1 chapter 8 inventories financial and managerial accounting 8th edition warren reeve fess ©...

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Chapter Chapter 88InventoriesInventories

Financial and Managerial Accounting

8th Edition

Warren Reeve Fess

© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.

Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

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1. Summarize and provide examples of internal control procedures that apply to inventories.

2. Describe the effect of inventory errors on the financial statement.

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

4. Compute the cost of inventory under the perpetual inventory system, using the following cost methods: first-in, first-out; last-in, first-out; average cost.

ObjectivesObjectives

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5. Compute the cost of inventory under the periodic inventory system, using the following costing methods: first-in, first-out; last-in, first-out; average cost.

ObjectivesObjectives

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

7. Compute the proper valuation of inventory at other than cost, using the lower-of-cost-or-market and net realization value concepts.

8. Prepare a balance sheet presentation of merchandise inventory.

9. Estimate the cost of inventory, using the retail method and the gross profit method.

10. Compute the interpret the inventory turnover ratio and number of days’ sales in inventory.

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Why is Inventory Control ImportantWhy is Inventory Control Important? Inventory is a significant asset and for many

companies the largest asset. Inventory is central to the main activity of

merchandising and manufacturing companies. Mistakes in determining inventory cost can

cause critical errors in financial statements. Inventory must be protected from external

risks ( such as fire and theft) and internal fraud by employees.

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Receiving report

Purchase order

Invoice

AGREEAGREE

AGREE

AGREE AGREE

AGREE

JOURNALDescription

Nov. 9

Post. Ref.

Date

Inventory 1 222 00

Accounts Payable—XYZ Co. 1 222 00Purchased merchandise on

account.

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LIABILITIES

STOCK-HOLDERS’

EQUITY

REVENUES

ASSETS

COSTS & EXPENSES

Effect of Inventory Errors on Effect of Inventory Errors on Financial StatementsFinancial Statements

MerchandiseMerchandiseInventoryInventory

Cost ofCost ofMerchandise SoldMerchandise Sold

If merchandise inventory is . . . . . . . Cost of merchandise sold is . . . . . . Gross profit and net income are . . . Total stockholders’ equity is . . . . .

overstated understated overstated overstated

Net Income

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If merchandise inventory is . . . . . . . Cost of merchandise sold is . . . . . . Gross profit and net income are . . . Ending owner’s equity is . . . . . . . . .

understated overstated understated understated

Effect of Inventory Errors on Effect of Inventory Errors on Financial StatementsFinancial Statements

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Purchased goods

Sold goods

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

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Purchased goods

Sold goods

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

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Purchased goodsSold

goods

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

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Purchased goods

Sold goods

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

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Inventory Costing MethodsInventory Costing Methods

40%

30%

20%

10%

0%

43%

34%

19%

4%

Fifo Lifo Average Other

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Perpetual Inventory CostsPerpetual Inventory CostsInventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

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Item 127B

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200

The firm begins the year with 10 The firm begins the year with 10 units of Item 127B on hand at a units of Item 127B on hand at a

total cost of $200.total cost of $200.

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Inventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

On January 4, 7 units of Item On January 4, 7 units of Item 127B are sold at $30 each.127B are sold at $30 each.

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Item 127B

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

The sale of 7 units leaves a

balance of 3 units.

Jan. 1 10 20 200 4 7 20 140 3 20 60Jan. 1 10 20 200

On January 4, 7 units of Item On January 4, 7 units of Item 127B are sold at $30 each.127B are sold at $30 each.

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Inventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

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

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Item 127B

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

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

Because the purchase price of $21 is

different than the cost of the previous 3 units on hand, the inventory balance of 11 units is accounted for separately.

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Inventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

On January 22, the firm sold On January 22, the firm sold four units for $31 each.four units for $31 each.

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Item 127B

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

22 3 20 601 21 21 7 21 147

Of the four units sold, three are from the first units in (fifo) at a

cost of $20.

On January 22, the firm sold four units for $31 each.On January 22, the firm sold four units for $31 each.

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FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

On January 28, the firm On January 28, the firm sold two units at $32.sold two units at $32.

Inventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

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Item 127B

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

FIFO FIFO PerpetualPerpetual Inventory Account Inventory Account

22 3 20 601 21 21 7 21 147

28 2 21 42 5 21 105

On January 28, the firm On January 28, the firm sold two units at $32.sold two units at $32.

