McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

17-2 Merchandise Inventory Section 1: Inventory Costing Methods Chapter 17 Section Objectives 1.Compute inventory cost by applying four commonly used costing methods. 2.Compare the different methods of inventory costing.

17-3 Based on a running total of number of units. Uses point-of-sale cash registers and scanners. Perpetual Inventory Periodic Inventory Based on a periodic count of goods on hand. Requires a physical inventory (count). Periodic inventory is the method used in this chapter. Two Types of Inventory System

17-4 Specific Identification Method Average Cost Method FIFO Method LIFO Method The methods used to assign costs to inventory are based on assumptions about the physical flow of goods. Compute inventory cost using four common methods Objective 1

17-5 A method of inventory costing based on the actual cost of each piece of merchandise. Automobile dealers, and merchants who deal with items having a large unit cost or one-of-a- kind items may account for their inventory by this method. Specific Identification Method

17-6 If the company’s inventory is composed of many similar items, it may be advantageous to use the average cost method to value the inventory. With this method, the average cost of all the similar items is used to value the ending inventory. Average Cost Method

Add the total number of units purchased plus the beginning inventory. 2. Calculate the total cost by adding the cost of beginning inventory plus purchases. 3. Divide the total cost by the number of units to determine the average cost of each item. Steps used in determining the value of the inventory using the average cost method: $20, (total cost) 1000 (number of units) = $20.60 average cost of each item Average Cost Method

17-8 Assumes that merchants sell the oldest items first. The merchandise on hand at any given time is usually the most recently purchased item. The cost of ending inventory is computed by referring to the cost of the latest purchases. First In, First Out Method (FIFO)

17-9 The inventory valuation on the balance sheet will reflect the most recent price levels. The cost of goods sold will reflect the cost applicable to the oldest goods handled during the period. In a time of rising prices, the difference in cost of goods sold may have a significant impact on the reported net income. Many accountants, owners, and managers believe that this method of valuation is less conservative and less realistic than the LIFO method. First In, First Out Method (FIFO)

17-10 Assumes that merchants sell the items that were most recently purchased. The value assigned to the ending inventory is the cost of the oldest merchandise on hand during the period. Last In, First Out Method (LIFO)

17-11 In a time of rising prices, the relatively lower inventory value tends to increase the reported cost of goods sold and decrease the reported net income. Last In, First Out Method (LIFO) The lower net income will produce a lower income tax liability for the company. Is considered the most conservative costing method in a period of rising prices.

In a period of rising prices, the LIFO method results in a higher reported cost of goods sold and a lower reported net income than the FIFO or average cost method. 2. In a period of falling prices, the LIFO method results in a lower reported cost of goods sold and a higher reported net income than the FIFO or average cost method. 3. Whatever direction prices take, the average cost method results in a reported net income somewhere between the amounts obtained with FIFO and LIFO. Since price trends are a vital element in any inventory costing method, remember these basic rules: Compare the effects of different methods of inventory costing Objective 2

17-13 Inventory Costing Methods Following the consistency principle, once the firm adopts a method, it should use that method consistently from one period to the next. A firm can generally use one inventory costing method for financial accounting purposes and another for federal income tax purposes. Exception: The firm must use the LIFO method for financial accounting if that method is adopted for tax purposes.

17-14 Merchandise Inventory Section 2: Inventory Valuation and Control Chapter 17 Section Objectives 3.Compute inventory value under the lower of cost or market rule. 4. Estimate inventory cost using the gross profit method. 5. Estimate inventory cost using the retail method.

17-15 The lower of cost or market rule is the principle by which inventory is reported at either its original cost or its replacement cost, whichever is lower. ANSWER: QUESTION: What is the lower of cost or market rule? There are three ways to apply the lower of cost or market rule: by item, in total, or by group Compute inventory value under the lower of cost or market rule Objective 3

17-16 The gross profit method assumes that the rate of gross profit on sales and the ratio of cost of goods sold to net sales are relatively constant from period to period. ANSWER: QUESTION: What is the gross profit method? Estimate inventory cost using the gross profit method Objective 4

17-17 Step 1. Estimate the cost of goods sold. (sales x ratio of cost of goods sold to net sales) Step 2. Determine the cost of goods available for sale. (beginning inventory plus purchases) Step 3. Compute the ending (destroyed) inventory. (cost of goods available for sale less estimated cost of goods sold) Gross Profit Method

17-18 The retail method estimates inventory cost by applying the ratio of cost to selling price in the current accounting period to the retail price of the inventory. ANSWER: QUESTION: What is the retail method? Estimate inventory cost using the retail method Objective 5

17-19 Step 1. List the beginning inventory at both cost and retail. Step 2. When merchandise is purchased, record it at cost and determine its retail value. Step 3. Compute merchandise available for sale at cost and at retail. Step 4. Determine net sales at retail. Retail Method

17-20 Internal Control of Inventories Typical inventory controls may include the following:  Limiting access to inventory of small valuable items.  Requiring documents, such as approved shipping orders, before allowing items to leave the warehouse.  Taking a physical count at least annually to verify that the goods on hand match the accounting records.  Newer technologies have also helped with inventory control including bar scanners and RFID or radio frequency identification.