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Inventories – Chapter 7
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Accounting for Inventories
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Key Concepts / Terms
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• Evaluating inventories:
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– Inventory turnover = Cost of Goods Sold ÷
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Average Inventory. The average number of
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times a company sells its inventory during an
accounting period.
– Days’ Inventory on Hand = 365 ÷ Inventory
Turnover. The average number of days it takes
a company to sell the inventory it has in stock.
Key Concepts / Terms
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• Inventory affects both the balance sheet and the income
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statement. Therefore, the value of the ending inventory
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and the cost of goods sold as reported are EXTREMELY
important.
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– The higher the value of ending inventory, the lower the
cost of goods sold and the higher the gross margin.
– The lower the value of ending inventory, the higher the
cost of goods sold and the lower the gross margin.
– Misstatements affect the current and subsequent
periods.
Effects of Inventory
Misstatements on Income Measurement
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If ending Cost of goods Gross margin is
inventory is sold is overstated
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overstated… understated
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If ending Cost of goods Gross margin is
inventory is sold is understated
understated… overstated
Important: Errors not only affect the current year, but also the following year.
Inventory Errors: Examples
Column 1 Column 2 Column 3
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Ending 1011
Inventory Ending Inventory Ending Inventory
Correctly Stated Overstated Understated
Net Sales $100,000 $100,000 $100,000
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$12,000 $12,000
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Beg. Inv. $12,000
58,000 58,000
Net cost of 58,000
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purchases
Cost of goods $70,000 $70,000 $70,000
available for sale
End. Inv. 10,000 16,000 4,000
Cost of goods sold 60,000 54,000 66,000
Gross margin $ 40,000 $ 46,000 $ 34,000
Operating expenses 32,000 32,000 32,000
Income before $ 8,000 $ 14,000 $ 2,000
income taxes
Merchandise in Transit
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Key Concepts / Terms
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• Inventory cost: includes the purchase price less
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purchase discounts + freight-in, including
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insurance in transit + applicable taxes and tariffs.
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• Lower-of-cost-or-market (LCM) rule: a valuation
method; requires that inventory be written down to
the lower of cost or market value and that a loss be
recorded. This occurs because of physical
deterioration, obsolescence, or decline in price
level.
Key Concepts / Terms
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• Periodic inventory system – four costing methods.
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1. Specific identification
2. Average-cost
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3. First-in, first-out (FIFO) method
4. Last-in, first-out (LIFO) method
• Choice of method depends on the nature of the
business, the financial effects of the method, and
the cost of implementing the method.
Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
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Inventory Data
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June 1 Inventory 80 units @ $10.00 $ 800
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6 Purchase 220 units @ $12.50 2,750
25 Purchase 200 units @ $14.00 2,800
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Goods available for sale 500 units $6,350
Sales 280 units
On hand June 30 220 units
Specific Identification Method
50 units @ $10.00 $ 500 Cost of goods avail. for sale $6,350
100 units @ $12.50 1,250 Less June 30 inventory 2,730
70 units @ $14.00 980 Cost of goods sold $3,620
220 units at cost of $2,730
Average-Cost Method
Inventory Data
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Inventory priced0001 0100 1011
June 1 Inventory 80 units @ $10.00 $ 800
at the average cost 6 Purchase 220 units @ $12.50 2,750
of the goods 25 Purchase 200 units @ $14.00 2,800
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available for sale
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Goods available for sale 500 units $6,350
during the period. Sales 280 units
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On hand June 30 220 units
Average Cost Method
Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost
$6,350 ÷ 500 units = $12.70
Ending Inventory = 220 units @ $12.70 = $2,794
Cost of goods avail. for sale $6,350
Less June 30 inventory 2,794
Cost of goods sold $3,556
Key Concepts / Terms
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• FIFO Method (Balance Sheet)
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– Assumes that the costs of the first items
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acquired should be to the first items sold.
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– Inventory is valued at the most recent costs and
includes earlier costs in cost of goods sold.
– In periods of rising prices, FIFO yields the
highest inventory valuation, the lowest cost of
goods sold, and hence a higher net income.
