2. Merchandise Inventory
Chapter 17
Merchandise Inventory
Section 1: Inventory Costing Methods
Section Objectives
In section 1 of this chapter, we will be discussing inventory costing methods and will compute inventory costs by applying four commonly used methods. In addition, we will compare the different methods. Assigning an appropriate value to inventory is very important because the valuation affects both the balance sheet and the income statement. Often inventory represents the largest current asset on the balance sheet. The costs of the goods sold is also used on the income statement.
Compute inventory cost by applying four commonly used costing methods.
Compare the different methods of inventory costing.
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc. All rights reserved.

3. Two Types of Inventory System
Perpetual Inventory
Based on a running total of number of units.
Uses point-of-sale cash registers and scanners.
Periodic Inventory
Based on a periodic count of goods on hand.
Requires a physical inventory (count).
There are two basic types of inventory systems. They are the perpetual inventory system and the periodic inventory system.
The perpetual inventory system is based on a running total of the number of units purchased and sold. The perpetual system also uses point-of-sale cash registers and scanners.
The periodic inventory system does not require a running total of the number of units of inventory purchased and sold. Rather, this system is based upon a periodic physical counts of inventory on hand. Please note that the periodic inventory system is the method used in the remainder of this chapter.
Periodic inventory is the method used in this chapter.

4. Compute inventory cost using four common methods
Objective 1
The methods used to assign costs to inventory are based on assumptions about the physical flow of goods.
Specific Identification Method
Average Cost Method
FIFO Method
LIFO Method
The first objective of this chapter is to compute inventory cost by applying four commonly used costing methods.
The four methods of assigning cost to inventory include: the specific identification method; the average cost method; the first in first out method; and the last in first out method. The method chosen by individual companies is often based on assumptions made about the physical flow of goods.

5. Specific Identification Method
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.
The specific identification method is based on the actual cost of each piece of merchandise inventory. It is often used by companies that have a low volume of highly priced inventory – for example automobile dealers.

6. Average Cost Method
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.
The average cost method is often used when a company’s inventory is composed of many similar items. It often produces a result that fall somewhere in-between the first in first out method and the last in first out method.

7. Average Cost Method
Steps used in determining the value of the inventory using the average cost method:
1. 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.
When using the average cost method, the first step is to add the total number of inventory units purchased to the beginning inventory units to get the total number of units available for sale. Second, the total cost of inventory units purchased is added to the total cost of beginning inventory to get the total cost of units available for sale. Third, the total cost of units available for sale is divided by the total units available for sale to get an average cost per unit. In this example, the twenty-thousand six-hundred dollars of total cost was divided by the one-thousand units available for sale to yield an average cost of 20.6 dollars per unit of inventory.
$20, (total cost)
1000 (number of units) =
$20.60 average cost of each item

8. Average Cost Method
In this example, there were two hundred six units in ending inventory. Taking the average cost per unit of 20.6 dollars and multiplying that amount by the number of units of ending inventory will give us the total cost of ending inventory of four-thousand two-hundred and forty-three dollars and sixty cents. Cost of goods sold is calculated by taking the total cost of units available for sale and subtracting the cost of ending inventory.

9. First In, First Out Method (FIFO)
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.
The first in first out method is based on the assumption that merchants sell the oldest items of inventory first. With this assumption, the most recently purchased items of inventory will be on hand at any given time.

10. First In, First Out Method (FIFO)
The first in first out method has both plusses and minuses associated with its use. On the plus side, the amount of inventory shown on the balance sheet reflects the most recent price levels and replacement cost of inventory. On the minus side, many accountants, owners, and managers believe this method is less conservative and less realistic than the last if first out method.
Take a moment to review the data shown. Notice that there are four layers of cost. Under the first in, first out method, the merchandise inventory left on hand at the end of the period is comprised of the most recently purchased items. You can see in this case that the ending inventory is comprised of hundred units purchased at $24 each and one hundred and sixteen units purchased at $22 each.

