods in transit :

A ) Sales of 1,500 units shipped December 31 FOB destination

B ) Purchases of 2,500 units shipped FOB shipping point by the
seller on December 31

Required compute the amount of inventory units in Hargrove Company.

Solve: inventory = 20,000 + 1,500 + 2,500 = 24,000 units

3 Mr. Kareem Abozeed

--1
 Chapter 6

b ) goods on consignment : under such an arrangement , the holder of the

goods " the consignee " does not own the
goods . owner ship remains with the shipper of
the goods " the consignor " until the goods are
actually sold to a customer.

C ) goods damaged : damaged goods are not counted in inventory

"cost should be reduced to net realizable
value"

Multiple choice :

Physical count depend on included one of the next equations :

A ) original goods + goods in transit + consigned goods + damaged goods

B ) original goods + goods in transit - consigned goods - damaged goods
C ) original goods + goods in transit + consigned goods
D ) None of the following are correct

Note that :

. Most companies make a physical count of inventory at least once each

year .
. When the physical count does not match the merchandise inventory
account , an adjustment must be made .

Inventory costing methods

4 Mr. Kareem Abozeed

--1
 Chapter 6

(i) first in , first out " FIFO "

(ii) last in , last out " LIFO "
(iii) weighted average " average cost "
(iv) specific identification

Unit costs can be applied to quantities on hand using these methods .

Note that : to compute the ending inventory under any of these methods we
must use inventory equation in merchandising companies .

Beg inventory + cost of goods purchased – ending inventory

= cost of goods sold

Note that :

The sum of Beg. Inv . and cost of goods purchased equals the cost
of goods available of sale " inventoriable costs "

We can derive this equation from the previous one .

Beg Inv + cost of goods purchased = ending inventory + cost of goods sold

Total of inputs Total of outputs

Example :

5 Mr. Kareem Abozeed

--1
 Chapter 6

Gerald D.Englehart uses a perpetual inventory system

had beginning inventory , purchases and sales as follows :

Units cost per unit

Inventory : March 1 200 @$ 4.00
Purchases : March 10 500 @$ 4.50
March 20 400 @$ 4.75
March 30 300 @$ 5.00
Sales : March 15 500
March 25 400

The physical inventory count on march 31 shows 500 units on hand .

Required : under perpetual inventory system , determine the cost of

inventory on hand at march 31 and the cost of goods sold for march
under the

(i) first in , first out " FIFO "

(ii) last in , last out "LIFO "
(iii) specific identification " assuming that 150 units from
beginning and solve from mar 10 and 350 from mar 20 are
sold
(iv) average cost method

(i)First in , First out (FIFO)

Unit purchased first are sold first

6 Mr. Kareem Abozeed

--1
 Chapter 6

(in) (out) (balance)

Purchases cost of goods sold ending inventory
Date Q P C Q P C Q P C
Mar 1 200 4 800
Mar 10 500 4.5 2,250 200 4 800
500 4.5 2250
200 4 800 200 4.5 900
Mar 15 300 4.5 1350
500 2,150
Mar 20 400 4.75 1,900 200 4.5 900
400 4.75 1,900
200 4.5 900 200 4.75 950
Mar 25 200 4.75 950
400 1.850
Mar 30 300 5 1,500 200 4.75 950
300 5 1,500
Total 1,200 $5,650 900 $4,000 500 $2,450

Note that :

cost of goods available for sale = 800+5.650 = $ 6.450

(ii) Last in , first out " LIFO "

7 Mr. Kareem Abozeed

--1
 Chapter 6

Units purchased last are first to be sold

(in) (out) (balance)

Purchases C.O.G.S End . inv
Date Q P C Q P C Q P C
Mar 1 200 4 800
Mar 10 500 4.5 2,250 200 4 800
500 4.5 2250
Mar 15 500 4.5 2,250 200 4 800

Mar 20 400 4.75 1,900 200 4 800

400 4.75 1,900
Mar 25 400 4.75 1,900 200 4 800
Mar 30 300 5 1,500 200 4 800
300 5 1,500
Total 1,200 $5,650 900 $4,150 500 $2,300

(iii) Specific identification

8 Mr. Kareem Abozeed

--1
 Chapter 6

(in) (out) (balance)

