Accounting Principles-10th edition-Ch06

Chapter
6-2
CHAPTERCHAPTER 66
IINVENTORIESNVENTORIES
The raw materials, work-in-process goods and completelyThe raw materials, work-in-process goods and completely
finished goods that are considered to be the portion of afinished goods that are considered to be the portion of a
business’s assets that are ready or will be ready for sale.business’s assets that are ready or will be ready for sale.
Accounting Principles, Eighth Edition

Chapter
6-3
1. Describe the steps in determining inventory
quantities.
2. Explain the accounting for inventories and apply the
inventory cost flow methods.
3. Explain the financial effects of the inventory cost
flow assumptions.
4. Explain the lower-of-cost-or-market basis of
accounting for inventories.
5. Indicate the effects of inventory errors on the
financial statements.
6. Compute and interpret the inventory turnover ratio.
Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter
6-4
Reporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing InventoryReporting and Analyzing Inventory
Taking aTaking a
physicalphysical
inventoryinventory
DeterminingDetermining
ownership ofownership of
goodsgoods
ClassifyingClassifying
InventoryInventory
ClassifyingClassifying
InventoryInventory
InventoryInventory
QuantitiesQuantities
InventoryInventory
QuantitiesQuantities
InventoryInventory
CostingCosting
InventoryInventory
CostingCosting
InventoryInventory
ErrorsErrors
InventoryInventory
ErrorsErrors
StatementStatement
PresentatioPresentatio
n andn and
AnalysisAnalysis
StatementStatement
n andn and
AnalysisAnalysis
FinishedFinished
goodsgoods
Work inWork in
processprocess
Raw materialsRaw materials
SpecificSpecific
identificationidentification
Cost flowCost flow
assumptionsassumptions
FinancialFinancial
statementstatement
and taxand tax
effectseffects
ConsistentConsistent
useuse
Lower-of-Lower-of-
cost-or-cost-or-
marketmarket
IncomeIncome
statementstatement
effectseffects
BalanceBalance
sheetsheet
effectseffects
nn
AnalysisAnalysis
Other
Method
s of
valuing
Invento
ry
•Lower of
cost and
market
•Estimating
inventories
•Lower of
cost and
market
•Estimating
inventories

Chapter
6-5
 Inventories affect both the balance sheet and the incomeInventories affect both the balance sheet and the income
statement. In the balance sheet of merchandisingstatement. In the balance sheet of merchandising
companies, inventory is frequently the most significantcompanies, inventory is frequently the most significant
current asset. Of course, its amount and relativecurrent asset. Of course, its amount and relative
importance can vary, even for enterprises in the sameimportance can vary, even for enterprises in the same
industry.industry.
 In the income statement, inventory is vital in determiningIn the income statement, inventory is vital in determining
the results of operations for a particular period.the results of operations for a particular period.

Chapter
6-6
Classifying InventoryClassifying InventoryClassifying InventoryClassifying Inventory
One Classification:
Merchandise
Inventory (is needed
to describe the many
different items that
make up the total
inventory.)
Three Classifications:
Raw Materials (that are
on hand waiting to be used in
production)
Work in Process (that
are on the assembly line in
various stage of production)
Finished Goods (that are
completed and ready for sale)
Merchandising
Company
Manufacturing
Company
Regardless of the classification, companies report all
inventories under Current Assets on the balance sheet.

Chapter
6-7
Classification InventoryClassification Inventory
Merchandising enterprise, inventory consists of many
different items. Canned goods, dairy products, meats, and
produce, for example, are just a few of the inventory items on
hand in grocery store. These items have two common
characteristics. (1) they are owned by the company, and (2)
they are in a form ready for sale to customers in the ordinaryin the ordinary
course of business.course of business.
In a manufacturing enterprise, inventories are also owned byIn a manufacturing enterprise, inventories are also owned by
the company, but some goods may not yet be ready for sale.the company, but some goods may not yet be ready for sale.

Chapter
6-8
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand
2. Determine the cost of goods sold for the period.
Determining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory QuantitiesDetermining Inventory Quantities
LO 1 Describe the steps in determining inventory quantities.LO 1 Describe the steps in determining inventory quantities.

Chapter
6-9
Involves counting, weighing, or measuring each
kind of inventory on hand.
Taken,
when the business is closed or when business
is slow.
at end of the accounting period.
Taking a Physical InventoryTaking a Physical Inventory

Chapter
6-10
Goods in Transit
Purchased goods not yet received.
Sold goods not yet delivered.
Determining Ownership of Goods (Determining Ownership of Goods (Goods areGoods are
considered to be in transit when they are in the hands of aconsidered to be in transit when they are in the hands of a
public carrier such as railway, airline, or trucking or shippingpublic carrier such as railway, airline, or trucking or shipping
company at the statement date.company at the statement date.
Goods in transit should be included in the inventory of
the company that has legal title to the goods. Legal
title is determined by the terms of sale.

