Ch06 wrd12e instructor_final

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Learning Objectives

1.

Describe the importance of control over
inventory.

2.

Describe three inventory cost flow assumptions
and how they impact the income statement and
balance sheet.

3.

Determine the cost of inventory under the
perpetual inventory system, using the FIFO, LIFO,
and weighted average cost methods.

4.

Determine the cost of inventory under the
periodic inventory system, using the FIFO, LIFO,
and weighted average cost methods.

Learning Objectives

5. Compare and contrast the use of the three
inventory costing method.

6. Describe and illustrate the reporting of
merchandise inventory in the financial
statements.

7. Describe and illustrate the inventory turnover
and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of
inventory management.

Lear
ning
Obje
De s c
ctive
ribe
the i
mpo
rtanc
e of
cont
over
rol
inve
nt or y
.

1


Control of Inventory

o Two primary objectives of control over
inventory are:

 Safeguarding the inventory from damage or theft.
 Reporting inventory in the financial statements.


Safeguarding Inventory

o

The purchase order authorizes the purchase of
the inventory from an approved vendor.



o The receiving report establishes an initial
record of the receipt of the inventory.



o Recording inventory using a perpetual

inventory system is also an effective means of
control. The amount of inventory is always
available in the subsidiary inventory ledger.



o Controls for safeguarding inventory should

include security measures to prevent damage
and customer or employee theft. Some
examples of security measures include the
following:
 Storing inventory in areas that are restricted to only

authorized employees.

 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags, and

guards.


Reporting Inventory

o

A physical inventory or count of inventory
should be taken near year-end to make sure
that the quantity of inventory reported in the
financial statements is accurate.


Lear
ning
Obje
De s c
ctive
r ibe
assu
mpti three inv
t
he in
o
e
com ns and h ntory co
e sta
teme ow they i st flow
m
n t an
d ba pact
l anc e
shee
t.

2


INVENTORY
COST FLOW
ASSUMPTIONS

Inventory Cost Flow Assumptions


o Assume that one unit is sold on May 30 for $20.

Depending upon which unit was sold, the gross
profit varies from $11 to $6 as shown below:



o Under the specific identification inventory cost
flow method, the unit sold is identified with a
specific purchase.



o

Under the first-in, first out (FIFO) inventory
cost flow method, the first units purchased are
assumed to be sold first and the ending
inventory is made up of the most recent
purchases.



o

Under the last-in, first out (LIFO) inventory
cost flow method, the last units purchased are
assumed to be sold first and the ending
inventory is made up of the first units
purchased.



o

Under the weighted average inventory cost
flow method, the cost of the units sold and in
ending inventory is a weighted average of the
purchase costs.


INVENTORY
COST FLOW
ASSUMPTIONS

(continued)

INVENTORY
COST FLOW
ASSUMPTIONS

(concluded)

Lear
ning
Obje
ctive
Dete
rmin
e t he
unde
c
r
ost o
syste r the p
f inve
m, u s
e r pe
weig
hted ing the F tual inve ntory
ntory
IFO,
aver
age
L
cost IFO, and
meth
ods.

3


Inventory Costing Methods

o For purposes of illustration, the data for Item

127B are used, as shown below. We will
examine the perpetual inventory system first.


FIRST-IN, FIRSTOUT METHOD

(continued)

LAST-IN, FIRSTOUT METHOD

(continued)

Weighted Average Cost Method

o

When the weighted average cost method is
used in a perpetual system, an average unit
cost for each item is computed each time a
purchase is made.

o

This unit cost is then used to determine the
cost of each sale until another purchase is
made and a new average is computed. This
averaging technique is called a moving
average.


Lear
ning
Obje
ctive
Dete
rmin
u n de e t h e c
ost o
syste er the
m, u s
perio f inve
weig
hted ing the F dic inve ntory
nt or y
IFO,
aver
age
L
cost IFO, and
meth
ods.

4


First-In, First-Out Method

o

Using FIFO, the earliest batch purchased is
considered the first batch of merchandise
sold. The physical flow does not have to match
the accounting method chosen. This time we
will be examining the periodic inventory
system.



o Beginning inventory and purchases of Item
127B in January are as follows:

Cost of merchandise
available for sale



o The physical count on January 31 shows that

800 units are on hand. (Conclusion: 1,300 units
were sold.) What is the cost of the ending
inventory?



o Now we can calculate the cost of merchandise
sold as follows:


Last-In, First-Out Method

o

Using LIFO, the most recent batch purchased
is considered the first batch of merchandise
sold. The actual flow of goods does not have to
be LIFO. For example, a store selling fresh fish
would want to sell the oldest fish first (which is
FIFO), even though LIFO is used for
accounting purposes.


Last-In, First-Out Method

o Assume again that the physical count on

January 31 is 800 units (and that 1,300 units
were sold). What is the cost of the
merchandise sold?


o

The weighted average cost method uses the
weighted average unit cost for determining
cost of merchandise sold and the ending
merchandise inventory.