Purchases C.O.G.S End . inv
Date Q P C Q P C Q P C

Mar 200 4 800

1
Mar 500 4.5 2,250 200 4 800
10 500 4.5 2250
Mar 150 4 600 50 4 200
15 350 4.5 1575 150 4.5 675
500 2,175
Mar 400 4.75 1,900 50 4 200
20 150 4.5 675
400 4.75 1,900
Mar 50 4.5 225 50 4 200
25 350 4.75 1662.5 100 4.5 450
400 1,887.5 50 4.75 237.5
Mar 300 5 1.500 50 4 200
30 100 4.5 450
50 4.75 237.5
300 5 1,500
Total 1,200 $5,650 900 $4,062.5 500 $2,300

(iv) weighted average method

9 Mr. Kareem Abozeed

--1
 Chapter 6

(in) (out) (balance)

Purchases C.O.G.S End . inv
Date Q P C Q P C Q P C
Mar 200 4 800
1
Mar 500 4.5 2,250 200 4 800
10
500 4.5 2,250
700 4.357 3050
Mar 500 4.357 2179 200 4.357 871
15
Mar 400 4.75 1,900 200 4.357 871
20
400 4.75 1,900
600 4.618 2771
Mar 400 4.618 1,847 200 4.618 924
25
Mar 300 5 1,500 200 4.618 924
30
300 5 1500
500 4.484 2,424
Total 1,200 $5,650 900 $4026 500 4.848 $2,424

Weight average cost per unit = cost of goods available for sale

No. of units available

According to pervious example we would want to compare the cost of

goods sold fewer than three methods.

Cost of good available for sale – ending inventory = C.O.G.S

10 Mr. Kareem Abozeed

--1
 Chapter 6

Under FIFO: 6,450 – 2,450 = $ 4,000

Under LIFO: 6,450 – 2,300 = $ 4,150

Under average: 6,450 – 2,424 = $ 4,026

Financial statement and tax effect

FIFO LIFO Average

Sales $ 10,000 $10,000 $10,000
(-)cost of goods sold 4,000 4,150 4,024
(=)gross profit 6,000 5,850 5,974
(-)operating expense 3,000 3,000 3,000
(=)income before tax 3,000 2,850 2,979
(-) income tax 900 855 892.2
expense (30%)
$2,100 $1,995 $2,081,8
(=)net income

Conclusion :

The lowest cost of goods sold is under FIFO method.

The highest gross profit and net income is under FIFO method.

The highest cost of goods sold is under LIFO method.

The lowest gross profit and net income is under LIFO method.

During the period of inflation the most preferable .

Method would be LIFO

In the case of deflation the FIFO method would be preferred to use

The average cost method is in between FIFO and LIFO amounts.

Inventory costing methods under periodic inventory system

11 Mr. Kareem Abozeed

--1
 Chapter 6

* solve *

According to inventory costing equation:

Costing of goods sold = cost of good available for sale – ending

inventory

In this example the cost of goods available for sale would be:

Q P C
Beg. Inventory 2oo 4 $ 2oo
Purchases :
Mar , 10 500 4.5 2,250
Mar , 20 400 4.75 1,900
Mar , 30 300 5 1,500
Cost of goods 1400 $ 6,450
available for sale

Under periodic inventory system, the cost of goods sold under each cost
flow method is a follow:

A) FIFO method
Ending inventory :

Date Units Unit cost Total cost

March , 30 300 $5.00 1,500
March , 20 200 4.75 950
500 $ 2,450

so , cost of goods sold = cost of goods available for sale – ending

inventory

C.O.G.S = 6,450 – 2,450 = $ 4,000

B) LIFO method

Ending inventory:

12 Mr. Kareem Abozeed

--1
 Chapter 6

Date Units Unit cost Total cost

March , 1 300 $4.00 $200
March , 10 200 4.50 1,350
500 $ 2,150

So , cost of goods sold = cost of goods available for sale –ending

inventory

C.O.G.S = 6,450 – 2,150 = $ 4,300

C) Average cost method

Weighted average cost per unit = Cost of goods available for sale

No. of units available

Weighted average cost per unit = $ 6,450

= 4.607
1,400

So , ending inventory = 500 x 4.607 = $ 2,303.5

Then , cost of goods sold = cost of goods available for sale – ending
inventory

C.O.G.S = 6,450 – 2,303.5 = $ 4146.5

Lower of cost or market " LCM "

When the value of inventory is lower than its cost , the inventory is
written down to its market value . This done by valuing the inventory at

13 Mr. Kareem Abozeed

--1
 Chapter 6

the " lower of cost or market " LCM " in the period in which the decline
occurs .

