PRINCIPLES OF

ACCOUNTING

Hanoi School of Business & Management

Nguyen Thi Hang Nga
6 Accounting for Merchandising Company

Learning Objectives

After studying this chapter, you should be able to:

[1] Define the components of merchandise inventory.
[2] Compute inventory in a perpetual system using methods of FIFO, LIFO and weighted-
average.
[3] Compute inventory in a periodic system using methods of FIFO, LIFO and weighted-
average.
[4] Analyze the effects of different accounting methods for inventories and inventories error
on financial statements.
 C1

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
 C1

Goods in Transit
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

 C1

Goods on Consignment
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Thanks for selling my
inventory in your
store.
Consignee

Consignor
 C1

Goods Damaged or Obsolete

Damaged or obsolete goods are not counted in
inventory if they cannot be sold.

Cost should be reduced to net realizable

value if they can be sold.
 C2

Determining Inventory Costs

Include all expenditures necessary to bring an item to
a salable condition and location.

Minus
Discounts Invoice Plus
Insurance
and
Allowances
Cost

Plus Import Plus

Duties Plus Storage
Freight
C2
Internal Controls and Taking a
Physical Count
Most companies take a  When the physical count
physical count of inventory does not match the
at least once each year. Merchandise Inventory
account, an adjustment
must be made.

Good internal controls over count include:

1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counts confirm existence, amount, and
quality of inventory item.
4. Second count is taken.
5. Manager confirms all items counted.
C2
Inventory Costing under
a Perpetual System
Inventory
affects . . .
Balance Income
Sheet Statement

The matching
principle requires
matching costs with
sales.
 C2

Inventory Cost Flow Assumptions

Management decisions in accounting for inventory involve
the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
 P1

Inventory Cost Flow Assumptions

First-In, First-Out Assumes costs flow in the order
(FIFO) incurred.

Last-In, First-Out Assumes costs flow in the reverse

(LIFO) order incurred.

Weighted Assumes costs flow at an average

Average of the costs available.
 P1

Inventory Costing Illustration

Here is information about the mountain bike inventory of Trekking
for the month of August.
 P1

Specific Identification
 Specific Identification
P1

Income
Income Statement
Statement
Cost
Cost of
of Goods
Goods Sold
Sold Balance
Balance Sheet
Sheet Inventory
Inventory
 P1

Specific Identification
Here are the entries to record the purchases and sales. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 P1

First-In, First-Out (FIFO)

Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory
 P1

First-In, First-Out (FIFO)

 P1

First-In, First-Out (FIFO)

 P1

First-In, First-Out (FIFO)

Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 P1

Last-In, First-Out (LIFO)

Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory
 P1

Last-In, First-Out (LIFO)

 P1

Last-In, First-Out (LIFO)

 P1

Last-In, First-Out (LIFO)

Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 P1

Weighted Average
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
 P1

Weighted Average
 P1

Weighted Average
 P1

Weighted Average
 P1

Weighted Average
Here are the entries to record the purchases and sales entries for Trekking.
The numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
Financial Statement Effects
A1

of Costing Methods
Because prices change, inventory methods nearly always
assign different cost amounts.
Financial Statement Effects
A1

of Costing Methods
Advantages of Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current of goods sold with
replacement cost. revenues.
 A1

Tax Effects of Costing Methods

The Internal Revenue Service (IRS) identifies several
acceptable inventory costing methods for reporting
taxable income.

If LIFO is used for tax

purposes, the IRS requires
it be used in financial
statements.
 A1

Consistency in Using Costing Methods

The consistency principle requires a

company to use the same accounting
methods period after period so that financial
statements are comparable across periods.
 P2

Lower of Cost or Market

Inventory must be reported at market value when
market is lower than cost.

Defined as current Can be applied three ways:

(1) separately to each
replacement cost
individual item.
(not sales price).
(2) to major categories of
Consistent with assets.
the conservatism (3) to the whole inventory.
principle.
 P2

Lower of Cost or Market

A motor sports retailer has the following items in
inventory:
Per
Per Unit
Unit
Units
Units on
on Total
Total
Inventory
Inventory Items
Items Hand
Hand Cost
Cost Market Total
Market Total Cost
Cost Market
Market
Cycles:
Cycles:
Roadster
Roadster 20
20 $$ 8,000
8,000 $$ 7,000
7,000 $$ 160,000
160,000 $$ 140,000
140,000
Sprint
Sprint 10
10 5,000
5,000 6,000
6,000 50,000
50,000 60,000
60,000
Off-Road
Off-Road
Trax-4
Trax-4 88 5,000
5,000 6,500
6,500 40,000
40,000 52,000
52,000
Blazer
Blazer 55 9,000
9,000 7,000
7,000 45,000
45,000 35,000
35,000
Totals
Totals $$ 295,000
295,000
 P2

Lower of Cost or Market

Here is how to compute lower of cost or market
for individual inventory items.

LCM
LCM Applied
Applied
to
to
Units
Unitson
on Total
Total
Inventory
Inventory Items
Items Hand
Hand Total
Total Cost
Cost Market
Market Items
Items
Cycles:
Cycles:
Roadster
Roadster 20
20 $$ 160,000
160,000 $$ 140,000
140,000 $$ 140,000
140,000
Sprint
Sprint 10
10 50,000
50,000 60,000
60,000 50,000
50,000
Off-Road
Off-Road
Trax-4
Trax-4 88 $$ 40,000
40,000 $$ 52,000
52,000 40,000
40,000
Blazer
Blazer 55 45,000
45,000 35,000
35,000 35,000
35,000
Totals
Totals $$ 295,000
295,000 $$ 265,000
265,000
A2 Financial Statement Effects of
Inventory Errors
Income Statement Effects
Inventory Error Cost of Goods Sold Net Income
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated
 A2 Financial Statement Effects of
Inventory Errors
Balance Sheet Effects
Inventory Error Assets Equity
Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated
 A3

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

Inventory Cost of goods sold

Turnover = Avg. inventory

Average
Inventory = (Beg. Inv. + End Inv.) ÷ 2
 A3

Days’ Sales in Inventory

Reveals how much inventory is available in
terms of the number of days’ sales.

Days' Sales in Ending Inventory

Inventory = Cost of goods sold
× 365
Global View
Items and Costs Making Up Inventory
Both U.S. GAAP and IFRS include in inventory all items that a company owns
and holds for sale and include in the cost expenditures necessary to bring
those items to a salable condition and location.

Assigning Costs to Inventory

Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO,
and Weighted Average. IFRS does not currently allow use of LIFO.

Estimating Inventory Costs

Both U.S. GAAP and IFRS require companies to write down inventory when its
value falls below recorded cost. U.S. GAAP prohibits any later increase in
value. IFRS does allow reversals of write downs up to the original acquisition
cost. Neither allow inventory to be adjusted upward beyond the original cost.
P3 Appendix 6A: Inventory Costing
under a Periodic System

LIFO computation of COGS

and ending inventory under
a periodic system.
Appendix 6B:
P4

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

END OF CHAPTER 06