2. 6-2
6-2
One Classification:
Merchandise Inventory
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Merchandising
Company
Manufacturing
Company
Helpful Hint: Regardless
of the classification,
companies report all
inventories under Current
Assets on the SoFP.
Classifying Inventory
Classification of Inventories
Inventories are asset items held for sale in the ordinary
course of business, or goods to be used in the production
of goods to be sold.
3. Cont’d…
1.Raw material inventory – are the basic goods that will be
used in production but have not yet been placed into
production.
Example, wood to make a chair or other office furniture’s,
the steel to make a car etc.
2. Work in process inventory- is that portion of
manufactured inventory that has been placed into the
production process but is not yet complete.
3. Finished goods inventory – manufactured items that are
completed and ready for sale.
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Fundamentals of Acc II: By Alemayo S.
4. 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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Fundamentals of Acc II: By Alemayo S.
5. Unfortunately, errors occasionally occur in
accounting for inventory.
In some cases, errors are caused by failure to
count or price inventory correctly.
In other cases, errors occur because companies
do not properly recognize the transfer of legal
title to goods that are in transit.
When errors occur, they affect both the
Income Statement and SoFP.
The Effects of Inventories on Financial Statements
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Fundamentals of Acc II: By Alemayo S.
6. Income Statement Effects
The ending inventory of one period automatically
becomes the beginning inventory of the next period.
Thus, inventory errors affect the computation of cost of
goods sold and net income in two periods.
Cost of goods sold = Beginning inventory + Net
purchase – Ending inventory.
If the error understates beginning inventory, cost of
goods sold will be understated.
If the error understates ending inventory, cost of
goods sold will be overstated.
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Fundamentals of Acc II: By Alemayo S.
7. Income Statement Effects
Gross Profit = Net sales – Cost of merchandise sold
Operating income = Gross Profit – Expenses
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Fundamentals of Acc II: By Alemayo S.
Illustration; Effects of inventory errors on current year’s income
statement
8. 6-8
6-8
Statement of Financial Position Effects
The ending inventory of an organization affects the two
major components of a balance sheet:
A. Current Assets: If ending inventory balance is
understated (overstated), the total current assets will be
understated (overstated).
B. Liabilities: Inventory misstatement has no effect on
liabilities.
C. Owners’ equity - The net income will be transferred to
the owners’ equity at the end of accounting period.
If ending inventory is understated (Overstated), the
owners’ equity will be understated (Overstated).
9. Effect of inventory errors on the statement of financial
position is determined by using the basic accounting
equation: Assets = Liabilities + Equity.
Errors in the ending inventory have the following effects.
Illustration: Effects of ending inventory errors on SoFP
Cont’d…
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Fundamentals of Acc II: By Alemayo S.
10. 6-10
6-10
Cont’d…
Illustration:
The first set of statements is based on a correct ending
inventory of $30,000; the second set, on an incorrect
ending inventory of $22,000; and the third set, on an
incorrect ending inventory of $37,000.
In all three cases, net sales are $200,000, merchandise
available for sale is $140,000, and expenses are
$55,000.
12. 6-12
6-12
Cost of inventories
The cost of inventories shall comprise all costs of:
Purchase, Costs of conversion and Other costs incurred
in bringing the inventories to their present location and
condition.
The costs of purchase of inventories comprise:
The purchase prices, Import duties and other taxes
Transport
Handling and other costs directly attributable to the
acquisition of finished goods, materials and services.
13. 6-13
6-13
Cont’d…
Trade discounts, rebates and other similar items are
deducted in determining the costs of purchase.
The costs of conversion of inventories include costs
directly related to the units of production, such as
direct labor.
16. 6-16
6-16
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to 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 Quantities
No matter whether they are using a periodic or perpetual
inventory system, all companies need to determine inventory
quantities at the end of the accounting period.
17. 6-17
6-17
Involves counting, weighing, or measuring each kind of
inventory on hand.
Companies often “take inventory”
when the business is closed or business is slow.
at the end of the accounting period.
1. Taking a Physical Inventory
Cont’d
Determining inventory quantities involves two steps:
(1) taking a physical inventory of goods on hand and
(2) determining the ownership of goods.
18. 6-18
6-18
GOODS IN TRANSIT
Purchased goods not yet received.
Sold goods not yet delivered.
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.
2. Determining Ownership of Goods
Cont’d
19. 6-19
6-19
Illustration 6-2 Terms of
sale
Goods In Transit
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.
Cont’d
20. 6-20
6-20
Cont’d
If goods in transit at the statement date are ignored,
inventory quantities may be seriously miscounted.
For example, assume, that XYZ Company has 20,000
units of inventory on hand on December 31. It also has the
following goods in transit:
1. Sales of 1,500 units shipped December 31 FOB
destination.