LCM is an example of the " conservatism "

When choosing among alternatives , the best choice is the method that is
least likely to overstate assets and net income .

Note that :

Under LCM basis " market is defined as current replacement cost not
selling price .

So, market value = current replacement cost .

Inventory is reported in the balance sheet at the lower of cost or

market value .

Lower of cost or market value " LCM " is applied in one of three ways :

A- Separately to each individual item .

B- To major categories of assets .
C- To the whole inventory .

Example : Assume that mena racer company has the following lines of
Merchandise

Category units in cost market Total Total LCM

hand cost market
Cycles :

14 Mr. Kareem Abozeed

--1
 Chapter 6

Road star 20 $8,000 $7000

Sprint 10 5,000 6,000
Category subtotal
Off road :
Trax 4 8 5,000 6,500
Blazer 5 9,000 7,000
Category subtotal
Total

Required : Compute lower cost or market value for ending inventory :

A- Separately to each individual item .

B- To major categories of assets .
C- To the whole inventory .

1- separately to each individual item .

Inventory units Unit Unit Total Total LCM

Item cost market cost market (separately)
(product)
Cycles :
Road star 20 8000 7000 160000 140000 140,000
Sprint 10 5000 6000 50000 60000 50,000
Off road:
Trax 4 8 5000 6500 40000 52000 40000
Blazer 5 9000 7000 45000 35000 35000
Total $265000

2- To major categories of assets .

Inventory units Unit Unit Total Total LCM

Item cost market cost market
(product)

15 Mr. Kareem Abozeed

--1
 Chapter 6

Cycles :
Road star 20 8000 7000 160000 140000
Sprint 10 5000 6000 50000 60000
Subtotal 210000 200000 200,000
Off road:
Trax 4 8 5000 6500 40000 52000
Blazer 5 9000 7000 45000 35000
subtotal 85000 87000 85,000
Total $285000

3- To the whole inventory .

Inventory units Unit Unit Total Total LCM

Item cost market cost market
(product)
Cycles :
Road star 20 8000 7000 160000 140000
Sprint 10 5000 6000 50000 60000
Subtotal 210000 200000
Off road:
Trax 4 8 5000 6500 40000 52000
Blazer 5 9000 7000 45000 35000
subtotal 85000 87000
Total 295000 287000 $287000

Note that : according to conservatism the first method is better

" separately to each individual item "

Conclusion :
Merchandising companies has only one inventory classification
" merchandising inventory "
Manufacturing companies classify inventories in to three categories :
A- Raw materials
B- Work in process
C- Finished goods

* conclusion *
Inventory costing methods

Unit costs can be applied to quantities on hand using the

following costing methods :
16 Mr. Kareem Abozeed
--1
 Chapter 6

1- specific identification method :

An 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 relative rare .

Most companies make assumptions " cost flow assumptions " about
which units sold .

2- First in first out (FIFO) 44 % :

Earliest goods purchased are first to be sold .
Often parallels actual physical flow of merchandise .
Generally good business practice to sell oldest units first .
Oldest costs are assigned to cost of goods sold .
Recent " new " costs are assigned to ending inventory .

3- Last in first out (LIFO) 30% :

Latest goods purchased are first to be sold .

Seldom coincides with actual physical flow of merchandise .
Exceptions include goods stored in piles , such as coal or hay .
Recent costs are charged " assigned " to cost of goods sold .
Oldest costs are assigned to ending inventory .

4- Weighted average " average cost " 21 % :

Allocates cost of goods available for sale on the basis of weighted

average unit cost incurred .
Assumes goods are similar in nature .
Applies weighted average unit cost to the units on hand to determine
cost of the ending inventory .

17 Mr. Kareem Abozeed

--1