Inventory

Costing and
Valuation

CHAPTER

6
Electronic Presentations in Microsoft®
PowerPoint® to accompany
Fundamental Accounting Principles, 16ce
Prepared by
Lise Wall, Red River College
© 2019 McGraw-Hill Education
 Learning Objectives
1. Identify the components and costs included in
merchandise inventory. (LO1)

2. Calculate cost of goods sold and merchandise

inventory using specific identification, moving
weighted average, and FIFO-perpetual. (LO2)

3. Analyze the effects of the costing methods on

financial reporting. (LO3)

© 2019 McGraw-Hill Education 6 -2

 Learning Objectives
4. Calculate the lower of cost and net realizable value
of inventory. (LO4)

5. Analyze the effects of merchandise inventory

errors on current and future financial
statements-perpetual. (LO5)

6. Apply both the gross profit and retail inventory

methods to estimate inventory. (LO6)

© 2019 McGraw-Hill Education 6-3

 Learning Objectives
7. Assess inventory management using both
merchandise turnover and days’ sales in inventory.
(LO7)
8. Calculate cost of goods sold and merchandise
inventory using FIFO-periodic, weighted average,
and specific identification (Appendix 6A) (LO8)
9. Analyze the effects of inventory errors on current
and future financial statements- periodic.
(Appendix 6A) (LO9)

© 2019 McGraw-Hill Education 6-4

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© 2019 McGraw-Hill Education 6-5

Assigning Costs to Merchandise
Inventory
Accounting for merchandise inventory requires
several decisions which include:
• Items included and their costs.
• Costing Method. (specific identification, moving
weighted average or FIFO)
• Merchandise Inventory System. (perpetual or
periodic)
• Use of net realizable value or other estimates.

© 2019 McGraw-Hill Education 6-6

Items in Merchandise Inventory
Merchandise inventory includes all goods
owned by a company and held for sale.

Items requiring special attention:

• Goods in Transit

• Goods on Consignment
• Goods Damaged or Obsolete

© 2019 McGraw-Hill Education 6-7

Costs of Merchandise Inventory
All expenditures necessary to bring an item to
a saleable condition and location.
Some examples include:
• Invoice price less discounts
• Import duties
• Transportation-in (freight costs)

• Storage
• Insurance
• Handling costs

© 2019 McGraw-Hill Education 6-8

 Assigning Costs to Merchandise
Inventory
• Management must decide on a method of
determining unit cost.
• This will affect both the income statement
and the balance sheet.
Methods:
1. First-in, first-out (FIFO)
2. Moving weighted average
3. Specific identification

© 2019 McGraw-Hill Education 6-9

Assigning Costs to Inventory Example
Using the information from Exhibit 6.2 and Exhibit 3 the
three inventory methods will be reviewed.
Cost Total
Units Per Unit Cost
Aug 1 Beginning Inventory 10 @ $ 91 = $ 910
3 Purchased 15 @ $ 106 = $ 1,590
17 Purchased 20 @ $ 115 = $ 2,300
Total goods and units available for sale 45 $ 4,800

Selling Price Total

Units Per Unit Cost
Aug 14 Sales 20 @ $ 133 = $ 2,660
28 Sales 14 @ $ 150 = $ 2,100
34 Units $ 4,760

© 2019 McGraw-Hill Education 6-10

 First-In, First-Out (FIFO)

Based on the assumption that the items are sold in

the order acquired.
When a sale occurs:
• The earliest units purchased are charged to Cost
of Goods Sold.
• The cost of the most recent purchases remain in
merchandise inventory.

© 2019 McGraw-Hill Education 6 - 11

 FIFO - Example

The opening inventory consists of 10 units @ $91/unit.

© 2019 McGraw-Hill Education 6 - 12

 FIFO - Example

Additional units
Additional re are
units This results in two layers of
purchased @ $106/unit.
purchased @ $106/unit. merchandise inventory.

© 2019 McGraw-Hill Education 6 - 13

 FIFO - Example

Under FIFO, units are assumed to be sold in the order acquired.

