CH 06

Chapter
6
Inventories
Chapter
6-1
Accounting Principles, Ninth Edition
Study
Study Objectives
Objectives
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.
Chapter
6-2
Reporting
Reporting and
and Analyzing
Analyzing Inventory
Inventory
Classifying
Inventory
Determining
Inventory
Quantities
Finished
goods
Work in
process
Raw materials
Taking a
physical
inventory
Determining
ownership of
goods
Chapter
6-3
Inventory
Costing
Specific
identification
Cost flow
assumptions
Financial
statement
and tax
effects
Consistent
use
Lower-ofcost-ormarket
Inventory
Errors
Income
statement
effects
Balance sheet
effects
Statement
Presentation
and Analysis
Presentation
Analysis
Classifying
Classifying Inventory
Inventory
Merchandising
Company
One Classification:
Merchandise Inventory
Manufacturing
Company
Three Classifications:
Raw Materials
Work in Process
Finished Goods
Regardless of the classification, companies report all

inventories under Current Assets on the balance sheet.
Chapter
6-4
Chapter
6-5
Determining
Determining Inventory
Inventory Quantities
Quantities
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.
Chapter
6-6
SO 1 Describe the steps in determining inventory quantities.
Determining
Quantities
Taking a Physical Inventory

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.
Chapter
6-7
Determining
Quantities
Determining Ownership of Goods

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.
Chapter
6-8
Determining
Quantities
Terms of Sale
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.
Chapter
6-9
Determining
Quantities
Review Question
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.
Chapter
6-10
Determining
Quantities
Determining Ownership of Goods

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 goods.
These are called consigned goods.
Chapter
6-11
Inventory
Inventory Costing
Costing
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)
Cost Flow
Assumptions
Average-cost
Chapter
6-12
SO 2 Explain the accounting for inventories and

apply the inventory cost flow methods.
Inventory
Inventory Costing
Costing
Specific Identification Method

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.
Practice is relatively rare.
Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.
Chapter
6-13

Inventory
Inventory Costing
Costing
Example
Young & Crazy Company makes the following purchases:
1.
One item on 2/2/10 for $10
2.
3.
Young & Crazy Company sells one item on 2/28/10 for

$90. What would be the balance of ending inventory,
cost of goods sold, and net income for the month ended
Feb. 28, 2010, assuming the company used the Specific
Identification method to cost inventories and the item
purchased on 2/15/10 is sold?
Chapter
6-14

Inventory
Inventory Costing
Costing
Assume one item is sold for $90
Inventory
Balance = $ 30
Purchase on
2/25/10 for $20
Purchase on
2/15/10 for $15
Purchase on
2/2/10 for $10
Chapter
6-15
Young & Crazy Company

Income Statement
For the Month of Feb. 2010
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40

Inventory
Inventory Costing
Costing
Specific Identification
Inventory
Balance = $ 30
Purchase on
2/25/10 for $20
Purchase on
2/15/10 for $15
Purchase on
2/2/10 for $10
Chapter
6-16

Income Statement
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
15
75
14
12
7
33
42
13
$ 29

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Cost Flow Assumption

does not need to equal
Physical Movement of
Goods
Illustration 6-11
Use of cost flow methods in
major U.S. companies
Chapter
6-17

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Example
Young & Crazy Company makes the following purchases:
1.
2.
3.
Young & Crazy Company sells one item on 2/28/10 for

$90. What would be the balance of ending inventory,
cost of goods sold, and net income for the month ended
Feb. 2010, assuming the company used the FIFO, LIFO,
and Average-cost flow assumptions? Assume a tax rate
of 30%.
Chapter
6-18

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
First-In-First-Out (FIFO)
Earliest goods purchased are first to be
sold.
Often parallels actual physical flow of
merchandise.
Generally good business practice to sell
oldest units first.
Chapter
6-19

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
First-In-First-Out (FIFO)
Inventory
Balance = $ 35
Purchase on
2/25/10 for $20
Purchase on
2/15/10 for $15
Purchase on
2/2/10 for $10
Chapter
6-20

Income Statement
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
10
80
14
12
7
33
47
14
$ 33

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Last-In-First-Out (LIFO)
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.
Chapter
6-21

