chapter 6

ACCT 100

Chapter 6

Inventories

Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 2

Objectives:1. Discuss inventory cost flow assumptions.

2. Apply cost flow assumptions to determine the CGS and the value of ending inventory.

3. Explain the lower-of-cost-or-market (LCM) rule for inventory reporting.

4. Discuss the financial effects of the inventory cost flow assumptions.

5. Learn the effects of inventory errors on financial statements.

6. Discuss the inventory turnover rate and the gross margin ratio.


Defining Inventory

1. Assets held for resale purpose in a normal course of business.

2. Assets used to produce products for resale purpose.

Merchandising Firms: merchandise

Manufacturing Firms: raw materialsWork-in-processFinished Goods


How to Account for Inventory Purchases, Sales and Reporting? Applying either the periodic inventory

system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories.

Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory count.


Inventory Systems

A. Perpetual Inventory System.

B. Periodic Inventory System.

Perpetual vs. Periodic Inventory System

Perpetual system Periodic System At purchase Inventory xxx Purchases xxxA/P xxx A/P xxx

At sale: CGS xxx None Inventory xxxA/R xxx A/R xxxSales xxx Sales xxx

Inventories 6


Perpetual Inventory System

Inventory account is used for the purchase and sale.

The balance of inventory is available at all time.

A physical count is needed at the end of a period.

Any discrepancy of book balance with physical count should be adjusted to a loss or gain account.


Perpetual Inventory System (contd.)

CGS account is used to record the CGS of a sale.

Therefore, the CGS is also known at all time.

CGS is determined by selecting a cost flow assumption.


Cost Flow Assumptions

In order to apply these assumptions, companies must keep a record of the cost of each inventory unit purchased.


Cost Flow Assumptions (contd.)

1.First-In, First Out (FIFO) method.

2.Last-in, First-Out (LIFO) method.

3.Weighted-Average Cost method.

4.Specific Identification method.


Perpetual Inventory SystemExample The following inventory information is

available for March:

Beginning balance of inventory on 3/1: Beginning balance of 100 units at $5

per unit3/5: Purchased 150 units at $63/7: Sold 200 units at $103/14: Purchased 100 units at $73/28: Sold 30 units at $11


Perpetual Inventory SystemExample (contd.) The following is a perpetual record using

different cost flow assumptions:Balance

Date Pur. Sold FIFO LIFO W-A3/1(Beg. Bal.) 100 $5 100 $5 100 $5

3/5 150 $6 100 $5 100 $5 250 $5.6150 $6 150 $6

3/7 200 $10 50 $6 50 $5 50 $5.63/14 100 $7 50 $6 50 $5 150 $6.53

100 $7 100 $73/28 30 $11 20 $6 50 $5 120 $6.53

100 $7 70 $7


Perpetual Inventory SystemExample (contd.)

Inventory (WA)

500 1120900 195.9700784.1

Inventory (FIFO)

500 1100900 180700820

Inventory (LIFO)

500 1150900 210700740


J. E. for Perpetual (FIFO)

3/5 Inventory 900 Cash 900

3/7 Cash 2,000 Sales Rev. 2,000

Cost of Goods Sold 1,100* Inventory 1,100

3/14 Inventory 700 Cash 700

3/28 Cash 330 Sales Rev. 330

Cost of Good Sold 180**Inventory 180


J. E. for Perpetual (FIFO) (contd.)

* Cost of goods sold of 200 units on 3/7 is based on a FIFO assumption:

Balance before the sale of 200 units on 3/7

$100 x 5 + 100 x 6 = $1100

Notes:

100 $5150 $6

** Balance before the sale 50 $6of 30 units on 3/28 100 $7

30 x $6 = $180


If the CGS Is Based on LIFO:

3/7 Cost of good sold* 1,150Inventory

1,150* Balance before the sale: 100 $5

150 $6 $150 x $6 + 50 x $5 = $1,150

3/28 Cost of goods sold** 210Inventory

210** Balance before the sale: 50 $5

100 $7 30 x $7 = $210


If the CGS Is Based on Weighted-Average Method:3/7 Cost of good sold* 1,120

Inventory1,120

* 200 x $5.6 = $1,120

3/28 Cost of goods sold** 195.90Inventory

195.90

** 30 x 6.53 = $195.90


CGS (FIFO)1,100 1801,280

The T Accounts of CGS at the End of Period (3/31):

CGS (LIFO)1,150 2001,360

CGS (WA)1,120 195.901,315.90


End of Period Adjustments

1. Adjustment for lost units

2. Adjustments for LCM (Lower-of-Cost-or-market) valuation


Adjustment for Lost Units Assuming ending units = 110 units on 3/31.

The lost units on 3/31 are 10.

Cost of 10 lost units (under FIFO)

=> $6 10 = $60


Adjustment for Lost Units (contd.)

Adjusting Ending:

3/31 Loss from Declining in inventory units

60

Inventory

60Inventory (FIFO)

820 60

760


Adjustments for LCM Valuation

LCM rule requires that inventory be reported in the statements at the lower of cost or market value (an application of conservatism)

Inventory (FIFO)B.B 500 1,100 900 180 700 820 60 -- 3/31 760

Cost (on 3/31, FIFO) = $760

Assuming market price = $600

LCM = $600.


Allowance

0 -- 3/1

160

160 -- 3/31

2. Adjustments for LCM Valuation (contd.) Adjusting entry ==>Given Allowance for

declining in market value of inventory with a beginning balance of zero.


B/S (3/31)Inventory 760 Allowance (160)Inv. At LCM 600

24

3/31 Loss Due to Market Decline of Inventory

160Allowance to reduceInventory to market

160I/S (for the period ended 3/31) Loss(from declining in units) $ 60Loss (or CGS) $160CGS

$1,280


Periodic Inventory System Using the example on page 11, the following

entries will be recorded under the periodic inventory system:

3/5 Purchases 900Cash 900

3/7 Cash 2,000Sales Revenue 2,000

3/14 Purchases 700Cash 700

3/28 Cash 330Sales Revenue 330


Periodic Inventory System (contd.)

At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and for the cost of goods sold:

1. Do an inventory count.

2. Apply a cost flow assumption to determine the cost of ending inventory.

3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.** No adjusting entries are required for lost units.


Periodic Inventory SystemExample Using the example on Page 11 and assuming

the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7 100 + $6 5 = $730

Inventory Data:Units Cost

3/1 (B.B) 100 $5 3/ 5 Pur 150 $6 3/ 7 Pur 100 $7


Periodic Inventory SystemExample (contd.) The cost of goods sold (based on a FIFO cost

flow) equals:

Beg. Inv. + Pur - Ending Inv.= 500 + 1,600 - 730= 1,370

If a LIFO cost assumption is used, the cost of ending inventory equals:

The CGS = 500 + 1,600 - 530* = 1,570

* Cost of Ending Inv. = $5 x 100 + 6 x 5 = 530


Periodic Inventory SystemExample (contd.) A weighted-average cost flow assumption:

WAUC = 100 x 5 + 150 x 6 + 100 x 7 350

= 6

Cost of ending inventory: 6 x 105 = 630

Cost of goods sold = 500 +1600 - 630 = 1470


Periodic Inventory SystemEnd of Period Adjustments1. No adjustment is needed for lost units

(because the cost of lost units is embedded in the CGS).

2. Adjustment for the LCM valuation assuming FIFO,

cost = $730

Assuming the market price = $600


Periodic Inventory SystemEnd of Period Adjustments (contd.) Adjusting entry:

Loss Due to Market Value Decline of Inventory (or CGS)

130

Allowance to Reduce Inventory to Market Value

130


B/S (3/31)Inventory 730 Allowance (130)Inv. At LCM 600

I/S (for the period ended 3/31) Loss Due to Market Value Decline of Inv. (or CGS)

130Cost of Good Sold:

Beginning Inventory $ 500 Net Purchase 1,600

Total Goods Available for Sale $2,100 Ending Inventory (730)

1,370

32


Periodic Inventory System

End of period entries to update inventory and related cost of goods sold accounts based on a FIFO cost-flow assumption:

a. Transfer the cost of beginning inventory to the CGS account:

CGS 500Inventory (Beg. Balance) 500

b. Transfer the cost of purchase to CGS:

CGS 1,600Purchase 1,600



c. Record the cost of ending inventory based on a physical count of 105 units and a FIFO cost-flow assumption:

Inventory (ending balance) 730CGS730



T- accounts: Inventory

B.B 500 a. 500c. 730

Purchase3/5 900 b.

