Principles of Financial Accounting, 11e 7 Inventories Principles of Financial Accounting, 11e Reeve • Warren • Duchac

1 2 3 Inventories Describe the importance of control over inventories. After studying this chapter, you should be able to: 1 Describe the importance of control over inventories. 2 Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet. 3 Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods. 7-2

Inventories (continued) After studying this chapter, you should be able to: 4 Describe the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods. 5 Compare and contrast the use of the three inventory costing methods. 6 Describe and illustrate the reporting of merchandise inventory in the financial statements. 7-3

Describe the importance of control over inventory. 1 Describe the importance of control over inventory. 7-4

Two primary objectives of control over inventory are: 1 Two primary objectives of control over inventory are: Safeguarding the inventory, and Properly reporting it in the financial statements.

1 The purchase order authorizes the purchase of the inventory from an approved vendor. The receiving report establishes an initial record of the receipt of the inventory. The amount of inventory is always available in the subsidiary inventory ledger.

1 Controls for safeguarding inventory should include security measures to prevent damage and customer or employee theft. Some examples of security measures include the following: Storing inventory in areas that are restricted to only authorized employees.

Locking high-priced inventory in cabinets. 1 Locking high-priced inventory in cabinets. Using two-way mirrors, cameras, security tags, and guards.

1 A physical inventory or count of inventory should be taken near year-end to make sure that the quantity of inventory reported in the financial statements is accurate.

2 Describe the three inventory cost flow assumptions and how they impact the income statement and balance sheet. 7-10

Inventory Costing Methods 2 Inventory Costing Methods

May 10 Purchase 1 $ 9 18 Purchase 1 13 24 Purchase 1 14 Total 3 $36 2 Average cost per unit $12 ($36 ÷ 3 units)

2 Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 as shown below:

2 Under the specific identification inventory cost flow method, the unit sold is identified with a specific purchase. Not practical unless each inventory unit can be separately identified.

2 Under the first-in, first out (FIFO) inventory cost flow method, the first units purchased are assumed to be sold and the ending inventory is made up of the most recent purchases.

2 Under the last-in, first out (LIFO) inventory cost flow method, the last units purchased are assumed to be sold first and the ending inventory is made up of the first units purchased.

2 Under the average inventory cost flow method, the cost of the units sold and in ending inventory is an average of the purchase costs.

2 Effect of Inventory Costing Methods on Financial Statements Exhibit 1 FIFO Method Income Statement Sales $20 Cost of merchan- dise sold 9 Gross profit $11 (continued)

2 Effect of Inventory Costing Methods on Financial Statements (continued) Exhibit 1 LIFO Method Income Statement Sales $20 Cost of merchan- dise sold 14 Gross profit $ 6 (continued)

2 Effect of Inventory Costing Methods on Financial Statements (continued) Exhibit 1 Average Cost Method Income Statement Sales $20 Cost of merchan- dise sold 12 Gross profit $ 8 $36 ÷ 3 = $12 $12 × 2 = $24

2 Exhibit 2 Inventory Costing Methods* *Firms may be counted more than once for using multiple methods

2 Example Exercise 7-1 7-22 Cost Flow Methods The three identical units of Item QBM are purchased during February, as shown below. Item QBM Units Cost Feb. 8 Purchase 1 $ 45 15 Purchase 1 48 26 Purchase 1 51 Total 3 $144 Average cost per unit $48 ($144 ÷ 3 units) Assume that one unit is sold on February 27 for $70. Determine the gross profit for February and ending inventory on February 28 using (a) first-in, first-out (FIFO); (b) last-in, first-out (LIFO); and (c) average cost methods. 7-22

2 Follow My Example 7-1 Gross Profit Ending Inventory Example Exercise 7-1 (continued) 2 Follow My Example 7-1 Gross Profit Ending Inventory First-in, first-out (FIFO): $25 ($70 – $45) $99 ($48 + $51) Last-in, first-out (LIFO): $19 ($70 – $51) $93 ($45 + $48) Average cost: $22 ($70 – $48) $96 ($48 × 2) For Practice: PE 7-1A, PE 7-1B 7-23

3 Determine the cost of inventory under the perpetual inventory system, using the FIFO, LIFO, and average cost methods. 7-24

First-In, First-Out Method 3 First-In, First-Out Method On January 1, the firm had 100 units of Item 127B that cost $20 per unit. Item 127B Units Cost Jan. 1 Inventory 100 $20

First-In, First-Out Method 3 First-In, First-Out Method On January 4, the firm sold 70 units of 127B at $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70

