Chapter 6 Merchandise Inventory

Learning Objectives Identify accounting principles and controls related to merchandise inventory Account for merchandise inventory costs under a perpetual inventory system Compare the effects on the financial statements when using the different inventory costing methods

Learning Objectives Apply the lower-of-cost-or-market rule to merchandise inventory Measure the effects of merchandise inventory errors on the financial statements Use inventory turnover and days’ sales in inventory to evaluate business performance

Learning Objectives Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

Learning Objective 1 Identify accounting principles and controls related to merchandise inventory

What Are the Accounting Principles and Controls That Relate to Merchandise Inventory? Accounting principles help accountants classify and report items on the financial statements. The accounting principles associated with merchandise inventory are: Consistency Disclosure Materiality Accounting conservatism There are several principles on which the foundations of accrual accounting are built. Some of those principles are consistency, full disclosure, materiality, and accounting conservatism. These principles are discussed in this presentation.

Consistency Principle The consistency principle states that a business should use the same accounting methods and procedures from period to period. Consistency helps investors and creditors compare financial statements from one period to the next. If changes are made in accounting methods, these changes must be reported, generally in the notes to the financial statements. The consistency principle states that a business should use the same accounting methods and procedures from period to period. Consistency helps investors and creditors compare a company’s financial statements from one period to the next. Companies must be consistent in the accounting methods they use. If changes are made in accounting methods, the company should communicate the changes to the stakeholders.

Disclosure Principle The disclosure principle states that a company should report enough information for outsiders to make knowledgeable decisions about the company. Information should be relevant and have faithful representation. See the note to the financial statements for Green Mountain Coffee Roasters, Inc., exhibiting this principle on the next slide. The disclosure principle states that a business’s financial statements must report enough information for outsiders to make knowledgeable decisions about the company.

Disclosure Principle An example of disclosing inventory information: The notes to the financial statements contain important information summarizing the accounting policies of the company. For example, Green Mountain Coffee Roasters, Inc., discloses the accounting policies it uses to ensure that the company is providing full disclosure to its investors and creditors. Source: Green Mountain Coffee Roasters, Inc., 2013 Financial Statements, Note 2.

Materiality Concept For example, $10,000 is material to a small business with sales of $100,000. However, $10,000 isn’t material to a large company with annual sales of $10,000,000. The materiality concept states that a company must perform strictly proper accounting only for significant items. Information is significant when it would cause someone to change a decision. The materiality concept states that a company must perform strictly proper accounting only for items that are significant to the business’s financial situation. In essence, the materiality concept recognizes that the size of the dollar amounts in transactions is most relevant when compared to the overall size of the company. For example, a $10,000 transaction is very relevant to a $100,000 company. However, to a $1 billion company, a $10,000 transaction is probably not large enough to, of itself, impact the decision of a stockholder or creditor.

Conservatism The conservatism principle states that a company should report the least favorable figures in the financial statements when two or more possible options are presented. Anticipate no gains but provide for all probable losses Conservatively report assets and liabilities When in doubt, record an expense instead of an asset Choose options that undervalue the business The conservatism principle states that a business should report the least favorable figures in the financial statements when two or more possible options are presented. Basically, conservatism is choosing the accounting treatment that is least likely to overstate assets or net income.

Control Over Merchandise Inventory Good inventory controls ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system by: Ensuring inventory is purchased with proper authorization. Tracking and documenting receipt of inventory. Recording damaged inventory properly. Performing physical counts of inventory annually. Recording and removing inventory from Merchandise Inventory when sold. Maintaining good controls over merchandise inventory is very important for a merchandiser. Good controls ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system. This can be accomplished by taking the following measures: The company should ensure that merchandise inventory is not purchased without proper authorization, including purchasing only from approved vendors and within acceptable dollar ranges. After inventory is purchased, the order should be tracked and properly documented when received. At the time of delivery, a count of inventory received should be completed, and each item should be examined for damage. Damaged inventory should be properly recorded and then should either be used, disposed of, or returned to the vendor. A physical count of inventory should be completed at least once a year to track inventory shrinkage due to theft, damage, and errors. When sales are made, the inventory sold should be properly recorded and removed from the inventory count. This will prevent the company from running out of inventory, often called a stockout.

Learning Objective 2 Account for merchandise inventory costs under a perpetual inventory system

How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? At the end of the period, count the units in ending inventory and assign dollars to the account. At the end of the period, determine the units sold during the period and assign dollars to Cost of Goods Sold. At the end of each fiscal period, two accounts reflect information about inventory: Merchandise Inventory and Cost of Goods Sold. The number of units in Merchandise Inventory at the end of the period can be determined by physically counting the amount of inventory owned by the company at the end of the period. The number of units sold during the period will be determined and then multiplied by the per-unit-cost of the inventory.