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FIFO FIFO PerpetualPerpetual Inventory Account Inventory Account

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

Inventory cost data to demonstrate Inventory cost data to demonstrate FIFO and LIFO Perpetual SystemsFIFO and LIFO Perpetual Systems

Cost ofCost ofMdse. SoldMdse. Sold

Item 127B Units Cost Price Jan. 1 Inventory 10 $20

4 Sale 7 $3010 Purchase 8 2122 Sale 4 3128 Sale 2 3230 Purchase 10 22

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Item 127B

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

FIFO Perpetual Inventory AccountFIFO Perpetual Inventory Account

22 3 20 601 21 21 7 21 147

28 2 21 42 5 21 105 30 10 22 220 5 21 105

10 22 220 Totals 18 $388 13 $263 15 $325

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

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200

The firm begins the year with The firm begins the year with 10 units of Item 127B on 10 units of Item 127B on

hand at a total cost of $200.hand at a total cost of $200.

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60

On January 4, the firm sold On January 4, the firm sold 7 units at $30 each.7 units at $30 each.

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

On January 10, the On January 10, the firm purchased eight firm purchased eight

units at $21 each.units at $21 each.Note that a new layer is formed.

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

On January 22, the On January 22, the firm sells four firm sells four

units at $31 each.units at $31 each.

22 4 21 84 3 20 604 21 84

Of the 4 units sold, all come Of the 4 units sold, all come from the most recent purchase from the most recent purchase

at a cost of $21 each.at a cost of $21 each.

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

On January 28, sold On January 28, sold two units at $32 each.two units at $32 each.

22 4 21 84 3 20 604 21 84

28 2 21 42 3 20 602 21 42

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168

On January 30, purchase On January 30, purchase 10 units at $22 each.10 units at $22 each.

22 4 21 84 3 20 604 21 84

28 2 21 42 3 20 602 21 42

30 10 22 220 3 20 602 21 42

10 22 220

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Item 127B

LIFO Perpetual Inventory AccountLIFO Perpetual Inventory Account

Purchases Cost of Mdse. Sold Inventory Balance

Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost

Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60

8 21 168 22 4 21 84 3 20 60

4 21 84 28 2 21 42 3 20 60

2 21 42 30 10 22 220 3 20 60

2 21 4210 22 220

Totals 18 $388 13 $266 15 $322

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Fifo Periodic

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Jan. 1 Beginning Inventory200 units @ $9200 units @ $9

Mar. 10 Purchase300 units @ $10300 units @ $10

400 units @ $11400 units @ $11 Sept. 21 Purchase

100 units @ $12100 units @ $12 Nov. 18 Purchase1,000 units available

for sale during year

Fifo PeriodicFifo Periodic

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Fifo PeriodicFifo Periodic

200 units @ $9200 units @ $9

300 units @ $10300 units @ $10

400 units @ $11400 units @ $11

100 units @ $12100 units @ $12

1,000 units available for sale during year

$10,400

= $1,800 Jan. 1

= 3,000 Mar. 10

= 4,400 Sept. 21

= 1,200 Nov. 18

Cost of merchandise available for sale

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Fifo PeriodicFifo PeriodicA physical count on

December 31 reveals that 700 of the 1,000 units

have been sold.

Using fifo, the first units purchased are theoretically the first units sold. We begin the

count with January 1.

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Fifo PeriodicFifo Periodic

200 units @ $9200 units @ $9

300 units @ $10300 units @ $10

400 units @ $11400 units @ $11

100 units @ $12100 units @ $12

1,000 units available for sale during year

$10,400

= $1,800 Jan. 1

= 3,000 Mar. 10

= 4,400 Sept. 21

= 1,200 Nov. 18

Sold these 200Sold these 200

Sold these 300Sold these 300

Sold 200 of theseSold 200 of these200 units @ $11200 units @ $11

= $ 0 Jan. 1

= 0 Mar. 10

= 2,200 Sept. 21

$ 3,400

Ending inventoryEnding inventory

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Cost of merchandise available for sale $10,400Less ending inventory 3,400Cost of merchandise sold $ 7,000

