Inventories and Cost of Sales

Chapter 6

Wild, Kwok, Venkatesh and Shaw

Fundamental Accounting Principles
3rd Edition

Copyright ©2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.
 Chapter 6 Learning Objectives
CONCEPTUAL
C1 Identify the items making up merchandise inventory.
C2 Identify the costs of merchandise inventory.

ANALYTICAL
A1 Analyze the effects of inventory methods for both financial and tax reporting.
A2 Analyze the effects of inventory errors on current and future financial statements.
A3 Assess inventory management using both inventory turnover and days’ sales in inventory.

PROCEDURAL
P1 Compute inventory in a perpetual system using the methods of specific identification, FIFO, and
weighted average.
P2 Compute the lower of cost and net realizable value of inventory.
P3 Appendix 6A—Compute inventory in a periodic system using the methods of specific identification,
FIFO, and weighted average.
P4 Appendix 6B—Apply both the retail inventory and gross profit methods to estimate inventory.
P5 Appendix 6C—Compute inventory in a perpetual system and a periodic system using LIFO.

© McGraw Hill 2
 Learning Objective C1

Identify the items making up

merchandise inventory.

© McGraw Hill 3
 Determining Inventory Items
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment

Learning Objective C1: Identify the items making up merchandise inventory © McGraw Hill 4
 Goods in Transit

• FOB shipping point – goods included in buyer’s

inventory when shipped.
• FOB destination – goods included in buyer’s
inventory after arrival at destination.

© McGraw Hill 5
Learning Objective C1: Identify the items making up merchandise inventory
 Goods on Consignment
• Consignor: owner of goods.
• Consignee: sells goods for the owner.
• Merchandise is included in the inventory of the
consignor.
• Consignee never reports consigned goods in
inventory.

Learning Objective C1: Identify the items making up merchandise inventory © McGraw Hill 6
 Goods Damaged or Obsolete
• Damaged or obsolete goods are not reported in
inventory if they cannot be sold.
• Damaged or obsolete goods which can be sold
are included in inventory at net realizable value.
• Net realizable value = sales price minus selling
costs.
• Loss is recorded when damage or obsolescence
occurs.

Learning Objective C1: Identify the items making up merchandise inventory © McGraw Hill 7
Learning Objective C2

Identify the costs of

merchandise inventory.

© McGraw Hill 8
 Determining Inventory Costs
• Include all expenditures necessary to bring
an item to a salable condition and location.
• Inventory cost = Invoice cost - discounts +
other costs
• Other costs include:
• Shipping
• Storage
• Insurance
• Import duties
© McGraw Hill 9
Learning Objective C2: Identify the costs of merchandise inventory
 Internal Controls and Taking a Physical Count
 Most companies take a  When the physical count
physical count of does not match the
Merchandise Inventory
inventory at least once account, an adjustment must
each year. be made.

Good internal controls over count include:

1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counters confirm existence, amount, and
condition of inventory.
4. Second count is taken by a different counter.
5. Manager confirms all items counted only once.

© McGraw Hill 10
Learning Objective C2: Identify the costs of merchandise inventory
 Inventory Costing Methods
Three methods are used to assign costs to
inventory and to cost of goods sold:

1. Specific identification
2. First-in, First-out (FIFO)
3. Weighted average

© McGraw Hill 11
Learning Objective C2: Identify the costs of merchandise inventory
 Inventory Cost Flow Assumptions
Exhibit
6.1

Learning Objective C2: Identify the costs of merchandise inventory © McGraw Hill 12
 Cost Flow of Inventory

Learning Objective C2: Identify the costs of merchandise inventory © McGraw Hill 13
 Learning Objective P1

Compute inventory in a
perpetual system using the
methods of specific
identification, FIFO, and
Weighted Average.

© McGraw Hill 14
 Inventory Costing under
a Perpetual System

Balance Income
Inventory Statement:
Sheet:
affects Cost of
Ending Goods Sold
Inventory
Physical flow does not
need to follow cost
flow.

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and weighted © McGraw Hill 15
average
 Inventory Costing Illustration:
Perpetual System Exhibit
6.2

Here is information about the mountain bike inventory of Trekking

for the month of August.

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and weighted © McGraw Hill 16
average
 Specific Identification:
Exhibit
Perpetual 6.3

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and weighted © McGraw Hill 17
average
 First-In, First-Out (FIFO):
Definition Perpetual
Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and © McGraw Hill 18
weighted average
 First-In, First-Out (FIFO):
Exhibit
Perpetual 6.4

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and © McGraw Hill 19
weighted average
 Weighted Average:
Perpetual
When a unit is sold, the average
cost of each unit in inventory is
assigned to cost of goods sold.
Cost of Goods Units on hand
Available for ÷ on the date of
Sale sale

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and weighted © McGraw Hill 20
average
 Weighted Average: Perpetual
Exhibit
6.5

Learning Objective P1: Compute inventory in a perpetual system using specific identification, FIFO, and weighted © McGraw Hill 21
average
 Learning Objective A1

Analyze the effects of

inventory methods for both
financial and tax reporting.

© McGraw Hill 22
 Financial Statement Effects of
Inventory Costing Methods: Exhibit
Perpetual Method 6.6

Because
Because prices
prices change,
change, inventory
inventory methods
methods nearly
nearly always
always assign
assign
different
different cost
cost amounts.
amounts.