Therefore, of the 20 units sold on August 14, the first 10 units come
from beginning inventory. Therefore, those 10 units are removed
from the inventory record based on the cost of those units of $91.

© 2019 McGraw-Hill Education 6 - 14

 FIFO - Example

The remaining 10 units sold on August 14th come from the next
purchase, made on August 3rd. Therefore, these units are removed
from the inventory record based on their cost of $106.

© 2019 McGraw-Hill Education 6 - 15

 FIFO - Example

The ending inventory consists of the 5

remaining units from the August 3 purchase.

© 2019 McGraw-Hill Education 6 - 16

 FIFO - Example
Exhibit 6.4

Both sales (at cost) and ending Inventory balance must equal goods available for sale.

© 2019 McGraw-Hill Education 6 - 17

 Mini-Quiz
A company that uses a perpetual merchandise inventory system
made the following cash purchases and sales:
Jan. 1-Purchased 100 units at $10 per unit.
Feb. 5-Purchased 60 units at $12 per unit.
Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a FIFO
system is used.
Cash 640
Sales (40x $16) 640

Cost of goods sold 400

Merchandise Inventory (40x $10 ) 400
© 2019 McGraw-Hill Education 6 - 18
 Moving Weighted Average Method

Under this method, the cost of all units are

averaged together.

Cost of goods available for sale

Average cost =
per unit Number of units available for sale

© 2019 McGraw-Hill Education 6 - 19

Moving Weighted Average - Perpetual

The opening inventory consists of 10 units @ $91/unit.

© 2019 McGraw-Hill Education 6 - 20

Moving Weighted Average - Perpetual

15 additional units are This results in an average cost of

purchased @ $106/unit. $100/unit.

(10 x $91) + (15 x $106)

25 units

© 2019 McGraw-Hill Education 6 - 21

Moving Weighted Average - Perpetual

These 20 units are sold at the

average cost of $100/unit.

© 2019 McGraw-Hill Education 6 - 22

Moving Weighted Average - Perpetual

This leaves 5 units remaining at

an average cost of $100/unit.

© 2019 McGraw-Hill Education 6 - 23

Moving Weighted Average - Perpetual
Exhibit 6.5

Both sales (at cost) and ending Inventory balance must equal goods available for sale.

© 2019 McGraw-Hill Education 6 - 24

 Mini-Quiz
A company that uses a perpetual merchandise inventory system made
the following cash purchases and sales:
• Jan. 1-Purchased 100 units at $10 per unit.
• Feb. 5-Purchased 60 units at $12 per unit.
• Mar.16-Sold for cash 40 units for $16 per unit.
Prepare journal entries to record the sale assuming a Moving Weighted
Average system is used.
Cash 640
Sales (40x $16) 640

Cost of goods sold 430

Merchandise Inventory 430
(100x$10 + 60x$12)/160 x 40
© 2019 McGraw-Hill Education 6 - 25
 Specific Identification
This method is used when items:
• Can be directly identified.
• Can be directly identified with a specific
purchase and its invoice.
Examples: Automobiles, art, custom furniture,
custom jewelry.

© 2019 McGraw-Hill Education 6 - 26

Specific Identification - Perpetual

The opening inventory consists of 10 units @ $91/unit.

© 2019 McGraw-Hill Education 6 - 27

 Specific Identification - Perpetual

15 additional units are This results in two layers of

purchased @ $106/unit. merchandise inventory.

© 2019 McGraw-Hill Education 6 - 28

 Specific Identification - Perpetual

On August 14, 20 units are sold. Eight of these units

came from the opening merchandise inventory and the
remaining 12 units came from the August 3 purchase.

© 2019 McGraw-Hill Education 6 - 29

 Specific Identification - Perpetual

This leaves 2 units remaining from the

original merchandise inventory and 3 units
remaining from the August 3 purchase.

© 2019 McGraw-Hill Education 6 - 30

 Specific Identification - Perpetual
Exhibit 6.6

Both sales (at cost) and ending Inventory balance must equal goods available for sale.