11. First In, First Out Method (FIFO)
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.
One of the advantages of FIFO is that the amount of inventory shown on the balance sheet reflects the most recent price levels and replacement cost of inventory. One disadvantage is that many accountants, owners, and managers believe this method is less conservative and less realistic than the last if first out method.

12. Last In, First Out Method (LIFO)
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.
The last in first out method assumes that merchants will sell inventory that were most recently purchased. The value assigned then to ending inventory is the cost of the oldest merchandise on hand.

13. Last In, First Out Method (LIFO)
Using the last in first out method, two hundred units of ending inventory are taken from the oldest items of inventory on hand and six units were taken from Feb 19 inventory. Since the cost of those items were eighteen dollars per unit and twenty dollars per unit respectively, the cost assigned to ending inventory is three-thousand seven-hundred twenty dollars.

14. Last In, First Out Method (LIFO)
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.
The lower net income will produce a lower income tax liability for the company.
One of the main advantages of the last in first out method is that during times of rising prices a company’s net income will be lower using this method. The lower a company’s net income, the lower their income tax liability will be. The last in first out is also considered the most conservative costing method during periods of rising prices.
Is considered the most conservative costing method in a period of rising prices.

15. Compare the effects of different methods of inventory costing
Objective 2
Since price trends are a vital element in any inventory costing method, remember these basic rules:
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.
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.
Whatever direction prices take, the average cost method results in a reported net income somewhere between the amounts obtained with FIFO and LIFO.
The second objective of this chapter is to compare the different methods of inventory costing.
Price trends are a vital element when selecting an inventory pricing method. Here are some basic rules to remember. During periods of rising prices, the last in first out method results in a higher reported cost of goods sold and a lower reported net income than the first in first out or average cost method. During periods of falling prices, the last in first out method results in a lower reported cost of goods sold and a higher reported net income than the first in first out or average cost method. Finally, whatever direction prices take, the average cost method will produce net income results that fall somewhere in between the first in first out method and the last in first out method.

16. 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.
Following the consistency principle, once a company adopts a inventory costing method it should use that method from one period to the next. A business can use one inventory costing method for financial accounting purposes and another method for federal income tax purposes, however, there is an exception with the last in first out method. A business must use the last in first out method for financial accounting purposes if that method is adopted 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. Merchandise Inventory
Chapter 17
Merchandise Inventory
Section 2: Inventory
Valuation and Control
Section Objectives
In section 2 of this chapter, we will learn how to complete the worksheet, prepare our financial statements and journalize and post the adjustments off of the worksheet.
The third objective of the chapter has us completing the worksheet.
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.
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc. All rights reserved.

18. Compute inventory value under the lower of cost or market rule
Objective 3
QUESTION:
What is the lower of cost or market rule?
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:
The third objective of this chapter is to learn how to compute inventory value under the lower of cost or market rule.
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. The items cost is what was paid to acquire it. Market price, or replacement cost, is the current price a business would have to pay to buy inventory through its usual channels.
There are three ways to apply the lower of cost or market rule: by item, by group, or in total.
There are three ways to apply the lower of cost or market rule: by item, in total, or by group

19. Lower of Cost or Market Rule by ITEM
When applying the lower of cost or market rule by item, we compare the inventory’s cost and market price individually. For example, with stock number 2810, the cost price is one dollar and eighty cents while its market price was one dollar and ninety-five cents. Since the cost price was lower than the market price, the cost amount was multiplied by the inventory quantity amount of one hundred and fifty units to give a total dollar cost of two-hundred seventy dollars. The same comparison was made for the other three stock numbers. Finally, the lower of cost or market for all four inventory stock numbers was added together to get an inventory valuation of one-thousand four-hundred sixty-one dollars and twenty-five cents.

