7-1

7

Inventories

Principles of Financial Accounting, 11eReeve • Warren • Duchac

Inventories

1 Describe the importance of control over inventories.

2 Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet.

3 Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods.

After studying this chapter, you should be able to:

7-2

Inventories (continued)

After studying this chapter, you should be able to:4 Describe the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods.

5 Compare and contrast the use of the three inventory costing methods.

6 Describe and illustrate the reporting of merchandise inventory in the financial statements.

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Describe the importance of control over inventory.

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Two primary objectives of control over inventory are:1. Safeguarding the inventory,

and2. Properly reporting it in the

financial statements.

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• The purchase order authorizes the purchase of the inventory from an approved vendor.

• The receiving report establishes an initial record of the receipt of the inventory.

• The amount of inventory is always available in the subsidiary inventory ledger.

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Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include the following:

1. Storing inventory in areas that are restricted to only authorized employees.

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2. Locking high-priced inventory in cabinets.

3. Using two-way mirrors, cameras, security tags, and guards.

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A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate.

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Describe the three inventory cost flow assumptions and how they impact the income statement and balance sheet.

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Inventory Costing Methods2

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May 10 Purchase 1 $ 918 Purchase 1 1324 Purchase 1 14

Total 3 $36

Average cost per unit $12 ($36 ÷ 3 units)

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Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 as shown below:

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Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase.

Not practical unless each inventory

unit can be separately identified..

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Under the first-in, first out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold and the ending inventory is made up of the most recent purchases.

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Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold first and the ending inventory is made up of the first units purchased.

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Under the average inventory cost flow method, the cost of the units sold and in ending inventory is an average of the purchase costs.

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2

Exhibit 1Effect of Inventory Costing Methods on Financial Statements

FIFO Method

Income Statement

Sales $20Cost of merchan- dise sold 9Gross profit $11

(continued)

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2

Exhibit 1Effect of Inventory Costing Methods on Financial Statements (continued)

LIFO Method

Income Statement

Sales $20Cost of merchan- dise sold 14Gross profit $ 6

(continued)

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2

Average Cost Method

Income Statement

Sales $20Cost of merchan- dise sold 12Gross profit $ 8

$36 ÷ 3 = $12

$12 × 2 = $24

Exhibit 1Effect of Inventory Costing Methods on Financial Statements (continued)

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2

Exhibit 2 Inventory Costing Methods*

*Firms may be counted more than once for using multiple methods

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Example Exercise 7-12

Cost Flow Methods

The three identical units of Item QBM are purchased during February, as shown below.

Feb. 8 Purchase 1 $ 4515 Purchase 1 4826 Purchase 1 51

Item QBM Units Cost

Assume that one unit is sold on February 27 for $70.

Determine the gross profit for February and ending inventory on February 28 using (a) first-in, first-out (FIFO); (b) last-in, first-out (LIFO); and (c) average cost methods.

Total 3 $144 Average cost per unit $48 ($144 ÷ 3 units)

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7-23

2Example Exercise 7-1 (continued)

Gross Profit Ending Inventory

(a) First-in, first-out (FIFO): $25 ($70 – $45) $99 ($48 + $51)

(b) Last-in, first-out (LIFO): $19 ($70 – $51) $93 ($45 + $48)

(c) Average cost: $22 ($70 – $48) $96 ($48 × 2)

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For Practice: PE 7-1A, PE 7-1B

Follow My Example 7-1

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Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods.

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On January 1, the firm had 100 units of Item 127B that cost $20 per unit.

First-In, First-Out Method3

Item 127B

Units Cost

Jan. 1 Inventory 100

$20

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On January 4, the firm sold 70 units of 127B at $30 each.

Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

First-In, First-Out Method3

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3

Exhibit 3 Entries and Perpetual Inventory Account (FIFO)

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On January 10, the firm purchased 80 units at $21 each.

Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 21

First-In, First-Out Method3

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Jan. 1

Date

3

Exhibit 3Entries and Perpetual Inventory Account (FIFO) (continued)

10 Merchandise Inventory 1,680 Accounts Payable 1,680

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On January 22, the firm sold 40 units for $30 each.

Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

First-In, First-Out Method3

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Jan. 1

Date

3Entries and Perpetual Inventory Account (FIFO) (continued)

Exhibit 3

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First-In, First-Out Method

On January 28, the firm sold 20 units at $30 each. Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

28 Sale 20

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Date

Jan. 1

3Exhibit 3

Entries and Perpetual Inventory Account (FIFO) (continued)

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Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

28 Sale 20

30 Purchase 100 22

On January 30, purchased one hundred additional units of Item 127B at $22 each.

First-In, First-Out Method3

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3

Exhibit 3Entries and Perpetual Inventory Account (FIFO) (continued)

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3

Cost of merchandise sold

January 31 inventory

Entries and Perpetual Inventory Account (FIFO) (concluded)

Exhibit 3

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Example Exercise 7-23

Perpetual Inventory Using FIFO

Beginning inventory, purchases, and sales for Item ER27 are as follows:

Nov. 1 Inventory 40 units at $55 Sale 32 units

11 Purchase 60 units at $721 Sale 45 units

Assuming a perpetual inventory system and the first-in, first-out (FIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30.

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3Example Exercise 7-2 (continued)

a) Cost of merchandise sold (November 21):

8 units @ $5 $40

37 units @ $7 259

45 units $299

b) Inventory, November 30:

$161 = (23 units × $7)

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For Practice: PE 7-2A, PE 7-2B

Follow My Example 7-2

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On January 1, the firm had 100 units of Item 127B that cost $20 per unit.

Last-In, First-Out Method3

Item 127B

Units Cost

Jan. 1 Inventory 100

$20

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On January 4, the firm sold 70 units of 127B at $30 each.

Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

Last-In, First-Out Method3

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3

Exhibit 4 Entries and Perpetual Inventory Account (LIFO)

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Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 21

Last-In, First-Out Method

On January 10, the firm purchased 80 units at $21 each.

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Date

Jan. 14

3

Exhibit 4Entries and Perpetual Inventory Account (LIFO) (continued)

10 Merchandise Inventory 1,680 Accounts Payable 1,680

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On January 22, the firm sold 40 units for $30 each.

Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

Last-In, First-Out Method3

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Date

Jan. 14

3

Exhibit 4Entries and Perpetual Inventory Account (LIFO) (continued)

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On January 28, the firm sold 20 units at $30 each. Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

28 Sale 20

Last-In, First-Out Method3

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3

Exhibit 4Entries and Perpetual Inventory Account (LIFO) (continued)

Jan. 14

Date

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Item 127B

Units Cost

Jan. 1 Inventory 100

$204 Sale 70

10 Purchase 80 2122 Sale 40

28 Sale 20

30 Purchase 100 22

Last-In, First-Out Method

On January 30, the firm purchased one hundred additional units of Item 127B at $22 each.

3

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Date

3Entries and Perpetual Inventory Account (LIFO) (continued)Exhibit 4

Jan. 14

10

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3Entries and Perpetual Inventory Account (LIFO) (concluded)Exhibit 4

Cost of Merchandise

Sold

January 31 Inventory

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Example Exercise 7-33

Perpetual Inventory Using LIFOBeginning inventory, purchases, and sales for Item ER27 are as follows:

Nov. 1 Inventory 40 units at $55 Sale 32 units

11 Purchase 60 units at $721 Sale 45 units

Assuming a perpetual inventory system and the last-in, first-out (LIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30.

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3Example Exercise 7-3 (continued)

b) Inventory, November 30:

8 units @ $5 $ 4015 units @ $7 10523 $145

a) Cost of merchandise sold:

$315 = (45 units × $7)

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For Practice: PE 7-3A, PE 7-3B

Follow My Example 7-3

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Moving Average

3

When the average cost is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. The unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average.

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Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods.

4

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7-55

Using FIFO, the earliest batch purchased is considered the first batch of merchandise sold. The physical flow does not have to match the accounting method chosen.

First-In, First-Out Method

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= $2,000

= 1,680

= 2,200

Cost of merchandise available for sale

100 units @ $20100 units @ $20

80 units @ $2180 units @ $21

100 units @ $22100 units @ $22

280 units available for sale during year

Jan. 1

Jan. 10

Jan. 30

$5,880

4FIFO Method

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The physical count on January 31 shows that 150 units are on hand (conclusion: 130 units were sold). What is the cost of the ending inventory?