© 2019 McGraw-Hill Education 6 - 31

 Comparison of Methods
Because costs change, the choice of an
merchandise inventory method is important.
EXHIBIT 6.7

Moving
Weighted Specific
FIFO Average Identification
Units $ Unit $ Units $
Cost of Goods Sold
(or Cost of Sales) 34 $3,535 34 $3,568 34 $ 3,562
Ending Inventory 11 1,265 11 1,232 11 1,238
Goods Available for Sales 45 $4,800 45 $4,800 45 $4,800

© 2019 McGraw-Hill Education 6 – 32

 Financial Reporting
EXHIBIT 6.9 Moving Weighted Specific
FIFO Average Identification
Advantages: Most current values are
Smooths out purchase Exactly matches costs
on the balance sheet as
price changes. and revenues.
ending inventory.
Matches the flow of
Matches the flow of Works well for
goods for businesses
goods for many companies that sell
that have a large
businesses that attempt differentiated products
volume of small items
to sell older inventory with a higher dollar
that don’t expire, such
first, such as a grocery value, such as a
as a landscape centre
retailer. jewellery store.
selling stones/gravel.
Disadvantages: Cost of goods sold does
not reflect current Averaging does not Relatively more costly
costs, so does not accurately match to implement and
accurately match expenses to revenues. maintain.
expenses to revenue.

© 2019 McGraw-Hill Education 6 - 33

 Financial Reporting
• A company is required to use the same accounting
methods from period to period (consistency
principle).

• A change is only acceptable when it improves

financial reporting.
• The costing method used must be disclosed in the
notes to the financial statements (full-disclosure
principle).

© 2019 McGraw-Hill Education 6 - 34

 Lower of Cost and Net Realizable
Value (LCNRV)
• The cost of inventory is not always the cost
reported on the balance sheet.
• Principle of faithful representation provides
guidance on how to report inventory:
• At the amount expected to be received on the sale
of the item (the net realizable value or NRV) if it is
lower than the cost of the item.
• Inventory must be reported at net realizable
value (NRV) when NRV is lower than cost.

© 2019 McGraw-Hill Education 6 - 35

 Lower of Cost and Net
Realizable Value (LCNRV)
May be applied in one of two ways:
1. Usually item by item, or, when not
practical,
2. To groups of similar or related items.

© 2019 McGraw-Hill Education

6 - 36
 LCNRV Calculation by Items
EXHIBIT 6.10
LCNRV
applied to:
Inventory No. of Cost/ NRV /
Items Units Unit Total Cost Unit Total NRV Items

Bicycles:

Roadster………….. 25 $ 750 $18,750 $ 790 $ 19,750 $18,750

Sprint………………. 60 1,100 66,000 1,100 66,000 66,000

Group Subtotal………… $ 84,750 $ 85,750

Kayaks:

A1 Series………….. 21 $1,800 $ 37,800 $ 1.300 $27,300 $ 27,300

Trax 4……………….. 29 2,200 63,800 2,250 65,250 63,800

Group Subtotal…………. $ 101,600 $ 92,550

Total Inventory………… $186,350 $ 175,850

LCNRV is lower than total cost. An entry would be required to reduce inventory costs by $10,500
($186,350 – 175,850).

© 2019 McGraw-Hill Education 6-37

 LCNRV Calculation by Groups
EXHIBIT 6.10
LCNRV
applied to:
Inventory No. of Cost/ NRV /
Items Units Unit Total Cost Unit Total NRV Groups

Bicycles:

Roadster………….. 25 $ 750 $18,750 $ 790 $ 19,750

Sprint………………. 60 1,100 66,000 1,100 66,000

Group Subtotal………… $ 84,750 $ 85,750 $ 84,750

Kayaks:

A1 Series………….. 21 $1,800 $ 37,800 $ 1.300 $27,300

Trax 4……………….. 29 2,200 63,800 2,250 65,250

Group Subtotal…………. $ 101,600 $ 92,550 $92,550

Total Inventory………… $186,350 $ 177,300

LCNRV is lower than total cost. An entry would be required to reduce inventory costs by $9,050
($186,350 – 177,300).

