Financial Accounting

Weygandt, Kieso, & Kimmel

Prepared by
Kurt M. Hull, MBA CPA
California State University, Los Angeles

John Wiley & Sons, Inc.

 CLASSIFYING INVENTORY
For manufacturers, inventory has three distinct categories.

INVENTORY

RAW WORK
FINISHED
MATERIALS IN
GOODS
PROCESS
 STUDY OBJECTIVE 1

DETERMINING INVENTORY QUANTITIES

At the balance sheet date, companies must determine

how many units are on hand, and value those units.
Two steps are required to achieve this:

1. Take a physical inventory count

2. Determine ownership of goods

 DETERMINING OWNERSHIP OF
GOODS IN TRANSIT
FOB Shipping Point FOB Destination Point

Seller Seller

Public Ownership passes to the buyer here Public

Carrier Carrier
Co. Co.
Ownership passes to the buyer here

Buyer Buyer
 DETERMINING OWNERSHIP OF
CONSIGNED GOODS

A consignment agreement transfers goods from a

consignor to a consignee, who agrees to sell the goods.

Sa
le
Consignor Consignee

Consignee remits proceeds (less fee) to consignor when

inventory is sold. Inventory on consignment is included
in the consignor’s inventory until sold. Customer
 SPECIFIC IDENTIFICATION

Tracks actual flow of goods. Each item marked with its unit cost.

Inventory
Purchases

Item 1 SOLD
$700

Item #2
Cost of Goods Sold
$750 $1,500
1

Item #3
SOLD
$800
ASSUMED COST FLOW METHODS

These methods assume cost flows that may be

unrelated to the actual physical flow of goods.

FIFO LIFO AVERAGE

COST

These cost flow assumptions do not have to be

consistent with the actual flow of goods.
 FIFO
FIRST-IN, FIRST-OUT

FIFO ASSUMPTIONS

1. Earliest goods purchased are the first to be sold.

2. Cost of earliest goods purchased are the first to
be recognized as cost of goods sold.
3. Ending inventory consists of items purchased late
in the year.
 ALLOCATION OF COSTS
FIFO METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 12,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
Unit Total
Date Units Cost Cost
11/27 400 $ 13 $ 5,200 Cost of goods available for sale $ 12,000
08/24 50 12 600 Less: Ending inventory 5,800
450 $5,800 Cost of goods sold $6,200
 REVIEW QUESTION

FIFO METHOD

In a period of rising prices, will FIFO will produce

a higher or lower net income than LIFO? Why?

Answer:
FIFO will produce a higher net income
when prices are rising because cost of goods
sold is made up of items purchased early
in the year at lower prices.
 LIFO
LAST-IN, FIRST-OUT

LIFO ASSUMPTIONS

1. Latest goods purchased are the first to be sold.

2. Cost of latest goods purchased are the first to be
recognized as cost of goods sold.
3. Ending inventory consists of items purchased
early in the year.
 ALLOCATION OF COSTS
LIFO METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 $12,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
Unit Total
Date Units Cost Cost
01/01 100 $ 10 $ 1,000
04/15 200 11 2,200 Cost of goods available for sale $ 12,000
08/24 150 12 1,800 Less: Ending inventory 5,000
450 $5,000 Cost of goods sold $7,000
 REVIEW QUESTION

LIFO METHOD

In a period of rising prices, will LIFO will produce

a higher or lower ending inventory than FIFO? Why?

Answer:
LIFO will produce a lower ending inventory
than FIFO when prices are rising because
ending inventory is made up of items
purchased early in the year at lower prices.
 AVERAGE COST

AVERAGE COST ASSUMPTIONS

1. Goods available for sale are homogeneous.

2. Cost of goods available for sale is allocated on the
basis of the weighted average unit cost incurred.
3. The weighted average unit cost is applied to the
units on hand to determine the cost of ending
inventory.
 ALLOCATION OF COSTS
AVERAGE COST
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total$ 12,000 1,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
$ 12,000 ÷ 1,000 = $12.00
Unit Total Cost of goods available for sale $ 12,000
Units Cost Cost Less: Ending inventory 5,400
450 x $ 12.00 $ =5,400 $ 6,600
Cost of goods sold
 USE COST FLOW METHODS
CONSISTENTLY

• A company needs to use its chosen cost flow method

consistently from one period to another.
• Consistent application makes more comparable financial
statements.
• Changes in cost flow method should be disclosed in the
financial statements.
 STUDY OBJECTIVE 4

LOWER OF COST OR MARKET

IF Market Value Cost

The inventory is written down to its market value.

When using LCM:

Market value = Replacement cost
 VALUING INVENTORY AT

LOWER OF COST OR MARKET

Illustration 6-18
Lower of
Cost or
Cost Market Market
Television sets
Consoles $ 60,000 $ 55,000 $ 55,000
Portables 45,000 52,000 45,000
Total 105,000 107,000
Video equipment
Recorders 48,000 45,000 45,000
Movies 15,000 14,000 14,000
Total 63,000 59,000
Total inventory $ 168,000 $ 166,000 $ 159,000
 STUDY OBJECTIVE 5

INVENTORY ERRORS

Ending inventory
Period 1 = Beginning inventory
Period 2

Inventory errors thus affect both COGS and NET INCOME.

