Chapter 5

Reporting and Analyzing

Inventories

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 Conceptual Chapter Objectives

C1: Identify the items making up

merchandise inventory
C2: Identify the costs of merchandise
inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 Analytical Chapter Objectives

A1: Analyze the effects of inventory methods

for both financial and tax reporting
A2: Analyze the effects of inventory errors on
current and future financial statements
A3: Assess inventory management using both
inventory turnover and days’ sales in
inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 Procedural Chapter Objectives

P1: Compute inventory in a perpetual system using the

methods of specific identification, FIFO, LIFO, and
weighted average
P2: Compute the lower of cost or market amount of
inventory
P3: Appendix 6A: Compute inventory in a periodic
system using the methods of specific identification,
FIFO, LIFO, and weighted average
P4: Appendix 6B: Apply both the retail inventory and
gross profit methods to estimate inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 C1

Determining Inventory Items

Merchandise inventory includes all goods that

a company owns and holds for sale,
regardless of where the goods are located
when inventory is counted.
Items requiring special attention include:
Goods
Goods in
Damaged or
Transit Goods on Obsolete
Consignment

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 C1

Goods in Transit
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 C1

Goods on Consignment

Merchandise is included in the inventory of

the consignor, the owner of the inventory.

Thanks for selling

my inventory in
your store.
Consignee

Consignor
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 C1

Goods Damaged or Obsolete

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.

Cost should be reduced to net realizable value if

they can be sold.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 C2

Determining Inventory Costs

Include all expenditures necessary to bring an

item to a salable condition and location.

Minus
Discounts Invoice Plus
and
Allowances Cost Insurance

Plus Import Plus

Duties Plus Storage
Freight
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 C2 Internal Controls and Taking a Physical
Count

 Most companies take

a physical count of
inventory at least once
each year.

Inv
 When the physical Cou entory
n
count does not match Qua t Tag
nt
Cou ity
the Merchandise nte
Cou d_
Inventory account, an by n t e
__
___ d
adjustment must be ___
_
made.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1 Inventory Costing Under a Perpetual
System

Inventory
affects . . .
Balance Income
Sheet Statement

The matching
principle requires
matching cost of
sales with sales.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1 Inventory Costing Under a Perpetual
System

Accounting for
inventory  Costing Method
requires several  Specific Identification, FIFO, LIFO,
decisions . . . or Weighted Average

 Inventory System
 Perpetual or Periodic

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Frequency in Use of Inventory
Methods

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Inventory Cost Flow
Assumptions
First-In, First-Out Assumes costs flow in the order
(FIFO) incurred.

Last-In, First-Out Assumes costs flow in the

(LIFO) reverse order incurred.

Weighted Assumes costs flow at an

Average average of the costs available.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Inventory Costing Illustration

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Specific Identification

When units are sold, the

specific cost of the unit
sold is added to cost of
goods sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1

Specific Identification

The above purchases were

made in August. On August 14,
a company sold eight bikes
originally costing $91 and 12
bikes originally costing $106.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Specific Identification

The Cost of Goods Sold for the August 14 sale

is $2,000.
8 bikes @ 91 = $ 728
12 bikes @ 106 = $1,272
After this sale, there are five units in inventory
at $500:
2 bikes @ $91 = $ 182
3 bikes @ $106 = $ 318

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Specific Identification

Additional purchases were made on August 17 and 28.

The cost of the 23 items sold on August 31 were as follows:
2 @ $91
3 @ $106
15 @ $115
3 @ $119
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Specific Identification

Cost of Goods Sold for

August 31 = $2,582
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Specific Identification

After the August 31 sale, there are

12 units in inventory at $1,408:
5 @ $115
McGraw-Hill/Irwin 7 @ $119 © The McGraw-Hill Companies, Inc., 2008
 P1
Specific Identification

Income
Statement COGS
= $4,582

Balance Sheet
McGraw-Hill/Irwin
Inventory = $1,408
© The McGraw-Hill Companies, Inc., 2008
 P1
Specific Identification
Here are the entries to record the purchases and sales. The
numbers in red are determined by the cost flow assumption
used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,000
The selling Merchandise inventory 2,000
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,582
McGraw-Hill/Irwin Merchandise inventory 2,582
© The McGraw-Hill Companies, Inc., 2008
 P1
First-In, First-Out (FIFO)

Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
First-In, First-Out (FIFO)

The above purchases were

made in August.
On August 14, the company
sold 20 bikes.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
First-In, First-Out (FIFO)

The Cost of Goods Sold for the

August 14 sale is $1,970.
After this sale, there are five units in
inventory at $530:
5 @ $106
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
First-In, First-Out (FIFO)

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
First-In, First-Out (FIFO)

Cost of Goods Sold for

August 31 = $2,600
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
First-In, First-Out (FIFO)