= $ 0

= 1,050

= 2,200

100 units @ $20100 units @ $20

80 units @ $2180 units @ $21

100 units @ $22100 units @ $22

Jan. 1

Jan. 10

Jan. 30

Sold these

Sold 30 of the 80

50 units @ $2150 units @ $21

100 units @ $22100 units @ $22

Ending inventory

$3,250

4

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Now we can calculate the cost of goods sold as follows:

Beginning inventory, January 1 (Slide 55) $2,000Purchases ($1,680 + $2,200) 3,880Cost of merchandise available for sale $5,880Ending inventory, January 31(Slide 56) 3,250Cost of merchandise sold $2,630

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4

Exhibit 5 First-In, First-Out Flow of Costs

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Using LIFO, the most recent batch purchased is considered the first batch of merchandise sold. The actual flow of goods does not have to be LIFO. For example, a store selling fresh fish would want to sell the oldest fish first (which is FIFO) even though LIFO is used for accounting purposes.

Last-In, First-Out Method

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= $2,000

= 1,680

= 2,200

Cost of merchandise available for sale

100 units @ $20100 units @ $20

80 units @ $2180 units @ $21

100 units @ $22100 units @ $22

280 units available for sale during year

Jan. 1

Jan. 10

Jan. 30

$5,880

4LIFO Method

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Assume again that the physical count on January 31 is 150 units (and that 130 units were sold).

What is the cost of the ending inventory?

= $2,000

= 1, 680

= 2,200

100 units @ $20100 units @ $20

80 units @ $2180 units @ $21

100 units @ $22100 units @ $22

Jan. 1

Jan. 10

Jan. 30 Sold these

Sold 30 of the 80

50 units @ $2150 units @ $21

= 0

= 1,050

Ending inventory

$3,050

4

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Now we can calculate the cost of goods sold as follows:

Beginning inventory, January 1 (Slide 60) $2,000Purchases ($1,680 + $2,200) 3,880Cost of merchandise available for sale $5,880Ending inventory, January 31(Slide 61) 3,050Cost of merchandise sold $2,830

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4

Exhibit 5 Last-In, First-Out Flow of Costs

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The average cost method is sometimes called the weighted average method. It uses the average unit cost for determining cost of merchandise sold and the ending merchandise inventory.

Average Cost Method

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The weighted average unit cost is determined as follows:

Average Unit Cost =

Total Cost of Units Available for SaleUnits Available for

Sale

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$5,880

= $2,000

= 1,680

= 2,200

100 units @ $20100 units @ $20

80 units @ $2180 units @ $21

100 units @ $22100 units @ $22

280

Jan. 1

Jan. 10

Jan. 30

Average unit cost: $5,880 ÷ 280 = $21Cost of merchandise sold: 130 units at $21 = $2,730Ending merchandise inventory: 150 units at $21= $3,150

100 units @ $22100 units @ $22

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Now we can calculate the cost of goods sold as follows:

Beginning inventory, January 1 (Slide 66) $2,000Purchases ($1,680 + $2,200) 3,880Cost of merchandise available for sale $5,880Ending inventory, January 31(Slide 66) 3,150Cost of merchandise sold $2,730

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Example Exercise 7-44

Periodic Inventory Using FIFO, LIFO, Average Cost Methods

The units of an item available for sale during the year were as follows:

Jan. 1 Inventory 6 units @ $50 $ 300Mar. 20 Purchase 14 units @ $55 770Oct. 30 Purchase 20 units @ $62 1,240 Available for sale 40 units $2,310

There are 16 units of the item in the physical inventory at December 31. The periodic inventory system is used. Determine the inventory cost by (a) the first-in, first-out (FIFO) method, (b) the last-in, first-out (LIFO) method, and (c) the average cost method.

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4Example Exercise 7-4 (continued)

a) First-in, first-out (FIFO) method: $992 (16 units × $62)

c) Average method: $924 (16 units × $57.75) where average cost = $57.75 ($2,310 ÷ 40 units)

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For Practice: PE 7-4A, PE 7-4B

b) Last-in, first-out (LIFO) method: $850 (6 units × $50) + (10 units × $55)

Follow My Example 7-4

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Compare and contrast the use of the three inventory costing methods.