Chapter
6-11
Illustration 6-1
Ownership of the goods
passes to the buyer when
the public carrier accepts
the goods from the seller.
Ownership of the goods
remains with the seller
until the goods reach the
buyer.
Terms of SaleTerms of Sale

Chapter
6-12
Goods in transit should be included in the
inventory of the buyer when the:
a. public carrier accepts the goods from the
seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
Review QuestionReview Question

Chapter
6-13
Consigned Goods
Goods held for sale by one party (the consignee)
does not own the goods. although ownership of
the goods is retained by another party (the
consignor) until the goods are actually sold to a
customer.
It is common to hold the goods of other parties
and try to sell the goods for them for a fee, but
without taking ownership of the goods is called
CG
Determining Ownership of GoodsDetermining Ownership of Goods

Chapter
6-14
Inventory CostInventory Cost
Inventory cost is the purchase price of the goods, not the
selling price of the goods.
 All expenditures related to acquiring the goods and
making them ready for sale are included in the cost of
goods available for sale. This expenditures are
commonly known as inventoriable cost.
 In accordance with the cost principle, the primary basis
of accounting for inventories is cost.
 under the matching principle, the primary objective in
accounting for inventories is the matching of appropriate
costs with sales revenue.

Chapter
6-15
Unit costs can be applied to quantities on hand
using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average cost
Inventory CostingInventory CostingInventory CostingInventory Costing
LO 2 Explain the accounting for inventories andLO 2 Explain the accounting for inventories and
apply the inventory cost flow methods.apply the inventory cost flow methods.
Cost Flow
Assumptions

Chapter
6-16
Young & Crazy Company makes the following purchases:
1. One item on 2/2/07 for $10
Young & Crazy Company sells one item on 2/28/07 for
$90. What would be the balance of ending inventory
and cost of goods sold for the month ended Feb. 2007,
assuming the company used the Specific Identification
method to cost inventories? Assume a tax rate of 30%.
Example

Chapter
6-17
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales $ 90
Cost of goods sold 0
Gross profit 90
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Income before tax 57
Taxes 17
Net Income $ 40
“Specific Identification”
Depends which one is soldDepends which one is sold

Chapter
6-18
An actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of the
ending inventory.
•This method tracks the actual physical flow of the cost. Each item of
inventory is marked, tagged, or coded with its specific unit cost.
Specific identification is possible when a company sell a limited
number of high unit cost that can be clearly identified from the time
of purchase through the time of sale.
Practice is relatively rare.
Most companies make assumptions (Cost Flow Assumptions)
about which units were sold.
Specific Identification MethodSpecific Identification Method

Chapter
6-19
Inventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow AssumptionsInventory Costing – Cost Flow Assumptions
Illustration 6-11
Use of cost flow methods in
major U.S. companies
Cost Flow Assumption does not
need to equal Physical Movement
of Goods.
Because specific identification is
often impractical, other cost flow
methods are allowed. These
differ from specific identification
by assuming flows of costs that
may be unrelated to the physical
flow of goods.

Chapter
6-20
Young & Crazy Company makes the following purchases:
Young & Crazy Company sells one item on 2/28/07 for
$90. What would be the balance of ending inventory
and cost of goods sold for the month ended Feb. 2007,
assuming the company used the FIFO, LIFO, and
Average cost flow assumptions? Assume a tax rate of
30%.
Example

Chapter
6-21
Earliest goods purchased are first to be
sold.
Often parallels actual physical flow of
merchandise.
Generally good business practice to sell
oldest units first.
““First-In-First-Out (FIFO)”First-In-First-Out (FIFO)”

Chapter
6-22
Perpetual Inventory SystemPerpetual Inventory System
Under perpetual FIFI, the cost of the oldest goods on hand prior toUnder perpetual FIFI, the cost of the oldest goods on hand prior to
each sale is charged to cost of goods sold. Therefore, the cost ofeach sale is charged to cost of goods sold. Therefore, the cost of
goods sold on May 1 is assumed to consist of all the January 1goods sold on May 1 is assumed to consist of all the January 1
beginning inventory and 50 units of the items purchased on April 15.beginning inventory and 50 units of the items purchased on April 15.
similarly, the cost of goods sold on September 1 is assumed tosimilarly, the cost of goods sold on September 1 is assumed to
consist of the remaining 150 units purchased on April 15, plus 250consist of the remaining 150 units purchased on April 15, plus 250
of the items purchased on August 24. the ending inventory in thisof the items purchased on August 24. the ending inventory in this
situation is 5800, and the cost of goods sold is 6200.situation is 5800, and the cost of goods sold is 6200.
Cost of goods available for sale (1000+11000)Cost of goods available for sale (1000+11000) 1200012000
Less ending inventoryLess ending inventory 58005800
Cost of goods soldCost of goods sold 62006200