2. Purchases of 2,500 units shipped FOB shipping point
by the seller on December 31.
21. 6-21
6-21
Cont’d
XYZ has legal title to both the 1,500 units sold and the
2,500 units purchased. If the company ignores the units
in transit, it would understate inventory quantities by
4,000 units (1,500 + 2,500).
22. 6-22
6-22
Consigned Goods
In some lines of business, 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.
These are called consigned goods.
For example, you might have a used car that you would
like to sell.
If you take the item to a dealer, the dealer might be
willing to put the car on its lot and charge you a commission
if it is sold.
23. 6-23
6-23
Cont’d…
Under this agreement, the dealer would not take
ownership of the car, which would still belong to you.
Therefore, if an inventory count were taken, the car would
not be included in the dealer’s inventory
25. 6-25
6-25
Inventory is accounted for at cost.
Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale.
Unit costs are applied to quantities to compute the
total cost of the inventory and the cost of goods
sold using the following costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Average-cost
Cost Flow
Assumption
s
Inventory Costing Methods
26. 6-26
6-26
Specific identification calls for identifying each item
sold and each item in inventory.
Historically, specific identification was possible only
when a company sold a limited variety of high-unit-cost
items that could be identified clearly from the time of
purchase through the time of sale.
It is inappropriate when there are large numbers of
items of inventory that are ordinarily interchangeable.
Specific Identification
27. Illustration: Crivitz TV Company purchases three identical
50-inch TVs on different dates at costs of £700, £750,
and £800. During the year Crivitz sold two sets at £1,200
each. These facts are summarized below.
Illustration: Data for Inventory Costing Example
Cont’d
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Fundamentals of Acc II: By Alemayo S.
28. If Crivitz sold the TVs it purchased on February 3 and May
22, then its cost of goods sold is £1,500 (£700 + £800),
and its ending inventory is £750.
Cont’d…
Specific Identification Method
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Fundamentals of Acc II: By Alemayo S.
29. 6-29
6-29
If Companies can positively identify which particular
units it sold and which are still in ending inventory, it can
use the specific identification method of inventory
costing.
Practice is relatively rare.
Most companies make
assumptions (cost flow
assumptions) about which
units were sold.
Cont’d
30. There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost
There is no accounting requirement that the cost flow
assumption be consistent with the physical movement of
the goods.
Company management selects the appropriate cost flow
method.
Cost Flow Assumptions
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Fundamentals of Acc II: By Alemayo S.
31. 6-31
6-31
Costs of the earliest goods purchased are the
first to be recognized in determining cost of goods
sold.
Often parallels actual physical flow of
merchandise.
Companies obtain the cost of the ending inventory
by taking the unit cost of the most recent
purchase and working backward until all units of
inventory have been costed.
FIRST-IN, FIRST-OUT (FIFO)
32. 6-32
6-32
Allocates cost of goods available for sale on the
basis of weighted-average unit cost incurred.
Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
And also, applies weighted-average unit cost to
the units sold to determine cost of good sold.
AVERAGE-COST
Cont’d
33. 6-33
6-33
A periodic inventory system determines cost of
merchandise sold and inventory at the end of the period.
To illustrate the inventory cost flow methods, we will use
the data for Houston Electronics’ Astro condensers, shown
below:
Inventory Costing Methods under Periodic Inventory
System
34. 6-34
6-34
Required: compute cost of goods sold and ending
inventory through periodic inventory system using
1.FIFO
2.WA
Cont’d
The cost of goods sold formula in a periodic system is:
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
36. 6-36
6-36
2) CGS and ending inventory using Average cost
Cont’d
Here, to determine CGS & EI first weighted average unit
cost should be calculated.
After weighted average unit cost is computed, we
multiply by the units sold to determine CGS and, the units
on hand to determine cost of the EI.
38. 6-38
6-38
The accounting records of XYZ show the following.
Beginning Inventory 4,000 units at £ 3
Purchases 6,000 units at £ 4
Sales 7,000 units at £12
Required: Determine the cost of goods sold during
the period under a periodic inventory system using:
(a) The FIFO method and (2.5 point)
(b) The average-cost method (2.5 point).
Quiz (5%)
40. 6-40
6-40
Inventory Cost Flow Methods in Perpetual Inventory
Systems
In a perpetual inventory system, all merchandise
increases and decreases are recorded in a manner similar
to the recording of increases and decreases in cash.
The merchandise inventory account at the beginning of
an accounting period indicated the merchandise in stock
on that date.
Companies which use perpetual inventory system, may
employ FIFO or Average cost to determine CGS & EI.