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Partial Income Statements

Net sales $3,900Cost of merchandise sold:

Beginning inventory $2,000Purchases 3,880Merchandise available for sale $5,880Less ending inventory 3,250 Cost of merchandise sold 2,630

Gross profit $1,270

First-In, First-Out

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Partial Income Statements

Net sales $3,900Cost of merchandise sold:

Beginning inventory $2,000Purchases 3,880Merchandise available for sale $5,880Less ending inventory 3,150 Cost of merchandise sold 2,730

Gross profit $1,170

Average Cost

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Net sales $3,900Cost of merchandise sold:

Beginning inventory $2,000Purchases 3,880Merchandise available for sale $5,880Less ending inventory 3,050 Cost of merchandise sold 2,830

Gross profit $1,070

Last-In, First-Out

Partial Income Statements

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5

Effects of Changing Costs (Prices): FIFO and LIFO Cost Methods

Exhibit 7

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Weighted FIFO Average LIFO

Ending inventory $3,250 $3,150 $3,050

Cost of merchandise sold $2,630 $2,730 $2,830

Gross profit $1,270 $1,170 $1,070

Recap

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Describe and illustrate the reporting of merchandise inventory in the financial statements.

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Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases:

6

Cost

(continued)

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1. The cost of replacing items in inventory is below the recorded cost.

2. The inventory cannot be sold at normal prices due to imperfections, style changes, or other causes.

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Market, as used in lower of cost or market, is the cost to replace the merchandise on the inventory date.

6

Market

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Cost and replacement cost can be determined for the following:1. Each item in the inventory.

2. Each major class or category of inventory.

3. Total inventory as a whole.

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6Determining Inventory at Lower of Cost or Market

Exhibit 8

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Example Exercise 7-56

Lower-of-Cost-or-Market Method

On the basis of the following data, determine the value of the inventory at the lower of cost or market. Apply lower of cost or market to each inventory item as shown in Exhibit 8.

Inventory Unit UnitCommodity Quantity Cost Price Market Price

C17Y 10 $ 39 $40B563 7 110 98

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6Example Exercise 7-5 (continued)

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For Practice: PE 7-5A, PE 7-5B

Follow My Example 7-5

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Merchandise that is out of date, spoiled, or damaged should be written down to its net realizable value. This is the estimated selling price less any direct cost of disposal, such as sales commissions.

6

Net Realizable Value

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Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following receivables.

6

Merchandise Inventory on the Balance Sheet

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The method of determining the cost of inventory (FIFO, LIFO, or weighted average) and the method of valuing the inventory (cost or the lower of cost or market) should be shown.

Merchandise Inventory on the Balance Sheet

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6

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Effect of Inventory Errors on the Financial Statements

Some reasons causing inventory errors to occur include the following:1. Physical inventory on hand was miscounted.2. Costs were incorrectly assigned to

inventory.3. Inventory in transit was incorrectly

included or excluded from inventory.4. Consigned inventory was incorrectly

included or excluded from inventory.

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6Effect of Inventory Errors on Current Period’s Income Statement

Exhibit 9

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6 Effect of Inventory Errors on Two Years’ Income Statements

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Exhibit 10

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6Effect of Inventory Errors on Current Period’s Balance Sheet

Exhibit 11

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Example Exercise 7-66

Effect of Inventory Errors

Zula Repair Shop incorrectly counted its December 31, 2010 inventory as $250,000 instead of the correct amount of $220,000. Indicate the effect of the misstatement on Zula’s December 31, 2010 balance sheet and income statement for the year ended December 31, 2010.

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6Example Exercise 7-6 (continued)

Amount of Misstatement Overstatement (Understatement)

Balance Sheet:Merchandise inventory overstated $30,000Current assets overstated 30,000Total assets overstated 30,000Owner’s equity overstated 30,000

Income Statement:Cost of merchandise sold understated $(30,000)Gross profit overstated 30,000Net income overstated 30,000

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For Practice: PE 7-6A, PE 7-6B

Follow My Example 7-6

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Appendix:

Estimating Inventory Cost

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Determining Inventory by the Retail MethodExhibit 12

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Estimating Inventory by the Gross Profit Method

Exhibit 13