© McGraw Hill 23
Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting
 Learning Objective P2

Compute the lower of cost and

net realizable value of
inventory.

© McGraw Hill 24
 Lower of cost and net realizable value
Inventory must be reported at net realizable value
when the net realizable value is lower than cost.

© McGraw Hill 25
Learning Objective P2: Compute the lower of cost and net realizable value of inventory
Lower of cost and net realizable value (continued)
A motor sports retailer has the following items in inventory:

Exhibit
6.7

Journal entry to write down inventory follows:

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Learning Objective P2: Compute the lower of cost and net realizable value of inventory
 Learning Objective A2

Analyze the effects of

inventory errors on current
and future financial
statements.

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 Income Statement Effects of
Exhibits
Inventory Errors 6.8 and
6.9

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Learning Objective A2: Analyze the effects of inventory errors on current and future financial statements
 Financial Statement Effects of
Inventory Errors
Balance Sheet Effects Exhibit
6.10

© McGraw Hill 29
Learning Objective A2: Analyze the effects of inventory errors on current and future financial statements
 Learning Objective A3

Assess inventory management

using both inventory turnover
and days’ sales in inventory.

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 Inventory Turnover
Shows how many times a company turns over its inventory
in a period. Indicator of how well management is
controlling the amount of inventory available.

Inventory Cost of goods sold Exhibit

turnover = Average inventory

6.11

Average
= (Beg. Inv. + End Inv.) ÷ 2
Inventory
Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales in inventory © McGraw Hill 31
 Days’ Sales in Inventory
Reveals how much inventory is available in
terms of the number of days’ sales.

Days‘ sales in Ending inventory Exhibit

inventory = × 365 6.12

Cost of goods sold

Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales © McGraw Hill 32
in inventory
 Analysis of Inventory Management
adidas’s inventory turnover and days’ sales in
inventory are shown below:

Exhibit
6.13

Learning Objective A3: Assess inventory management using both inventory turnover and days’ sales in © McGraw Hill 33
inventory
 Learning Objective P3
Appendix 6A:
Compute inventory in a
periodic system using the
methods of specific
identification, FIFO, and
weighted average.
© McGraw Hill 34
 Inventory Costing under
a Periodic System

Balance Income
Inventory Statement:
Sheet:
affects Cost of
Ending Goods Sold
Inventory
Physical flow does not
need to follow cost flow.

Learning Objective P3: Compute inventory in a perpetual system using specific identification, FIFO, LIFO and © McGraw Hill 35
weighted average
 Inventory Costing Illustration
Periodic System Exhibit
6A.1

Learning Objective P3: Compute inventory in a periodic system using specific identification, FIFO, LIFO and © McGraw Hill 36
weighted average
Inventory Costing Illustration Periodic System
Specification Identification
Exhibit
6A.2

Learning Objective P3: Compute inventory in a periodic system using specific identification, FIFO, LIFO and © McGraw Hill 37
weighted average
 Inventory Costing Illustration
Periodic System - FIFO

Learning Objective P3: Compute inventory in a periodic system using specific identification, FIFO, LIFO and © McGraw Hill 38
weighted average
 Inventory Costing Illustration
Periodic System – Weighted Exhibits
Average: Cost per Unit 6A.4 &
6A.5

Learning Objective P3: Compute inventory in a periodic system using specific identification, FIFO, LIFO and © McGraw Hill 39
weighted average
 Periodic Inventory System Financial
Statement Effects of Costing Methods
Because prices change, inventory methods nearly always
assign different cost amounts.

© McGraw Hill 40
Learning Objective A1: Analyze the effects of inventory methods for both financial and tax reporting
 Learning Objective P4
Appendix 6B:
Apply both the retail
inventory and gross profit
methods to estimate inventory.

© McGraw Hill 41
 Inventory Estimation Methods
Inventory sometimes requires estimation for interim statements
or if some casualty such as fire or flood makes taking a
physical count impossible.
Retail Inventory Method Gross Profit Method

Exhibits
6B.1 &
6B3 © McGraw Hill 42
Learning Objective P4: Apply both the retail inventory and gross profit methods to estimate inventory
 Learning Objective P4

Appendix 6C:
Compute inventory in a
perpetual system and a
periodic system using LIFO.

© McGraw Hill 43
 LIFO Inventory Systems Exhibit
6C.1

Learning Objective P5: Compute inventory in a perpetual system and a periodic system using LIFO © McGraw Hill 44
 Inventory Costing Illustration
Perpetual System - LIFO
Exhibit
6C.2

Learning Objective P5: Compute inventory in a perpetual system and a periodic system using LIFO © McGraw Hill 45
 Inventory Costing Illustration
Perpetual System – LIFO (continued)
Exhibit
6C.3

Learning Objective P5: Compute inventory in a perpetual system and a periodic system using LIFO © McGraw Hill 46
 Inventory Costing Illustration
Periodic System - LIFO

Exhibit
6C.4

Learning Objective P5: Compute inventory in a perpetual system and a periodic system using LIFO © McGraw Hill 47
End of Chapter 6

© McGraw Hill 48