Financial Accounting

John J. Wild
Sixth Edition
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 05

Reporting and Analyzing

Inventories
 Conceptual Chapter Objectives

C1: Identify the items making up

merchandise inventory.
C2: Identify the costs of merchandise
inventory.

5-3
 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.

5-4
 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 5A – Compute inventory in a
periodic system using the methods of
specific identification, FIFO, LIFO, and
weighted average (see text for details).
P4: Appendix 5B – Apply both the retail
inventory and gross profit methods to
estimate inventory (see text for details).

5-5
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

5-6
C1

Goods in Transit
FOB Shipping Point
Public

Carrier
Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

5-7
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
5-8
C2 Internal Controls and Taking a Physical
Count


 Most
Most companies
companies take take
aa physical
physical count
count ofof
inventory
inventory at
at least
least once
once
each
each year.
year.

Inv

 When
When the
the physical
physical Cou entory
count nt
count does
does not
not match
match Qua
nt
Tag
the
the Merchandise
Merchandise Cou ity
nte
Cou d_
Inventory
Inventory account,
account, an
an by n te
__
___ d
adjustment
adjustment must
must be
be ___
_
made.
made.
5-9
P1 Inventory Costing Under a Perpetual
System

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


 Inventory
Inventory System
System
 Perpetual
 Perpetual or
or Periodic
Periodic

5-10
P1 Frequency in Use of Inventory
Methods

5-11
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.

5-12
P1
Inventory Costing Illustration

5-13
P1

Specific Identification

The
The above
above purchases
purchases were
were
made
made inin August.
August. OnOn August
August 14,
14,
aa company
company sold
sold 88 bikes
bikes
originally
originally costing
costing $91
$91 and
and 12
12
bikes
bikes originally
originally costing
costing $106.
$106.

5-14
P1
Specific Identification

The
Thecost
costof
ofgoods
goodssold
soldfor
forthe
the20
20bikes
bikessold
soldon
on
the
theAugust
August1414sale
saleis
is$2,000.
$2,000.
88bikes
bikes@@91
91 == $$ 728
728
12
12bikes
bikes@@106
106== $1,272
$1,272
After
Afterthis
thissale,
sale,there
thereare
arefive
fiveunits
unitsin
ininventory
inventory
at
at$500:
$500:
22bikes
bikes@ @$91
$91 == $$182
182
33bikes
bikes@ @$106
$106== $$318
318

5-15
P1
Specific Identification

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and28.
28.
The
Thecost
costof
ofthe
the23
23items
itemssold
soldon
onAugust
August31
31were
wereas
asfollows:
follows:
22@
@$91
$91
33@
@$106
$106
15
15@@$115
$115
33@
@$119
$119 5-16
P1
Specific Identification

Cost
Cost of
of goods
goods sold
sold for
for
August
August 31
31 == $2,582
$2,582 5-17
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.
Aug. 3 Merchandise Inventory 1,590
All purchases Accounts Payable 1,590
and sales are Aug. 14 Accounts Receivable 2,600
made on Sales 2,600
Aug. 14 Cost of Goods Sold 2,000
credit.
Merchandise Inventory 2,000
The selling Aug. 17 Merchandise Inventory 2,300
price of Accounts Payable 2,300
inventory was Aug. 28 Merchandise Inventory 1,190
Accounts Payable 1,190
as follows:
Aug. 31 Accounts Receivable 3,450
8/14 $130 Sales 3,450
Aug. 31 Cost of Goods Sold 2,582
8/31 150 Merchandise inventory 2,582
5-18
P1
First-In, First-Out (FIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.

5-19
P1
First-In, First-Out (FIFO)

The
The Cost
Cost ofof goods
goods sold
sold for
for the
the August
August
14
14 sale
sale is
is $1,970.
$1,970.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory at at $530:
$530: 55 @
@ $106
$106

5-20
P1
First-In, First-Out (FIFO)

Cost
Cost of
of goods
goods sold
sold for
for
August
August 31
31 == $2,600
$2,600
5-21
P1
First-In, First-Out (FIFO)

Income Statement
COGS = $4,570

Balance Sheet
Inventory = $1,420
5-22
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.
Aug. 3 Merchandise Inventory 1,590
All purchases
Accounts Payable 1,590
and sales are Aug. 14 Accounts Receivable 2,600
made on Sales 2,600
credit. Aug. 14 Cost of Goods Sold 1,970
Merchandise Inventory 1,970
The selling Aug. 17 Merchandise Inventory 2,300
price of Accounts Payable 2,300
inventory was Aug. 28 Merchandise Inventory 1,190
Accounts Payable 1,190
as follows:
Aug. 31 Accounts Receivable 3,450
8/14 $130 Sales 3,450
Aug. 31 Cost of Goods Sold 2,600
8/31 150 Merchandise Inventory 2,600
5-23
P1
Last-In, First-Out (LIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.

5-24
P1
Last-In, First-Out (LIFO)

The
The Cost
Cost of
of goods
goods sold
sold for
for the
the August
August
14
14 sale
sale is
is $2,045.
$2,045.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory at
at $455:
$455:
55 @@ $91
$91
5-25
P1
Last-In, First-Out (LIFO)

Cost
Cost of
of goods
goods sold
sold for
for
August
August 3131 == $2,685
$2,685
5-26
P1
Last-In, First-Out (LIFO)

Income
Statement COGS
= $4,730

Balance Sheet
Inventory = $1,260
5-27
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.
Aug. 3 Merchandise Inventory 1,590
All purchases Accounts Payable 1,590
and sales are Aug. 14 Accounts Receivable 2,600
made on Sales 2,600
Aug. 14 Cost of Goods Sold 2,045
credit.
Merchandise Inventory 2,045
The selling Aug. 17 Merchandise Inventory 2,300
price of Accounts Payable 2,300
inventory was Aug. 28 Merchandise Inventory 1,190
Accounts Payable 1,190
as follows:
Aug. 31 Accounts Receivable 3,450
8/14 $130 Sales 3,450
Aug. 31 Cost of Goods Sold 2,685
8/31 150 Merchandise Inventory 2,685
5-28
P1
Weighted Average

When
When aa unit
unit is
is sold,
sold, the
the
average
average costcost ofof each
each unit
unit
in
in inventory
inventory is
is assigned
assigned
to
to cost
cost of
of goods
goods sold.
sold.

