1. Grades
Reminder:
If you are taking this for SCC credit, your SCC grade is determined:
LNS 1st semester grade (includes final) %
LNS 2nd semester grade (does not include final) %
SCC final (required by SCC)---25%
B problems for A problems (on some….)
Individual help from me
I am available before/after school

2. Merchandise Inventory
Chapter 6
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

3. Account for inventory by the FIFO, LIFO, and average cost methods
Objective 1
Account for inventory by the FIFO, LIFO, and average cost methods

4. 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?

5. The need for different costing methods. . .
When cost of inventory per unit does not change, accounting for cost of inventory is easy.
But what happens when costs do change?
If 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?

6. Specific Unit Cost
When units are sold, the specific cost of the unit sold is added to cost of goods sold
Let’s say you own an art gallery. Each work of art is unique and each work of art costs a different amount. It would make sense to assign the actual cost of a sculpture you sell to cost of goods sold.
Let’s say you own an art gallery. Each work of art is unique and each work of art costs a different amount. It would make sense to assign the actual cost of a sculpture you sell to cost of goods sold.
Can you think of other businesses where this method would make sense to use?

7. First-In, First-Out (FIFO)
Oldest Costs
Cost of Goods Sold
Recent Costs
Ending Inventory

8. First-In, First-Out (FIFO)
Then we sell 4 shirts for $20 each.
What costs should be assigned to
Cost of Goods Sold?
Beginning Inventory
$10
First-In, First-Out
$12
$12
$12
$12
$12
Purchase 5 shirts
Inventory = $48
Cost of good sold = $42

9. First-In, First-Out (FIFO)
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Accounts Receivable ($20 x 4) 80
Sales Revenue 80
To record sales on account
Cost of Goods Sold 42
Inventory 42
To record cost of sales

10. First-In, First-Out (FIFO)
Sales $80
Cost of Goods Sold 42
Gross Profit $38

11. Last-In, First-Out (LIFO)
Recent Costs
Cost of Goods Sold
Oldest Costs
Ending Inventory

12. Last-In, First-Out (LIFO)
Then we sell 4 shirts for $20 each.
What costs should be assigned to
Cost of Goods Sold?
Beginning Inventory
$10
Last-In, First-Out
$12
$12
Purchase 5 shirts
Inventory = $42
Cost of good sold = $48

13. Last-In, First-Out (LIFO)
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Accounts Receivable ($20 x 4) 80
Sales Revenue 80
To record sales on account
Cost of Goods Sold 48
Inventory 48
To record cost of sales

14. Last-In, First-Out (LIFO)
Sales $80
Cost of Goods Sold 48
Gross Profit $32

15. Cost of Inventory on Hand
Average Cost
The average cost of each unit in inventory is assigned to cost of goods sold
Cost of Inventory on Hand
Number of Units on Hand ÷ =
Average Cost

16. Average Cost Then we sell 4 shirts for $20 each.
What costs should be assigned to
Cost of Goods Sold?
Beginning Inventory
$10
Compute the Average Cost
Units Cost
Beginning inventory 3 $30
Purchases 5 60
Total 8 $90
Average = $90/8 = $11.25
$12
$12
Purchase 5 shirts
Inventory = $11.25 x 4 = $45
Cost of good sold = $11.25 x 4 = $45

17. Average Cost Accounts Receivable ($20 x 4) 80 Sales Revenue 80
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Accounts Receivable ($20 x 4) 80
Sales Revenue 80
To record sales on account
Cost of Goods Sold 45
Inventory 45
To record cost of sales

18. Average Cost
Sales $80
Cost of Goods Sold 45
Gross Profit $35

19. Practice
S6-1
S6-2
S6-3

20. Friday, December 5 Today: Open new Word document
Complete Quick Check (p. 332)
#1 & #2-Save this for future days
Open Excel E-working papers
E6-13—yesterday
E6-14
E6-15
E6-16
E6-17
Today:
Continue with Objectives #1 & #2
Rocket Daily Info

21. Compare the effects of FIFO, LIFO, and average cost
Objective 2
Compare the effects of FIFO, LIFO, and average cost

22. Comparison FIFO LIFO Average Ending Inventory $48 $42 $45 Gross Profit
$38
$32
$35
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.

