C H A P T E R

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• C H A P T E R

Inventory
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Learning Objective 1

• Identify what items and costs should be included
  in inventory and cost of goods sold.

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Define Inventory and COGS. What are some of their
characteristics?

• Inventory is reported on balance sheet as an
  asset.
• When sold, inventory is reported on income
  statement as an expense (cost of goods sold).
• COGS the cost of inventory sold during the
  period.

Goods either manufactured or purchased for
resale.
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Describe the Time Line of Business.
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What is Inventory?

• Defined according to type and nature of the
  company.

Merchandising Items to be resold. For a
supermarket, food is inventory, the shopping
cart is not.

• Manufacturing
• raw materials
• work in process
• finished goods

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Define Each Manufacturing Inventory

• Raw materials
• Goods acquired in a relatively undeveloped state.
• Eventually will compose a major part of the
  finished product.
• Work in process
• Partly finished products.
• Manufacturing plant contains work- in-process
  inventory.
• Finished goods
• Completed products waiting for sale.

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What Costs are Included in Inventory?

• Costs incurred in buying inventory and preparing
  it for sale.
• Cost of raw materials.
• Cost of work-in-process inventory.
• Cost of finished goods.

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Who Owns the Inventory?
When goods are in transit? Q Who owns the
inventory on a truck or railroad car? A The
party who is paying the shipping costs. When
goods are on consignment? Q Who owns inventory
stocked in a warehouse? A The supplier until
the inventory is sold. The warehouse owner
stocks and sells the inventory and receives a
commission on sales as payment for services
rendered.
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Ending Inventory COGS
Cost of goods available for sale
Beginning inventory
Net purchases


The question is where is the inventory that could
have been sold this period? Only two choices

• At periods end, is allocated between
• inventory still remaining (an asset), and
• inventory sold during the period (an expense,
  Cost of Goods Sold).

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Learning Objective 2

• Account for inventory purchases and sales using
  both a perpetual and a periodic inventory system.

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What are the Two Methods for Accounting for
Inventory?

• Perpetual
• Records are updated when a purchase or sale is
  made.
• Records reflect total items in inventory or sold
  at any given time.
• Most often used when
• each item has a relatively high value, or
• the cost of running out of or overstocking an
  item is expensive.

• Periodic
• Records are not updated when a purchase or a sale
  is made.
• Only the dollar amount of the sale is recorded.
• Used when
• inventory is composed of a large number of
  diverse items,
• each with a relatively low value.

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Example Accounting for Inventory Purchases and
Sales
Harpers Hats recorded the following transactions
for 2001
Beginning inventory 10 hats _at_ 10 each
100 March 1 Purchase 15 hats _at_ 15 each
225 March 1 Freight in 10 March 1 Purchase
return 3 hats _at_ 15 each 45 May 2
Purchase 10 hats _at_ 20 each 200 May 2 Purchase
discount 2/10, n/30 June 30 Sales 20 hats (10 _at_
10, 10 _at_ 15) July 3 Sales return 1 hat _at_
15 15 Ending inventory 13 hats
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Example 2001 Inventory
Purchase Sale Balance
Date Units Total Units Total Units Cost
Total
Jan. 1 10 10 100 Mar. 1 15 225
10 10 100 15 15 225 (3)
(45) 12 15 180 May 2 10 200
10 10 100 12 15 180 10 20 200 Jun
e 30 10 100 10 150 2 15
30 10 20 200 July 3 (1) (15) 3 15
45 10 20 200
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Purchases
Harper purchased 10 hats at 10 each on January
1. Record the entries for both the perpetual and
the periodic systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Transportation Cost
Harper hired a trucking company to deliver its
March 1 purchase of 15 hats. The trucking
company charged 10. Record the entries for both
the perpetual and the periodic systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Purchase Returns
Of the 15 hats delivered on March 1, three were
defective and Harper returned them the same day.
Record the entries for both the perpetual and the
periodic inventory systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Purchase Discounts
On May 2, Harper purchased 10 hats at 20 each.
The supplier offered terms of 2/10, n/30. Record
the entries for both the perpetual and the
periodic inventory systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts

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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Sales
In June, Harpers Hats sold 20 hats for 25 each
(selling the old ones first). Record the entries
for both the perpetual and the periodic systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Journal Entriesfor Sales Returns
On July 3, one hat was returned from a late June
purchase. Record the entries for both the
perpetual and the periodic inventory systems.
PERPETUAL
PERIODIC
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Perpetual PeriodicJournal Entries