How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? When the cost of the inventory does not change during the month, the assignment of dollars to ending inventory and to Cost of Goods Sold becomes a fairly easy exercise. Simply multiply the number of units on hand by the cost per unit. Likewise, multiply the number of units sold by the cost per unit. Note: Each unit originally cost $350 Ending Inventory = Units on hand × Unit cost = 4 units × $350 per unit = $1,400 COGS = Units sold × Unit cost = 14 units × $350 per unit = $4,900

How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? When the costs are different for different groups of inventory, it is more difficult to decide which dollars to assign to the ending inventory. When the cost of acquiring inventory changes during the period, it becomes more unclear how much cost should be applied to each unit in ending inventory.

How Are Merchandise Inventory Costs Determined Under a Perpetual Inventory System? Four basic inventory costing methods are allowable by GAAP: Specific identification First-in, first-out (FIFO) Last-in, last-out (LIFO) Weighted-average Basically, there are four approaches that are acceptable according to GAAP for computing the amount of dollars to assign to ending inventory and to cost of goods sold. An inventory costing method is a method of approximating the flow of inventory costs in a business that is used to determine the amount of cost of goods sold and ending merchandise inventory. The costing methods are specific identification; first-in, first-out (FIFO); last-in, last-out (LIFO); and weighted-average.

Specific Identification Method The specific identification method is used when the company knows exactly which item was sold and exactly what the item cost. Used for inventories that include: Automobiles Unique artwork Jewels Real estate The specific identification method is an inventory costing method based on the specific cost of particular units of inventory. The specific identification method is dependent on being able to identify the specific cost associated with each individual item in inventory. This is most efficient when each item in inventory is unique, with a unique identifier. Examples include automobiles that have a unique vehicle identification number (VIN), real estate (identified by address), and jewels (a specific diamond ring).

Specific Identification Method Assume that of the 4 tablets sold on August 15, 1 had a cost $350 and 3 had a cost of $360. As for the August 31 sale, 1 had a cost of $350, and 9 had a cost of $380. The Cost of Goods Sold and ending Merchandise Inventory are shown in Exhibit 6-3. In effect, each time there is a sale, we remove from inventory only the cost that is specifically identified with the specific units that are sold. This method requires the business to keep detailed records of inventory sales and purchases and to also be able to carefully identify the inventory that is sold.

First-In, First-Out (FIFO) Method The first-in, first-out method (FIFO) assumes the first units purchased are the first to be sold. Cost of Goods Sold is based on the oldest purchases. Ending Inventory closely reflects current replacement cost. The first-in, first-out (FIFO) method is an inventory costing method in which the first costs into inventory are the first costs out to Cost of Goods Sold. Ending Inventory is based on the cost of the most recent purchases. When using perpetual FIFO, we account for each purchase and sale as it happens. When we sell items, we are usually unable to identify which specific items we have sold, since they are all homogenous. For accounting purposes, we will assume that the units sold were the oldest units in inventory at the time of the sale. We will remove the oldest units, along with their costs from the inventory record, leaving the newest units available and as part of ending Merchandise Inventory.

First-In, First-Out (FIFO) Method Smart Touch Learning began August with 2 TAB0503s that cost $350 per unit. On August 5, an additional 4 units were purchased for $360 each. The company now has 6 units on hand. On August 15, the company sold 4 units. Under FIFO the first 2 units sold had the oldest cost (from beginning inventory) of $350 per unit. The other 2 units will be assigned from the August 5 purchase of $360. That leaves 4 units in inventory on August 15, at $360 each. On August 26, Smart Touch Learning purchases 12 units of inventory at a cost of $380 per unit. The sale on August 31 indicates 10 units were sold. Because the oldest units in inventory at this time are the 2 units remaining from the August 5 purchase, they will be assigned to the sale first. The remaining 8 units will come from the August 26 purchase, leaving 4 units at $380 per unit in ending inventory.

Last-In, First-Out (LIFO) Method Last-in, first-out (LIFO) method is the opposite of FIFO. As inventory is sold, the cost of the newest item in inventory is assigned to each unit as Cost of Goods Sold. Cost of Goods Sold closely reflects current replacement cost. Ending Inventory contains the oldest costing units. The last-in, first-out (LIFO) method is an inventory costing method in which the last costs into inventory are the first costs out to Cost of Goods Sold. The method leaves the oldest costs—those of beginning inventory and the earliest purchases of the period—in ending inventory. When we sell items, we are usually unable to identify which specific items we have sold, since they are all homogenous. For accounting purposes, we will assume that the units sold were the newest units in inventory at the time of the sale. We will remove the newest units along with their cost from the inventory record, leaving the oldest units available to be assigned to the next sale.

