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Chapter 6
Inventories
ACCT 100
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
2
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 materials
Work-in-process
Finished Goods
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
3
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
4
Inventory Systems
A. Perpetual Inventory System.
B. Periodic Inventory System.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
5
Perpetual vs. Periodic Inventory System
Perpetual system
At purchase
Inventory
xxx
A/P
xxx
At sale:
CGS
xxx
Inventory
xxx
A/R
xxx
Sales
xxx
Periodic System
Purchases
A/P
xxx
xxx
None
A/R
Sales
Inventories
xxx
xxx
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
7
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
8
Cost Flow Assumptions

In order to apply these assumptions,
companies must keep a record of the
cost of each inventory unit purchased.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit
9
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 10
Example

Perpetual Inventory System
The following inventory information is
available for March:
Beginning balance of inventory on
3/1: Beginning balance of 100 units at $5
per unit
3/5: Purchased 150 units at $6
3/7: Sold 200 units at $10
3/14: Purchased 100 units at $7
3/28: Sold 30 units at $11
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 11
Perpetual Inventory System
Example (contd.)

The following is a perpetual record using
different cost flow assumptions:
Date
3/1(Beg. Bal.)
3/5
3/7
3/14
3/28
Pur.
Sold
FIFO
100 $5
150 $6
100 $5
150 $6
200 $10 50 $6
100 $7
50 $6
100 $7
30 $11 20 $6
100 $7
Balance
LIFO
W-A
100 $5
100 $5
100 $5 250 $5.6
150 $6
50 $5
50 $5.6
50 $5 150 $6.53
100 $7
50 $5 120 $6.53
70 $7
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 12
Perpetual Inventory System
Example (contd.)
Inventory (FIFO)
500
1100
900
180
700
820
Inventory (LIFO)
500
1150
900
210
700
740
Inventory (WA)
500
1120
900
195.9
700
784.1
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 13
J. E. for Perpetual (FIFO)
3/5 Inventory
Cash
3/7 Cash
Sales Rev.
Cost of Goods Sold
Inventory
3/14 Inventory
Cash
3/28 Cash
Sales Rev.
Cost of Good Sold
Inventory
900
900
2,000
2,000
1,100*
1,100
700
700
330
330
180**
180
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 14
J. E. for Perpetual (FIFO) (contd.)
Notes:
* Cost of goods sold of 200 units on 3/7 is
based on a FIFO assumption:
Balance before the sale 100 $5
of 200 units on 3/7
150 $6
$100 x 5 + 100 x 6 = $1100
** Balance before the sale
of 30 units on 3/28
50 $6
100 $7
30 x $6 = $180
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 15
If the CGS Is Based on LIFO:
3/7 Cost of good sold*
Inventory
1,150
1,150
* Balance before the sale:
100 $5
150 $6
$150 x $6 + 50 x $5 = $1,150
3/28 Cost of goods sold**
Inventory
** Balance before the sale:
210
210
50 $5
100 $7
30 x $7 = $210
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 16
If the CGS Is Based on WeightedAverage Method:
3/7 Cost of good sold*
Inventory
1,120
1,120
* 200 x $5.6 = $1,120
3/28 Cost of goods sold**
Inventory
195.90
195.90
** 30 x 6.53 = $195.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 17
The T Accounts of CGS at the End
of Period (3/31):
CGS (FIFO)
1,100
180
1,280
CGS (LIFO)
1,150
200
1,360
CGS (WA)
1,120
195.90
1,315.90
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 18
End of Period Adjustments
1. Adjustment for lost units
2. Adjustments for LCM (Lower-of-Costor-market) valuation
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 19
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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 20
Adjustment for Lost Units (contd.)

Adjusting Ending:
3/31 Loss from Declining
in inventory units
Inventory
60
60
Inventory (FIFO)
820
60
760
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 21
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 22
2. Adjustments for LCM Valuation
(contd.)

Adjusting entry ==>Given Allowance for
declining in market value of inventory with a
beginning balance of zero.
Allowance
0 -- 3/1
160
160 -- 3/31
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 23
B/S (3/31)
Inventory
Allowance
Inv. At LCM
760
(160)
600
3/31 Loss Due to Market
Decline of Inventory
Allowance to reduce
Inventory to market
160
160
I/S (for the period ended 3/31)
Loss(from declining in units)
Loss (or CGS)
CGS
$ 60
$160
$1,280
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 24
Periodic Inventory System

Using the example on page 11, the following
entries will be recorded under the periodic
inventory system:
3/5
Purchases
Cash
3/7 Cash
Sales Revenue
3/14 Purchases
Cash
3/28 Cash
Sales Revenue
900
900
2,000
2,000
700
700
330
330
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 25
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 26
Example

Periodic Inventory System
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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 27
Periodic Inventory System
Example (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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 28
Periodic Inventory System
Example (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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 29
Periodic Inventory System
End of Period Adjustments
1. 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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 30
Periodic Inventory System
End of Period Adjustments (contd.)