3 Exhibit 3 Entries and Perpetual Inventory Account (FIFO)

First-In, First-Out Method 3 First-In, First-Out Method On January 10, the firm purchased 80 units at $21 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21

3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3 10 Merchandise Inventory 1,680 Accounts Payable 1,680 Date Jan. 1

First-In, First-Out Method 3 First-In, First-Out Method On January 22, the firm sold 40 units for $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40

3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3 Jan. 1 Date

First-In, First-Out Method 3 First-In, First-Out Method On January 28, the firm sold 20 units at $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40 28 Sale 20

3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3 Date Jan. 1

First-In, First-Out Method 3 First-In, First-Out Method On January 30, purchased one hundred additional units of Item 127B at $22 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40 28 Sale 20 30 Purchase 100 22

3 Entries and Perpetual Inventory Account (FIFO) (continued) Exhibit 3

Cost of merchandise sold 3 Entries and Perpetual Inventory Account (FIFO) (concluded) Exhibit 3 Cost of merchandise sold January 31 inventory

3 Example Exercise 7-2 Perpetual Inventory Using FIFO Beginning inventory, purchases, and sales for Item ER27 are as follows: Nov. 1 Inventory 40 units at $5 5 Sale 32 units 11 Purchase 60 units at $7 21 Sale 45 units Assuming a perpetual inventory system and the first-in, first-out (FIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30. 7-37

3 Follow My Example 7-2 Cost of merchandise sold (November 21): Example Exercise 7-2 (continued) 3 Follow My Example 7-2 Cost of merchandise sold (November 21): 8 units @ $5 $40 37 units @ $7 259 45 units $299 Inventory, November 30: $161 = (23 units × $7) For Practice: PE 7-2A, PE 7-2B 7-38

Last-In, First-Out Method 3 Last-In, First-Out Method On January 1, the firm had 100 units of Item 127B that cost $20 per unit. Item 127B Units Cost Jan. 1 Inventory 100 $20

Last-In, First-Out Method 3 Last-In, First-Out Method On January 4, the firm sold 70 units of 127B at $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70

3 Exhibit 4 Entries and Perpetual Inventory Account (LIFO)

Last-In, First-Out Method 3 Last-In, First-Out Method On January 10, the firm purchased 80 units at $21 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21

3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4 10 Merchandise Inventory 1,680 Accounts Payable 1,680 Date Jan. 1 4

Last-In, First-Out Method 3 Last-In, First-Out Method On January 22, the firm sold 40 units for $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40

3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4 Date Jan. 1 4

Last-In, First-Out Method 3 Last-In, First-Out Method On January 28, the firm sold 20 units at $30 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40 28 Sale 20

3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4 Date Jan. 1 4

Last-In, First-Out Method 3 Last-In, First-Out Method On January 30, the firm purchased one hundred additional units of Item 127B at $22 each. Item 127B Units Cost Jan. 1 Inventory 100 $20 4 Sale 70 10 Purchase 80 21 22 Sale 40 28 Sale 20 30 Purchase 100 22

3 Entries and Perpetual Inventory Account (LIFO) (continued) Exhibit 4 Date Jan. 1 4 10

Cost of Merchandise Sold 3 Entries and Perpetual Inventory Account (LIFO) (concluded) Exhibit 4 Cost of Merchandise Sold January 31 Inventory

3 Example Exercise 7-3 Perpetual Inventory Using LIFO Beginning inventory, purchases, and sales for Item ER27 are as follows: Nov. 1 Inventory 40 units at $5 5 Sale 32 units 11 Purchase 60 units at $7 21 Sale 45 units Assuming a perpetual inventory system and the last-in, first-out (LIFO) method, determine (a) the cost of the merchandise sold for the November 21 sale and (b) the inventory on November 30. 7-51

3 Follow My Example 7-3 Cost of merchandise sold: Example Exercise 7-3 (continued) 3 Follow My Example 7-3 Cost of merchandise sold: $315 = (45 units × $7) Inventory, November 30: 8 units @ $5 $ 40 15 units @ $7 105 23 $145 For Practice: PE 7-3A, PE 7-3B 7-52

3 Moving Average When the average cost is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. The unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed. This averaging technique is called a moving average.

4 Determine the cost of inventory under the periodic inventory system, using the FIFO, LIFO, and average cost methods. 7-54

First-In, First-Out Method 4 First-In, First-Out Method Using FIFO, the earliest batch purchased is considered the first batch of merchandise sold. The physical flow does not have to match the accounting method chosen.