Chapter
6-23
Purchased Sold Balance
Date Units Cost Total Units cost Total Units Cost total
1/1 100 10 1000
4/15 200 11 2200 100
200
10
11
3200
5/1 100
50
10
11
1550 150 11 1650
8/24 300 12 3600 150
300
11
12
5250
9/1 150
250
11
12
4650 50 12 600
11/2
7
400 13 5200 50
400
12
13
5800
900 11000 550 6200 450 5800

Chapter
6-24
Periodic Inventory SystemPeriodic Inventory System
In the periodic inventory system, we ignore the timing of the dates of
each of the sales. Instead, we make the allocation at the end of
period and assume that the entire pool of costs is available for
allocation at that time.
Pool of Costs
Cost of goods available for sale
Date Explanation Units Units Cost Total cost
1/1 Beginning Inventory 100 10 1000
4/5 Purchase 200 11 2200
8/24 Purchase 300 12 3600
11/27 Purchase 400 12 5200
Total 1000 12000

Chapter
6-25
Periodic Inventory SystemPeriodic Inventory System
Step 1
Cost of Goods Sold
Step 2
Ending Inventory
Date Units Unit cost Total cost Date Units Unit cost Total cost
1/1 100 10 1000 11/27 400 13 5200
4/15 200 11 2200 8/24 50 12 600
8/24 250 12 3000
550 6200 450 5800

Chapter
6-26
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 45
Income Statement
Sales $ 90
Gross profit 90
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 17
Net Income $ 40
“First-In-First-Out (FIFO)”

Chapter
6-27
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 35
Income Statement
Sales $ 90
Gross profit 80
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 1414
Net Income $ 33$ 33
“First-In-First-Out (FIFO)”

Chapter
6-28
Latest goods purchased are first to be sold.
Seldom coincides with actual physical flow of
merchandise.
Exceptions include goods stored in piles, such
as coal or hay.
““Last-In-First-Out (LIFO)”Last-In-First-Out (LIFO)”

Chapter
6-29
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 45
Income Statement
Sales $ 90
Gross profit 90
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 17
Net Income $ 40
“Last-In-First-Out (LIFO)”

Chapter
6-30
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Inventory
Balance = $ 25
Purchase on
2/25/07 for $20
Income Statement
Sales $ 90
Gross profit 70
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 1111
Net Income $ 26$ 26
“Last-In-First-Out (LIFO)”

Chapter
6-31
Allocates cost of goods available for sale on
the basis of weighted average unit cost
incurred.
Assumes goods are similar in nature.
Applies weighted average unit cost to the
units on hand to determine cost of the ending
inventory.
““Average Cost”Average Cost”

Chapter
6-32
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 45
Income Statement
Sales $ 90
Gross profit 90
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 17
Net Income $ 40
“Average Cost”

Chapter
6-33
Purchase on
2/2/07 for $10
Purchase on
2/15/07 for $15
Purchase on
2/25/07 for $20
Inventory
Balance = $ 30
Income Statement
Sales $ 90
Gross profit 75
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Taxes 1212
Net Income $ 30$ 30
“Average Cost”

Chapter
6-34
FIFO
LO 3 Explain the financial effects of the inventory cost flow assumptions.LO 3 Explain the financial effects of the inventory cost flow assumptions.
Sales $90 $90 $90
Cost of goods sold 10 15 20
Gross profit 80 75 70
Admin. & selling expense 33 33 33
Income before taxes 47 42 37
Income tax expense 14 12 11
Net income $33 $30 $26
Inventory balance $35 $30 $25
LIFOAverage
Comparative Financial Statement SummaryComparative Financial Statement Summary

Chapter
6-35
In Period of Rising Prices,In Period of Rising Prices, FIFO Reports:FIFO Reports:
FIFO
Highest
Lowest
Sales $90 $90 $90
LIFOAverage

Chapter
6-36
In Period of Rising Prices,In Period of Rising Prices, LIFO Reports:LIFO Reports:
FIFO
Highest
Lowest
Sales $90 $90 $90
LIFOAverage

Chapter
6-37
The cost flow method that often parallels the
actual physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