• Purchases
• Transportation costs
• Purchase returns
• Purchase discounts
• Sales
• Sales returns
• Closing entries for COGS

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Example Accounting for Inventory Purchases and
Sales
Harpers Hats recorded the following transactions
for 2001
Beginning inventory 10 hats _at_ 10 each
100 March 1 Purchase 15 hats _at_ 15 each
225 March 1 Freight in 10 March 1 Purchase
return 3 hats _at_ 15 each 45 May 2
Purchase 10 hats _at_ 20 each 200 May 2 Purchase
discount 2/10, n/30 June 30 Sales 20 hats (10 _at_
10, 10 _at_ 15) July 3 Sales return 1 hat _at_
15 15 Ending inventory 13 hats
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Example Closing Entries for Cost of Goods Sold

• Perpetual the inventory account will have an
  ending balance of 255.

Inventory
COGS
1/1 100 3/1 225 3/1 45 3/1 10 5/2 200 6/30 250
7/3 15 Bal. 255
6/30 250 7/3 15 Bal. 235
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Example Closing Entries for Cost of Goods Sold

• Periodic the inventory account will be debited
  by 386, which represents the net purchases for
  the year.

Jul. 31 Inventory. . . . . . . . . . . . . . . .
. . . 386 Purchase Returns. . . . . . . . . . .
. 45 Purchase Discounts. . . . . . . . .
. 4 Freight In. . . . . . . . . . . . . . . .
. 10 Purchases. . . . . . . . . . . . . . .
. 425
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Periodic Inventory
With a periodic system, a physical count is the
only way to get the information necessary to
compute COGS
Beginning Inventory, January 1, 2001 Purchases
for the year Cost of goods
available for sale during 2001 Ending
Inventory, December 31, 2001 Cost of Goods Sold
for 2001
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Learning Objective 3

• Calculate cost of goods sold using the results of
  an inventory count and understand the impact of
  errors in ending inventory on reported cost of
  goods sold.

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Physical Count of Inventory
Essential to maintaining reliable inventory
accounting records.
Periodic The only way to get information
necessary to compute COGS
Perpetual Physical count either confirms records
are accurate or highlights shortages and clerical
errors.

• Quantity count.
• Inventory costing (assigning a unit cost to each
  type of merchandise).
• Ending inventory quantity of each type x its
  unit cost.

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COGS Computation

• Periodic
• Company does not know what ending inventory
  should be.
• Assumes physical count is the difference between
  cost of goods available for sale and ending
  inventory.
• Cannot tell whether goods were sold, lost,
  stolen, or spoiled.

• Perpetual
• The accounting records yield the COGS for the
  period as well as the amount of inventory that
  should be found with a physical count.
• The difference between the records and actual
  count inventory lost, stolen, or spoiled.

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What is the Income Effect of an Error in Ending
Inventory?
An error in inventory results in COGS being
overstated or understated. The inventory error
has the opposite effect on gross margin and net
income.

• Any uncorrected error will affect the financial
  statements for two years.

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Effects of Inventory Errors
OK OK LOW LOW OK LOW HIGH OK HIGH
OK LOW OK LOW OK LOW HIGH OK HIGH
LOW OK OK OK OK OK LOW OK LOW
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Learning Objective 4

• Apply the four inventory cost flow alternatives
  specific identification, FIFO, LIFO, and average
  cost.

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Inventory Cost Flow

• Kernel King buys and sells corn and had the
  following transactions for 2002
• June 10 Purchased 10 tons at 6 per ton.
• July 28 Purchased 10 tons at 9 per ton.
• October 10 Sold 10 tons at 11 per ton.
• How much did Kernel King make in 2002?

Case 1 Case 2 Case 3 Sold Sold Sold Old
Corn New Corn Mixed Corn Sales (11 x 10
tons) 110 110 110 COGS (10 tons) 60
90 75 Gross margin 50 20 35
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Specific Identification Cost Flow

• Specifically identify the cost of each unit sold.
• The individual cost of each unit is charged
  against revenue as COGS.
• To compute COGS and ending inventory, a firm must
  know each unit sold and its cost.

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Inventory Cost Flow Methods

• FIFO
• The oldest units are sold and the newest units
  remain in inventory.
• The cost of the oldest units purchased is
  transferred to COGS.

• LIFO
• The newest units are sold and the oldest units
  remain in inventory.
• The cost of the most recent units purchased is
  transferred to COGS.

