ACC60104

Introduction to Accounting
Lecture :
Merchandise Inventory

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 Learning Outcomes…
• Explain the different inventory costing methods- specific-unit cost,
average-cost, FIFO and LIFO

• Identify the profit effects of the inventory costing methods

• Appreciate why LIFO is disallowed in practice

• Understand the conservatism principle and lower-of cost-or-market

rule to inventory

• Understand the impact of inventory errors

• Use the gross profit method to estimate ending inventory

Inventory Costing Methods

Specific First-In,
Unit Cost First-Out

Last-In, Average
First-Out Cost
 Specific Unit Cost

• Each inventory item is identified by its specific cost

• Used by business that sell unique, easily identified items

o Examples: Cars, fine jewelry, real estate
 Specific Unit Cost

Acquired on Jan Acquired on Feb Acquired on March

Cost: $6,000 Cost: $5,000 Cost: $7,000

Cost of goods sold= $5,000

Ending inventory = $13,000
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 First-In, First-Out (FIFO)

Assumes oldest items are sold first

Oldest
Oldest Cost
Cost of
of Goods
Goods
Costs
Costs Sold
Sold

Therefore, newest items are on hand

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory
 Last-In, First-Out (LIFO)

Assumes newest items are sold first

Recent
Recent Cost
Cost of
of Goods
Goods
Costs
Costs Sold
Sold

Therefore, oldest items are on hand

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory
 Average Cost

The average cost of each unit in inventory is assigned to

cost of goods sold

Cost of Inventory Number of Units

on Hand ÷ on Hand = Average Cost
 First-In, First-Out (FIFO)

Beginning Inventory

2
$1

Purchase 5 shirts
 First-In, First-Out (FIFO)

Beginning Inventory
We sell 4 shirts for $20 each.
What costs should be assigned to
0 cost of goods sold?
0 $1
0 $1
$1 Consider: First-In, First-Out

2
$1

Purchase 5 shirts

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 First-In, First-Out (FIFO)

Beginning Inventory
We sell 4 shirts for $20 each.
What costs should be assigned to
cost of goods sold?
Consider: First-In, First-Out

2 0
$1 0 $1
0 $1
$1

Purchase 5 shirts

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 First-In, First-Out (FIFO)

We sell 4 shirts for $20 each.

What costs should be assigned to
cost of goods sold?
Consider: First-In, First-Out

0
0 $1
0 $1
2 $1
$1
Inventory = $48
Cost of good sold = $42

Now let’s look at our grapes examples

 Last-In, First-Out (LIFO)
We sell 4 shirts for $20 each.
Beginning Inventory
What costs should be assigned to
cost of goods sold?
0
0 $1 Consider: Last-In, First-Out
0 $1
$1

2
$1

Purchase 5 shirts
Inventory = $42 Cost of good sold = $48

Now let’s look at our grapes examples

 Average Cost
Beginning Inventory We sell 4 shirts for $20 each.
What costs should be assigned to
0 cost of goods sold?
0 $1
0 $1
$1 Compute the Average Cost
Units Cost
Beginning inventory 3 $30
Purchases 5 60
2 Total 8 $90
$1
2 $12
2 $1 Average = $90/8 = $11.25
2 $1
$1
Purchase 5 shirts
Cost of good sold = $11.25 x 4 = $45
Inventory = $11.25 x 4 = $45

Now let’s look at our grapes examples

 Learning Objective 3…

Compare the effects of the three most common

costing methods
 Comparison

FIFO LIFO Average

Sales $80 $80 $80
Cost of goods $42 $48 $45
sold
Gross profit $38 $32 $35
If inventory Highest Lowest
prices are gross gross
increasing profit; profit;
highest lowest
net net
income income
 Advantage of Each Method

First-In, Last-In, First- Average

First-Out Out Cost

High income Lower income “Middle ground”

attracts investors = Less taxes
 The Income Tax Advantage of LIFO

• During periods of inflation, LIFO’s income is the lowest.

• The most attractive feature of LIFO is reduced income

tax payments.

• That is probably why it cannot be used in many

countries!
 Learning Objective 4…

Measuring the effects of inventory errors

 Cost Vs NRV
Inventory is recorded and reported at cost following
historical cost principle via a certain cost flow
assumption either SU, FIFO, LIFO, AVCO. Another
way of measuring inventory value is based on net
realizable value (NRV).

Under normal circumstances, cost of inventory is

always lesser than the net amount business can earn
by selling the inventory, called net realizable value
(NRV). Common sense dictates that cost has to be
lesser than NRV to make profit.

NRV 1000
- COST 600
= Profit 400
 Cost Vs NRV
However, if NRV of inventory falls below the cost of
inventory, the business entity must write down the value of
inventory to the amount that can be realized. Hence the
recognition of loss to the extent expenditure on inventory
are not expected to be recovered. 

It doesn’t make sense to report an asset at any value

higher than the amount it can recover and may overstate
the assets materially. Therefore, the business entity must
switch to NRV basis from historical cost basis of
measurement if recoverable amount falls below cost of
asset.
NRV 500
- COST 600
= Profit? (100)
 Reasons for lower NRV

NRV may fall below cost; either cost has increased or sales
price has dropped. Some of the examples include:

1. Goods are now obsolete. With newer products in the market

offered at competitive rates, entity is unable to make sales at
profitable rate.
2. Goods are damaged. Though price is good, but the cost to
repair the goods causes NRV to be lesser than the cost itself.
3. Seasonal effects can alter prices significantly, though can
be temporary.
 Reasons for lower NRV - continued
4. Wrong sales strategy of entity may cause oversaturation of
goods in the market. This can cause prices to plummet
below original cost.
5. If entity is minting profits, sooner or later competitors in the
market will jump in as well offering similar products and it
may be the case that they start offering products with same
utility at lower prices.
6. It might be possible that entity can produce units at lower
cost but has to spend a lot of carriage cost to move
inventory to market before it can be sold.

Let’s have a look at a simple example

 Inventory Errors: Ending Inventory Overstated

Ending inventory
overstated

Cost of goods sold

understated

Gross profit and net income overstated

Next period beginning inventory overstated

Inventory Errors: Ending Inventory Understated

Ending inventory
understated

Cost of goods sold

overstated

Gross profit and net income understated

Next period beginning inventory understated

 Tutorial Questions
 
Perpetual System
 
Short Exercises Questions: S6-3, S6-4, S6-5, S6-6, S6-7
 
Exercises: E6-16, E6-17, E6-18, E6-19, E6-20, E6A-28
 
Problems: P6-33B, P6-34B
 
Periodic System
 
Exercises: E6A-26
 
Problems: P6A-37B

See you next lecture

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