6

Reporting and Analyzing

Inventory

Kimmel ● Weygandt ● Kieso

Financial Accounting, Eighth Edition
6-1
 CHAPTER OUTLINE

LEARNING OBJECTIVES

Discuss how to classify and determine

1 inventory.

Apply inventory cost flow methods and

2 discuss their financial effects.

Explain the statement presentation and

3 analysis of inventory.

6-2
 Discuss how to classify and determine
LEARNING
OBJECTIVE 1 inventory.

Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
 Merchandise  Raw Materials
Inventory  Work in Process
 Finished Goods
▼ HELPFUL HINT
Regardless of the classification,
companies report all inventories
under Current Assets on the
balance sheet.

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 DETERMINING INVENTORY QUANTITIES

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
3. Determine the inventory on hand.

4. Determine the cost of goods sold for the period.

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 Taking a Physical Inventory

Involves counting, weighing, or measuring each kind of

inventory on hand.

Taken,
 when the business is closed or business is slow.
 at the end of the accounting period.

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 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.

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 Determining Ownership of Goods ILLUSTRATION 6-2
Terms of sale

Ownership of the goods Ownership of the goods

passes to the buyer when remains with the seller until
the public carrier accepts the goods reach the buyer.
the goods from the seller.

Freight costs incurred by the seller are an operating expense.

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 Determining Ownership of Goods

Consigned Goods
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.
Many car, boat, and antique dealers sell goods on
consignment. Why?

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 DO IT! 1 Rules of Ownership
Hasbeen Company completed its inventory count. It arrived at a total inventory value
of $200,000. You have been given the information listed below. Discuss how this
information affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for Falls Co.,
costing $15,000.
2. The company did not include in the count purchased goods of $10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of $12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of $15,000 held on consignment should be deducted from the inventory
count.
2. The goods of $10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be $195,000
($200,000 - $15,000 + $10,000).
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 Apply inventory cost flow methods
LEARNING
OBJECTIVE 2 and discuss their financial effects.

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 determine the total
cost of the inventory and the cost of goods sold using
the following costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Last-in, first-out (LIFO) Cost Flow
Assumptions
► Average-cost

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 SPECIFIC IDENTIFICATION

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 6-3
Data for inventory costing example

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 SPECIFIC IDENTIFICATION

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.
ILLUSTRATION 6-4
Specific identification method

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 SPECIFIC IDENTIFICATION

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.

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 COST FLOW ASSUMPTIONS

Cost flow assumption

does not need to be
consistent with the
physical movement of
goods

Illustration 6-12
Use of cost flow methods
in major U.S. companies

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 COST FLOW ASSUMPTIONS

Illustration: Data for Houston Electronics’ Astro condensers.

ILLUSTRATION 6-5
Data for Houston Electronics

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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 First-In, First-Out (FIFO)

 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 determine 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.

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 First-In, First-Out (FIFO)

ILLUSTRATION 6-6
Allocation of costs—FIFO method
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 First-In, First-Out (FIFO)

▼ HELPFUL HINT
Another way of thinking about
the calculation of FIFO ending
inventory is the LISH
assumption—last in still here.

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 Last-In, First-Out (LIFO)

 Costs of the latest goods purchased are the first

to be recognized in determining cost of goods sold.
 Seldom coincides with actual physical flow of
merchandise.
 Exceptions include goods stored in piles, such as
coal or hay.

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 Last-In, First-Out (LIFO)

ILLUSTRATION 6-8
Allocation of costs—LIFO method
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 Last-In, First-Out (LIFO)

▼ HELPFUL HINT
Another way of thinking about
the calculation of LIFO ending
inventory is the FISH
assumption—first in still here.

ILLUSTRATION 6-8
Allocation of costs—LIFO method

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 Average-Cost

 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.

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 Average-Cost

ILLUSTRATION 6-11
Allocation of costs—average-cost method

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 Average-Cost

ILLUSTRATION 6-11
Allocation of costs—average-cost method

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 FINANCIAL STATEMENT AND TAX EFFECTS

ILLUSTRATION 6-13
Comparative effects of cost flow methods

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 Income Statement Effects
In periods of changing prices, the cost flow assumption can have
significant impacts both on income and on evaluations of income,
such as the following.
1. In a period of inflation, FIFO produces a higher net income
because lower unit costs of the first units purchased are matched
against revenue.
2. In a period of inflation, LIFO produces a lower net income because
higher unit costs of the last goods purchased are matched against
revenue.
3. If prices are falling, the results from the use of FIFO and LIFO are
reversed. FIFO will report the lowest net income and LIFO the
highest.
4. Regardless of whether prices are rising or falling, average-cost
produces net income between FIFO and LIFO.
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 USING INVENTORY 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
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 DO IT! 2 Cost Flow Methods

The accounting records of Shumway Ag Implement show the

following data.
Beginning inventory 4,000 units at $3
Purchases 6,000 units at $4
Sales 7,000 units at $12
Determine the cost of goods sold during the period under a
periodic system using FIFO.

SOLUTION

4,000 units × $3 = $12,000

3,000 units × $4 = 12,000
$24,000
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 DO IT! 2 Cost Flow Methods

The accounting records of Shumway Ag Implement show the

following data.
Beginning inventory 4,000 units at $3
Purchases 6,000 units at $4
Sales 7,000 units at $12
Determine the cost of goods sold during the period under a
periodic system using LIFO.

SOLUTION

6,000 units × $4 = $24,000

1,000 units × $3 = 3,000
$27,000
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 DO IT! 2 Cost Flow Methods

The accounting records of Shumway Ag Implement show the

following data.
Beginning inventory 4,000 units at $3 = $12,000
$36,000
Purchases 6,000 units at $4 = $24,000
Sales 7,000 units at $12
Determine the cost of goods sold during the period under a
periodic system using average cost.

