1.Internal Control of Inventories

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Power Notes
Chapter F8
Inventories
Learning Objectives

• 1. Internal Control of Inventories
• 2. Effect of Inventory Errors
• 3. Inventory Cost Flow Assumptions
• 4. Perpetual Inventory Costing Methods
• 5. Periodic Inventory Costing Methods
• 6. Comparing Inventory Costing Methods
• 7. Inventory Valuation Other Than Cost
• 8. Balance Sheet Presentation of Merchandise
• 9. Estimating Inventory Cost
• 10. Financial Analysis and Interpretation

C8
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Power Notes
Chapter F8
Inventories
Slide Power Note Topics
3 7 23 31 33 37

• Inventory Control and Relationships
• Perpetual Inventory Accounting
• LIFO and FIFO Cost Flow Assumptions
• Inventory at Lower-of-Cost-or-Market
• Retail and Gross Profit Methods
• Inventory Turnover Ratio

Note To select a topic, type the slide and
press Enter.
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Why 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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Inventory Costs and Relationships
LIABILITIES
Merchandise Inventory
OWNERS EQUITY
ASSETS
Net Income
Cost of Mdse. Sold
REVENUES
COSTS EXPENSES
If merchandise inventory is . . . . . . .
overstated Cost of merchandise sold is . . . .
. . Gross profit and net income are . . .
Ending owners equity is . . . . . . . . .

• understated
• overstated
• overstated

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Inventory Costs and Relationships
LIABILITIES
Merchandise Inventory
OWNERS EQUITY
ASSETS
Net Income
Cost of Mdse. Sold
REVENUES
COSTS EXPENSES
If merchandise inventory is . . . . . . .
understated Cost of merchandise sold is . . . .
. . Gross profit and net income are . . .
Ending owners equity is . . . . . . . . .

• overstated
• understated
• understated

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Merchandising and Inventory

• Merchandising involves selling inventory.
• Inventory is usually an important asset.
• Inventory must be accounted for periodically or
  perpetually.
• Traditional periodic method is often being
  replaced by perpetual inventory accounting.

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Advantages of Using Perpetual Inventory

• Continuous determination of inventory value
• Continuous determination of gross profit
• Affordable with computers, scanners, and bar
  codes on most products
• Perpetual inventory accounting provides
  management controls.
• Managers know which items are selling fastest and
  the profit margin on those items.

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Perpetual Inventory Costs
Inventory cost data to demonstrate FIFO and LIFO
Perpetual Systems
Item 127B Units Cost
Price Jan. 1 Inventory 10 20 4 Sale 7 30
10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 3
0 Purchase 10 22
Cost of Mdse. Sold
Sale price assumptions are added to demonstrate
journal entries and ease of calculating gross
profit.
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FIFO Perpetual Inventory Account
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


The sale of 7 units leaves a balance of 3 units.
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FIFO Perpetual Inventory Account
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 6
0 8 21 168


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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FIFO Perpetual Inventory Account
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 6
0 8 21 168 22 3 20 60 1 21
21 7 21 147


Of the 4 units sold, 3 come from the first units
in (FIFO) at a cost of 20.
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FIFO Perpetual Inventory Account
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 6
0 8 21 168 22 3 20 60 1 21
21 7 21 147 28 2 21 42 5 21 105

Sold 2 units from the 7 units on hand. No
allocation is necessary.
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FIFO Perpetual Inventory Account
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 6
0 8 21 168 22 3 20 60 1 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
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FIFO Perpetual Inventory Account
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 22 3 20 60 1 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
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FIFO Perpetual Inventory Accounting
Date Description Debit Credit

• Accounts Receivable 390
• Sales 390
• Cost of Merchandise Sold 263
• Merchandise Inventory 263
• Gross Profit Sales (390) minus
• Cost of Merchandise Sold (263) 127

Jan. 31
To record January sales of item 127B. (7
units_at_30, 4 units_at_30, 2 units_at_30)
Jan. 31
To record cost of January sales of item 127B.
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of
Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost Cost Qty. Cost Cost Qty. Cost Cost
Jan. 1 10 20 200
4 7 20 140 3 20 60