41. 6-41
6-41
1. FIFO
Under perpetual FIFO, the company charges to cost of
goods sold the cost of the earliest goods on hand prior
to each sale.
Or Costs are included in the merchandise sold in the
order in which they were incurred.
Cont’d
42. 6-42
6-42
Cont’d…
2. Average-Cost
The average-cost method in a perpetual inventory
system is called the moving-average method.
Under this method, the company computes a new
average after each purchase by dividing the cost of
goods available for sale by the units on hand.
The average cost is then applied to (1) the units sold, to
determine the cost of goods sold, and (2) the remaining
units on hand, to determine the ending inventory
amount.
43. 6-43
6-43
To illustrate the application of the assumed cost flow methods
(FIFO and average-cost), let us use the following data;
44. 6-44
6-44
Cost of goods sold Ending inventory
You can see that the results under FIFO in a perpetual system are the same as in a
periodic system. In both cases, the ending inventory is $5,800 and cost of goods
sold is $6,200.
46. 6-46
6-46
FS and Tax Effects of Cost Flow Methods
The reasons companies adopt different inventory cost
flow methods are varied, but they usually involve one of
three factors:
1. Income statement effects
2. Statement of financial position effects, or
3. Tax effects.
47. 6-47
6-47
INCOME STATEMENT EFFECTS
In periods of changing prices, the cost flow assumption
can have a significant impact on net income.
In a period of inflation, FIFO produces a higher net
income because the lower unit costs of the first units
purchased are matched against revenues.
Therefore; in a period of rising prices, FIFO reports a
higher net income than average-cost.
If prices are falling, the results from the use of FIFO
and average-cost are reversed.
FIFO will report the lower net income and average-cost
the higher.
48. 6-48
6-48
Cont’d…
To management, higher net income is an advantage.
It causes external users to view the company more
favorably.
In addition, management bonuses, if based on net
income, will be higher.
Therefore, when prices are rising (which is usually the
case), companies tend to prefer FIFO because it
results in higher net income.
49. 6-49
6-49
A major advantage of the FIFO method is that in a
period of inflation, the costs allocated to ending
inventory will approximate their current cost.
A major shortcoming of the average-cost method is
that in a period of inflation, the costs allocated to
ending inventory may be understated in terms of
current cost.
The understatement becomes greater over prolonged
periods of inflation if the inventory includes goods
purchased in one or more prior accounting periods.
Statement of Financial Position Effect
50. 6-50
6-50
Both inventory on the statement of financial
position and net income on the income statement
are higher when companies use FIFO in a period
of inflation.
Some companies use average-cost instead of
FIFO.
The reason is that average-cost results in lower
income taxes (because of lower net income)
during times of rising prices.
TAX EFFECTS
51. 6-51
6-51
Whatever cost flow method a company chooses, it should
use that method consistently from one accounting period
to another.
This approach is often referred to as the consistency
concept, which means that a company uses the same
accounting principles and methods from year to year.
Consistent application enhances the comparability of
financial statements over successive time periods.
Using Cost Flow Methods Consistently
52. 6-52
6-52
In contrast, using the FIFO method one year and the
average-cost method the next year would make it
difficult to compare the net incomes of the two years.
Although consistent application is preferred, it does not
mean that a company may never change its inventory
costing method.
When a company adopts a different method, it should
disclose in the financial statements the change and its
effects on net income.
Cont’d…
53. 6-53
6-53
When the value of inventory is lower than its cost
companies must “write down” the inventory to
its net realizable value.
Net realizable value: Amount that a company
expects to realize (receive from the sale of
inventory).
Lower-of-Cost-or-Net Realizable Value
54. 6-54
6-54
Illustration: Assume that Gao TV has the following lines
of merchandise with costs and market values as
indicated.
Computation of lower-of-cost-or-net realizable value
Cont’d
55. Estimates the cost of ending inventory by applying a gross
profit rate to net sales.
Gross Profit Method
Illustration: Gross profit Method Formulas
Estimating Inventories
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Fundamentals of Acc II: By Alemayo S.
56. Illustration: Kishwaukee Company’s records for January show
net sales of $200,000, beginning inventory $40,000, and cost of
goods purchased $120,000. The company expects to earn a 30%
gross profit rate. Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Illustration: Example of Gross Profit Method
Cont’d
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Fundamentals of Acc II: By Alemayo S.
57. Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.
Retail Inventory Method
Illustration 6B-3: Retail Inventory Method Formulas
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Fundamentals of Acc II: By Alemayo S.
58. Note that it is not necessary to take a physical inventory
to estimate the cost of goods on hand at any given time.
Cont’d
Illustration; Application of Retail Inventory Method
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Fundamentals of Acc II: By Alemayo S.
59. The End of Chapter 1
Thank You!!!
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