7 Inventories

After studying this chapter, you should be able to: Describe the importance of control over inventory. Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet.

After studying this chapter, you should be able to: After studying this chapter, you should be able to: Determine the cost of inventory under the perpetual system, using the FIFO, LIFO, and average cost methods. Determine the cost of inventory under the periodic system, using the FIFO, LIFO, and average cost methods. Compare and contrast the use of the three inventory costing methods.

After studying this chapter, you should be able to: After studying this chapter, you should be able to: Describe and illustrate the reporting of merchandise inventory in the financial statement. Estimate the cost of inventory using the retail method and the gross profit method.

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

Two primary objectives of control over inventory are: 7-1 Two primary objectives of control over inventory are: Safeguarding the inventory, and Properly reporting it in the financial statements.

7-1 Controls over inventory include developing and using security measures to prevent inventory damage or customer or employee theft.

7-1 To ensure the accuracy of the amount of inventory reported in the financial statements, a merchandising business should take a physical inventory.

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

Inventory Costing Methods 7-2 10

7-2 (Continued) 11

7-2 (Continued) 12

7-2 (Concluded) 13

Number of firms (> $1B Sales) Inventory Costing Methods 7-2 400 300 200 100 371 299 Number of firms (> $1B Sales) 130 FIFO LIFO Average cost 14

7-2 - Example Exercise 7-1 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. 15

Gross Profit Ending Inventory 7-2 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 x 2) $144/3 units 16 For Practice: PE 7-1A, PE 7-1B

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

FIFO Perpetual 7-3 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 18

On January 4, the firm sold 70 units of 127B at $30 each. FIFO Perpetual 7-3 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 19

On January 4, the firm sold 70 units of 127B at $30 each. FIFO Perpetual 7-3 On January 4, the firm sold 70 units of 127B at $30 each. 4 Accounts Receivable 2 100 00 Sales 2 100 00 On January 22, the firm sold twenty units at $30. 4 Cost of Merchandise Sold 1 400 00 Merchandise Inventory 1 400 00 20

FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 21

On January 10, the firm purchased 80 units at $21 each. FIFO Perpetual 7-3 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 22

On January 10, the firm purchased 80 units at $21 each. FIFO Perpetual 7-3 On January 10, the firm purchased 80 units at $21 each. 10 Merchandise Inventory 1 680 00 Accounts Payable 1 680 00 23

FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 24

On January 22, the firm sold 40 units for $30 each. FIFO Perpetual 7-3 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 25

On January 22, the firm sold 40 units for $30 each. FIFO Perpetual 7-3 On January 22, the firm sold 40 units for $30 each. 22 Accounts Receivable 1 200 00 Sales 1 200 00 On January 22, the firm sold twenty units at $30. 22 Cost of Merchandise Sold 810 00 Merchandise Inventory 810 00 26

FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 30 20 600 10 21 210 70 21 1,470 Of the forty sold, thirty are considered to be from those acquired at $20 each. The other ten are considered to be from the January 10 purchase. 27

On January 28, the firm sold 20 units at $30 each. FIFO Perpetual 7-3 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 28

On January 28, the firm sold 20 units at $30 each. FIFO Perpetual 7-3 On January 28, the firm sold 20 units at $30 each. 28 Accounts Receivable 600 00 Sales 600 00 28 Cost of Merchandise Sold 420 00 Merchandise Inventory 420 00 29

FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 30 20 600 10 21 210 70 21 1,470 28 20 21 420 50 21 1,050 30

FIFO Perpetual 7-3 On January 30, purchased ten 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 31

FIFO Perpetual 7-3 On January 30, purchased ten additional units of Item 127B at $22 each. 30 Merchandise Inventory 2 200 00 Accounts Payable 2 200 00 32

FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 30 20 600 10 21 210 70 21 1,470 28 20 21 420 50 21 1,050 30 100 22 2,200 50 21 1,050 100 22 2,200 33

Cost of merchandise sold for January is $2,630. FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 30 20 600 10 21 210 70 21 1,470 28 20 21 420 50 21 1,050 30 100 22 2,200 50 21 1,050 100 22 2,200 Cost of merchandise sold for January is $2,630. 34

January 31, inventory is $3,250 ($1,050 + $2,200) FIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 30 20 600 10 21 210 70 21 1,470 28 20 21 420 50 21 1,050 30 100 22 2,200 50 21 1,050 100 22 2,200 January 31, inventory is $3,250 ($1,050 + $2,200) 35

Nov. 1 Inventory 40 units at $5 5 Sale 32 units 7-3 - Example Exercise 7-2 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. 36

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

LIFO Perpetual 7-3 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 38

On January 4, the firm sold 70 units of 127B at $30 each. LIFO Perpetual 7-3 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 39

On January 4, the firm sold 70 units of 127B at $30 each. LIFO Perpetual 7-3 On January 4, the firm sold 70 units of 127B at $30 each. 4 Accounts Receivable 2 100 00 Sales 2 100 00 On January 22, the firm sold twenty units at $30. 4 Cost of Merchandise Sold 1 400 00 Merchandise Inventory 1 400 00 40

LIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 41

On January 10, the firm purchased 80 units at $21 each. LIFO Perpetual 7-3 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 42

On January 10, the firm purchased 80 units at $21 each. LIFO Perpetual 7-3 On January 10, the firm purchased 80 units at $21 each. 10 Merchandise Inventory 1 680 00 Accounts Payable 1 680 00 43

LIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 44

On January 22, the firm sold 40 units for $30 each. LIFO Perpetual 7-3 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 45

On January 22, the firm sold 40 units for $30 each. LIFO Perpetual 7-3 On January 22, the firm sold 40 units for $30 each. 22 Accounts Receivable 1 200 00 Sales 1 200 00 On January 22, the firm sold twenty units at $30. 22 Cost of Merchandise Sold 840 00 Merchandise Inventory 840 00 46

All of the 40 sold are considered to be from the January 10 purchase. LIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 40 21 840 30 20 600 40 21 840 All of the 40 sold are considered to be from the January 10 purchase. 47

On January 28, the firm sold 20 units at $30 each. LIFO Perpetual 7-3 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 48

On January 28, the firm sold 20 units at $30 each. LIFO Perpetual 7-3 On January 28, the firm sold 20 units at $30 each. 28 Accounts Receivable 600 00 Sales 600 00 28 Cost of Merchandise Sold 420 00 Merchandise Inventory 420 00 49

All of the 20 sold are considered to be from the January 22 purchase. LIFO Perpetual 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 40 21 840 30 20 600 40 21 840 28 20 21 420 30 20 600 20 21 420 All of the 20 sold are considered to be from the January 22 purchase. 50

LIFO Perpetual 7-3 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 51

LIFO Perpetual 7-3 On January 30, the firm purchased one hundred additional units of Item 127B at $22 each. 30 Merchandise Inventory 2 200 00 Accounts Payable 2 200 00 52

7-3 7-3 LIFO Perpetual LIFO Perpetual 53 33 Item 127B LIFO Perpetual LIFO Perpetual 7-3 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 40 21 840 30 20 600 40 21 840 28 20 21 420 30 20 600 20 21 420 30 100 22 2,200 30 20 600 20 21 420 100 22 2,200 53 33

Cost of merchandise sold $2,660 LIFO Perpetual LIFO Perpetual 7-3 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 40 21 840 30 20 600 40 21 840 28 20 21 420 30 20 600 20 21 420 30 100 22 2,200 30 20 600 20 21 420 100 22 2,200 33 54 Cost of merchandise sold $2,660

7-3 7-3 LIFO Perpetual LIFO Perpetual 33 55 LIFO Perpetual LIFO Perpetual 7-3 7-3 Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 100 20 2,000 4 70 20 1,400 30 20 600 10 80 21 1,680 30 20 600 80 21 1,680 22 40 21 840 30 20 600 40 21 840 28 20 21 420 30 20 600 20 21 420 30 100 22 2,200 30 20 600 20 21 420 100 22 2,200 33 55 January 31, inventory….. $3,220

Nov. 1 Inventory 40 units at $5 5 Sale 32 units 7-3 - Example Exercise 7-3 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. 56

Cost of merchandise sold: $315 = (45 units x $7) 7-3 Follow My Example 7-3 Cost of merchandise sold: $315 = (45 units x $7) Inventory, November 30: 8 units @ $5 $ 40 15 units @ $7 105 23 $145 57 For Practice: PE 7-3A, PE 7-3B

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

FIFO Periodic 7-4 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 FIFO Periodic 7-4 100 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 60

FIFO Periodic 7-4 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 these = 1,050 50 units @ $21 100 units @ $22 = 2,200 61 Ending inventory $3,250

Now we can calculate the cost of goods sold as follows: FIFO Periodic 7-4 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) 3,250 Cost of merchandise sold $2,630 62

LIFO Periodic 7-4 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 LIFO Periodic 7-4 100 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 64

LIFO Periodic 7-4 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 = 1,050 = 1, 680 Sold 30 of these Sold these = 0 = 2,200 Ending inventory $3,050 65

Now we can calculate the cost of goods sold as follows: LIFO Periodic 7-4 Now we can calculate the cost of goods sold as follows: Beginning inventory, January 1 (Slide 64) $2,000 Purchases ($1,680 + $2,200) 3,880 Cost of merchandise available for sale $5,880 Ending inventory, January 31(Slide 65) 3,050 Cost of merchandise sold $2,830 66

Average Cost 7-4 The weighted average unit cost method is based on the average cost of identical units. The total cost of merchandise available for sale is divided by the related number of units of that item.