• Average Cost
• An average cost is computed for all inventory
  available for sale during the period.
• COGS is computed by multiplying the number of
  units sold by the average cost per unit.

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Comparison ofInventory Methods

• LIFO gives a better reflection of COGS in the
  income statement.
• Therefore, LIFO is a better measure of income.

• FIFO gives a better measure of inventory on the
  balance sheet.
• Therefore, FIFO is a better measure of inventory
  value.

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Learning Objective 5

• Use financial ratios to evaluate a companys
  inventory level.

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Why Use JIT Inventory Management?

• Money tied up in inventory cannot be used for
  other purposes.
• JIT attempts to have exactly enough inventory
  arrive just in time for sale.
• Its purpose is to minimize investment in
  inventories while at the same time having
  enough inventory on hand to meet customer demand.

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Evaluating Inventory Levels

• Inventory Turnover
• Measures how many times a company turns over (or
  replenishes) its inventory.
• Average inventory average of the beginning and
  ending inventory balances.
• Number of Days Sales in Inventory

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Example Evaluating Inventory Management
Buster Boots had cost of goods sold of 60,000
during 2002. The inventory account decreased by
1,000 to 4,000 during the same time. Calculate
the inventory turnover ratio and number of days
sales in inventory.
Inventory turnover ratio
Number of days sales in inventory
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Expanded MaterialLearning Objective 6

• Analyze the impact of inventory errors on
  reported cost of goods sold.

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What Is the Effect of These Inventory Errors?

• If a sale is recorded but the merchandise remains
  in inventory and is counted in ending inventory,
• gt COGS Ô understated
• gt gross margin Ô overstated
• gt net income Ô overstated
• If a sale is not recorded, but inventory is
  shipped and not counted in ending inventory,
• gt COGS Ô overstated
• gt gross margin Ô understated
• gt net income Ô understated

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Expanded MaterialLearning Objective 7

• Describe the complications that arise when LIFO
  or average cost is used with a perpetual
  inventory system.

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Using Average Cost or LIFO with a Perpetual System

• Using average cost or LIFO with perpetual leads
  to complications.
• The average cost of units available for sale
  changes every time a purchase is made.
• The identification of the last in units also
  changes with every purchase.
• With periodic,
• One overall average cost is used for all goods
  available for sale during the period.
• The last in units are identified at the end of
  the period.

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Describe the Similarities of Using FIFO for
Perpetual and Periodic Systems.

• No complications arise as no matter when sales
  occur, the first in units are always the same
  in both systems.
• FIFO periodic and FIFO perpetual yield the same
  numbers for COGS and ending inventory.

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Expanded MaterialLearning Objective 8

• Apply the lower-of-cost-or-market method of
  accounting for inventory.

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When Do You Report Inventory Below Cost?

• All inventory costing alternatives report
  inventory at cost.
• Inventory is reported at less than cost when
• the future value of the inventory is in doubt
  (damaged, used, or obsolete), or
• it can be replaced new at a price less than the
  original cost.

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When Do You Report Inventory at Net Realizable
Value (NRV)?

• When inventory is damaged, used, or obsolete, it
  should be reported at no more than its net
  realizable value (the amount it can be sold for,
  less any selling costs).
• NRV should be recognized as soon as a firm
  determines that an economic loss has occurred.
• Loss is recognized when inventory is written
  down, not when inventory is finally sold.
• Therefore, assets are not being reported at more
  than their future economic benefit.

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Lower of Cost or Market (LCM)

• LCM A basis for valuing inventory at the lower
  of original cost or current market value.

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Example LCM
Market Inventory
Replacement NRV Item Cost
Floor Cost Ceiling
A 34 20 32 30 B 42
32 36 46 C 52 44
42 62 D 38 50 32 68

• Define market value as
• replacement cost, if it falls between the ceiling
  and the floor.
• the floor, if the replacement cost is less than
  the floor.
• the ceiling, if the replacement cost is higher
  than the ceiling.
• When replacement cost, ceiling, and floor are
  compared, market is always the middle value.

Compare the defined market value with the
original cost and choose the lower amount.
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Expanded MaterialLearning Objective 9

• Explain the gross margin method of estimating
  inventories.

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Gross Margin Method

• There are times when a physical count of
  inventory is either impossible or impractical.
• If perpetual is used, the inventory account
  balance is assumed to be correct.
• If periodic is used, an estimate of the inventory
  balance must be made.
• Gross margin method.
• COGS and ending inventory are estimated using
  available information
• beginning inventory
• purchases
• historical gross margin percentage