SOLUTION

$36,000 ÷ 10,000 units = $3.60 average cost per unit

$36,000 – ($3,000 ending units × $3.60) = $25,200

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 Explain the statement presentation
LEARNING
OBJECTIVE 3 and analysis of inventory.

PRESENTATION
 Inventory is classified in the balance sheet as a current
asset immediately below receivables.
 In a multiple-step income statement, cost of goods sold
is subtracted from net sales.
 There also should be disclosure of
1. the major inventory classifications,
2. the basis of accounting (cost, or lower-of-cost-or-
market), and
3. the cost method (FIFO, LIFO, or average-cost).
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 LOWER-OF-COST-OR-MARKET

When the value of inventory is lower than its cost.

 Applied to items in inventory after the company has used
one of the cost flow methods (specific identification,
FIFO, LIFO, or average-cost) to determine 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.

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 LOWER-OF-COST-OR-MARKET

Illustration: Assume that Ken Tuckie TV has the following

lines of merchandise with costs and market values as
indicated.

ILLUSTRATION 6-16
Computation of lower-of-cost-or-market

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 DO IT! 3a LCM Basis

Tracy Company sells three different types of home heating stoves

(gas, wood, and pellet). The cost and market value of its inventory of
stoves are as follows.
Cost Market
Gas $ 84,000
$ 79,000
Wood 250,000
280,000
Pellet 112,000
101,000
SOLUTION Determine the value of the company’s inventory
under the lower-of-cost-or-market approach.

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 DO IT! 3a LCM Basis

Tracy Company sells three different types of home heating stoves

(gas, wood, and pellet). The cost and market value of its inventory of
stoves are as follows.
Cost Market
Gas $ 84,000
$ 79,000
Wood 250,000
280,000
Pellet 112,000
101,000
SOLUTION Determine the value of the company’s inventory
The lower valueunder the inventory
for each lower-of-cost-or-market approach.
type is gas $79,000, wood
$250,000, and pellet $101,000. The total inventory value is the sum
of these figures, $430,000.
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 ANALYSIS

Inventory management is a critical task

1. High Inventory Levels - storage costs, interest cost
(on funds tied up in inventory), and costs associated
with the obsolescence of technical goods or shifts in
fashion.

2. Low Inventory Levels – may lead to lost sales.

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 Inventory Turnover

ILLUSTRATION 6-17
Inventory turnovers and
days in inventory

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 Inventory Turnover

Illustration: Data available for Wal-Mart.

ILLUSTRATION 6-17
Inventory turnovers and days in inventory
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 ADJUSTMENTS FOR LIFO RESERVE

Companies using LIFO are required to report the difference

between inventory reported using LIFO and Inventory using
FIFO. This amount is referred to as the LIFO reserve.

ILLUSTRATION 6-18
Caterpillar’s LIFO reserve

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 ADJUSTMENTS FOR LIFO RESERVE

If Caterpillar had used FIFO all along, its inventory would

be $14,635 million, rather than $12,205 million.

ILLUSTRATION 6-19
Conversion of inventory from LIFO to FIFO

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 ADJUSTMENTS FOR LIFO RESERVE

The LIFO reserve can have a significant effect on ratios

analysts commonly use.

Illustration 6-20

ILLUSTRATION 6-20
Impact of LIFO reserve on ratios

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 DO IT! 3b Inventory Turnover
Early in 2017, Westmoreland Company switched to a just-in-time inventory
system. Its sales, cost of goods sold, and inventory amounts for 2016 and
2017 are shown below
2016 2017
Sales revenue $2,000,000
$1,800,000
Cost of goods sold 1,000,000
910,000
Beginning inventory 290,000
210,000
SOLUTION Ending inventory 210,000
50,000
Determine the inventory turnover and days in inventory for 2016
and 2017.

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 APPENDIX 6A: Apply inventory cost flow
LEARNING
OBJECTIVE *4 methods to perpetual inventory records.

Illustration: ILLUSTRATION 6A-1

Inventoriable units and costs

Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO, LIFO, and Average cost.

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 FIRST-IN, FIRST-OUT (FIFO)

ILLUSTRATION 6A-2
Perpetual system—FIFO

Cost of Goods
Ending Inventory
Sold
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 LAST-IN, FIRST-OUT (LIFO)

ILLUSTRATION 6A-3
Perpetual system—LIFO

Cost of Goods
Ending Inventory
Sold
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 AVERAGE COST

ILLUSTRATION 6A-4
Perpetual system—
average-cost method

Cost of Goods
Ending Inventory
Sold

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 APPENDIX 6B: Indicate the effects of
LEARNING
OBJECTIVE *5 inventory errors on the financial statements.

Inventory 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.

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 INCOME STATEMENT EFFECTS

Inventory errors affect the computation of cost of goods

sold and net income.
ILLUSTRATION 6B-1
Formula for cost of goods sold

ILLUSTRATION 6B-2
Effects of inventory errors on current year’s income statement

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 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.
 Ending inventory depends entirely on the accuracy of
taking and costing the inventory.

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 INCOME STATEMENT EFFECTS
ILLUSTRATION 6B-3
Effects of inventory errors on two
years’ income statements

Combined income for ($3,000) $3,000

2-year period is Net Income Net Income
correct. understated overstated

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 BALANCE SHEET EFFECTS

Effect of inventory errors on the balance sheet is

determined by using the basic accounting equation:
Assets = Liabilities + Stockholders’ Equity

Errors in the ending inventory have the effects shown:

ILLUSTRATION 6B-4
Effects of ending inventory errors
on balance sheet

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