Cost of merchandise available for sale 4 FIFO Method 100 units @ $20 = $2,000 Jan. 1 80 units @ $21 Jan. 10 = 1,680 100 units @ $22 Jan. 30 = 2,200 280 units available for sale during year $5,880 Cost of merchandise available for sale

4 The physical count on January 31 shows that 150 units are on hand (conclusion: 130 units were sold). What is the cost of the ending inventory? 100 units @ $20 80 units @ $21 100 units @ $22 Jan. 1 Jan. 10 Jan. 30 Sold these = $ 0 Sold 30 of the 80 = 1,050 50 units @ $21 100 units @ $22 = 2,200 Ending inventory $3,250

Now we can calculate the cost of goods sold as follows: 4 Now we can calculate the cost of goods sold as follows: Beginning inventory, January 1 (Slide 55) $2,000 Purchases ($1,680 + $2,200) 3,880 Cost of merchandise available for sale $5,880 Ending inventory, January 31(Slide 56) 3,250 Cost of merchandise sold $2,630

4 Exhibit 5 First-In, First-Out Flow of Costs

Last-In, First-Out Method 4 Last-In, First-Out Method Using LIFO, the most recent batch purchased is considered the first batch of merchandise sold. The actual flow of goods does not have to be LIFO. For example, a store selling fresh fish would want to sell the oldest fish first (which is FIFO) even though LIFO is used for accounting purposes.

Cost of merchandise available for sale 4 LIFO Method = $2,000 = 1,680 = 2,200 Cost of merchandise available for sale 100 units @ $20 80 units @ $21 100 units @ $22 280 units available for sale during year Jan. 1 Jan. 10 Jan. 30 $5,880

4 Assume again that the physical count on January 31 is 150 units (and that 130 units were sold). What is the cost of the ending inventory? 100 units @ $20 80 units @ $21 100 units @ $22 Jan. 1 Jan. 10 Jan. 30 = $2,000 50 units @ $21 = 1, 680 = 1,050 Sold 30 of the 80 Sold these = 2,200 = 0 Ending inventory $3,050

Now we can calculate the cost of goods sold as follows: 4 Now we can calculate the cost of goods sold as follows: Beginning inventory, January 1 (Slide 60) $2,000 Purchases ($1,680 + $2,200) 3,880 Cost of merchandise available for sale $5,880 Ending inventory, January 31(Slide 61) 3,050 Cost of merchandise sold $2,830

4 Exhibit 5 Last-In, First-Out Flow of Costs

4 Average Cost Method The average cost method is sometimes called the weighted average method. It uses the average unit cost for determining cost of merchandise sold and the ending merchandise inventory.

Total Cost of Units Available for Sale Units Available for Sale 4 The weighted average unit cost is determined as follows: Total Cost of Units Available for Sale Units Available for Sale Average Unit Cost =

4 $5,880 = $2,000 = 1,680 = 2,200 100 units @ $20 80 units @ $21 100 units @ $22 280 Jan. 1 Jan. 10 Jan. 30 100 units @ $22 Average unit cost: $5,880 ÷ 280 = $21 Cost of merchandise sold: 130 units at $21 = $2,730 Ending merchandise inventory: 150 units at $21= $3,150

Now we can calculate the cost of goods sold as follows: 4 Now we can calculate the cost of goods sold as follows: Beginning inventory, January 1 (Slide 66) $2,000 Purchases ($1,680 + $2,200) 3,880 Cost of merchandise available for sale $5,880 Ending inventory, January 31(Slide 66) 3,150 Cost of merchandise sold $2,730

4 Example Exercise 7-4 Periodic Inventory Using FIFO, LIFO, Average Cost Methods The units of an item available for sale during the year were as follows: Jan. 1 Inventory 6 units @ $50 $ 300 Mar. 20 Purchase 14 units @ $55 770 Oct. 30 Purchase 20 units @ $62 1,240 Available for sale 40 units $2,310 There are 16 units of the item in the physical inventory at December 31. The periodic inventory system is used. Determine the inventory cost by (a) the first-in, first-out (FIFO) method, (b) the last-in, first-out (LIFO) method, and (c) the average cost method. 7-69

Example Exercise 7-4 (continued) Follow My Example 7-4 First-in, first-out (FIFO) method: $992 (16 units × $62) Last-in, first-out (LIFO) method: $850 (6 units × $50) + (10 units × $55) Average method: $924 (16 units × $57.75) where average cost = $57.75 ($2,310 ÷ 40 units) For Practice: PE 7-4A, PE 7-4B 7-70

Compare and contrast the use of the three inventory costing methods. 5 Compare and contrast the use of the three inventory costing methods. 7-71

