1. Inventory Chapter 8 Why is accounting for inventory so important?
A. It is one of the largest current assets for a merchandising company – affects the balance sheet
B. Cost of goods sold is one of the largest expenses on the income statement – affects the income statement
Proper valuation of inventory has a material impact on the financial reports 1 1

2. Describe inventory and discuss the related internal controls
Objective 1
Describe inventory and discuss the related internal controls

3. Inventory
Goods that a business owns and has available to sell to customers as part of normal operations
Current asset – usually listed after accounts receivable

4. Internal Controls Separation of access to assets from access to record
Secure inventory items
Physical count at least once a year
Maintain perpetual records of inventory transactions
Document purchases and sales
Goals are to keep inventory physically safe and organized. Also to ensure that the accounting records are accurate

5. Objective 2
Compute inventory costs using first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost methods and journalize inventory transactions

6. Inventory Costing Methods
Specific Unit Cost
FIFO
LIFO
Average Cost
When cost of inventory per unit does not change, accounting for cost of inventory is easy. But what happens when costs do change….let’s say you have 5 units inventory on the shelf that cost $1 per unit, but when you buy 10 new units of inventory in January, they cost $2 per unit. When you later sell 6 units, which cost should be assigned to cost of goods sold? $1 or $2?
All of these methods are acceptable according to GAAP.

7. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

8. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40

9. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

10. FIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory. 270
Accounts Payable 270
July 5

11. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $270
Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

12. First-In, First-Out (FIFO)
Valued based on the earlier cost of purchases.
Cost of Goods Sold
Valued based on the most recent costs of purchases
Ending Inventory

13. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

14. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Mdse. Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $470
Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

15. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $135

16. FIFO Perpetual Inventory Accounting
Date Description Debit Credit
Accounts Receivable 320
Sales 320
Cost of Goods Sold 175
Inventory 175
July 15

17. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

18. FIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory. 350
Accounts Payable 350
July 26

19. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $ $50 $ $45 $ $50 $350

20. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

21. First-In, First-Out (FIFO)
Valued based on the earlier cost of purchases.
Cost of Goods Sold
Valued based on the most recent costs of purchases
Ending Inventory

22. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $ $50 $ $45 $ $50 $350

23. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $ $50 $ $45 $ $50 $ $45 $135
$50 $250 2 $50 $100

24. FIFO Perpetual Inventory Accounting
Date Description Debit Credit
Accounts Receivable 640
Sales 640
Cost of Goods Sold 385
Inventory 385
July 31

25. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

26. FIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory. 275
Accounts Payable 275
July 31

27. FIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $ $50 $ $45 $ $50 $ $45 $135
$50 $250 2 $50 $ $55 $ $50 $100
$55 $275

28. Inventory Shrinkage Loss of inventory
Compare physical count with balance in books
Sources
Breakage
Theft
Obsolescence

29. Inventory Shrinkage
Took a physical count of DVD’s and determined that two were damaged during shipment.
Record the adjusting entry for inventory shrinkage.

30. FIFO Perpetual Inventory Account
Item Suede Jacket
Purchases Cost Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $135 3 $45 $ $50 $ $45 $ $50 $ $45 $135
$50 $250 2 $50 $ $55 $ $50 $100
$55 $275

31. First-In, First-Out (FIFO)
Valued based on the earlier cost of purchases.
Cost of Goods Sold and shrinkage
Valued based on the most recent costs of purchases
Ending Inventory

32. Inventory value of 5 units Remaining
Inventory Shrinkage
Inventory value of units Remaining
5 at $55 = $275
($375-$275 = $100)

33. FIFO Inventory Shrinkage
Date Description Debit Credit
Cost of Goods Sold 100
Inventory 100
July 31

34. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

35. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40

36. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

37. LIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory 270
Accounts Payable 270
July 5

38. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
Nov $40 $ $45 $ $40 $40
$45 $270
Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

39. Last-In, First-Out (LIFO)
Valued based on the most recent costs of purchases
Cost of Goods Sold
Valued based on the earlier costs of purchases
Ending Inventory

40. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $270
Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

41. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

42. Last-In, First-Out (LIFO)
Valued based on the most recent costs of purchases
Cost of Goods Sold
Valued based on the earlier costs of purchases
Ending Inventory

43. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $270
Because the purchase price of $45 is different than the cost of the previous unit on hand, the inventory balance of 7 units is accounted for separately.

44. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $ $45 $90

45. LIFO Perpetual Inventory Accounting
Date Description Debit Credit
Accounts Receivable 320
Sales 320
Cost of Goods Sold 180
Inventory 180
July 15

46. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

47. LIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory. 350
Accounts Payable 350
July 26

48. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $ $45 $ $50 $ $ $ $45 $90
7 $50 $350

49. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

50. Last-In, First-Out (LIFO)
Valued based on the most recent costs of purchases
Cost of Goods Sold
Valued based on the earlier costs of purchases
Ending Inventory

51. LIFO Perpetual Inventory Account
Item DVD’s
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $ $45 $ $50 $ $ $ $45 $90
7 $50 $350

52. LIFO Perpetual Inventory Account
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$45 $ $40 $ $45 $ $45 $ $50 $ $ $ $ $90
7 $50 $350
$50 $350 1 $ $ $45 $45 1 $ $45

53. LIFO Perpetual Inventory Accounting
Date Description Debit Credit
Accounts Receivable 640
Sales 640
Cost of Goods Sold 395
Inventory 395
July 31

54. Perpetual Inventory Costs
Inventory cost data to demonstrate
FIFO and LIFO Perpetual Systems
Smart Touch Learning Units Cost Price
July 1 Inventory 1 $40
5 Purchase 6 $45
15 Sale 4 $80
26 Purchase $50
31 Sale 8 $80
31 Purchase 5 $55
Cost of
Mdse. Sold
Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

55. LIFO Perpetual Inventory Accounting
Date Description Debit Credit
Inventory. 275
Accounts Payable 275
July 31

56. LIFO Perpetual Inventory Account
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$ $ $ $ $45 $ $45 $ $50 $ $ $ $ $90
7 $50 $350
$50 $350 1 $ $ $45 $45 1 $ $45
31 5 $55 $ $ $ $ $ $ $275

57. Inventory Shrinkage Loss of inventory
Compare physical count with balance in books
Sources
Breakage
Theft
Obsolescence

58. Inventory Shrinkage
Took a physical count of DVD’s and determined that two were damaged during shipment.
Record the adjusting entry for inventory shrinkage.

59. LIFO Perpetual Inventory Account
Purchases Cost of Goods Sold Inventory Balance
Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
July $40 $ $45 $ $40 $40
$ $ $ $ $45 $ $45 $ $50 $ $ $ $ $90
7 $50 $350
$50 $350 1 $ $ $45 $45 1 $ $45
31 5 $55 $ $ $ $ $ $ $275

60. Last-In, First-Out (LIFO)
Valued based on the most recent costs of purchases
Cost of Goods Sold and shrinkage
Valued based on the earlier costs of purchases
Ending Inventory

61. Inventory value of 5 units Remaining
Inventory Shrinkage
Inventory value of units Remaining
1 at $40 = $40
1 at $45 = $45
3 at $55= $165
$250
($360-$250 = $110)

62. LIFO Inventory Shrinkage
Date Description Debit Credit
Cost of Goods Sold 110
Inventory 110
July 31

63. Objective 3
Compare the effects of the different costing methods on the financial statements

64. Comparison FIFO LIFO Sales $960 COGS Gross Profit $660 $300 $685 $275
During rising costs, FIFO will have a larger gross profit and net income that LIFO. Average will be in the middle. Discuss how the opposite is true when price decrease.

65. Comparison FIFO LIFO Inventory $275 $250
During rising costs, FIFO will have a larger gross profit and net income that LIFO. Average will be in the middle. Discuss how the opposite is true when price decrease.

66. Advantage of Each Method
Weighted Average
First-In, First-Out
Last-In, First-Out
Smoothes out price changes
Matches actual flow of goods. Inventory valued closest to replacement value
During inflation minimizes net income and income taxes. Better matching of current costs in cost of goods sold with revenues
“If you were responsible for deciding which method your company should use, what method would you select, why? “
Talk about which costing method might be most appropriate for various types of inventory.

67. Use of Inventory Methods in Practice

68. Apply the lower-of-cost-or-market (LCM) rule to value inventory
Objective 4
Apply the lower-of-cost-or-market (LCM) rule to value inventory

69. Conservatism Principle
Exercise caution in reporting items in the financial statements
Report realistic figures
Talk about recognizing losses when indicated and gains when realized – goal is not to overstate net income
Another goal is to not overstate assets or understate liabilities.

70. Lower-of-Cost-or-Market
Inventory is reported at whichever is lower – historical cost or market value (current replacement cost)
If market is lower than cost – write inventory down
Debit Cost of Goods Sold
Credit Inventory

71. Lower-of-Cost-or-Market
Must disclose method of valuation in financial statements
As parenthetical in statements or
In notes to financial statements

72. Objective 5
Report inventory on the balance sheet and measure the effect of inventory errors

73. Materiality Concept
A company must perform strictly proper accounting only for significant items
An item is material if its presentation in the financial statements would cause a reader to change a decision. If an item is considered immaterial, GAAP does not have to be strictly applied

74. Full Disclosure Principle
Report enough information for outsiders to make wise decisions about the company
Must disclose the method used to value inventory

75. Consistency in Reporting
A company should use the same accounting methods from period to period so that financial statements are comparable across periods

76. Effects of Inventory Errors
Ending inventory becomes next year’s beginning inventory
Results in misstatement of income statement over two years
Misstatement of balance sheet in first year and then error counterbalances itself
Even with the best internal controls over inventory, errors can be made. Mistakes can be made when taking a physical count of inventory.

77. Effects of Inventory Errors
If ending inventory is overstated, so is net income and gross profit. Cost of Goods sold is understated.
If ending inventory is understated, so is net income and gross profit. Cost of Goods sold is overstated.
In year two, the effects of year one are reversed.
Hint: Remember, the two I’s are affected the same way
I – Inventory
I – Income

78. End of Chapter 6