Fifo PeriodicFifo Periodic

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Jan. 1200 units at $9

Summary of Fifo PeriodicSummary of Fifo Periodic

Mar. 10300 units at $10

Sep. 21400 units at $11

Nov. 18100 units at $12

$1,800

$3,000

$4,400

$1,200

Purchases

MerchandiseAvailablefor Sale

$1,800

$3,000

$2,200

Cost ofMerchandise

Sold200 units at $9

$10,400$10,400 $2,200

$1,200

$7,000$7,000

MerchandiseInventory

$3,400$3,400

300 units at $10

200 units at $11

200 units at $11

100 units at $121,000 units

700 units

300 units

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Lifo Periodic

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Jan. 1 Beginning Inventory200 units @ $9200 units @ $9

Mar. 10 Purchase300 units @ $10300 units @ $10

400 units @ $11400 units @ $11 Sept. 21 Purchase

100 units @ $12100 units @ $12 Nov. 18 Purchase1,000 units available

for sale during year

Lifo Periodic

Using lifo, the most recent batch purchased is considered the first batch of merchandise sold.

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Jan. 1 Beginning Inventory200 units @ $9200 units @ $9

Mar. 10 Purchase300 units @ $10300 units @ $10

400 units @ $11400 units @ $11 Sept. 21 Purchase

100 units @ $12100 units @ $12 Nov. 18 Purchase1,000 units available

for sale during year

Lifo Periodic

Assume again that 700 units were sold during the year.

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200 units @ $9200 units @ $9

300 units @ $10300 units @ $10

400 units @ $11400 units @ $11

100 units @ $12100 units @ $12

1,000 units available for sale during year

Lifo Periodic

Sold these 100Sold these 100

Sold these 400Sold these 400

Sold 200 of theseSold 200 of these100 units @ $10100 units @ $10

= $1,800 Jan. 1

= 3,000 Mar. 10

= 4,400 Sept. 21

= 1,200 Nov. 18

$10,400

0

0

1,000

Ending Inventory

$2,800

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Cost of merchandise available for sale $10,400Less ending inventory 2,800Cost of merchandise sold $ 7,600

Lifo Periodic

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Jan. 1200 units at $9

Summary of Lifo Periodic

Mar. 10300 units at $10

Sep. 21400 units at $11

Nov. 18100 units at $12

$1,800

$3,000

$4,400

$1,200

$1,800

$1,000

Cost ofMerchandise

Sold

200 units at $9

$10,400$10,400$4,400

$1,200

$2,800$2,800

$7,600$7,600

100 units at $10

200 units at $10

400 units at $11

100 units at $12

$2,000

700 units

1,000 units

300 units

Purchases

MerchandiseAvailablefor Sale

$1,800

MerchandiseInventory

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Jan. 1 Beginning Inventory200 units @ $9200 units @ $9

Mar. 10 Purchase 300 units @ $10300 units @ $10

400 units @ $11400 units @ $11 Sept. 21 Purchase

100 units @ $12100 units @ $12 Nov. 18 Purchase1,000 units available

for sale during year

The average cost periodic method is based on the average cost of identical units.

Average Cost Periodic Average Cost Periodic

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Average Cost Periodic Average Cost Periodic

200 units @ $9 200 units @ $9 = $ 1,800 = $ 1,800

1,000 units available for sale during year

300 units @ $10 300 units @ $10 = $ 3,000 = $ 3,000

400 units @ $11 400 units @ $11 = $ 4,400 = $ 4,400

100 units @ $12 100 units @ $12 = $ 1,200 = $ 1,200

$10,400 Cost of merchandise available for sale

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Cost of Merchandise Available for Sale

Units Available for Sale During Year

= Average Unit Cost

$10,4001,000 Units = $10.40 per Unit

Average Cost Periodic Average Cost Periodic

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Cost of merchandise available for sale $10,400Less ending inventory ($10.40 x 300) 3,120Cost of merchandise sold $ 7,280

To verify this amount, multiply

700 units sold times $10.40 to get the same $7,280.