© 2019 McGraw-Hill Education 6-38

 LCNRV Calculation
EXHIBIT 6.10

LCNRV applied to:

Inventory No. of Cost/ NRV /
Items Units Unit Total Cost Unit Total NRV Items Groups

Bicycles:

Roadster………….. 25 $ 750 $18,750 $ 790 $ 19,750 $18,750

Sprint………………. 60 1,100 66,000 1,100 66,000 66,000

Group Subtotal………… $ 84,750 $ 85,750 $ 84,750

Kayaks:

A1 Series………….. 21 $1,800 $ 37,800 $ 1.300 $27,300 $ 27,300

Trax 4……………….. 29 2,200 63,800 2,250 65,250 63,800

Group Subtotal…………. $ 101,600 $ 92,550 $92,550

Total Inventory………… $186,350 $ 175,850 $ 177,300

© 2019 McGraw-Hill Education 6-39

 Merchandise Inventory Errors
Errors in the computation of or physical count of
merchandise inventory will cause a misstatement
of:
• Cost of goods sold
• Gross profit
• Profit
• Current assets
• Equity

© 2019 McGraw-Hill Education 6 - 40

 Cost of Goods Sold Components -
Periodic
EXHIBIT 6.11

Plus Cost of Minus Equals

Beginning Cost of Ending
Goods
Inventory Goods Sold Inventory
Purchased

Merchandise Inventory Cost of Good Sold

Beginning
Inventory
Cost of Goods
Cost of Goods Cost of Goods
Sold
Purchased Sold
Ending Inventory

© 2019 McGraw-Hill Education 6-41

 Inventory Errors- Effect on This
Period’s Income Statement
EXHIBIT 6.13
Inventory Error Cost of Goods Sold Profit
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated

© 2019 McGraw-Hill Education 6 - 42

 Graphing the Effects of Inventory
Errors on Profit
EXHIBIT 6.14

© 2019 McGraw-Hill Education 6-43

 Inventory Errors- Effect on This
Period’s Balance Sheet
EXHIBIT 6.16

Inventory Error Assets Equity

Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated

© 2019 McGraw-Hill Education 6 - 44

 Gross Profit Method
Ending merchandise inventory is estimated by
applying the gross profit ratio to net sales. It is
used:
• When merchandise inventory has been destroyed, lost,
or stolen.
• For testing the reasonableness of the physical
merchandise inventory count.
• This method uses the historical relationship between
cost of good sold and net sales to estimate the cost of
good sold with current sales.

© 2019 McGraw-Hill Education 6 -45

 Gross Profit Method

Calculating the inventory using the gross profit method:

EXHIBIT 6.17

Step One Step Two

Sales………………………… Inventory, Jan 1,
………… $ 31,500 2020……………………………….. $12,000
Less: Sales Add: Net cost of goods
Returns………… 1,500 purchased………… 20,500
Net Less:
Sales………………………… COGS…………………………………………
…. $ 30,000 ….. 21,000
Less: profit equals 30% of net sales or $9,000 (30% x $30,000),
*If gross Estimated March
then COGS most equal 70% of net sales or $21,000 (70%
COGS*…………………..
x $30,000) 21,000 Inventory…………………………. $11,500
Gross profit from
sales……….. 30%

Or $ 9,000
© 2019 McGraw-Hill Education 6-46
 Retail Inventory Method
Occasionally used for interim period
reporting.
Information required:
1. Beginning inventory at cost and retail.
2. Net purchases at cost and retail.
3. Dollar value of net sales at retail.