20. Lower of Cost or Market Rule by Total Cost or Total Market
When applying the lower of cost or market rule by total cost or total market, we simply compare the total cost and total market values for the inventory as a whole. Since the total cost amount of one-thousand four-hundred seventy-seven dollars and fifty cents was less than the total market cost of one-thousand five-hundred eight dollars and seventy-five cents, we used the lower cost figure as our inventory valuation amount.

21. Lower of Cost or Market Rule by Groups
When applying the lower of cost or market rule by groups, we find that the total cost amount in group one and group two were lower than the total market. Finally, the total cost price in group one is added to the total cost amount in group two to get the inventory valuation amount of one-thousand four-hundred seventy-seven dollars and fifty cents.

22. Estimate inventory cost using the gross profit method
Objective 4
QUESTION:
What is the gross profit method?
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:
The fourth objective of this chapter is to estimate inventory cost using the gross profit method. On occasion, a company may need to know inventory cost without taking a physical count. There are two methods commonly used for estimating inventory, the gross profit method and the retail method. What is the gross profit method? The gross profit method assume the rate of gross profit on sales and the ratio or cost of goods sold to net sales are relatively constant from period to period.

23. Gross Profit Method
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)
The first step to calculate estimated inventory using the gross profit method is to estimate the cost of goods sold. This is calculated by multiplying sales by the ratio of cost of goods sold to net sales. The second step is to determine the cost of goods available for sale. This is calculated by adding the beginning inventory cost to the cost of inventory purchased during the period. Finally we compute the ending inventory by subtracting the estimated cost of goods sold from the cost of goods available for sale.

24. Gross Profit Method
Assume that an analysis of income statements for two preceding years shows the following:
In this example, we calculate the gross profit rate to be forty two percent and the cost of goods sold ratio to be fifty eight percent.

25. Gross Profit Method
On June 10 the store lost its entire merchandise inventory in a fire.
Beginning inventory, January 1, was $210,000
Net purchases, January 1 to June 30, were $315,000
Net sales, January 1 to June 30, were $450,000
What is the value of the destroyed inventory?
Step Estimated cost of goods sold
In this example, the first step is to calculated the estimated cost of goods sold. This is done by multiplying the net sales of four-hundred fifty thousand dollars by the cost of goods sold ratio of fifty eight percent. The end result is an estimated cost of goods sold of two-hundred sixty one thousand dollars.
Sales $450,000
x % Cost of goods sold ratio
$261, Estimated cost of goods sold

26. Gross Profit Method
Step Determine the cost of goods available for sale
Beginning inventory $210,000
Net purchases ,000
Cost of goods available for sale $525,000
Step Compute the ending (destroyed) inventory
In step two, the cost of goods available for sale is calculated by adding the beginning inventory cost of two-hundred ten thousand dollars to the net purchases for the period of three-hundred fifteen thousand dollars. In step three, the estimated cost of ending inventory was calculated by subtracting step one from step two.
Cost of goods available for sale $525, Step 2
Estimated cost of goods sold (261,000) - Step 1
Estimated cost of ending inventory $264,000

27. Estimate inventory cost using the retail method
Objective 5
QUESTION:
What is the retail method?
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:
The fifth objective of this chapter is to estimate inventory cost using the retail method.
What is the retail method? 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.

28. Retail Method
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.
Eight steps are involved when using the retail method. First, we list the beginning inventory at both cost and retail. Second, when merchandise is purchased, we record it at cost and determine its retail value. Third, we compute merchandise available for sale at cost and at retail. Finally, we record sales at retail.

29. Retail Method
Step 5. Subtract retail sales from retail merchandise available for sale. The difference is ending inventory at retail.
Step 6. Compute the cost ratio: Merchandise Available for Sale at Cost Merchandise Available for Sale at Retail
Step 7. Multiply ending inventory at retail by the cost ratio The result is an estimate of ending inventory at cost.
Step 8. Estimate the cost of goods sold: merchandise available for sale at cost – ending inventory at cost
In step five we subtract retail sales from retail merchandise available for sale. The difference is ending inventory at retail. In step six we compute the cost ratio by dividing merchandise available for sale at cost by merchandise available for sale at retail. In step seven, we estimate ending inventory at cost by multiplying ending inventory at retail by the cost ratio calculated in step six. Finally, in step eight the estimated cost of goods sold is calculated by subtracting the ending inventory at cost from the merchandise available for sale at cost.

