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C O P Y R I G H T © 2 0 1 2 P E A R S O N E D U C AT I O N I N C . P U B L I S H I N G A S P R E N T I C E H A L L


Inventory

CHAPTER F IVE

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LEARNING OBJECTIVES

Describe the four different inventory costing methods

Compute inventory costs using first-in, first-out (FIFO); last-in, first-out (LIFO); and average cost methods and journalize inventory transactions

Compare the effects of the different costing methods on the financial statements

Value inventory using the lower-of-cost-or-market (LCM) rule

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LEARNING OBJECTIVES

Illustrate the reporting of inventory in the financial statements

Determine the effect of inventory errors on the financial statements

Use the gross profit method to estimate ending inventory

Compute the inventory turnover rate and the days-sales-in-inventory ratio

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Descr ibe the four d iff erent inventory cost ing methods

LEARNING OBJECTIVE ONE

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Inventory Costing Methods

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Specific- Identification First-in, first-out (FIFO)

Last-in, first-out (LIFO) Average Cost


Specific-Identification

◘ Cost assigned to inventory item when sold is the actual cost paid for item

◘ Cost flow through accounting records exactly matches physical flow of goods

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FIRST-IN, FIRST-OUT (FIFO)

◘ Assumes earliest inventory costs are assigned to items when sold

◘ Cost flow through accounting records will closely match physical flow of goods

LAST-IN, FIRST-OUT (LIFO)

◘ Assumes most recent inventory costs are assigned to items when sold

◘ Cost flow through accounting records will be nearly opposite of physical flow of goods

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FIFO and LIFO

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Average Cost

◘ Assumes a weighted-average cost per item is assigned to items as sold

◘ Cost of goods sold and ending inventory will fall between amounts determined by FIFO and LIFO

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Cost Flow vs. Physical Flow

◘ Cost Flow How accounting records reflect cost of goods sold

using inventory costing method business has chosen

◘ Physical Flow How goods are stocked and how they are removed

when sold

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LEARNING OBJECTIVE TWO

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Compute inventory costs us ing fi rst- in , fi rst-out (FIFO); last- in , fi rst-out (L IFO); and average cost methods and journal ize inventory transact ions


Inventory Account

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Inventory

Beginning Balance

Purchases

Shipping

Ending Balance

Sales

Purchase Discounts

Purchase Returns and Allowances


Ending InventoryUnits on hand

Cost of Goods Sold

Units sold

Inventory Cost Flows

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Cost of Goods

Available for Sale

Purchases

Beginning Inventory


FIFO Illustrated (1 of 2)

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$10$10

Beginning Inventory:2 units @ $10/ea.

$12

$12

$12$12

$12$12

$12

$12

Purchases:8 units @ $12/ea.

10 units on hand,Company sells 7 unitsCompany sold 7 units,3 units remain on hand

Ending Inventory

$36• 3 units @

12/ea.

Cost of Goods Sold$80

• 2 units @ $10/ea.• 5 units @ $12/ea.


FIFO Illustrated (2 of 2)

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Purchases Cost of Goods Sold

Inventory on Hand

Date Qty Unit Cost

TotalCost

Qty UnitCost

TotalCost

Qty UnitCost

TotalCost

Apr 1

2 $10 $20

Apr 9

8 $12 $96 2 $10 $20

8 $12 $96

Apr 15

2 $10 $20

5 $12 $60 3 $12 $36

Apr 30

8 $96 7 $80 3 $36


FIFO Journal Entries

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GENERAL JOURNAL

DATE ACCOUNTS DEBIT CREDIT

Apr. 9 Inventory (8 x $12) 96

Accounts Payable 96

Apr.15

Accounts Receivable 175

Sales Revenue 175

Cost of Goods Sold 80

Inventory 80


10 units on hand,Company sells 7 unitsCompany sold 7 units,3 units remain on hand

LIFO Illustrated

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$10$10


$12

$12

$12$12

$12$12

$12

$12


Ending Inventory

$32• 1 unit @ 12/ea.• 2 units @

10/ea.

Cost of Goods Sold$84

• 7 units @ $12/ea.


