CHAPTER 7

INVENTORY

Remember our Inventory Journal Entries:

To purchase inventory:
Dr. Inventory
Cr. Cash or Accounts payable

To sell inventory:
Dr. Cash or Accounts receivable
Cr. Sales
Dr. Cost of goods sold
Cr. Inventory

Where is inventory in the balance sheet?

1|Page
1. Discuss the importance of inventory to a company’s overall success.

For retailers and manufacturers, inventory is a significant current asset and the largest asset to
be converted into cash within the next year. They must understand it and manage it efficiently
and effectively.

Sample Co
Inventory Listing
At December 31, 2024

Inventory
Description Item no. Selling price Cost Quantity Total Cost
($) ($) on Hand ($)

Lawn Mower LM31 4HP 31L 159.00 87.44 16 1,399

Lawn Mower LM44 6HP 44L 249.00 136.96 26 3,561
Lawn Mower LM55 8HP 55L 399.00 219.43 14 3,072
Lawn Mower LM62 9HP 62L 469.00 257.93 15 3,869
Lawn Mower LM73 11HP 73L 649.00 356.92 12 4,283
Weed Eater WE78 78P 189.00 103.95 22 2,287
Rake - Lawn RA81 81R 18.00 9.91 35 347
Rake - Hybrid RA85 85R 28.00 15.39 41 631
Rake - Garden RA88 88R 33.00 18.16 50 908

Total inventory 20,357

2|Page
3. Explain the differences between perpetual inventory systems and periodic inventory
systems.

Key consideration by management in determining which system to use include:

 Importance of complete, timely inventory information for managing the business
 Importance of the ability to identify inventory shrinkage
 Costs of purchasing and maintaining the inventory system (cost / benefit)

3|Page
5. Explain the value at which inventory is carried on the statement of financial position
and determine the impact of inventory valuation errors.

The inventory must be reported on the statement of financial position at the lower of cost or net
realizable value (NRV). If the cost is higher than the NRV, then the company must write down
the inventory to its realizable value and reflect this amount on the statement of financial position.

Example:
Cranky's bike shop sells two types of bikes: Road and Mountain. The cost of each type is listed
below. Review the table that applies the lower of cost or market method to the bikes on an
individual basis, category basis and total basis.

Lower of Cost or NRV Applied to:

Description Category Cost NRV Individual Groups
CCM Mountain 10,000 8,000
Mikado Mountain 8,000 5,500
Oryx Mountain 2,000 3,100
Total Mountain Bikes 20,000 16,600
Giant Road 7,000 3,000
Norco Road 6,000 4,000
Total Road Bikes 13,000 7,000
Electra Hybrid 2,800 2,300
Acquila Hybrid 2,600 800
Total Hybrid Bikes 5,400 3,100
Total 38,400 26,700

Amount of Adjustment required:

The adjusting entry, if LCNRV was applied using individual products:

Date Account Title Debit Credit

Dec 31 Cost of goods sold
Inventory

The adjusting entry, if LCNRV was applied using groups.

Date Account Title Debit Credit

Dec 31 Cost of goods sold
Inventory

4|Page
Excel:

-Do it 7-1
-Do it 7-2
-Do it 7-3

5|Page
6. Explain how a company’s gross profit (margin) is determined and why it is an
important measure.

Remember the multi-step income statement and all of the information it provides to users:

Warren Photo Studio

Income Statement - Multi-step
For the year ended December 31, 2022
Sales Revenue $ 86,342
Cost of goods sold (27,800)
Gross profit $ 58,542
Operating expenses:
Depreciation Expense, Building 4,000
Depreciation Expense, Equipment 3,000
Insurance Expense 2,850
Supplies Expense 1,800
Telephone Expense 842
Utilities Expense 3,640
Wages Expense 34,000
Total Operating Expenses 50,132
Operating income 8,410
Other revenues and expenses:
Interest Expense (2,400)
Interest Revenue 240
Profit before taxes 6,250
Income Tax Expense (3,000)
Net Income 3,250

How is Gross Profit (Margin) computed?

What are other costs of a company that are not included in the Gross Profit (Margin)?

What are some factors that can affect the gross profit (margin) positively?

6|Page
What are some factors that can affect the gross profit (margin) negatively?

If you are the manager of a company and you notice a decrease in the Gross Profit (Margin),
what should be done?

Excel:
-Do it 7-4
-Do it 7-5

7|Page
7. Describe management’s responsibility for internal control measures related to
inventory.

Management’s main objective with internal controls for inventory is to ensure that the inventory
is not lost or stolen, that it is in the right place at the right time, that it does not spoil or get
damaged prior to sale, and that it does not become obsolete.

Some common internal control procedures for managing inventory include:

 The use of electronic tags that set off an alarm when the goods leave the premises
(physical controls)
 Division of responsibility related to inventory ordering, checking inventory when it is
received, entering inventory into the data management system (separation of duties)
 Protecting inventory (physical controls)
 Regular inventory counts (independent verification)

If inventory is stolen or there is a difference between the inventory count and accounting records
an adjustment is required called shrinkage:
DR COGS (actual per count-accounting records)
CR Merchandise Inventory

8. Calculate the inventory turnover ratio and the days to sell inventory ratio and explain
how they can be interpreted by users.

The inventory turnover ratio the user how fast inventory is sold or how long it is held before it
is sold. It is calculated as:

The days to sell inventory ratio. This ratio tells us how many days, on average, that it took the
company to sell through its inventory. It is calculated as follows:

Excel:
-Do it 7-6

8|Page
 ADDITIONAL HOMEWORK PROBLEMS BY OBJECTIVE

Chapter 7: Inventory
End of Chapter Questions
Competency
Learning Objectives: Level DQ UP WIP AP RI Cases
1. Discuss the importance of inventory to a A DQ7-1 UP7-2
company's overall success.
2. Distinguish between the different inventory D - Optional
classifications and determine which goods
should be included in a company's inventory.
3. Explain the differences between perpetual C DQ7-2, WIP7-2 C7-5
inventory systems and periodic inventory DQ7-12
systems.
4. Explain why cost formulas are necessary and D- Optional
calculate the cost of goods sold and ending
inventory under the specific identification,
weighted-average, and first-in, first-out cost
formulas under a perpetual inventory system.

5. Explain the value at which inventory is carried B - LCNRV DQ7-17, AP7-10A, RI7-2 C7-3, C7-5
on the statement of financial position and D - Inventory Errors, DQ7-18, AP7-11A,
determine the impact of inventory valuation omit DQ7-19, AP7-10B,
errors. DQ7-20 AP7-11B

6. Explain how a company's gross margin is A DQ7-21, UP7-4, AP7-15A,

determined and why it is an important measure. DQ7-22 UP 7-5 AP7-16A,
AP7-15B,
AP7-16B

7. Describe management's responsibility for B DQ 7-23 UP7-1 C7-5

internal control measures related to inventory.
8. Calculate the inventory turnover ratio and the A DQ7-24, UP7-6, WIP7-5 RI7-2, C7-2
days to sell inventory ratio and explain how they D - OMIT Inventory DQ7-25 UP7-7, RI7-4
can be interpreted by users. estimation UP7-8,
9. Appendix: Calculate the cost of goods sold D - OMIT
and ending inventory under the specific
identification, weighted-average, and first-in, first-
out cost formulas under a periodic inventory
system.

9|Page