Cost of goods Units on hand

available for ÷ on the date of
sale sale

5-29
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

The
Thecost
costofofgoods
goodssold
soldfor
forthe
theAugust
August1414
sale
saleisis$2,000.
$2,000. After
After this
thissale,
sale,there
thereare
arefive
five
units
unitsinininventory
inventoryatat$500:
$500:
5-30
P1
Weighted Average

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August 17
17and
and28.
28.
Twenty-three
Twenty-threebikes
bikeswere
weresold
soldon
onAugust
August31.
31.

What is the weighted average cost per unit

of items in inventory?
5-31
P1
Weighted Average

Units
Units
Inventory
Inventory 8/14
8/14 55 Cost of goods available for sale $ 3,990
Purchase
Purchase 8/17
8/17 20
20 Total units in inventory ÷ 35
Purchase
Purchase 8/28
8/28 10
10
Units
Weighted average cost per unit $ 114
Units available
available for
for sale
sale 35
35

5-32
P1
Weighted Average

Cost
Cost of
of goods
goods sold
sold for
for
August Ending inventory is
August 3131 == $2,622
$2,622 comprised of 12 units @ an
average cost of $114 each or
$1,368.
5-33
P1
Weighted Average

Income
Statement COGS
= $4,622

Balance Sheet
Inventory = $1,368

5-34
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.
Aug. 3 Merchandise Inventory 1,590
All purchases Accounts Payable 1,590
and sales are Aug. 14 Accounts Receivable 2,600
made on Sales 2,600
credit. Aug. 14 Cost of Goods Sold 2,000
Merchandise Inventory 2,000
The selling Aug. 17 Merchandise Inventory 2,300
price of Accounts Payable 2,300
inventory was Aug. 28 Merchandise Inventory 1,190
Accounts Payable 1,190
as follows:
Aug. 31 Accounts Receivable 3,450
Sales 3,450
8/14 $130
Aug. 31 Cost of Goods Sold 2,622
8/31 150 Merchandise Inventory 2,622
5-35
A1 Financial Statement Effects of Costing
Methods

Because
Because prices
prices change,
change, inventory
inventory methods
methods nearly
nearly
always
always assign
assign different
different cost
cost amounts.
amounts.

5-36
A1 Financial Statement Effects of Costing
Methods

Advantages
Advantages of
of Methods
Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending
Ending inventory
inventory Better
Better matches
matches
Smoothes
Smoothes out
out approximates
approximates current
current costs
costs in
in cost
cost
price
price changes.
changes. current
current of
of goods
goods sold
sold with
with
replacement
replacement cost.
cost. revenues.
revenues.
5-37
A1
Tax Effects of Costing Methods

The
The Internal
Internal Revenue
Revenue Service
Service (IRS)
(IRS)
identifies
identifies several
several acceptable
acceptable
methods
methods for for inventory
inventory costing
costing for
for
reporting
reporting taxable
taxable income.
income.

If LIFO is used for tax

purposes, the IRS requires
it be used in financial
statements.
5-38
A1 Consistency in Using Costing
Methods
The
The consistency
consistency concept
concept requires
requires aa
company
company to to use
use the
the same
same accounting
accounting
methods
methods period
period after
after period
period so
so that
that
financial
financial statements
statements areare comparable
comparable
across
across periods.
periods.

5-39
P2
Lower of Cost or Market

Inventory
Inventory must
must be
be reported
reported atat market
market
value
value when
when market
market is
is lower
lower than
than
cost.
cost.

Defined
Defined asas current
current Can
Can be
be applied
applied three
three ways:
ways:
replacement
replacement cost
cost (1)
(1) separately
separately to to each
each
(not
(not sales
sales price).
price). individual
individual item.
item.
Consistent
Consistent with
with (2)
(2) to
to major
major categories
categories of of
the
the conservatism
conservatism assets.
assets.
principle.
principle. (3)
(3) to
to the
the whole
whole inventory.
inventory.

5-40
P2
Lower of Cost or Market

A
A motorsports
motorsports retailer
retailer has
has the
the following
following items
items in
in
inventory:
inventory:

5-41
P2
Lower of Cost or Market

Here
Here is
is how
how to
to compute
compute lower
lower of
of cost
cost or
or
market
market for
for individual
individual inventory
inventory items
items..

5-42
A2
Financial Statement Effects of Inventory
Errors

Income Statement Effects

5-43
A2 Financial Statement Effects of Inventory
Errors

Balance Sheet Effects

5-44
A3
Inventory Turnover
Shows
Shows how
how many
many times
times aa company
company turns
turns over
over its
its
inventory
inventory during
during aa period.
period. Indicator
Indicator of
of how
how well
well
management
management is is controlling
controlling the
the amount
amount ofof inventory
inventory
available.
available.

Inventory Cost of goods sold

turnover = Average inventory

5-45
A3
Days’ Sales in Inventory

Reveals
Reveals how
how much
much inventory
inventory is
is available
available in
in
terms
terms of
of the
the number
number of
of days’
days’ sales.
sales.

Days' sales in Ending inventory

inventory = Cost of goods sold
× 365

5-46
End of Chapter 05

5-47