Partial Income Statements 5 Partial Income Statements First-In, First-Out Net sales $3,900 Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Merchandise available for sale $5,880 Less ending inventory 3,250 Cost of merchandise sold 2,630 Gross profit $1,270

Partial Income Statements 5 Partial Income Statements Average Cost Net sales $3,900 Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Merchandise available for sale $5,880 Less ending inventory 3,150 Cost of merchandise sold 2,730 Gross profit $1,170

Partial Income Statements 5 Partial Income Statements Last-In, First-Out Net sales $3,900 Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Merchandise available for sale $5,880 Less ending inventory 3,050 Cost of merchandise sold 2,830 Gross profit $1,070

5 Effects of Changing Costs (Prices): FIFO and LIFO Cost Methods Exhibit 7

Cost of merchandise sold $2,630 $2,730 $2,830 5 Recap Weighted FIFO Average LIFO Ending inventory $3,250 $3,150 $3,050 Cost of merchandise sold $2,630 $2,730 $2,830 Gross profit $1,270 $1,170 $1,070

6 Describe and illustrate the reporting of merchandise inventory in the financial statements. 7-77

6 Cost Cost is the primary basis for valuing and reporting inventories in the financial statements. However, inventory may be valued at other than cost in the following cases: (continued)

The cost of replacing items in inventory is below the recorded cost. 6 The cost of replacing items in inventory is below the recorded cost. The inventory cannot be sold at normal prices due to imperfections, style changes, or other causes.

6 Market Market, as used in lower of cost or market, is the cost to replace the merchandise on the inventory date.

Cost and replacement cost can be determined for the following: 6 Cost and replacement cost can be determined for the following: Each item in the inventory. Each major class or category of inventory. Total inventory as a whole.

6 Determining Inventory at Lower of Cost or Market Exhibit 8

6 Example Exercise 7-5 Lower-of-Cost-or-Market Method On the basis of the following data, determine the value of the inventory at the lower of cost or market. Apply lower of cost or market to each inventory item as shown in Exhibit 8. Inventory Unit Unit Commodity Quantity Cost Price Market Price C17Y 10 $ 39 $40 B563 7 110 98 7-83

6 Follow My Example 7-5 For Practice: PE 7-5A, PE 7-5B 7-84 Example Exercise 7-5 (continued) 6 Follow My Example 7-5 For Practice: PE 7-5A, PE 7-5B 7-84

6 Net Realizable Value Merchandise that is out of date, spoiled, or damaged should be written down to its net realizable value. This is the estimated selling price less any direct cost of disposal, such as sales commissions.

Merchandise Inventory on the Balance Sheet 6 Merchandise Inventory on the Balance Sheet Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following receivables.

Merchandise Inventory on the Balance Sheet 6 Merchandise Inventory on the Balance Sheet The method of determining the cost of inventory (FIFO, LIFO, or weighted average) and the method of valuing the inventory (cost or the lower of cost or market) should be shown.

6

Effect of Inventory Errors on the Financial Statements 6 Effect of Inventory Errors on the Financial Statements Some reasons causing inventory errors to occur include the following: Physical inventory on hand was miscounted. Costs were incorrectly assigned to inventory. Inventory in transit was incorrectly included or excluded from inventory. Consigned inventory was incorrectly included or excluded from inventory.

6 Effect of Inventory Errors on Current Period’s Income Statement Exhibit 9

6 Effect of Inventory Errors on Two Years’ Income Statements Exhibit 10 7-91

6 Effect of Inventory Errors on Current Period’s Balance Sheet Exhibit 11

6 Example Exercise 7-6 Effect of Inventory Errors Zula Repair Shop incorrectly counted its December 31, 2010 inventory as $250,000 instead of the correct amount of $220,000. Indicate the effect of the misstatement on Zula’s December 31, 2010 balance sheet and income statement for the year ended December 31, 2010. 7-93

Amount of Misstatement Overstatement (Understatement) Example Exercise 7-6 (continued) 6 Follow My Example 7-6 Amount of Misstatement Overstatement (Understatement) Balance Sheet: Merchandise inventory overstated $30,000 Current assets overstated 30,000 Total assets overstated 30,000 Owner’s equity overstated 30,000 Income Statement: Cost of merchandise sold understated $(30,000) Gross profit overstated 30,000 Net income overstated 30,000 For Practice: PE 7-6A, PE 7-6B 7-94

Estimating Inventory Cost Appendix: Estimating Inventory Cost 7-95

Exhibit 12 Determining Inventory by the Retail Method

Estimating Inventory by the Gross Profit Method Exhibit 13