Average Cost Periodic Average Cost Periodic

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$ 3,8002,7004,6503,920

Total $15,520$15,472$15,070

Valuation of Inventory at Valuation of Inventory at Lower-of-Cost-or-MarketLower-of-Cost-or-Market

A 400 $10.25 $ 9.50 $ 4,100 $ 3,800 B 120 22.50 24.10 2,700 2,892 C 600 8.00 7.75 4,800 4,650 D 280 14.00 14.75 3,920 4,130

Unit UnitInventory Cost Market Total Total Lower

Item Quantity Price Price Cost Market C or M

The market decline based on individual items ($15,520 – $15,070) = $450

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AssetsCurrent assets:

Cash $ 19 400 00Accounts receivable $80 000 00

Less allowance for doubtful accounts 3 000 00 77 000 00

Merchandise inventory at lower of cost (first-in, first-out method) or market 216 300 00

Metro-ArtsBalance SheetDecember 31, 2007

Presentation of Merchandise Inventory on the Balance Sheet

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Retail Method of Estimating Inventory CostRetail Method of Estimating Inventory Cost

Retail method is based on relationship between cost of merchandise available for sale and the retail price.

Retail prices of all merchandise must be accumulated and totaled.

Inventory at retail is calculated at retail price of merchandise available for sale less net sales at retail.

Ratio is calculated as cost divided by retail price. Inventory at retail price times cost ratio equals

estimated cost of inventory.

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Retail Inventory MethodRetail Inventory Method

Step 1: Step 1: Determine the ratio of Determine the ratio of cost to the retail price.cost to the retail price.

Cost RetailMerchandise inventory, Jan. 1 $19,400 $ 36,000Purchases in January (net) 42,600 64,000Merchandise available for sale $62,000 $100,000

Ratio of cost to retail price =$62,000

$100,000= 62%

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Retail Inventory MethodRetail Inventory Method

Step 2: Step 2: Determine the ending Determine the ending inventory at retail.inventory at retail.

Sales for January (net) 70,000Merchandise inventory, January 31, at retail $ 30,000

Cost RetailMerchandise inventory, Jan. 1 $19,400 $ 36,000Purchases in January (net) 42,600 64,000Merchandise available for sale $62,000 $100,000

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Retail Inventory MethodRetail Inventory Method

Step 3: Step 3: Calculate the estimated Calculate the estimated inventory at cost.inventory at cost.

Merchandise inventory, January 31, at cost($30,000 x 62%) $18,600

Sales for January (net) 70,000Merchandise inventory, January 31, at retail $ 30,000

Cost RetailMerchandise inventory, Jan. 1 $19,400 $ 36,000Purchases in January (net) 42,600 64,000Merchandise available for sale $62,000 $100,000

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Gross Profit Method of Estimating Gross Profit Method of Estimating Inventory CostInventory Cost

1. A gross profit percentage rate is estimated based on previous experience adjusted for known changes.

2. Estimated gross profit is calculated by multiplying the estimated gross profit rate times the actual net sales.

3. Estimated cost of merchandise sold is calculated by subtracting the gross profit from actual sales.

4. The cost of merchandise sold estimate is deducted from actual merchandise available for sale to determine the estimated cost of merchandise inventory.

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Merchandise inventory, January 1 $ 57,000Purchases in January (net) 180,000Merchandise available for sale Sales in January (net) $250,000Less: Estimated gross profit Estimated cost of merchandise soldEstimated merchandise inventory, January 31

($250,000 x 30%) 75,000

175,000$ 62,000

Gross Profit MethodGross Profit Method

The gross profit method is useful for estimating The gross profit method is useful for estimating inventories for monthly or quarterly financial inventories for monthly or quarterly financial

statements in a periodic inventory system.statements in a periodic inventory system.

$237,000

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Inventory TurnoverInventory Turnover SUPERVALU Zale

Cost of merchandise sold $15,620,127,000 $ 737,188,000Inventories:

Beginning of year $1,115,529,000 $478,467,000End of year 1,067,837,000 571,669,000Total $2,183,366,000 $1,050,136,000Average $1,091,683,000 $525,068,000

Inventory turnoverInventory turnover 14.3 times14.3 times 1.4 times1.4 times

Use: Inventory turnover measures the relationship between the volume of goods sold and the amount of inventory carried during the period.

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Average daily cost of merchandise sold: $15,620,127,000/365 $42,794,868 $737,188,000/365 $2,019,693Ending inventory $1,067,837,000 $571,669,000

Number of Days’ Sales in InventoryNumber of Days’ Sales in Inventory SUPERVALU Zale

Average selling periodAverage selling period 25 days25 days 283 days283 days

Use: To assess the efficiency in the management of inventory

The End