LIFO Illustrated (2 of 2)

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Inventory on Hand

Date Qty Unit Cost

TotalCost

Qty UnitCost

TotalCost

Qty UnitCost

TotalCost

Apr 1

2 $10 $20

Apr 9

8 $12 $96 2 $10 $20

8 $12 $96

Apr 15

7 $12 $84 2 $10 $20

1 $12 $12

Apr 30

8 $96 7 $84 3 $32


LIFO Journal Entries

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GENERAL JOURNAL



Accounts Payable 96

Apr.15


Sales Revenue 175


Inventory 84


$10$10


$12

$12

$12$12

$12$12

$12

$12


Units

UnitCost

TotalCost

Beginning Inventory

2 $10 $20

Purchases 8 12 96

10 $116

Company sold 7 units,3 units remain on hand

Average Cost Illustrated (1 of 2)

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10 units on hand,Company sells 7 units

Ending Inventory

$34.80• 3 units @

11.60/ea.

Cost of Goods Sold

$81.20• 7 units @

$11.60/ea

Available for Sale10 units @ $11.60/ea.

$11.60

$11.60

$11.60

$11.60

$11.60

$11.60

$11.60

$11.60

$11.60

$11.60


Average Cost Illustrated (2 of 2)

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Inventory on Hand

Date Qty

Unit Cost

Total

Cost

Qty

UnitCost

TotalCost

Qty UnitCost

TotalCost

Apr 1

2 $10 $20

Apr 9

8 $12 $96 2 $10 $20

8 $12 $96

10 $11.60

$116

Apr 15

7 $11.60

$81.20

3 $11.60

$34.80

Apr 30

8 $96 7 $81.20

3 $34.80


Average Cost Journal Entries

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GENERAL JOURNAL



Accounts Payable 96

Apr.15


Sales Revenue 175

Cost of Goods Sold 81.20

Inventory 81.20


Compare the eff ects of the d iff erent cost ing methods on the fi nancia l statements

LEARNING OBJECTIVE

THREE04/13/2023

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Comparison of Inventory Methods(under assumption prices are increasing)

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Inventory

Costing Method Description Benefit

First-in, First-out(FIFO)

Cost of Goods Sold has older, lower costs;Ending Inventory has newer, higher costs

Most closely matches actual flow of goods;Maximizes net income which attracts investors and creditors

Last-in, First-out(LIFO)

Cost of Goods Sold has newer, higher costs;Ending Inventory has older, lower costs

Minimizes net income, income taxes, and ending inventory;Reduces cash needed to pay taxes

Average Cost

Averages costs in Cost of Goods Sold and Ending Inventory

A “middle-ground” solution for reporting net income, ending inventory, and paying taxes


Consistency Principle

◘ Companies should use same accounting methods from period to period

◘ If a company does change methods, it must be justified and disclosed in the financial statements

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Value inventory us ing the lower-of-cost-or-market (LCM) ru le

LEARNING OBJECTIVE FOUR

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Lower-of-Cost-or-Market (LCM)

◘ Inventory is recorded at the lesser of: Historical cost Current replacement cost (market value)

◘ If market value is less than cost: Record a loss and reduce inventory

◘ If cost is less than market: No entry needed

◘ Application of conservatism principle

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Problem P5-44A (1 of 3)

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Ending Inventory (unadjusted)

$163,300

Decrease in market value (15,900)

Current replacement cost (adj.)

$147,400

Inventory amount on Balance Sheet



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Cost of Goods Sold (unadjusted)

$614,000

Loss on inventory value 15,900

Cost of Goods Sold (adjusted)

$629,900

Cost of Goods Sold amount

on Income Statement



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GENERAL JOURNAL Page 3


Oct.31

Cost of Goods Sold 15,900

Inventory 15,900

To write down inventory to market


I l lustrate the report ing of inventory in the fi nancia l statements

LEARNING OBJECTIVE FIVE

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Inventory on the Balance Sheet

◘ Reported as a current asset

◘ Financial statement footnotes describe inventory costing method and whether valued at LCM

Full-disclosure principle

Sample footnote:

NOTE 2: Statement of Significant Accounting Policies:

Inventory: Inventory is carried at lower-of-cost-or-market. Cost is determined by using the first-in, first-out method.