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Last-In-First-Out (LIFO)
Inventory
Balance = $ 25
Purchase on
2/25/10 for $20
Purchase on
2/15/10 for $15
Purchase on
2/2/10 for $10
Chapter
6-22

Income Statement
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
20
70
14
12
7
33
37
11
$ 26

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Average-Cost
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.
Chapter
6-23

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Average Cost
Inventory
Balance = $ 30
Purchase on
2/25/10 for $20
Purchase on
2/15/10 for $15
Purchase on
2/2/10 for $10
Chapter
6-24

Income Statement
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
15
75
14
12
7
33
42
13
$ 29

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Comparative Financial Statement Summary
FIFO
Average
LIFO
$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
13
11
Net income
$33
$29
$26
Inventory balance
$35
$30
$25
Sales
Chapter
6-25
SO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
In Period of Rising Prices, FIFO Reports:
Lowest
Highest
Chapter
6-26
FIFO
Average
LIFO
$90
$90
$90
Cost of goods sold
10
15
20
Gross profit
80
75
70
33
33
33
Income before taxes
47
42
37
Income tax expense
14
13
11
Net income
$33
$29
$26
Inventory balance
$35
$30
$25
Sales
Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
In Period of Rising Prices, LIFO Reports:
Highest
Lowest
Chapter
6-27
FIFO
Average
LIFO
$90
$90
$90
Cost of goods sold
10
15
20
Gross profit
80
75
70
33
33
33
Income before taxes
47
42
37
Income tax expense
14
13
11
Net income
$33
$29
$26
Inventory balance
$35
$30
$25
Sales
Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Review Question
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
6-28

Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Review Question
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
6-29
Inventory
Inventory Costing
Costing Cost
Cost Flow
Flow Assumptions
Assumptions
Discussion Question
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?
See notes page for discussion
Chapter
6-30
Inventory
Inventory Costing
Costing
Using 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
6-31
Chapter
6-32
Inventory
Inventory Costing
Costing
Lower-of-Cost-or-Market
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
6-33
SO 4 Explain the lower-of-cost-or-market

basis of accounting for inventories.
Inventory
Inventory Costing
Costing
Lower-of-Cost-or-Market
BE6-7: Alou Appliance Center accumulates the
following cost and market data at December 31.
$ 12,000
9,500
12,800
$ 34,300
Compute the lower-of-cost-or-market valuation for the

companys total inventory.
Chapter
6-34
SO 4 Explain the lower-of-cost-or-market

basis of accounting for inventories.
Inventory
Inventory Errors
Errors
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
6-35
SO 5 Indicate the effects of inventory errors on the financial statements.
Inventory
Inventory Errors
Errors
Income Statement Effects

Inventory errors affect the computation of cost of
goods sold and net income.
Illustration 6-16
Illustration 6-17
Chapter
6-36
Inventory
Inventory Errors
Errors
Income Statement Effects

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.
Chapter
6-37
Inventory
Inventory Errors
Errors
Illustration 6-18
Combined income for

2-year period is correct.
Chapter
6-38
($3,000)
Net Income
understated
$3,000
Net Income
overstated
Inventory
Inventory Errors
Errors
Review Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
Chapter
6-39
Inventory
Inventory Errors
Errors
Balance Sheet Effects

Effect of inventory errors on the balance sheet is
determined by using the basic accounting equation:.
Illustration 6-16
Illustration 6-19
Chapter
6-40
Statement
Statement Presentation
Presentation and
and Analysis
Analysis
Presentation
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).
Chapter
6-41
Statement
Presentation and
and Analysis
Analysis
Analysis
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.
Chapter
6-42
SO 6 Compute and interpret the inventory turnover ratio.
Statement
Presentation and
and Analysis
Analysis
Inventory turnover measures the number of times
on average the inventory is sold during the period.
Inventory
Turnover
Cost of Goods Sold