23. Advantage of Each Method
Weighted Average
First-In, First-Out
Last-In, First-Out
Smoothes out price changes
Ending inventory approximates current replacement cost
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.

24. Use of Inventory Methods in Practice

25. E6-13
Nov 1 Bal $70 $350
$ $
8 10 $79 $
$70 140
Emphasize to students that the Cost of Goods Sold section is using the “cost” of the inventory. Many students want to use the selling price here.
Total cost of goods sold for November = $903
Cost of ending inventory for November = $237

26. E6-14 Nov 8 Inventory 790 Accounts Payable 790
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Nov 8 Inventory 790
Accounts Payable 790
Purchased inventory on account
Nov 17 Cash 480
Sales Revenue 480
To record sales for cash
17 Cost of Goods Sold 298
Inventory 298
To record cost of sales

27. E6-15
Nov 1 Bal $70 $350
$ $
8 10 $79 $
Total cost of goods sold for November = $921
Cost of ending inventory for November = $219

28. E6-16
Nov 1 Bal $70.00 $350.00
$ $
8 10 $79 $
Total cost of goods available for sale
Total number of units available for sale
$140 + $790 / 12 units = $77.50
Total cost of goods sold for November = $907.50
Cost of ending inventory for November = $232.50

29. Monday, December 8 Open Quick Check. . . Open Short Exercises
p text
Complete Qs #3, #4, #5
Open Short Exercises
Open Excel Exercises. . .
Continue Chap 6
Objective #2

30. Analysis of` E6-13, 15, 16
In this illustration, prices are rising. What impact do these different methods have on the income statement? Lets assume that all items were sold for $100 each
FIFO
LIFO
AVERAGE
Sales
$1,200
Cost of goods sold
903
921
908*
Gross profit
$297
$279
$292
During rising prices FIFO gives you the highest net income,
LIFO the lowest.
Average will always be in between
During rising prices FIFO gives you the highest net income, LIFO the lowest
* Rounded

31. Analysis of E6-13, 15, 16 How about the balance sheet? Inventory $237
FIFO
LIFO
AVERAGE
Inventory
$237
$219
$233*
During rising prices FIFO gives you the highest inventory valuation, LIFO the lowest.
Average will always be in between.
During rising prices FIFO gives you the highest inventory valuation, LIFO the lowest. Average will always be in between.
* Rounded

32. Accounting Principles
Consistency Principle
Use same accounting methods from period to period
Switching from FIFO to LIFO or reverse could mean increase in net income
Disclosure Principle
Company should report enough information
For outsiders to make wise decisions about the co.
Should report
relevant, reliable, and comparable info.

33. Principles, continued. . . Materiality Concept Accounting Conservatism
A company must perform strictly proper account only for significant items
Information is material when it would cause someone to change a decision
Accounting Conservatism
Means exercising caution in reporting items in the financial statements
Anticipate no gains, but provide for all probable losses
If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount
When there’s a question, record an expense rather than an asset
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.

34. Fill in the blanks (higher/lower)
Using FIFO in times of rising prices will result in a _________ ending inventory value and _________ cost of goods sold, producing a ________ net income.
higher
lower
higher

35. Fill in the blanks (higher/lower)
Using LIFO in times of rising prices will result in a _________ ending inventory value and _________ cost of goods sold, producing a ________ net income.
lower
higher
lower

36. Apply the lower-of-cost-or market rule to inventory
Objective 3
Apply the lower-of-cost-or market rule to inventory

37. Lower-or-Cost-or-Market Rule
Example of Accounting Conservatism
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

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

39. E6-22 Dec 31 Cost of Goods Sold 1,000 Inventory 1,000 LCM adjustment
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Dec 31 Cost of Goods Sold 1,000
Inventory 1,000
LCM adjustment
Inventory
Cost of Goods Sold
When market value of inventory is below cost, you must decrease the inventory account. The corresponding debit increases cost of goods sold
14,000
72,000
1,000
1,000
Bal 13,000
Bal 73,000