First-In, First-Out (FIFO) Method
0011Assumes that1101
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first units Inventory Data
purchased will be June 1 Inventory 80 units @ $10.00 $ 800
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the first units sold; 6 Purchase 220 units @ $12.50 2,750
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ending inventory 25 Purchase 200 units @ $14.00 2,800
is priced using the Goods available for sale 500 units $6,350
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most recent Sales 280 units
purchases. On hand June 30 220 units
First-In, First-Out (FIFO) Method
200 units @ $14.00 from purchase of June 25 $2,800
20 units @ $12.50 from purchase of June 6 250
220 units at a cost of $3,050
Cost of goods avail. for sale $6,350
Less June 30 inventory 3,050
Cost of goods sold $3,300
Key Concepts / Terms
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• LIFO Method (Income Statement)
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– Assumes that the cost of the last items
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purchased should be assigned to the first items
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sold and that the cost of ending inventory
should reflect the cost of the goods purchased
earliest.
– In periods of rising prices, LIFO yields the
lowest inventory valuation, the highest cost of
goods sold, and thus a lower net income.
Last-In, First-Out (LIFO) Method
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Ending inventory Inventory Data
is priced using the June 1 Inventory 80 units @ $10.00 $ 800
earliest purchases.
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6 Purchase 220 units @ $12.50 2,750
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25 Purchase 200 units @ $14.00 2,800
Goods available for sale 500 units $6,350
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Sales 280 units
On hand June 30 220 units
Last-In, First-Out (LIFO) Method
80 units @ $10.00 from June 1 inventory $ 800
140 units @ $12.50 from purchase of June 6 1,750
220 units at a cost of $2,550
Cost of goods avail. for sale $6,350
Less June 30 inventory 2,550
Cost of goods sold $3,800
Key Concepts / Terms
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• Perpetual inventory system – three costing methods.
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1. Average cost
2. First-in, first-out (FIFO) method
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3. Last-in, first-out (LIFO) method
• Average cost: under the periodic system, average
cost is computed for ALL goods available for sale
during the period; under the perpetual system, an
average is computed after each purchase or series of
purchases.
Average-Cost Under the
Perpetual Inventory System: Example
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An average is computed after each purchase or series of purchases
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Inventory Data
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June 1 Inventory 80 units @ $10.00 $ 800
6 Purchase 220 units @ $12.50 2,750
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6 Balance 300 units @ $11.83* $3,550
10 Sale 280 units @ $11.83 3,313
10 Balance 20 units @ $11.88 $ 237
25 Purchase 200 units @ $14.00 2,800
30 Inventory 220 units @ $13.80* $3,037
Cost of goods sold $3,313
*Rounded
FIFO Under the
Perpetual Inventory System: Example
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Keep track of inventory costs and amounts in
date order as purchases and sales are made
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Inventory Data
June 1 Inventory 80 units @ $10.00 $ 800
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6 Purchase 220 units @ $12.50 2,750
10 Sale 80 units @ $10.00 ($ 800)
200 units @ $12.50 (2,500) (3,300)
10 Balance 20 units @ $12.50 $ 250
25 Purchase 200 units @ $14.00 2,800
30 Inventory 20 units @ $12.50 $250
200 units @ $14.00 2,800 $3,050
Cost of goods sold $3,300
Cost of goods sold is the total of sales on June 10
LIFO Under the
Perpetual Inventory System: Example
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Keep track of inventory costs and amounts in
date order as purchases and sales are made
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Inventory Data
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June 1 Inventory 80 units @ $10.00 $ 800
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6 Purchase 220 units @ $12.50 2,750
10 Sale 220 units @ $12.50 ($2,750)
60 units @ $10.00 (600) (3,350)
10 Balance 20 units @ $10.00 $ 200
25 Purchase 200 units @ $14.00 2,800
25 Inventory 20 units @ $10.00 $200
200 units @ $14.00 $2,800 $3,000
Cost of goods sold $3,350
Cost of goods sold is the total of sales on June 10
Key Concepts / Terms
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• When costing using the FIFO or LIFO methods, it is
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necessary to keep track of components of inventory
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at each step of the way because as sales are made,
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the costs must be assigned in proper order.
• The value of ending inventory when using the FIFO
method yields the same result whether using the
periodic or perpetual inventory system.
• See slides 12 and 14 for detailed information on the
FIFO and LIFO methods.