30. Retail Method A company’s financial records show the following:
At Cost At Retail
Beginning inventory $ 95, $138,700
Purchases , ,500
Freight in , —
In this example, the following information is presented for beginning inventory, purchases, freight-in, and sales.
Sales — $815,300

31. Retail Method
Step 2: When merchandise is purchased, record it at cost ($526,800 including $1,800 in freight) and determine its retail value ($819,500).
Cost Retail
Step 1: Beginning inventory $ 95, $138,700
Step 2: Purchases , ,500
Freight in ,400
Step one is to list the beginning inventory at both cost and retail. We assume that the beginning inventory was $95,400 at cost and $138,700 at retail.
When merchandise is purchased, its cost and retail value are reported for the second step.

32. Retail Method
Step 3: Compute merchandise available for sale at cost ($622,200) and at retail ($958,200).
Cost Retail
Step 1: Beginning inventory $ 95, $138,700
Step 2: Purchases , ,500
Freight in ,400
In step three, the total merchandise available for sale is calculated by adding the beginning inventory amount found in step one, with the purchases and freight in amounts found in step two. This is done for both the cost amount and retail value.
Step 3: Total merchandise $622, $958, available for sale

33. Retail Method Step 4: Determine net sales at retail ($815,300).
Cost Retail
Step 1: Beginning inventory $ 95, $138,700
Step 2: Purchases , ,500
Freight in ,400
In step four records sales at retail.
Step 3: Total merchandise $622, $958, available for sale
Step 4: Less sales ,300

34. Retail Method
Step 5: Subtract retail sales from the retail merchandise available for sale.
Cost Retail
Step 1: Beginning inventory $ 95, $138,700
Step 2: Purchases , ,500
Freight in ,400
Step five subtracts retail sales from merchandise available for sale at retail to yield an estimated ending inventory priced at retail. In this example the estimated ending inventory at retail is one-hundred forty-two thousand nine hundred dollars.
Step 3: Total merchandise $622, $958, available for sale
Step 4: Less sales ,300
Step 5: Ending inventory priced at retail $ 142,900

35. Retail Method Step 6: Compute cost ratio.
Merchandise Available for Sale at Cost $622,200
Merchandise Available for Sale at Retail $958,200 =
65%
To calculate the cost ratio, merchandise available for sale at cost is divided by merchandise available for sale at retail. In this example, the cost ratio is equal to sixty-five percent.

36. Retail Method
Step 7: Multiply the ending inventory at retail by the cost ratio The result is an estimate of the ending inventory at cost.
Step 7: Conversion to approximate cost:
$142,900 x = $92,885
In step seven, an estimate of ending inventory at cost is calculated by multiply the ending inventory at retail calculated in step five, by the cost ratio calculated in step six. In this example, the estimated ending inventory at cost is ninety-two thousand eight-hundred eighty-five dollars.

37. Retail Method
Step Estimate the cost of goods sold by subtracting the ending inventory at cost from the merchandise available for sale at cost.
Step 8: $622, Merchandise available for sale at cost
– 92, Ending inventory at cost
$529,315 = Cost of goods sold
Finally, cost of goods sold is calculated by subtracting the ending inventory at cost calculated in step seven from the merchandise available for sale at cost calculated in step three.

38. 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.
The internal controls over inventory depend on the nature of the inventory. Take a moment to review some typical inventory controls as shown on the slide. Regardless of which inventory costing method is chosen, a physical count of inventory must be taken at least once a year to uncover theft, errors in inventory records, or unreported loss or damage of inventory.

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