The sale of 7 units leaves a balance of 3 units.
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of Mdse. Sold
Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost 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 6
0 8 21 168


The purchase price of 21 is different than the
cost of the previous 3 units on hand therefore,
the inventory balance of 11 units is accounted
for separately.
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of Mdse. Sold
Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost 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 6
0 8 21 168 22 4 21 84 3 20 60
4 21 84

Of the 4 units sold, all come from the last units
in (LIFO) at a cost of 21.
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost 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 6
0 8 21 168 22 4 21 84 3 20 60
4 21 84 28 2 21 42 3 20 60
2 21 42


Of the 2 units sold, all come from the last units
in (LIFO) at a cost of 21, leaving 2 units from
that group.
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost 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 6
0 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
42 10 22 220
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LIFO Perpetual Inventory Account
Item 127B
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. C
ost 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 2
1 42 10 22 220
Totals 18 388 13 266 15 322
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LIFO Perpetual Inventory Accounting
Date Description Debit Credit

• Accounts Receivable 390
• Sales 390
• Cost of Merchandise Sold 266
• Merchandise Inventory 266
• Gross Profit Sales (390) minus
• Cost of Merchandise Sold (266) 124

Jan. 31
To record January sales of item 127B. (7
units_at_30, 4 units_at_30, 2 units_at_30)
Jan. 31
To record cost of January sales of item 127B.
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First-In, First-Out Flow of Costs
Merchandise Available for Sale
Purchases
Jan. 1 200 units at 9
1,800
Mar. 10 300 units at 10
3,000
Sep. 21 400 units at 11
4,400
Nov. 18 100 units at 12
Using FIFO costing, which units are assumed to be
sold first?
1,200
10,400
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First-In, First-Out Flow of Costs
Cost of Merchandise Sold
Merchandise Available for Sale
Purchases
200 units at 9
1,800
Jan. 1 200 units at 9
1,800
3,000
300 units at 10
Mar. 10 300 units at 10
3,000
200 units at 11
2,200
Sep. 21 400 units at 11
7,000
4,400
Nov. 18 100 units at 12
FIFO cost flow assumes merchandise acquired first
is sold first.
1,200
10,400
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First-In, First-Out Flow of Costs
Cost of Merchandise Sold
Merchandise Available for Sale
Purchases
200 units at 9
1,800
Jan. 1 200 units at 9
1,800
3,000
300 units at 10
Mar. 10 300 units at 10
3,000
200 units at 11
2,200
Sep. 21 400 units at 11
7,000
4,400
Merchandise Inventory
Nov. 18 100 units at 12
1,200
2,200
200 units at 11
10,400
100 units at 12
1,200
3,400
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First-In, First-Out Flow of Costs
Cost of Merchandise Sold
Merchandise Available for Sale
Purchases
200 units at 9
1,800
Jan. 1 200 units at 9
1,800
3,000
300 units at 10
Mar. 10 300 units at 10
3,000
200 units at 11
2,200
Sep. 21 400 units at 11
7,000
700 units
4,400
Merchandise Inventory
Nov. 18 100 units at 12
1,200
2,200
200 units at 11
10,400
1,000 units
100 units at 12
1,200
3,400
300 units
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Last-In, First-Out Flow of Costs
Merchandise Available for Sale
Purchases
Using LIFO costing, which units are assumed to be
sold first?
Jan. 1 200 units at 9
1,800
Mar. 10 300 units at 10
3,000
Sep. 21 400 units at 11
4,400
Nov. 18 100 units at 12
1,200
10,400
1,000 units total
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Last-In, First-Out Flow of Costs
Merchandise Available for Sale
Purchases
LIFO cost flow assumes merchandise acquired last
is sold first.
Jan. 1 200 units at 9
1,800
Mar. 10 300 units at 10
3,000
Cost of Merchandise Sold
Sep. 21 400 units at 11
4,400
2,000
200 units at 10
Nov. 18 100 units at 12
1,200
4,400
400 units at 11
10,400
1,000 units total
1,200
100 units at 12
7,600
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Last-In, First-Out Flow of Costs
Merchandise Inventory
Merchandise Available for Sale
200 units at 9
Purchases
1,800
Jan. 1 200 units at 9
1,000
100 units at 10
1,800
2,800
Mar. 10 300 units at 10
3,000
Cost of Merchandise Sold
Sep. 21 400 units at 11
4,400
2,000
200 units at 10
Nov. 18 100 units at 12
1,200
4,400
400 units at 11
10,400
1,200
100 units at 12
7,600
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Last-In, First-Out Flow of Costs
Merchandise Inventory
Merchandise Available for Sale
200 units at 9
Purchases
1,800
Jan. 1 200 units at 9
1,000
100 units at 10
1,800
2,800
300 units
Mar. 10 300 units at 10
3,000
Cost of Merchandise Sold
Sep. 21 400 units at 11
4,400
2,000
200 units at 10
Nov. 18 100 units at 12
1,200
4,400
400 units at 11
10,400
1,000 units
1,200
100 units at 12
7,600
700 units
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Valuation of Inventory at Lower-of-Cost-or-Market
Unit Unit Inventory Cost Market Total Total Low
er Item Quantity Price Price Cost Market C or M
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