1,6003/14 700

CGSa. 500 c. 730b. 1,600

1,370


LIFO(matchingcurrent costwith revenue ifthe inventory isnot depleted toearly layers)

Income

Low

Tax

Low

B/S

Unfair

I/S

Fair

FIFO High High Fair Unfair

Comparison of FIFO vs. LIFO

During an Inflation Period

Inventories: Measurement 37

Survey: (Source: Accounting Trends & Techniques and KWW Textbook) a, b,c

Yearl Firms LIF1O FIFO W-A Others1984 1061

100%408 38%

366 30%

225 22%

52 5%

1988 1038 100%

379 36.5%

396 38%

213 20.5%

50 5%

1991 1032 100%

361 35%

421 41%

200 19%

50

5%2000 887

100%

283 32%

386 44%

180 20%

38

4%

2006 802

100%

228

28%

385

48%

159

20%

30

4%2010 666d

100%

176

26.4%

325

49%

147

22%

18

2.6%


Survey: (Source: Accounting Trends & Techniques ) (contd.)a. Sample firms are 600 firms. Most companies

adopt more than one inventory method.b. Due to low inflation, the number of firms

adopting LIFO has declined since mid-1980s.c. IAS No. 2 does not permit LIFO, and

therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries.

d. The number of disclosures.


Items to Be Included in Inventory Count Any goods with the legal title transferred to the buyer should be included in the inventory count of the buyer (including goods in transit with a FOB shipping point term).

Consigned Goods: Legal title remained with the consignor (i.e., the manufacturers).

Inventory shipped for an “on approval” sale. Note: FOB shipping point – the ownership transfers to the buyer at the shipping point. FOB destination – the ownership transfers to the buyer at the destination.


Reason of Switching to LIFO

1. Tax savings.

2. Income Manipulation.


Reason of Switching to LIFO

Income Manipulation When LIFO cost flows assumption is

used and price is rising, income maybe subject to management manipulation as follows:

a. Liquidation LIFO (to reduce CGS and therefore increase income)

b. To decrease income by increasing CGS


Income Manipulation

a. Liquidation LIFO When the inventory is depleted to the

early layers, the CGS would be low and the income would be high.

Strategy: to delay the purchase of inventory so that the cost of inventory would be depleted to the cost of early layers.


Income Manipulationb. To Decrease Income

by Increasing CGS Strategy: order more inventory at the

end of period so that CGS would be high (under LIFO) and income would be low.


Advantages of FIFO

a. Less likely to be subject to management manipulation;

b. Produce higher income during an inflation period;

c. Inventory cost reported on the B/S is close to the replacement cost.


Disadvantage of FIFO

a. Bad match of sales revenue with CGS; match current sales revenue with old costs;

b. Producing higher income during an inflation period results in paying more income tax.


Advantages of LIFO

a. Good match of sales revenue with CGS; match the most recent inventory cost against sales revenue;

b. Produce lower income during an inflation period; result in tax savings (defer income tax).

(This is only true when the inventory level is not decreasing. If inventory is decreasing, there would be liquidation profits).


Disadvantages of LIFO

a. Inventory cost presented on the B/S is not fair.

b. Subject to management.


IRS

1. Does not allow firms to use LCM if firms are using LIFO.

2. If firms are using LIFO for income tax filing purposes, firms must also use LIFO for financial reporting purposes (referred to as LIFO conformity rule).


IRS (contd.)