Average Cost 7-4 $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 68

Now we can calculate the cost of goods sold as follows: Average Cost 7-4 Now we can calculate the cost of goods sold as follows: Beginning inventory, January 1 (Slide 68) $2,000 Purchases ($1,680 + $2,200) 3,880 Cost of merchandise available for sale $5,880 Ending inventory, January 31(Slide 68) 3,150 Cost of merchandise sold $2,730 69

7-4 - Example Exercise 7-4 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. 70

First-in, first-out (FIFO) method: $992 (16 units x $62) 7-4 Follow My Example 7-4 First-in, first-out (FIFO) method: $992 (16 units x $62) Last-in, first-out (LIFO) method: $850 (6 units x $50) + (10 units x $55) Average method: $924 (16 units x $57.75) where average cost = $57.75 ($2,310 ÷ 40 units) 71 For Practice: PE 7-4A, PE 7-4B

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

Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Partial Income Statements 7-5 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 73

Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Partial Income Statements 7-5 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 74

Cost of merchandise sold: Beginning inventory $2,000 Purchases 3,880 Partial Income Statements 7-5 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 75

Cost of merchandise sold $2,630 $2,730 $2,830 Recap 7-5 Weighted FIFO LIFO Average 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

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

Lower-of-Cost-or-Market Method 7-6 If the cost of replacing an item in inventory is lower than the original purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory.

7-6 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— 7-6 Cost and replacement cost can be determined for— each item in the inventory, major classes or categories of inventory, or the inventory as a whole.

7-6 Determining Inventory at Lower-of-Cost-or-Market Method 81

7-6 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 7-6 Merchandise inventory is usually presented in the Current Assets section of the balance sheet, following receivables.

7-6 Both the method of determining the cost of inventory (FIFO, LIFO, or weighted average) should be shown.

Commodity Quantity Cost Price Market Price 7-6 - Example Exercise 7-5 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 7. Inventory Unit Unit Commodity Quantity Cost Price Market Price C17Y 10 $ 39 $40 B563 7 110 98 85

For Practice: PE 7-5A, PE 7-5B 7-6 - Follow My Example 7-5 Unit Unit Lower of Commodity Qty Cost Price Market Price Cost Market C or M C17Y 10 $ 39 $40 $ 390 $ 400 $ 390 B563 7 110 98 770 686 686 Total $1,160 $1,086 $1,076 86 For Practice: PE 7-5A, PE 7-5B

7-6 - Example Exercise 7-6 Zula Repair Shop incorrectly counted its December 31, 2008 inventory as $250,000 instead of the correct amount of $220,000. Indicate the effect of the misstatement on Zula’s December 31, 2008 balance sheet and income statement for the year ended December 31, 2008. 87

Amount of Misstatement Overstatement (Understatement) - 7-6 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 88 For Practice: PE 7-6A, PE 7-6B

7-7 Objective 7 Estimate the cost of inventory, using the retail method and the gross profit method.

Retail Inventory Method 7-7 The retail inventory method of estimating inventory cost is based on the relationship of the cost of merchandise available for sale to the retail price of the same merchandise.

7-7 Determining Inventory by the Retail Method 91

For Practice: PE 7-7A, PE 7-7B 7-7 Example Exercise 7-7 A business using the retail method of inventory costing determines that merchandise inventory at retail is $900,000. If the ratio of cost to retail price is 70%, what is the amount of inventory to be reported on the financial statements? Follow My Example 7-7 $630,000 ($900,000 x 70%) For Practice: PE 7-7A, PE 7-7B 92

61 Gross Profit Method 7-7 The gross profit method uses the estimated gross profit for the period to estimate the inventory at the end of the period.

7-7 Estimating Inventory by Gross Profit Method 94

7-7 The gross profit method is useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system.

Sales (net) $1,250,000 Estimated gross profit rate 40% 7-7 Example Exercise 7-8 Based on the following data, estimate the cost of ending merchandise inventory: Sales (net) $1,250,000 Estimated gross profit rate 40% Beginning merchandise inventory $100,000 Purchases (net) 800,000 Merchandise available for sale $900,000 96

Merchandise available for sale $900,000 Less cost of merchandise sold 7-7 Follow My Example 7-8 Merchandise available for sale $900,000 Less cost of merchandise sold [$1,250,000 x (100% – 40%)] 750,000 Estimated ending merchandise inventory $150,000 97 For Practice: PE 7-8A, PE 7-8B

Cost of merchandise sold 7-7 Inventory turnover measures the relationship between the volume of goods (merchandise) sold and the amount of inventory carried during the period. Cost of merchandise sold Average inventory Inventory turnover =

Inventory turnover 15.8 times 1.4 times 7-7 SUPERVALU Zale Cost of merchandise sold $16,681,472,000 $1,157,226,000 Inventories: Beginning of year $1,078,343,000 $826,824,000 End of year $1,032,034,000 $853,580,000 Average $1,055,188,500 $840,202,000 Inventory turnover 15.8 times 1.4 times 99

7-7 Generally, the larger the inventory turnover, the more efficient and effective the management of inventory.

7-7 The number of days’ sales in inventory is a rough measure of the length of time it takes to acquire, sell, and replace the inventory. Number of days’ sales in inventory = Average inventory Average daily cost of merchandise sold

7-7 SUPERVALU Zale Number of days’ sales 7-7 SUPERVALU Zale Average daily cost of merchandise sold: $16,681,472,000/365 $45,702,663 $1,157,226,000/365 $3,170,482 Average inventory $1,055,188,500 $840,202,000 Number of days’ sales in inventory 23.1 days 265.0 days 102