Chapter 7

Inventory

Slide 7.1
 Chapter 7 Learning
Objectives
Define the key information needs of decision makers
regarding inventory.
Account for common inventory transactions.
Apply the four major inventory costing methods.
Apply the lower-of-cost-or-market rule to inventory.
Identify key control activities for inventory.
Compute the inventory turnover ratio and the age of
inventory.
(Appendix) Discuss key differences between the
periodic and perpetual inventory systems.
(Appendix) Estimate inventory using the gross profit
method.

Slide 7.2
 Inventory Terms
“Inventory”: goods that businesses
intend to sell to their customers or
raw materials or in-process items that
will be converted into salable goods
“Take inventory”
“Physical inventory”
“Inventory cost flow”

Slide 7.3
 Inventory Cost Flow for a
Merchandising Company

Purchases*

Cost of Goods
Sold (expense)

Beginning Cost of Goods

Inventory Available for
Sale

Ending
Inventory
*Including delivery costs incurred (asset)
to acquire merchandise

Slide 7.4
 Perpetual vs. Periodic
Inventory Systems
Perpetual
Inventory System
Sales revenue and cost of
goods sold recorded
simultaneously when a
sale is made
A “perpetually” updated
record of the quantity of
individual inventory
items and their per unit
costs is maintained
Key advantage: “information
availability”
Key disadvantage: cost . . .
but this disadvantage is
gradually fading away
Slide 7.5
Periodic Inventory
System
Sales revenues is booked when
a sale is made . . . but not
cost of goods sold
Records documenting quantity
and per unit cost of
individual inventory items
are typically not maintained
Period-ending inventory is
determined via a physical
count, then cost of goods
sold is computed
Key advantage: low cost
Key disadvantage: lack of
readily available inventory
data
Inventory Errors . . . Financial
Statement Impact

Inventory errors can significantly distort a company’s

key financial statement data.
Inventory affects: current assets, total assets, gross
profit, net income, and numerous financial ratios.
If inventory is misstated at the end of one accounting
period, the next period’s beginning inventory will be
misstated as well.
A misstatement of inventory typically
results in a much larger
percentage error in a company’s net
income.
As a result, inventory is often
the “weapon of choice” of
business executives who want
to intentionally misrepresent their
firm’s financial data.

Slide 7.6
Inventory: Information Needs of
Decision Makers

Inventory balances . . . how much?

Inventory accounting methods:
FIFO, LIFO . . .
“What if” information: What if this
company had used FIFO instead
of LIFO?

Slide 7.7
 Accounting for Common Inventory
Transactions in a Perpetual Inventory System
. . . Debit This and Credit That

Inventory purchases (Dr. Inventory, Cr. Accounts

Payable)
Purchase returns and allowances (Dr. Accounts Payable,
Cr. Inventory)
Sales of inventory (Dr. Accounts Receivable, Cr. Sales;
Dr. Cost of Goods Sold, Cr. Inventory)
Payment of delivery costs (Dr. Inventory, Cr. Cash)
Sales returns (Dr. Sales Returns and Allowances, Cr.
Accounts Receivable; Dr. Inventory, Cr. Cost of
Goods Sold)
Payment of inventory purchases--within discount
period (Dr. Accounts Payable, Cr. Cash and Cr.
Inventory)

Slide 7.8
 Inventory Costing Methods . . .
businesses can use any rational and systematic
method to assign costs to the inventory sold
during an accounting period.

Specific Identification Method

Moving-Average Method
FIFO
LIFO

Slide 7.9
Specific Identification Method

To use this method, the actual cost of

each sold and unsold unit must be
available
Electronic scanners at point-of-sale
terminals often collect data
required to apply this method
Recognize that only ending inventory
or cost of goods sold must be
determined . . .
the other item is simply the known
amount subtracted from COGAS

Exhibit 7.6:
COGAS $25,190
Ending Inventory 6,120
COGS $19,070

Slide 7.10
 Moving-Average Method

A new “moving-average” cost per unit is

computed after each inventory purchase
Exhibit 7.7, page 300: Following the
January 8 purchase, the average cost
was $34 per unit
Year-end inventory: unsold units x year-
end moving-average cost

Exhibit 7.7:
Ending Inventory 170 units
Moving-average cost per unit x $37
Ending Inventory $ Value $6,290

Slide 7.11
FIFO (first-in, first-out) Method

Under this method, a business assumes that

the oldest or earliest acquired goods are
sold first . . .
meaning that the most recently acquired
goods are assumed to be unsold (that is,
in ending inventory)
Both FIFO and LIFO are inventory cost flow
assumptions
Notice in Exhibit 7.8, page 301, that the 100
books in beginning inventory are
assumed to have been sold first (on
January 17)
On the other hand, ending inventory is
“costed out” at the most recent per unit
purchase price

