3. 8-3
1. Identify major classifications of inventory.
2. Distinguish between perpetual and periodic inventory systems.
3. Identify the effects of inventory errors on the financial statements.
4. Understand the items to include as inventory cost.
5. Describe and compare the cost flow assumptions used to account for
inventories.
6. Explain the significance and use of a LIFO reserve.
7. Understand the effect of LIFO liquidations.
8. Explain the dollar-value LIFO method.
9. Identify the major advantages and disadvantages of LIFO.
10. Understand why companies select given inventory methods.
Learning Objectives
4. 8-4
Inventory
Issues
Physical
Goods
Included in
Inventory
Costs
Included
in Inventory
Cost Flow
Assumptions
LIFO: Special
Issues
Classification
Cost flow
Control
Basic
inventory
valuation
Basis for
Selection
Goods in
transit
Consigned
goods
Special sales
agreements
Inventory
errors
Product costs
Period costs
Purchase
discounts
Specific
identification
Average cost
FIFO
LIFO
LIFO reserve
LIFO
liquidation
Dollar-value
LIFO
Comparison of
LIFO
approaches
Advantages of
LIFO
Disadvantages
of LIFO
Summary of
inventory
valuation
methods
Valuation of Inventories:
Cost-Basis Approach
5. 8-5
Inventories are:
items held for sale, or
goods to be used in the production of goods to be sold.
Inventory Issues
LO 1 Identify major classifications of inventory.
Merchandiser Manufacturer
Businesses with Inventory
or
Classification
6. 8-6
One inventory
account.
Purchase goods
in form ready for
sale.
Inventory Issues
LO 1 Identify major classifications of inventory.
Illustration 8-1
Classification
7. 8-7
Three accounts
Raw materials
Work in process
Finished goods
Inventory Issues
Classification
Illustration 8-1
LO 1 Identify major classifications of inventory.
9. 8-9
Inventory Cost Flow
Inventory Issues
Illustration 8-3
Companies use one of two types of systems for maintaining
inventory records — perpetual system or periodic system.
LO 2 Distinguish between perpetual and periodic inventory systems.
10. 8-10
Inventory Cost Flow
LO 2 Distinguish between perpetual and periodic inventory systems.
Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each
sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.
The perpetual inventory system provides a continuous
record of Inventory and Cost of Goods Sold.
11. 8-11
Inventory Cost Flow
LO 2 Distinguish between perpetual and periodic inventory systems.
Periodic System
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
Beginning inventory $ 100,000
Purchases, net 800,000
Goods available for sale 900,000
Ending inventory 125,000
Cost of goods sold $ 775,000
12. 8-12
Inventory Cost Flow
LO 2 Distinguish between perpetual and periodic inventory systems.
Illustration: Fesmire Company had the following transactions
during the current year.
Record these transactions using the Perpetual and Periodic
systems.
14. 8-14
Inventory Cost Flow
LO 2 Distinguish between perpetual and periodic inventory systems.
Illustration: Assume that at the end of the reporting period,
the perpetual inventory account reported an inventory balance
of $4,000. However, a physical count indicates inventory of
$3,800 is actually on hand. The entry to record the necessary
write-down is as follows.
Inventory Over and Short 200
Inventory 200
Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies
sometimes report Inventory Over and Short in the “Other income and expense” section
of the income statement.
15. 8-15
Inventory Control
Inventory Issues
LO 2 Distinguish between perpetual and periodic inventory systems.
All companies need periodic verification of the inventory
records by actual count, weight, or measurement, with the
counts compared with the detailed inventory records.
Companies should take the physical inventory near the
end of their fiscal year, to properly report inventory
quantities in their annual accounting reports.
16. 8-16
Basic Issues in Inventory Valuation
LO 2 Distinguish between perpetual and periodic inventory systems.
Companies must allocate the cost of all the goods available
for sale (or use) between the goods that were sold or used
and those that are still on hand.
Illustration 8-5
17. 8-17
Basic Issues in Inventory Valuation
LO 2 Distinguish between perpetual and periodic inventory systems.
The physical goods (goods on hand, goods in transit,
consigned goods, special sales agreements).
The costs to include (product vs. period costs).
The cost flow assumption (specific Identification,
average cost, FIFO, retail, etc.).
Valuation requires determining
18. 8-18
A company should record purchases when it obtains legal
title to the goods.
Physical Goods Included in Inventory
LO 2 Distinguish between perpetual and periodic inventory systems.
Illustration 8-6
19. 8-19
Physical Goods Included in Inventory
LO 3 Identify the effects of inventory errors on the financial statements.
Effect of Inventory Errors
The effect of an error on net income in one year (2011) will be counterbalanced in
the next (2012), however the income statement will be misstated for both years.