Chapter
6-38
In a period of inflation, the cost flow method
that results in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

Chapter
6-39
Q6-12 Casey Company has been using the FIFO
cost flow method during a prolonged period of
rising prices. During the same time period,
Casey has been paying out all of its net
income as dividends. What adverse effects
may result from this policy?
Discussion QuestionDiscussion Question
See notes page for discussion

Chapter
6-40
Using Cost Flow Methods ConsistentlyUsing Cost Flow Methods Consistently
Method should be used consistently, enhances
comparability.
Although consistency is preferred, a company
may change its inventory costing method.
Illustration 6-14
Disclosure of change
in cost flow method

Chapter
6-41
Lower-of-Cost-or-MarketLower-of-Cost-or-Market
LO 4 Explain the lower-of-cost-or-marketLO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.basis of accounting for inventories.
When the value of inventory is lower than its cost
Companies can “write down” the inventory to
its market value in the period in which the
price decline occurs.
Market value = Replacement Cost
Example of conservatism.

Chapter
6-42
Lower-of-Cost-or-MarketLower-of-Cost-or-Market
LO 4 Explain the lower-of-cost-or-marketLO 4 Explain the lower-of-cost-or-market
basis of accounting for inventories.basis of accounting for inventories.
BE6-7 Alou Appliance Center accumulates the
following cost and market data at December 31.
Inventory Cost Market Lower of
Categories Data Data Cost or Market
Cameras 12,000$ 12,100$
Camcorders 9,000 9,700
VCRs 14,000 12,800
Compute the lower-of-cost-or-market valuation for the
company’s total inventory.
$ 12,000
9,000
12,800
$ 33,800

Chapter
6-43
Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors
LO 5 Indicate the effects of inventory errors on the financial statements.LO 5 Indicate the effects of inventory errors on the financial statements.
Common Cause:
Failure to count or price inventory correctly.
Not properly recognizing the transfer of
legal title to goods in transit.
Errors affect both the income statement and
balance sheet.

Chapter
6-44
Inventory errors affect the computation of cost of
goods sold and net income.
Income Statement EffectsIncome Statement Effects
Illustration 6-17
Illustration 6-16

Chapter
6-45
Inventory errors affect the computation of cost of
goods sold and net income in two periods.
An error in ending inventory of the current period
will have a reverse effect on net income of the
next accounting period.
Over the two years, the total net income is correct
because the errors offset each other.
The ending inventory depends entirely on the
accuracy of taking and costing the inventory.
Income Statement EffectsIncome Statement Effects

Chapter
6-46
Incorrect Correct Incorrect Correct
Sales 80,000$ 80,000$ 90,000$ 90,000$
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income 22,000$ 25,000$ 13,000$ 10,000$
2008 2009
($3,000)
Net Income
understated
$3,000
Net Income
overstated
Combined income for
2-year period is correct.
Illustration 6-18

Chapter
6-47
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.

Chapter
6-48
Effect of inventory errors on the balance sheet is
determined by using the basic accounting equation:.
Balance Sheet EffectsBalance Sheet Effects
Illustration 6-16
Illustration 6-19

Chapter
6-49
Statement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and AnalysisStatement Presentation and Analysis
Balance Sheet - Inventory classified as current
asset.
Income Statement - Cost of goods sold subtracted
from sales.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost or LCM), and
3) costing method (FIFO, LIFO, or average).
PresentationPresentation

Chapter
6-50
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying
costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stockouts and
lost sales.
AnalysisAnalysis
LO 6 Compute and interpret the inventory turnover ratio.LO 6 Compute and interpret the inventory turnover ratio.

Chapter
6-51
Inventory turnover measures the number of times
on average the inventory is sold during the period.
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
Days in inventory measures the average number of
days inventory is held.
Days in Year (365)
Inventory Turnover
Days in
Inventory
=

Chapter
6-52
BE6-9 At December 31, 2008, the following
information was available for J. Graff Company: ending
inventory $40,000, beginning inventory $60,000, cost
of goods sold $270,000, and sales revenue $380,000.
Calculate inventory turnover and days in inventory for
J. Graff Company.
$270,000
($60,000 + 40,000) / 2
5.4=Inventory
Turnover
365
5.4
67.59
days
=Days in
Inventory

Chapter
6-53
“Copyright © 2008 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.”
CopyrightCopyrightCopyrightCopyright

Accounting Principles-10th edition-Ch06

More Related Content

What's hot (20)

Viewers also liked (7)

Similar to Accounting Principles-10th edition-Ch06 (20)

More from Fahad Aziz (20)

Recently uploaded (20)

Accounting Principles-10th edition-Ch06

Editor's Notes