Exhibit 7.8:
Ending Inventory 170 units
August 20th purchase price x $39
Ending Inventory $ Value $6,630

Slide 7.12
LIFO (last-in, first-out) Method
Under this method, a business assumes that the
newest or most recently acquired goods are
sold first . . .
meaning that the “oldest” or earliest acquired
goods are assumed to be unsold (that is, in
ending inventory)
Notice in Exhibit 7.9, page 302, that the 100
books in beginning inventory are also
assumed to be in ending inventory
More correctly, the per unit costs attached to
beginning inventory are assigned to 100 of the
units in ending inventory

Exhibit 7.9:
Ending Inventory:
100 units @ $30 per unit $3,000
40 units @ $35 per unit 1,400
30 units @ $39 per unit 1,170
Ending Inventory $ Value $5,570

Slide 7.13
 Comparison of Income Statement
Effects of Inventory Costing
Methods

Specific Moving
I.D. Average FIFO LIFO
Sales $27,000 $27,000 $27,000 $27,000
Cost of goods sold 19,070 18,900 18,560 19,620
Gross profit $ 7,930 $ 8,100 $ 8,440 $ 7,380

Slide 7.14
 FIFO vs. LIFO

Frequency of Use:
70 When balance sheet
valuation is
60 deemed the key
FIFO issue, FIFO is
50 typically preferred
LIFO
to LIFO
40
If income
30 Avg. measurement is
Cost more important,
20 LIFO is typically
Other
preferred to FIFO
10

Slide 7.15
Applying the Lower-of-Cost-
or-Market (LCM) Rule

This rule requires ending inventory to be

stated at the lower of cost or market
value.
The conservatism principle provides the
justification for the LCM rule.
“Market value” is generally current
replacement cost” for
purposes of the
LCM rule.
Two alternative approaches
to applying the LCM
rule: item-by-item
basis and total inventory basis.

Slide 7.16
Key Control Activities
for Inventory

Physical security controls

Periodic inventory counts
Inventory management
systems

Slide 7.17
Analyzing Inventory
Decision makers closely monitor the
age of a business’s inventory.
“Age” problems: spoilage,
obsolescence, significant storage
costs, etc.
Computing age of inventory:
1) Inventory turnover ratio:
Cost of Goods Sold /
Average Inventory; 2) Age of
Inventory: 360
days / Inventory turnover ratio
Similar to most financial ratios, age of
inventory should be compared
against a company’s historical
norm and the industry norm.

Slide 7.18
 Key Differences in Accounting for
Inventory Transactions: Periodic vs.
Perpetual Inventory Systems
A Cost of Goods Sold account is not
maintained in a periodic inventory system
The following accounts are maintained in a
periodic inventory system:
Purchases
Purchase Returns and Allowances
Purchase Discounts
Transportation In
In a periodic inventory system, cost of goods
sold is computed in a period-ending cost of
goods sold schedule:

Beginning Inventory $ XX
Net Purchases XXX
Transportation In X
COGAS $XXX
Less: Ending Inventory XX
COGS $XXX
Slide 7.19
 Inventory Costing Methods in
Periodic Inventory Systems . . .

The specific identification and FIFO

methods yield the same ending
inventory and cost of goods sold
amounts in both types of inventory
systems.
Under periodic LIFO, the “LIFO
concept” is applied only at year-end,
which often results in large
differences between perpetual LIFO
and periodic LIFO inventory values.
In a periodic inventory system, the
“average” costing method is the
weighted-average method.

Slide 7.20
Estimating Inventory in a Periodic
Inventory System

Businesses that use a periodic inventory system

must sometimes estimate their inventory
dollar value
One inventory estimation method is the gross
profit method
Information needed to apply the gross profit
method:
1) beginning inventory for the “interim”
period 2)
the business’s normal gross profit percentage
3)
merchandise sales and purchases for the
interim period

Slide 7.21
 4 Steps in Applying the Gross
Profit Method

Determine COGAS for the interim period

Estimate gross profit by multiplying the
business’s normal gross profit percentage
by its sales for that period
Estimate cost of goods sold by subtracting
estimated gross profit from sales
Determine estimated inventory by subtracting
cost of goods sold from COGAS

Inventory, January 1 $ 70,000

Net purchases, January 1-June 30 * 65,000
COGAS $135,000
Less: Estimated COGS
Sales, January 1-June 30 $150,000
Estimated gross profit (40%) 60,000 90,000
Estimated inventory, June 30 $ 45,000
*Includes Transportation In

Slide 7.22