Last-In, First-Out (LIFO) Method Again, Smart Touch Learning had 2 TAB0503s at the beginning. After the purchases on August 5, the company holds 6 units of inventory (2 units at $350 plus 4 units at $360). On August 15, Smart Touch Learning sells 4 units. Under LIFO we assign all 4 units from the August 5 purchase (along with their costs) to the sale. The remaining 2 units in inventory are from the beginning inventory and are available, if needed, to be assigned to the next sale. On August 26, Smart Touch Learning purchases 12 units of inventory at a cost of $380 per unit. The sale on August 31 indicates 10 units were sold. Since the newest units in inventory at this time are the 12 units remaining from the August 26 purchase, they will be assigned to the sale first. The remaining 2 units from the August 26 purchase at $380 per unit will be added to the 2 units from the beginning inventory at $350 and will comprise ending inventory for the period.

Weighted-Average Method The weighted-average method computes a new weighted-average cost per unit after each purchase. Ending Inventory and Cost of Goods Sold are based on the same weighted-average cost per unit. The weighted-average method is an inventory costing method based on the weighted-average cost per unit of inventory that is calculated after each purchase. Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available. When units are sold, they are removed from inventory using the weighted-average cost at the time of the sale. When new purchases are added, the weighted-average cost per item will change again and will become the new weighted-average cost that will be used for the next sale.

Weighted-Average Method Average cost is computed as: Cost of goods available for sale ÷ Number of units available = Weighted-average cost per unit To compute weighted-average cost per unit at any given point in time, simply divide the cost of goods available for sale by the number of units available. Again, each time new items are purchased, the weighted-average cost per unit will have to be recomputed. However, when units are sold and removed from inventory at their weighted-average cost per unit, the number of units may decline, but the weighted-average cost of the remaining units will remain the same.

Weighted-Average Method In our example, the weighted-average cost on August 1 is $350 per unit ($700 ÷ 2 units). When 4 units are purchased on August 5 @ $360 per unit, $1,440 is added to inventory, and 4 units are added. There is now $2,140 ($700 + $1,440) in inventory and 6 units, leaving a weighted-average cost per unit of $356.67 per unit. On August 15, 4 units are sold. For purposes of removing items from inventory, we will cost those sold units at the current weighted-average cost per unit, or $356.67 per unit. This will remove $1,427 from inventory ($356.67 × 4), leaving $713 in inventory. The remaining 2 units are valued at the weighted-average cost of $356.67 per unit. When we add 12 units @ $380 each on August 26, there will now be $5,273 in inventory ($713 + $4,560) and 14 units. The new weighted-average cost per unit will be $376.64, which will result in ending inventory having a total cost of $1,507.

Learning Objective 3 Compare the effects on the financial statements when using the different inventory costing methods

How Are Financial Statements Affected by Using Different Inventory Costing Methods? Income statement Cost of Goods Sold is higher under LIFO than under FIFO when costs are rising. Net income is lower under LIFO than under FIFO when costs are rising. Balance sheet When costs are increasing, FIFO inventory will be the highest, and LIFO inventory will be the lowest. What leads Smart Touch Learning to select the specific identification, FIFO, LIFO, or weighted-average inventory costing method? The different methods have different benefits. Many companies prefer high income in order to attract investors and borrow on favorable terms. FIFO offers this benefit in a period of rising costs. Lower profits mean lower taxable income; thus, LIFO lets companies pay the lowest income taxes when inventory costs are rising. Therefore, companies that seek a “middle-ground” solution use the weighted-average method for inventory.

How Are Financial Statements Affected by Using Different Inventory Costing Methods? Exhibit 6-7 summarizes the result for the four inventory costing methods for Smart Touch Learning. It shows revenue, cost of goods sold, and gross profit for specific identification, FIFO, LIFO, and weighted-average. First, we see FIFO produces a lower cost of goods sold and a higher gross profit than either LIFO or weighted-average. Also, we see that LIFO provides a higher cost of goods sold and a lower gross profit than FIFO or weighted-average. Weighted-average provides a cost of goods sold and a gross profit that is between LIFO and FIFO. Note that FIFO results in the highest gross profit, while LIFO shows the highest cost of goods sold.