After the August 31 sale, there are

12 units in inventory at $1,420:
2 @ $115
10 @ $119
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
First-In, First-Out (FIFO)

Income Statement
COGS = $4,570

Balance Sheet
Inventory = $1,420
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
First-In, First-Out (FIFO)
Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost flow
assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 1,970
The selling Merchandise inventory 1,970
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,600
McGraw-Hill/Irwin Merchandise inventory 2,600
© The McGraw-Hill Companies, Inc., 2008
 P1
Last-In, First-Out (LIFO)

Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Last-In, First-Out (LIFO)

The above purchases were

made in August.
On August 14, the company
sold 20 bikes.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Last-In, First-Out (LIFO)

The Cost of Goods Sold for the

August 14 sale is $2,045.
After this sale, there are five units in
inventory at $455:
5 @ $91
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Last-In, First-Out (LIFO)

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Last-In, First-Out (LIFO)

Cost of Goods Sold for

August 31 = $2,685
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Last-In, First-Out (LIFO)

After the August 31 sale, there are

12 units in inventory at $1,260:
5 @ $91
7 @ $115
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Last-In, First-Out (LIFO)

Income
Statement COGS
= $4,730

Balance Sheet
Inventory = $1,260
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Last-In, First-Out (LIFO)
Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost flow
assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,045
The selling Merchandise inventory 2,045
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,685
McGraw-Hill/Irwin Merchandise inventory 2,685
© The McGraw-Hill Companies, Inc., 2008
 P1
Weighted Average

When a unit is sold, the

average cost of each unit
in inventory is assigned
to cost of goods sold.

Cost of Goods Units on hand

Available for ÷ on the date of
Sale sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

The above purchases were

made in August.
On August 14, 20 bikes were
sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

First, we need to compute the weighted

average cost per unit of items in inventory.

Cost of goods available for sale $ 2,500

Total units in inventory ÷ 25
Weighted average cost per unit $ 100

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

The Cost of Goods Sold for the August 14

sale is $2,000.
After this sale, there are five units in
inventory at $500:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

What is the weighted average cost per unit

of items in inventory?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 P1
Weighted Average

Units
Inventory 8/14 5 Cost of goods available for sale $ 3,990
Purchase 8/17 20 Total units in inventory ÷ 35
Purchase 8/28 10
Units available for sale 35
Weighted average cost per unit $ 114

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

Cost of Goods Sold for

August 31 = $2,622

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

After the August 31 sale, there are

12 units in inventory at $1,368:
12 @ $114

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average

Income
Statement COGS
= $4,622

Balance Sheet
Inventory = $1,368

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P1
Weighted Average
Here are the entries to record the purchases and sales
entries for Trekking. The numbers in red are determined by
the cost flow assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,000
The selling Merchandise inventory 2,000
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,622
McGraw-Hill/Irwin Merchandise inventory 2,622
© The McGraw-Hill Companies, Inc., 2008
 A1 Financial Statement Effects of Costing
Methods

Because prices change, inventory methods nearly

always assign different cost amounts.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 A1 Financial Statement Effects of Costing
Methods

Advantages of Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current of goods sold with
replacement cost. revenues.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 A1
Tax Effects of Costing
Methods
The Internal Revenue Service (IRS)
identifies several acceptable
methods for inventory costing for
reporting taxable income.

If LIFO is used for tax

purposes, the IRS requires
it be used in financial
statements.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 A1
Consistency in Using Costing
Methods

The consistency principle requires a

company to use the same accounting
methods period after period so that
financial statements are comparable
across periods.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P2
Lower of Cost or Market

Inventory must be reported at market

value when market is lower than
cost.

Defined as current Can be applied three ways:

replacement cost (1) separately to each
(not sales price). individual item.
Consistent with (2) to major categories of
the conservatism assets.
principle. (3) to the whole inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P2
Lower of Cost or Market

A motorsports retailer has the following items in

inventory:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P2
Lower of Cost or Market

Here is how to compute lower of cost or

market for individual inventory items.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P2
Lower of Cost or Market

Here is how to compute lower of cost or market

for the two groups of inventory items.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 P2
Lower of Cost or Market

Here is how to compute lower of cost or market

for the entire inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 Exh.
5.10
A2 Financial Statement Effects of Inventory
Errors

Income Statement Effects

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 A2 Financial Statement Effects of Inventory
Errors

Balance Sheet Effects

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 A3
Inventory Turnover

Shows how many times a company turns over its

inventory during a period. Indicator of how well
management is controlling the amount of
inventory available.

Inventory Cost of goods sold

Turnover = Avg. inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 A3
Days’ Sales in Inventory

Reveals how much inventory is available in

terms of the number of days’ sales.

Days' Sales in Ending Inventory

Inventory = Cost of goods sold
× 365

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 End of Chapter 5

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008