© 2019 McGraw-Hill Education 6 - 47

 Inventory Estimation Using the
Retail Inventory Method
Goods Ending
Step 1 Net Sales at
Available for Inventory at
Retail
Sale at Retail Retail

Goods Goods
Step 2
Available for ÷ Available for
Cost to
Retail Ratio
Sale at Cost Sale at Retail

Step 3 Estimated
Ending
Inventory at × Cost to
Retail Ratio
Ending
Inventory at
Retail
Cost
EXHIBIT 6.18

© 2019 McGraw-Hill Education 6-48

 Review
Q Describe how management’s decisions can affect
the determination of the cost of merchandise
inventory.
• Choice of method –FIFO, moving weighted average or
specific identification.
• Choice of application of LCNRV -separate item or
categories.
• Choice of periodic or perpetual system.
• Items to include in cost.

© 2019 McGraw-Hill Education 6 - 49

 Financial Statement Analysis
Merchandise inventory ratios may be used to
assess:
1. Current liquidity.

2. Merchandise Inventory management.

© 2019 McGraw-Hill Education 6 - 50

 Financial Statement Analysis
Inventory Turnover Ratio
• Measures how many times a company turns its
merchandise inventory over each period.
• The ratio will vary from industry to industry.
EXHIBIT 6.20

Inventory turnover ₌ Cost of goods sold

Average merchandise inventory

© 2019 McGraw-Hill Education 6 - 51

 Financial Statement Analysis
Days’Sales in Inventory Ratio
• Used to estimate how many days it will take to convert
merchandise inventory to cash or receivables.
• Used to assess if merchandise inventory levels can
meet sales demand.
EXHIBIT 6.22

Day’s sales in inventory ₌ Ending inventory

X 365
Cost of goods sold

© 2019 McGraw-Hill Education 6 -52

 Periodic System-Appendix 6A
• The periodic system also uses FIFO, specific
identification, and weighted average methods
to assign costs to merchandise inventory and
cost of goods sold.

• The results may be the same or different

under both systems.

© 2019 McGraw-Hill Education 6 - 53

 FIFO-Appendix 6A
Yields same results as perpetual system since
most recent purchases are in ending
merchandise inventory and older costs are
assigned to cost of goods sold.

© 2019 McGraw-Hill Education 6 - 54

 Weighted Average-Appendix 6A
Steps:
1. Calculate weighted average unit cost.
(# units beg. Inv.
X unit cost) + (#units purchased x unit cost)
# units available for sale
= one weighted average unit cost

2. Use weighted average unit cost to assign costs

to cost of goods sold and ending merchandise
inventory.
Does not yield the same results as perpetual.
© 2019 McGraw-Hill Education 6 -55
 Specific Identification-Appendix 6A
• Applied in same manner as periodic system.

• Yields same results as perpetual system since

units are specifically identified leaving specific
inventory cost in both cost of goods sold and
merchandise inventory.

© 2019 McGraw-Hill Education 6 - 56

 Merchandise Inventory Errors in a
Periodic System-Appendix 6A
• An error in the ending merchandise inventory
affects the assets, profit, and equity of that
period.

• The ending merchandise inventory of one

period becomes the opening merchandise
inventory of the next period. The cost of goods
sold and profit of the next period are affected
as well.

© 2019 McGraw-Hill Education 6 - 57

 Summary
1. Identify the components and costs included in
merchandise inventory.
2. Calculate cost of goods sold and merchandise
inventory using specific identification, moving
weighted average, and FIFO-perpetual.
3. Analyze the effects of the costing methods on
financial reporting.

© 2019 McGraw-Hill Education 6-58

 Summary
4. Calculate the lower of cost and net realizable value
of inventory.

5. Analyze the effects of merchandise inventory errors

on current and future financial
statements-perpetual.

6. Apply both the gross profit and retail inventory

methods to estimate inventory.

© 2019 McGraw-Hill Education 6-59

 Summary
7. Assess inventory management using both
merchandise turnover and days’ sales in inventory
ratios.
8. Calculate cost of goods sold and merchandise
inventory using FIFO-periodic, weighted average,
and specific identification (appendix 6A).
9. Analyze the effects of inventory errors on current
and future financial statements- periodic (appendix
6A).

© 2019 McGraw-Hill Education 6-60

End of Chapter

© 2019 McGraw-Hill Education 6 - 61