GreatLand College
College of Business and
Economics
Department of Accounting &
Finance
Course Title: Fundamentals
of [Link]
Credit hour: 4
Instructor: Ifa A.(MSc)
Chapter
One
Inventories
1.1. Classification of Inventories
Inventories are asset items held for sale in the
ordinary course of business, or goods to be used in
the production of goods to be sold.
Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
Merchandise Raw Materials
Helpful Hint:
Inventory
Regardless of the Work in Process
classification,
companies report all Finished Goods
inventories under
Current Assets on the
6-3
1.2. Determining Inventory Quantities
No matter whether they are using a periodic or
perpetual inventory system, all companies need to
determine inventory quantities at the end of the
accounting period.
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.
6-4
4. Determine the cost of goods sold for the period.
Cont’d
Determining inventory quantities involves two steps:
(1) taking a physical inventory of goods on hand and
(2) determining the ownership of goods.
Taking a Physical Inventory
Involves counting, weighing, or measuring each
kind of inventory on hand.
Companies often “take inventory”
when the business is closed or
business is slow.
at the end of the accounting period.
6-5
Cont’d
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.
6-6
Cont’d
Goods In Transit Illustration 6-2 Terms
of sale
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.
6-7
Cont’d
Question # 1:
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.
6-8
Cont’d
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?
6-9
> DO IT!
Deng Yaping 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. Deng Yaping 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
6-10
1.3. Inventory Costing Methods
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 compute
the total cost of the inventory and the cost of
goods sold using the following costing methods:
► Specific identification
Cost Flow
► First-in, first-out (FIFO) Assumpti
► Average-cost ons
6-11
Cont’d
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
1.3.1. 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
Cont’d
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.
6-14
1.3.2. Cost Flow Assumptions
There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost
Cost flow does not need be consistent with the
physical movement of the goods.
Cont’d
Data for Lin Electronics’ Astro condensers.
Illustration 6-
5
(Beginning Inventory + Purchases) - Ending Inventory = Cost of
6-16
Goods Sold
Cont’d
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 obtain the cost of the ending
inventory by taking the unit cost of the most
recent purchase and working backward until
6-17 all units of inventory have been costed.
Cont’d
Illustration 6-6: Allocation of costs—FIFO
method
6-18
Cont’d
Illustration 6-6: Allocation of costs—FIFO
method
• HELPFUL HINT
Another way of thinking about the calculation of FIFO
ending inventory is the LISH assumption—last in still here.
6-19
Cont’d
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
Illustration 6-8: on hand
Formula to determine cost of the
for weighted-average
unit cost
ending inventory.
6-20
Cont’d
Illustration 6-9 Allocation of costs—Average-Cost
Method
6-21
Cont’d
Illustration 6-9 Allocation of costs—Average-Cost
Method Illustration 6-11
6-22
> DO IT!
The accounting records of Shumway Ag
Implement show the following.
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 inventory system using:
(a) the FIFO method and
(b) the average-cost method.
6-23
Cont’d
6-24
1.3.3. Inventory CF Methods in Perpetual
Inventory Systems
Data for Lin Electronics’ Astro condensers.
Illustration
6A-1
Assuming the Perpetual Inventory System, compute
CGS and Ending Inventory under FIFO and Average-
cost.
First-In-First-Out (FIFO)
Illustration 6A-2: Perpetual System—
FIFO
Cost of Goods Ending
Sold Inventory
Average-Cost
Illustration 6A-3: Perpetual System—Average-
cost method
Cost of Goods Ending
Sold Inventory
Cont’d
FS and Tax Effects of Cost Flow
Methods
Either of the two cost flow assumptions is
acceptable for use. For example,
adidas (DEU) and Lenovo (CHN) use the
average-cost method, whereas
Syngenta Group (CHE) and Nokia (FIN) use FIFO.
A recent survey of IFRS companies, approximately
► 60% use the average-cost method,
► 40% use FIFO, and
► 23% use both for different parts of their
inventory.
6-29
INCOME STATEMENT EFFECTS
Illustration 6-10: Comparative effects of cost flow
methods
6-30
SoFP EFFECTS
A major advantage of the FIFO method is
that in a period of inflation, the costs allocated
to ending inventory will approximate their
current cost.
A major shortcoming of the average-cost
method is that in a period of inflation, the
costs allocated to ending inventory may be
understated in terms of current cost.
6-31
TAX EFFECTS
Both inventory and net income are higher
when companies use FIFO in a period of
inflation.