• 3,800
• 2,700
• 4,650
• 3,920
• Total 15,520 15,472 15,070
• The market decline is either
• 1. Based on total inventory (15,520
  15,472) 48
• 2. Based on individual items (15,520
  15,070) 450
• The decline is reported on the income statement
  as a
• separate item or included in the cost of
  merchandise sold.

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Afro-ArtsBalance SheetDecember 31, 2004

• Assets
• Current assets
• Cash 19,400
• Accounts receivable 80,000
• Less allowance 3,000 77,000
• Merchandise inventory
• at lower of cost (first-in,
• first-out method) or market 216,300

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Retail 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.
• Inventory at retail is calculated as retail price
  of merchandise available for sale less sales.
• 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 Method Calculation
Cost Retail
Merchandise inventory, January 1 19,400 36,000 P
urchases in January (net) 42,600 64,000 Merchandis
e available for sale Ratio of cost to retail
price Sales for January
(net) 70,000 Merchandise inventory, January 31,
at retail Merchandise inventory, January 31, at
est. cost

• 62,000 100,000
• (62,000 / 100,000 62)
• 30,000
• (30,000 x 62) 18,600

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Gross Profit Method of Estimating Inventory 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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Gross Profit Method Calculation
Merchandise inventory, January 1
57,000 Purchases in January (net) 180,000 Merchan
dise available for sale Sales in January
(net) 250,000 Less Estimated gross profit
Estimated cost of merchandise sold Estimated
merchandise inventory, January 31

• 237,000
• (250,000 x 30) 75,000
• 175,000
• 62,000
• Many firms generate a surprisingly stable and
  predictable gross profit as a percentage of sales.

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Inventory Turnover Ratios
SUPERVALU Zale
Cost of goods sold 15,620,127,000
737,188,000 Inventories Beginning of
year 1,115,529,000 478,467,000 End of year
1,067,837,000 571,669,000 Average 1,091,683,000
525,068,000
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Inventory Turnover Ratios
SUPERVALU Zale
Cost of goods sold 15,620,127,000
737,188,000 Inventories Beginning of
year 1,115,529,000 478,467,000 End of year
1,067,837,000 571,669,000 Average 1,091,683,000
525,068,000
Inventory turnover 14.3 times 1.4 times
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Inventory Turnover Ratios
SUPERVALU La-Z-Boy
Cost of goods sold 15,620,127,000
737,188,000 Inventories Beginning of
year 1,115,529,000 478,467,000 End of year
1,067,837,000 571,669,000 Average 1,091,683,000
525,068,000
Inventory turnover 14.3 times 1.4 times Average
selling period 25 days 283 days
Use To assess the efficiency in the management
of inventory
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Power Notes
Chapter F8
Inventories
This is the last slide in Chapter F8.