How Are Financial Statements Affected by Using Different Inventory Costing Methods? Exhibit 6-8 shows the results of Smart Touch Learning’s ending merchandise inventory for each of the costing methods for August. Notice that when using the FIFO inventory costing method, ending merchandise inventory will be the highest when costs are increasing. LIFO produces the lowest ending merchandise inventory, and weighted-average is again in the middle.

How Are Financial Statements Affected by Using Different Inventory Costing Methods? Exhibit 6-9 summarizes the effects on the financial statements during periods of rising and declining inventory costs. The relationship that we observed with our inventory example will be true any time that costs are constantly increasing. When prices are constantly decreasing, the relationship will be just the opposite.

Learning Objective 4 Apply the lower-of-cost-or-market rule to merchandise inventory

How Is Merchandise Inventory Valued When Using the Lower-of-Cost-or-Market Rule? The lower-of-cost-or-market rule requires that inventory be reported in the financial statements at the lower of the inventory’s original cost or its market value. Even after we have used one of the inventory methods to determine the cost of the ending inventory and cost of goods sold, there is a limiting rule in accounting called the lower-of-cost-or-market (LCM) rule. Under the LCM rule, the final carrying amount of the inventory on the books will be the lower of the cost (as determined using one of our inventory methods) or the market value of the inventory. In some cases, inventory will decrease permanently in value while it is being held by the company. For example, a new product may be introduced by a competitor that makes all existing inventories obsolete. In such cases, the market value of the inventory on hand may actually be lower than its original cost. In those cases, we will adjust inventory to the lower amount.

Recording the Adjusting Journal Entry to Adjust Merchandise Inventory Smart Touch Learning paid $3,000 for its TAB0503 inventory. By December 31, it can be replaced for only $2,200, and the decline value appears permanent. Let’s assume that Smart Touch Learning paid $3,000 for inventory. By December 31, that inventory is worth only $2,200, and the decline value appears permanent. We will adjust the $3,000 debit balance in inventory by crediting if for $800, bringing the balance to $2,200. The debit for the adjustment will be to Cost of Goods Sold.

Learning Objective 5 Measure the effects of merchandise inventory errors on the financial statements

What Are the Effects of Merchandise Inventory Errors on the Financial Statements? An error in inventory can lead to errors in other related accounts. Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect, such as: Cost of goods sold Gross profit Net income It is crucial that the ending inventory amount on the balance sheet be correct. If it is incorrect, it will have a domino effect on several other numbers, such as cost of goods sold, gross profit, and net income.

What Are the Effects of Merchandise Inventory Errors on the Financial Statements? To illustrate an inventory error, assume Smart Touch Learning accidentally reported $5,000 more ending merchandise inventory than it actually had. In that case, Ending Merchandise Inventory would be overstated by $5,000 on the balance sheet. As such, Cost of Goods Sold is understated, and Gross Profit and Net Income are both overstated.

What Are the Effects of Merchandise Inventory Errors on the Financial Statements? Understating the ending inventory—reporting the inventory too low—has the opposite effect of an overstatement. If Smart Touch Learning’s inventory is understated by $1,200, the Cost of Goods Sold would be overstated. As such, the Gross Profit and Net Income would be understated.

What Are the Effects of Merchandise Inventory Errors on the Financial Statements? Exhibit 6-10 illustrates the effect of an inventory error, assuming all other items on the income statement are unchanged for the three periods. Period 1’s Ending Merchandise Inventory is overstated by $5,000; Period 1’s Ending Merchandise Inventory should be $10,000. The error carries over to Period 2. Period 3 is correct. In fact, both Period 1 and Period 2 should look like Period 3.

What Are the Effects of Merchandise Inventory Errors on the Financial Statements? The effects of inventory errors are summarized in Exhibit 6-11.

Learning Objective 6 Use inventory turnover and days’ sales in inventory to evaluate business performance

Inventory Turnover The inventory turnover ratio measures how rapidly inventory is sold. The ratio should be evaluated against industry averages. A high turnover rate indicates ease of selling. A low turnover rate indicates difficulty of selling. Companies try to manage their inventory levels such that they will have just enough inventory to meet customer demand without investing large amounts of money in inventory sitting on the shelves gathering dust. The inventory turnover ratio measures the number of times a company sells its average level of Merchandise Inventory during a period. Inventory turnover = Cost of goods sold / Average merchandise inventory. A high rate of turnover indicates ease in selling inventory; a low rate indicates difficulty.