 FORMULA FOR
COST OF GOODS SOLD

Cost of Cost of
Beginning _ Ending
Inventory
+ Goods
Inventory = Goods
Purchased Sold

To find the effect of an inventory error using this formula:

1. Input INCORRECT DATA
2. Input CORRECT DATA
3. Compare results.
 INCOME STATEMENT EFFECTS
OF INVENTORY ERRORS

INVENTORY ERROR COGS NET INCOME

Beginning inventory understated Understated Overstated
Beginning inventory understated Overstated Understated
Ending inventory understated Overstated Understated
Ending inventory overstated Understated Overstated

An error in ending inventory in the current period will

have the reverse effect on net income in the next period.
 INCOME STATEMENT EFFECTS
OF INVENTORY ERRORS

The effect of ending-inventory errors on the balance sheet

can be determined by using the accounting equation:

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

Ending Inventory Error Assets Liabilities Stockholders’ Equity

Overstated Overstated None Overstated
Understated Understated None Understated
 INVENTORY DISCLOSURES
Inventory is classified as a current asset in the balance sheet.
COGS is subtracted from sales in the income statement.

Notes to financial statements should include:

•Major inventory classes (if not on balance sheet)
•Basis of accounting (Cost or LCM)
•Costing Method (FIFO, LIFO, AVERAGE COST)
 STUDY OBJECTIVE 6

INVENTORY TURNOVER

Measures the number of times on average

the inventory is sold during a period.

COGS
INVENTORY
= TURNOVER
AVERAGE INVENTORY

$198,747
= 7.79 times
($24,401 +26,612) / 2

Average days to sell = 365 / 7.79 = 47 days

 APPENDIX 6A

COST FLOWS—PERPETUAL INVENTORY

The product data shown below for Bow Valley Electronics

will be used to explain perpetual inventory costing using
three assumed cost flow methods:

FIFO LIFO AVERAGE COST

Bow Valley Electronics

Z202 Astro Condensers
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total $ 12,000
 APPENDIX 6A

PERPETUAL INVENTORY – FIFO

Under FIFO, the cost of the earliest goods on hand prior to each sale
is charged to cost of goods sold. Therefore, the cost of goods sold on
September 10 consists of the units on hand January 1 and the units
purchased April 15 and August 24.

Date Purchases Sales Balance

January 1 (100 @ $10) $1,000
April 15 (200 @ $11) $2,200 (100 @ $10)
(200 @ $11) $3,200
August 24 (300 @ $12) $3,600 (100 @ $10)
(200 @ $11)
(300 @ $12) $6,800
September 10 (100 @ $10)
(200 @ $11) $6,200 (50 @ $12) $600
(250 @ $12)

November 27 (400 @ $13) $5,200 (50 @ $12)

(400 @ $13) $5,800
 APPENDIX 6A

PERPETUAL INVENTORY – LIFO

Under the LIFO method using a perpetual system, the cost of the most recent
purchase prior to sale is allocated to the units sold. The cost of the goods sold
on September 10 consists entirely of goods from the August 24 and April 15
purchases and 50 of the units in beginning inventory.

Date Purchases Sales Balance

January 1 (100 @ $10) $1,000
April 15 (200 @ $11) $2,200 (100 @ $10)
(200 @ $11) $3,200
August 24 (300 @ $12) $3,600 (100 @ $10)
(200 @ $11)
(300 @ $12) $6,800
September 10 (300 @ $20)
(200 @ $11) $6,300 (50 @ $10) $500
(50 @ $10)

November 27 (400 @ $13) $5,200 (50 @ $10)

(400 @ $13) $5,700
 APPENDIX 6A

PERPETUAL INVENTORY – AVG COST

• The average cost method in a perpetual inventory system is
called the moving average method.
• Under this method a new average is computed after each
purchase.
• The average cost is computed by dividing the cost of goods
available for sale by the units on hand.
• The average cost is then applied to:

Average Cost x Units Sold = COGS

Average Cost x Remaining Units = ENDING INVENTORY

 APPENDIX 6A

PERPETUAL INVENTORY – AVG COST

A new average is computed each time a purchase is made.
On April 15, after 200 units are purchased for $2,200,
a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand.
The average cost is $10.667 ($3,200/300).

Date Purchases Sales Balance

January 1 (100 @ $10)
$1,000
April 15 (200 @ $11) $2,200 (300 @ 10.667)
$3,200
August 24 (300 @ $12) $3,600 (600 @ 11.333)
$6,800
September 10 (550 @ 11.333)
$6,233 (50 @ $11.333)
$567
November 27 (400 @ $13) $5,200 (450 @ 12.816)
$5,767
 APPENDIX 6B
INVENTORY ESTIMATION – GROSS PROFIT METHOD

• The gross profit method estimates the cost of ending

inventory by applying a gross profit rate to net
sales.
• It is used in preparing monthly financial statements
under a periodic system.
• It should NOT be used in preparing the
company’s financial statements at year-end.
• The gross profit rate is assumed to remain
constant from one year to the next.
 APPENDIX 6B
GROSS PROFIT METHOD FORMULAS

Estimated Estimated
Net Sales Gross Cost of
Profit Goods Sold

Cost of Estimated Estimated

Goods Cost of Cost of
Available for Goods Sold Ending
Sale Inventory