Illustration 8-7
Ending
Inventory
Misstated
20. 8-20
Effect of Inventory Errors
Illustration: Jay Weiseman Corp. understates its ending inventory by
$10,000 in 2011; all other items are correctly stated.
Illustration 8-8
LO 3
21. 8-22
Costs Included in Inventory
LO 4 Understand the items to include as inventory cost.
Product Costs
Costs directly connected with bringing the goods to the
buyer’s place of business and converting such goods to a
salable condition.
Period Costs
Generally selling, general, and administrative expenses.
Treatment of Purchase Discounts
Gross vs. Net Method
22. 8-23
*
**
Costs Included in Inventory
LO 4
Treatment of Purchase Discounts
Illustration 8-11
* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800
23. 8-24
Method adopted should be one that most clearly reflects periodic income.
Cost Flow Assumption Adopted
does not need to equal
Physical Movement of Goods
Which Cost Flow Assumption to Adopt?
Specific Identification --- Average Cost
LIFO --- FIFO
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
24. 8-25
Young & Crazy Company makes the following purchases:
1. One item on 2/2/11 for $10
2. One item on 2/15/11 for $15
3. One item on 2/25/11 for $20
Young & Crazy Company sells one item on 2/28/12 for $90. What
would be the balance of ending inventory and cost of goods sold
for the month ended February 2012, assuming the company used
the FIFO, Average Cost, and Specific Identification cost flow
assumptions? Assume a tax rate of 30%.
Illustration
Cost Flow Assumptions
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
25. 8-26
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Inventory Balance
= $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
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
Cost Flow Assumptions
“First-In-First-Out (FIFO)”
LO 5
26. 8-27
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Cost Flow Assumptions
Inventory Balance
= $ 35
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales $ 90
Cost of goods sold 10
Gross profit 80
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Income before tax 47
Taxes 14
Net Income $ 33
“First-In-First-Out (FIFO)”
LO 5
27. 8-28
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Inventory Balance
= $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
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
Cost Flow Assumptions
“Average Cost”
LO 5
28. 8-29
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Inventory Balance
= $ 30
Cost Flow Assumptions
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales $ 90
Cost of goods sold 15
Gross profit 75
Expenses:
Administrative 14
Selling 12
Interest 7
Total expenses 33
Income before tax 42
Taxes 12
Net Income $ 30
“Average Cost”
LO 5
29. 8-30
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Inventory Balance
= $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
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
Cost Flow Assumptions
“Specific Identification”
LO 5
30. 8-31
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
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
Depends which one is sold
Purchase on
2/2/12 for $10
Purchase on
2/15/12 for $15
Purchase on
2/25/12 for $20
Inventory Balance
= $ 45
Cost Flow Assumptions
“Specific Identification”
LO 5
31. 8-32
Financial Statement Summary
FIFO Average
Sales 90
$ 90
$
Cost of goods sold 10 15
Gross profit 80 75
Operating expenses:
Administrative 14 14
Selling 12 12
Interest 7 7
Total expenses 33 33
Income before taxes 47 42
Income tax expense 14 12
Net income 33
$ 30
$
Inventory Balance 30
35
Cost Flow Assumptions
LO 5
32. 8-33
Cost Flow Assumptions
LO 5
Illustration: Call-Mart Inc. had the following transactions in
its first month of operations.
Beginning inventory (2,000 x $4) $ 8,000
Purchases:
6,000 x $4.40 26,400
2,000 x 4.75 9,500
Goods available for sale $43,900
Calculate Goods Available for Sale
33. 8-34
Specific Identification
Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from the March
15 purchase, and 2,000 from the March 30 purchase. Compute the
amount of ending inventory and cost of goods sold.
Illustration 8-12
36. 8-37
Average Cost
Illustration 8-14
In this method, Call-Mart computes a new average unit cost
each time it makes a purchase.
Moving Average
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
37. 8-38
First-In, First-Out (FIFO)
Illustration 8-15
Periodic Method
Determine cost of ending inventory by taking the cost of the most
recent purchase and working back until it accounts for all units in the
inventory.
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
38. 8-39
First-In, First-Out (FIFO)
Illustration 8-16
Perpetual Method
In all cases where FIFO is used, the inventory and cost of goods sold
would be the same at the end of the month whether a perpetual or
periodic system is used.
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
39. 8-40
Illustration 8-31
Inventory Valuation Methods - Summary
Notice that gross profit and net income are lowest under LIFO, highest under
FIFO, and somewhere in the middle under average cost.
LO 10 Understand why companies select given inventory methods.
40. 8-41
Illustration 8-32
Inventory Valuation Methods - Summary
LIFO results in the highest cash balance at year-end (because taxes are
lower). This example assumes that prices are rising. The opposite result
occurs if prices are declining.
LO 10 Understand why companies select given inventory methods.