Adjusting entry:
Loss Due to Market Value
Decline of Inventory (or CGS)
Allowance to Reduce
Inventory to Market Value
130
130
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 31
B/S (3/31)
Inventory
Allowance
Inv. At LCM
730
(130)
600
I/S (for the period ended 3/31)
Loss Due to Market Value
Decline of Inv. (or CGS)
Cost of Good Sold:
Beginning Inventory
Net Purchase
Total Goods Available for Sale
Ending Inventory
130
$ 500
1,600
$2,100
(730)
1,370
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 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
500
Inventory (Beg. Balance)
500
b. Transfer the cost of purchase to CGS:
CGS
1,600
Purchase
1,600
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 33
Periodic Inventory System (contd.)
c. Record the cost of ending inventory based
on a physical count of 105 units and a FIFO
cost-flow assumption:
Inventory (ending balance)
CGS
730
730
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 34
Periodic Inventory System (contd.)
T- accounts:
B.B
c.
Inventory
500
a. 500
730
3/5
3/14
Purchase
900
b. 1,600
700
a.
b.
CGS
500
c. 730
1,600
1,370
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 35
Comparison of FIFO vs. LIFO

During an Inflation Period
Income
Tax
B/S
I/S
LIFO
(matching
current cost
with revenue if
the inventory is
not depleted to
early layers)
Low
Low
Unfair
Fair
FIFO
High
High
Fair
Unfair
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 36
Survey: (Source: Accounting Trends &
Techniques and KWW Textbook) a, b,c
Yearl
1984
Firms
1061
100%
1038
100%
LIF1O
408
38%
379
36.5%
FIFO
366
30%
396
38%
W-A
225
22%
213
20.5%
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%
1988
325
147
Inventories:
49% Measurement
22%
Others
52
5%
50
5%
18
2.6%
37
Survey: (Source: Accounting Trends &
Techniques ) (contd.)
c.
Sample firms are 600 firms. Most companies
adopt more than one inventory method.
Due to low inflation, the number of firms
adopting LIFO has declined since mid-1980s.
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.
a.
b.
Inventories: Measurement
38
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
Inventories: Measurement
39
Reason of Switching to LIFO
1. Tax savings.
2. Income Manipulation.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 40
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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 41
a. Liquidation LIFO


Income Manipulation
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 42
Income Manipulation
b. 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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 43
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 44
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 45
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).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 46
Disadvantages of LIFO
a. Inventory cost presented on the B/S is
not fair.
b. Subject to management.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 47
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).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 48
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).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 49
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 for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 50
Accounting Principles and Theory
Related to Inventories
1. Consistency Principle
2. Disclosure Principle
3. Materiality
4. Conservatism
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 51
The Impact of Inventory Errors on the
Financial Statements
Year 1:
Income CGS Gross Margin = Beg Inv + Net Pur - End Inv
under over
over under
Year 2:
over under
under over
under
over
over
under
under *
over **
under
over
* either understating the units or understating the value
** either overstating the units or the value
*** Gross Margin = Sales Revenue - CGS
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 52
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).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 53
Estimating Inventory: Gross Margin
Method



Reasons: For some companies, inventory
information is needed between accounting
periods. 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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 54
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 55
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)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 56
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)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 57
Using Gross Profit Method to Estimate
the Cost of Ending Inventory
Selling Price
Beg, Inv.
Purchase (net)
Goods Avai. For Sale
Sales
Less: gross margin*
Sales (at cost)
Estimated Inv. (at cost)
Cost
$60,000
200,000
260,000
280,000
(84,000)
196,000 **
64,000
* gross margin = 280,000 x 30%
** also equalsAccounting
280,000
x (1-30%)
= 196,000
for Merchandise
Inventory, Cost
of Goods Sold and the Gross Profit
58
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 59
Analyzing Financial Statements
1. Inventory turnover rate
2. Gross margin percentage
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 60
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
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 61
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 62
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).
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 63
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.
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 64
Inventory Transaction on the
Cash Flow Statement
Cash Flows from Operating Activities:
Collection from Customers
$xxx
Cash Payments to Suppliers
($xxx)
Accounting for Merchandise Inventory, Cost of Goods Sold and the Gross Profit 65