Average-cost results in the lower income
taxes (because of lower net income) during
times of rising prices.
6-32
Using Cost Flow Methods
Consistently
Method should be used consistently,
enhances comparability.
Although consistency is preferred, a
company may change its inventory costing
method.
6-33
Cont’d
Question # 2:
In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. NI equal to the specific identification method.
6-34 LO 3
Cont’d
Question # 3:
Factors that affect the selection of an inventory
costing method do not include:
a. tax effects.
b. statement of financial position effects.
c. income statement effects.
d. perpetual vs. periodic inventory system.
6-35
1.3.4. Lower-of-Cost-or-Net
Realizable Value
When the value of inventory is lower than its
cost
companies must “write down” the
inventory to its net realizable value.
Net realizable value: Amount that a
company expects to realize (receive from the
sale of inventory).
6-36
Cont’d
Illustration: Assume that Gao TV has the
following lines of merchandise with costs and
market
Illustrationvalues as indicated.
6-11: Computation of lower-of-cost-or-net realizable
value
6-37
> DO IT!
LCNRV Basis
Tracy Company sells three different types of home
heating stoves (wood, gas, and pellet). The cost and net
realizable value of its inventory of stoves are as follows.
Determine the value of the company’s inventory under
the lower-of-cost-or-net realizable value approach.
Total inventory value is the sum of these amounts,
1.4. Inventory Errors
Unfortunately, errors occasionally occur in
accounting for inventory.
In some cases, errors are caused by failure
to count or price inventory correctly.
In other cases, errors occur because
companies do not properly recognize the
transfer of legal title to goods that are in
transit.
When errors occur, they affect both the
Income Statement and SoFP.
Income Statement Effects
Inventory errors affect the computation of Cost of
Goods Sold and Net Income in two periods.
Illustration 6-12: Formula for cost of
goods sold
Illustration 6-13: Effects of inventory errors on current year’s
income statement
Cont’d
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.
Illustration 6-13 shows this effect.
Illustration 6-13: Effects of Inventory Errors on Two Years’ Income
Statements
Cont’d
As you study the illustration, you will see that
the reverse effect comes from the fact that
understating ending inventory in 2013
results in understating beginning inventory
in 2014 and overstating net income in 2014.
Over the two years, though, total net income
is correct because the errors offset each
other.
Notice that total income using incorrect data is
€35,000 (€22,000 + €13,000), which is the
same as the total income of €35,000 (€25,000
+ €10,000) using correct data.
Cont’d
Also note in this example that an error in
the beginning inventory does not result in
a corresponding error in the ending
inventory for that period.
The correctness of the ending inventory
depends entirely on the accuracy of taking
and costing the inventory at the SoFP date
under the periodic inventory system.
Cont’d
Question # 4:
Atlantis Company’s ending inventory is understated
by NT$122,000. The effects of this error on the current
year’s CGS and Net Income, respectively, are:
a. understated, overstated.
b. overstated, understated.
c. overstated, overstated.
d. understated, understated.
SoFP Effects
Effect of inventory errors on the statement of financial
position is determined by using the basic accounting
equation: Assets = Liabilities + Equity.
Errors in the ending inventory have the following
effects.
Illustration 6-15: Effects of ending inventory errors on SoFP
> DO IT!
Inventory Errors
Visual Company overstated its 2016 ending inventory
by NT$22,000. Determine the impact this error has on
ending inventory, cost of goods sold, and equity in
2016 and 2017. 2016 2017
Ending inventory NT$22,000 overstated No effect
Cost of goods sold NT$22,000 understated NT$22,000
overstated
Equity
Equity NT$22,000 overstated No effect
1.5. Estimating Inventories
Gross Profit Method
Estimates the cost of ending inventory by applying a
gross profit rate to net sales.
Illustration 6B-1: Gross profit Method
Formulas
Cont’d
Illustration: Kishwaukee Company’s records for January
show net sales of $200,000, beginning inventory $40,000,
and cost of goods purchased $120,000. The company
expects to earn a 30% gross profit rate. Compute the
estimated cost of the ending inventory at January 31 under
the gross profit
Illustration method.
6B-2: Example of Gross Profit Method
Retail Inventory Method
Company applies the cost-to-retail percentage to
ending inventory at retail prices to determine inventory
at cost.
Illustration 6B-3: Retail Inventory Method
Formulas
Cont’d
Illustration 6B-4: Application of Retail Inventory
Method
Note that it is not necessary to take a physical
inventory to estimate the cost of goods on hand at any
given time.
The End of Chapter
1
Thank You!!!