3. LIFO is not acceptable by the IRS until late 1930’s.

Switch from FIFO to LIFO, firms do not need the approval of the IRS. However, switch from LIFO to FIFO, firms need to receive the approval of the IRS and need to pay back taxes (the cumulative effect).


International Perspective

Many countries do not permit the use of LIFO.

For example, Australia, Singapore, and United Kingdom do not permit the use of LIFO.


Accounting Principles and Theory Related to Inventories

1. Consistency Principle

2. Disclosure Principle

3. Materiality

4. Conservatism


The Impact of Inventory Errors on the Financial Statements

Year 1:Income CGS Gross Margin = Beg Inv + Net Pur - End Invunder over under under *over under over over ** Year 2:over under over underunder over under over

* either understating the units or understating the value** either overstating the units or the value*** Gross Margin = Sales Revenue - CGS


Ethical Issues

To artificially inflate the net income, a company may

1. Overstating the ending inventory to decrease the cost of goods sold.

2. Ship the goods to distributors at the end of a period (i.e., 12/20/x1). The goods are later returned but in the next period (I.e., 1/3/x2) (Parking transactions).


Estimating Inventory: Gross Margin Method Reasons: For some companies, inventory

information is needed between accountingperiods. Companies cannot afford to

do physical inventory count every quarter.

Thus, a gross margin method (gross profit method) can be used to estimate value of ending inventory for interim reports.

No physical count of inventory is needed for this method. The value of inventory is based on estimation.


Estimating Inventory: Gross Margin Method (contd.) This method is not acceptable for annual

financial reporting purposes.

This method is acceptable for interim reporting

The insurance companies may use this method to estimate the loss of inventory in case of fire or flood.


Gross Profit Method (Gross margin Method)Data Required

Beginning Inventory (at cost)

Purchase (net) (at Cost)

Sales Price

Gross margin ratio (Gross margin/sales price)


Example

Beginning Inv. = $60,000

Purchase (net) = $200,000

Sales = $280,000

Gross margin ratio* = 30%

* gross marking ratio is obtained from past years’ experience (assuming the ratio is stable over years)


Using Gross Profit Method to Estimate the Cost of Ending Inventory

Selling Price Cost Beg, Inv. $60,000Purchase (net) 200,000Goods Avai. For Sale 260,000Sales 280,000 Less: gross margin* (84,000)Sales (at cost) 196,000 **Estimated Inv. (at cost) 64,000

* gross margin = 280,000 x 30%** also equals 280,000 x (1-30%) = 196,000


Comments for Gross Profit Method

If the relationship between the gross profit and shelling price has been changed, the ratio should be adjusted accordingly.

A separate gross profit ratio should be applied to different type of inventory with different relationship between the gross profit and selling price.


Analyzing Financial Statements

1. Inventory turnover rate

2. Gross margin percentage


1. Inventory Turnover Rate

Inventory turnover rate

Cost of Goods Sold= ___________________________

Average Inventory

This ratio measures how fast inventory is sold.

Average Inventory = (Beg. Inv. + End Inv.)/2


2. Gross Margin Percentage

Gross margin percentage

Gross Margin= _______________________________

Net Sales Revenue

This percentage is an indication of profitability. A 40% gross margin means that each dollar of sales generate 40 cents of gross profit.


2. Gross Margin Percentage (contd.)

This percentage varies among industries. In general, the average gross profit is 14.1% for automobile dealers, 22.8% for grocery stores and 55.7% for restaurants.

Sources: Robert Morris Associates’ Annual Statement Studies).


Inventory Control

1. Keeping inventory handles away from the accounting.

2. Physical count of inventory. ( At lease once a year)

3. Keeping perpetual inventory system for high-cost inventory.


Inventory Transaction on the Cash Flow Statement

Cash Flows from Operating Activities:

Collection from Customers $xxx

Cash Payments to Suppliers ($xxx)

chapter 6

Documents

merchandise inventory

inventory count

purchase inventory

inventory purchases

inventory reporting

balance of inventory

cost of goods

inventory xxxar