=
Average Inventory
Days in inventory measures the average number of

days inventory is held.
Days in Year (365)
Days in
=
Inventory
Inventory Turnover
Chapter
6-43
Statement
Presentation and
and Analysis
Analysis
BE6-9 At December 31, 2011, 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.
Inventory
Turnover
Days in
Inventory
Chapter
6-44
$270,000
($60,000 + 40,000) / 2
365
5.4
5.4
67.59
days
Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual Systems
Systems
Example
Appendix
Appendix 6A
6A
Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO, LIFO, and Average cost.
Chapter
6-45
SO 7 Apply the inventory cost flow methods to perpetual inventory records.
Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual Systems
Systems
Perpetual Inventory
Chapter
6-46
FIFO Method
Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual Systems
Systems
Perpetual Inventory
Chapter
6-47
LIFO Method
Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual Systems
Systems
Perpetual Inventory
Moving Average
Cost per unit
sold is
determined by
dividing total
inventory $ by
total units on
hand after each
purchase.
Chapter
6-48
Cost
Cost Flow
Flow Methods
Methods in
in Perpetual
Perpetual Systems
Systems
Perpetual Inventory
Moving Average
Cost per unit
sold is
determined by
dividing total
inventory $ by
total units on
hand after each
purchase.
Chapter
6-49
Estimating
Estimating Inventories
Inventories
Gross Profit Method
The gross profit method estimates the cost of ending
inventory by applying a gross profit rate to net sales.
Illustration 6B-1
Chapter
6-50
SO 8 Describe the two methods of estimating inventories.
Estimating
Inventories
*BE6-11 At May 31, Creole Company has net sales of
$330,000 and cost of goods available for sale of
$230,000. Compute the estimated cost of the ending
inventory, assuming the gross profit rate is 35%.
Chapter
6-51
Estimating
Inventories
Retail Inventory Method
Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.
Illustration 6B-3
Chapter
6-52
Estimating
Inventories
*BE6-12 On June 30, Fabre Fabrics has the following data
pertaining to the retail inventory method: Goods available for
sale: at cost $35,000, at retail $50,000; net sales $40,000, and
ending inventory at retail $8,000. Compute the estimated cost
of the ending inventory using the retail inventory method.
Chapter
6-53
Copyright
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Chapter
6-54

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Chapter

Accounting Principles, Ninth Edition

Describe the steps in determining inventory

Explain the accounting for inventories and apply the

Explain the financial effects of the inventory cost

Explain the lower-of-cost-or-market basis of

Indicate the effects of inventory errors on the

Compute and interpret the inventory turnover ratio.

Regardless of the classification, companies report all

Physical Inventory taken for two reasons:

materials, shoplifting, or employee theft).

SO 1 Describe the steps in determining inventory quantities.

Taking a Physical Inventory

SO 1 Describe the steps in determining inventory quantities.

Determining Ownership of Goods

SO 1 Describe the steps in determining inventory quantities.

Ownership of the goods

Ownership of the goods

SO 1 Describe the steps in determining inventory quantities.

SO 1 Describe the steps in determining inventory quantities.

Determining Ownership of Goods

SO 1 Describe the steps in determining inventory quantities.

SO 2 Explain the accounting for inventories and

Specific Identification Method

SO 2 Explain the accounting for inventories and

One item on 2/2/10 for $10

One item on 2/15/10 for $15

One item on 2/25/10 for $20

Young & Crazy Company sells one item on 2/28/10 for

SO 2 Explain the accounting for inventories and

Young & Crazy Company

SO 2 Explain the accounting for inventories and

Young & Crazy Company

SO 2 Explain the accounting for inventories and

Cost Flow Assumption

SO 2 Explain the accounting for inventories and

One item on 2/2/10 for $10

One item on 2/15/10 for $15

One item on 2/25/10 for $20

Young & Crazy Company sells one item on 2/28/10 for

SO 2 Explain the accounting for inventories and

SO 2 Explain the accounting for inventories and

Young & Crazy Company

SO 2 Explain the accounting for inventories and

SO 2 Explain the accounting for inventories and

Young & Crazy Company

SO 2 Explain the accounting for inventories and

SO 2 Explain the accounting for inventories and

Young & Crazy Company

SO 2 Explain the accounting for inventories and

Cost of goods sold

Admin. & selling expense

Income before taxes

Income tax expense

SO 3 Explain the financial effects of the inventory cost flow assumptions.

Cost of goods sold

Admin. & selling expense

Income before taxes

Income tax expense

SO 3 Explain the financial effects of the inventory cost flow assumptions.

Cost of goods sold

Admin. & selling expense

Income before taxes