Days’ Sales in Inventory The days’ sales in inventory ratio measures the average number of days inventory is held by the company. Some types of inventory will move faster than others. For inventory with an expiration date, this measure is very important. The days’ sales in inventory measures the average number of days that inventory is held by a company. Days’ sales in inventory = 365 days / Inventory turnover. A lower days’ sales in inventory is preferable because it indicates the company is able to sell its inventory quickly, thereby reducing its inventory storage and insurance costs, as well as reducing the risk of holding obsolete inventory.

Learning Objective 7 Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

How Are Merchandise Inventory Costs Determined Under a Periodic Inventory System? Inventory is not tracked in the accounting system continuously. The beginning inventory balance is carried until the end of the period. Purchases are accumulated during the period. The ending inventory balance replaces the beginning inventory balance. An alternative to accounting for inventory using a perpetual approach is to account for the inventory using a periodic approach. Under the periodic approach, the tedious task of recording each sale as it impacts Cost of Goods Sold and the inventory account is eliminated. Essentially, we will start the month with a balance in beginning inventory. As we acquire additional inventory, we record that inventory in a Purchases account. When we sell inventory, we do not record an adjustment to the inventory or Cost of Goods Sold account. Rather, we only record the sale and its impact on Cash or Accounts Receivable.

How Are Merchandise Inventory Costs Determined Under a Periodic Inventory System? We will start with the information in the accounting records regarding the flow of inventory during the period. We can see from the inventory record that we started the month with 2 units in inventory. We purchased more inventory on August 5 (4 units) and on August 26 (12 units), for a total of 16 units purchased during the month. Combined with the beginning inventory of 2 units, there are 18 units available for sale during the month. We sold inventory on August 15 (4 units) and on August 31 (10 units), for a total of 14 units sold during the month. Once we know this information, we can compute Ending Inventory using one of our three methods.

First-In, First-Out (FIFO) Method Ending Inventory will be calculated using the newest items in inventory. Cost of Goods Sold will include the oldest unit costs. With FIFO, we assume that the oldest units in inventory will be sold first, so we take those out of inventory before taking any other units out of inventory. We assume that the ending inventory is comprised of the newest units in inventory. In our example, the beginning inventory of 2 units @ $350 ($700) plus the net purchases for the period ($6,000) will give us $6,700 of inventory available for sale during the month. We know that we have 4 units left in ending inventory, and those units will represent the 4 most recently purchased units. The 4 most recently purchased units were purchased at a cost of $380 per unit, giving us an ending inventory of $1,520 (4 × $380). The Cost of Goods Sold is determined by subtracting the ending inventory ($1,520) from the Cost of Goods Available for Sale ($6,700) to arrive at COGS for the period of $5,180. Or the Cost of Goods Sold can be calculated by taking the 2 units from beginning inventory at $350, plus 4 units at $360, and 8 units at $380, for a total of $5,180.

Last-In, First-Out (LIFO) Method Ending Inventory will be calculated using the oldest items in inventory. Cost of Goods Sold will include the newest unit costs. With LIFO, we assume that the newest units in inventory will be sold first. We assume that the ending inventory is comprised of the oldest units in inventory. In our example, the beginning inventory of 2 units @ $350 ($700) plus the net purchases for the period ($6,000) will give us $6,700 of inventory available for sale during the month. We know that we have 4 units left in ending inventory, and those units will represent the 4 oldest units. The 4 oldest units will be comprised of the 2 units from beginning inventory (2 × $350 = $700) plus 2 of the units from the August 5 purchase (2 × $360 = $720), giving us an ending inventory of $1,420 ($700 + $720 = $1,420). The Cost of Goods Sold is determined by subtracting the ending inventory ($1,420) from the Cost of Goods Available for Sale ($6,700) to arrive at COGS for the period of $5,280. Or the Cost of Goods Sold can be found by taking the 12 units at $380 from the August 26th purchase plus 2 units at $360 from the August 4th purchase, for a total of $5,280.

Weighted-Average Method Ending Inventory is calculated using the average cost per unit. Cost of Goods Sold will also be costed using average cost per unit. With the periodic weighted-average method, the order of the sale is irrelevant. All inventory will be removed from inventory using the average cost of the inventory for the period. The first step is to determine the weighted-average cost per unit of inventory. The weighted-average cost per unit is determined by the following formula: Cost of Goods Available for Sale during the period / Number of units available for sale during the period: $6,700 ÷ 18 units = $372.22 per unit To estimate the cost of ending inventory, we multiply the weighted-average cost per unit by the number of units in ending inventory: $372.22 × 4 = $1,489 The Cost of Goods Sold is determined by subtracting the ending inventory ($1,489) from the Cost of Goods Available for Sale ($6,700), to arrive at COGS for the period of $5,211.