40. E6-22 Eagle Resources Income Statement (partial)
For the Year Ended December 31, 2006
Sales revenue $118,000
Cost of goods sold 73,000
Gross profit $45,000

41. Measure the effects of inventory errors
Objective 4
Measure the effects of inventory errors

42. 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

43. 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 (Inventory and Income)
Hint: Remember, the two I’s are affected the same way
I – Inventory
I – Income

44. E6-25
Sales revenue $137,000 $120,000
Cost of Goods Sold
Beginning inventory $14,000 $12,000
Net purchases 72, ,000
Cost of goods available $86,000 $78,000
Ending inventory (16,000) (14,000)
Cost of goods sold 70, ,000
Gross profit $67,000 $56,000
Operating expenses 25, ,000
Net income $42,000 $36,000
$11,000
$83,000
(11,000)
67,000
67,000
$70,000
$53,000
$45,000
$33,000
Notice:
Net income for the two years combined is the same in both cases.
The error in 2006 counterbalances the error in 2005

45. Ethical Issues
How might companies try to mislead readers of financial statements by manipulating inventory?
Discuss some of the ways companies could try to mislead readers of the financial statements by manipulating inventory.
Check the internet for some examples like

46. Estimate ending inventory by the gross profit method
Objective 5
Estimate ending inventory by the gross profit method

47. Gross Profit Method
Estimate ending inventory by applying the gross profit ratio to net sales
Useful when inventory has been destroyed, lost, or stolen

48. Things to Remember Compute Gross Profit: Compute Gross Profit Percent:
Sales
- Cost of Goods Sold
Gross Profit
Compute Gross Profit Percent:
Gross Profit / Net Sales

49. Things to Remember Compute Cost of Goods Sold Beginning inventory
+ Purchases
- Purchases returns
+ Freight-in
Goods available for sale
- Ending inventory
Cost of goods sold

50. E6-26 Sales - Cost of Goods Sold Gross Profit 100% 60% 40% $1,000,000
400,000
600,000
????

51. E6-25 Beginning inventory $150,000 + Purchases 800,000
Goods available for sale $950,000
- Ending inventory
Cost of goods sold $400,000
550,000
????

52. Review of Chap 6 Quiz
The FIFO inventory costing method is consistent with the physical movement of inventory for most companies.
True—p. 315
In a period of increasing prices, FIFO produces lower cost of goods sold and higher gross profit than LIFO.
True
First out goods (cheaper) are leaving the store sooner than higher cost goods; cheaper the C of G sold, the higher gross profit

53. Quiz -continued
The specific unit cost method of inventory costing is recommended when a business deals in unique inventory items.
True
We used art gallery as example in discussion
The lower-of-cost-or-market rule demonstrates accounting conservatism in action.
P. 325—mentioned several times in class

54. Quiz -continued
Estimated ending inventory can be computed by subtracting estimated cost of goods sold from cost of goods available for sale.
True
See calculation-p. 328
Under which of the following inventory costing methods is the cost of goods sold based on the cost of the oldest purchases?
FIFO

55. Quiz -continued
Which of the following inventory costing methods yields the highest ending inventory when prices increase during the accounting period
First in first out
Which of the following requires that financial statement should report the least favorable figures?
Accounting conservatism

56. Which of the following is used for “market” when valuing inventory at lower of cost or market?
Current replacement price
Ending inventory for the current accounting period is overstated by $3,500. What will be the effect of this error?
Net Income for the current period will be overstated by $3,500

57. Quiz
Haley’s Florist Shop has the following account balances at the end of the current account period.
Beginning inventory $53,500
Net Purchases ,500
Net Sales Revenue ,700
A normal gross profit % is 30%. What is the estimated ending inventory as determined by gross profit?

58. Beginning inventory 53,500 +net purchases +75,500 =Cost of goods avail 129,000 -Cost of good sold (Sales-GrossProfit) 93,700 – 28,110 (30% of sales) -65,590 =Ending Inventory 63,410

59. End of Chapter 6