Average cost
per unit

Ending
Inventory

Lear
ning
Obje
Com
ctive
pare
three and con
tr
i
nven
a
tory st the us
e of
costi
t he
ng m
etho
ds.

5


Comparing Inventory Cost Methods

o Using the perpetual inventory system

illustration with sales of $39,000 (1,300 units x
$30), the differences in ending inventory, cost
of merchandise sold, and gross profit are
illustrated in the next three slides.


PARTIAL
INCOME
STATEMENTS
(FIFO)

PARTIAL INCOME
STATEMENTS
(WEIGHTED AVERAGE
COST)

PARTIAL
INCOME
STATEMENTS
(LIFO)

COMPARING
INVENTORY
COST METHODS


o When the FIFO method is used during a

period of inflation or rising prices, FIFO will
show a larger profit than the other two
inventory costing methods.


o When the LIFO method is used during a

period of inflation or rising prices, LIFO will
show a lower profit than the other two
inventory costing methods.

o During a period of rising prices, using LIFO

offers an income tax savings compared to the
other two inventory costing methods.


o The weighted average cost method of

inventory costing is a compromise between
FIFO and LIFO. Net income for the weighted
average cost method is somewhere between
the net incomes of LIFO and FIFO.


Lear
ning
Obje
ctive
De s c
repo
ribe
rting
a nd
of m
illust
erch
rate
in th
an di
t he
e f in
se in
ancia
vent
or y
l stat
em e
nts.

6


Reporting Merchandise Inventory

o Cost is the primary basis for valuing and

reporting inventories in the financial
statements. However, inventory may be valued
at other than cost in the following cases:
 The cost of replacing items in inventory is below the

recorded cost.

 The inventory cannot be sold at normal prices due

to imperfections, style changes, or other causes.


Valuation at Lower of Cost or Market
o Market, as used in lower-of-cost-or-market

method, is the cost to replace the merchandise
on the inventory date.


Valuation at Lower of Cost or Market

o Cost and replacement cost can be determined
for the following:

 Each item in the inventory.
 Each major class or category of inventory.
 Total inventory as a whole.


VALUATION AT
LOWER OF COST
OR MARKET

Valuation at Net Realizable Value
o

Merchandise that is out of date, spoiled, or
damaged should be written down to its net
realizable value. This is the estimated selling
price less any direct costs of disposal, such as
sales commissions or special advertising.


Valuation at Net Realizable Value

o Assume the following data about an item of
damaged merchandise:
Original cost
Estimated selling price
Selling expenses

$1,000
800
150

o The merchandise should be valued at its net
realizable value of $650 ($800 – $150).


Merchandise Inventory on the Balance Sheet

o

Merchandise inventory is usually presented in
the Current Assets section of the balance
sheet, following receivables.


Merchandise Inventory on the Balance Sheet

o The method of determining the cost of the

inventory (FIFO, LIFO, or weighted average)
and the method of valuing the inventory (cost
or the lower of cost or market) should be
shown.


MERCHANDISE
INVENTORY ON
THE BALANCE
SHEET

Inventory Errors

o Some reasons that inventory errors may occur
include the following:

 Physical inventory on hand was miscounted.
 Costs were incorrectly assigned to inventory.
 Inventory in transit was incorrectly included or

excluded from inventory.

 Consigned inventory was incorrectly included or

excluded from inventory.


Inventory Errors
o

Inventory errors often arise from consigned
inventory. Manufacturers sometimes ship
merchandise to retailers who act as the
manufacturer’s agent.


Inventory Errors

o The manufacturer, called the consignor, retains

title until the goods are sold. Such merchandise
is said to be shipped on consignment to the
retailer, called the consignee.


Lear
ning
Obje
Desc
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in in ver and nd illus
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in an number the inve
and
effecalyzing of days’ ntory
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nc
f
man inventor y
agem y
ent.

7


Inventory Turnover
o

Inventory turnover measures the relationship
between cost of merchandise sold and the
amount of inventory carried during the
period. It is calculated as follows:
Cost of Merchandise Sold
Inventory Turnover =
Average Inventory


Inventory Turnover

o Inventory turnover for Best Buy is shown below
(in millions).


Inventory Turnover

o The number of days’ sales in inventory

measures the length of time it takes to acquire,
sell, and replace the inventory. It is computed
as follows:
Number of Days’ =
Sales in Inventory

Average Inventory
Average Daily Cost of
Merchandise Sold


Inventory Turnover

o The number of days’ sales in inventory for Best
Buy is computed below (in millions).


dix
en ting
pp ima
A st
E
ost
E ry C o
nt o
nve
I


Retail Method of Inventory Costing

o

The retail inventory method of estimating
inventory cost requires costs and retail prices
to be maintained for the merchandise
available for sale.

o

A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate
the ending inventory cost.


RETAIL METHOD
OF INVENTORY
COSTING

Gross Profit Method of Inventory Costing

o The gross profit method uses the estimated
gross profit for the period to estimate the
inventory at the end of the period.


GROSS PROFIT
METHOD OF
INVENTORY
COSTING

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