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Inventory Shrinkage

◘ Loss due to employee or customer theft, damage, and spoilage

◘ Physical inventory count taken to adjust inventory records

Inventory account is debited or credited as needed Cost of Goods Sold account is corresponding offset

account

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Determine the eff ect of inventory errors on the fi nancia l statements

LEARNING OBJECTIVE SIX

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Causes of Inventory Errors

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Improper Counting

Double-counting

Not counting some items

Ignoring obsolete or damaged

goods


Impact of Inventory Errors

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Period One Period Two

Ending Inventory

Cost of Goods Sold

Gross Profit

& Net

Income

Cost of Goods Sold

Gross Profit &

Net Income

Overstated → Understated

Overstated

Overstated

Understated

Understated→

Overstated

Understated

Understated

Overstated


Use the gross profi t method to est imate ending inventory

LEARNING OBJECTIVE

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Gross Profit Method

◘ Estimates the value of ending inventory

◘ Based on format for Cost of Goods Sold:

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Cost of Goods Sold Modified for Gross Profit Method

Beginning Inventory Beginning Inventory

+ Purchases + Purchases

(net of purchase discounts, returns & allowances plus shipping costs)

= Cost of Goods Available for Sale

= Cost of Goods Available for Sale

- Ending Inventory - Cost of Goods Sold (estimated)

= Cost of Goods Sold = Ending Inventory (estimated)


Gross Profit Method Illustrated

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Gross Profit Method of estimating Ending Inventory

Step 1 Beginning Inventory $14,000

+ Purchases (net) 66,000

= Cost of Goods Available for Sale 80,000

Step 2 Estimated Cost of Goods Sold:

Net Sales Revenue $100,000

- Estimated Gross Profit of 40% ($100,000 x 40%) 40,000

= Estimated Cost of Goods Sold

(60,000)

Step 3 Estimated Ending Inventory $20,000


LEARNING OBJECTIVE

EIGHT04/13/2023

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Compute the inventory turnover rate and the days-sales- in- inventory rat io


How Much Inventory Does a Business Need?

◘ Too little inventory may result in lost sales and profits

A customer may go elsewhere if merchandise not in-stock

◘ Too much inventory is expensive to maintain

Uses space in warehouse Must pay for or finance inventory that isn’t

generating cash May become obsolete or lose value

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Inventory Ratios

◘ Inventory Turnover How many times in a year the inventory was

purchased and then sold

◘ Days-Sales-in-Inventory Compares inventory sold during a day with the

average amount of inventory held by a business during the year

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Beginning Inventory + Ending Inventory

2

Inventory Turnover

◘ Usually computed for an annual period

◘ Average inventory is

◘ Result described as number of “times per year”

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Average Inventory

Inventory Turnover

Cost of Goods Sold


Days-Sales-in-Inventory

◘ Cost of Goods Sold / 365 approximates the amount of inventory sold each day

◘ Result described as number of “days”

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Average Inventory

Days-Sales-in-Inventory



Exercise E5-27A (1 of 2)

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White Water Kayak, Inc.Income Statement

For the Year Ended December 31, 2012

Sales Revenue $1,752,300

Cost of Goods Sold:

Beginning Inventory $ 35,000

Net Purchases 750,600

Cost of Goods Available 785,600

Ending Inventory 48,700

Cost of Goods Sold 736,900

Gross Profit 1,015,400

Operating Expenses 66,000

Net Income $ 949,400


Cost of Goods Sold

$35,000 + $48,7002

Exercise E5-27A (2 of 2)

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Average Inventory

$41,850

Inventory Turnover

Inventory Turnover

17.61 times per year

Cost of Goods Sold$736,900


CHAPTER SUMMARY

Four inventory costing methods are permitted by GAAP. The costing method chosen by a business impacts their Cost of Goods Sold on the Income Statement and Inventory balance on the Balance Sheet and must be consistent from period to period.

Adjustments for Lower-of-Cost-or-Market, shrinkage, and inventory counting errors may be made to ensure conservatism and accuracy in reporting inventory.

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Documents

actual cost

ending inventory units

pearson education

inventory item

sale cost of goods

lifo average cost

reporting of inventory

inventory ratio