1. 7
C H A P T E R
Inventory

2. Learning Objective 1
Identify what items and costs should be included in inventory and cost of goods sold.

3. Define Inventory and COGS. What are some of their characteristics?
Inventory is reported on balance sheet as an asset.
When sold, inventory is reported on income statement as an expense (cost of goods sold).
COGS: the cost of inventory sold during the period.
Goods either manufactured or purchased for resale.

4. Describe the Time Line of Business.
BUY
raw materials or goods for resale
ADD
value
SELL
finished inventory
COMPUTE
cost of goods sold
ending inventory

5. Defined according to type and nature of the company.
What is Inventory?
Defined according to type and nature of the company.
Merchandising:
Items to be resold.
For a supermarket, food is inventory, the shopping cart is not.
Manufacturing:
raw materials
work in process
finished goods

6. Define Each Manufacturing Inventory
Raw materials
Goods acquired in a relatively undeveloped state.
Eventually will compose a major part of the finished product.
Work in process
Partly finished products.
Manufacturing plant contains work- in-process inventory.
Finished goods
Completed products waiting for sale.

7. What Costs are Included in Inventory?
Costs incurred in buying inventory and preparing it for sale.
Cost of raw materials.
Cost of work-in-process inventory.
Cost of finished goods.
Costs NOT included in inventory costs:
sales effort
general non-factory administrative costs

8. Who Owns the Inventory? When goods are in transit?
Q: Who owns the inventory on a truck or railroad car?
A: The party who is paying the shipping costs.
When goods are on consignment?
Q: Who owns inventory stocked in a warehouse?
A: The supplier until the inventory is sold. The warehouse owner stocks and sells the inventory and receives a commission on sales as payment for services rendered.

9. Ending Inventory & COGS
Cost of goods available for sale
Beginning inventory
Net purchases = +
The question is where is the inventory that could have been sold this period? Only two choices:
At period’s end, is allocated between
inventory still remaining (an asset), and
inventory sold during the period (an expense, Cost of Goods Sold).

10. Learning Objective 2
Account for inventory purchases and sales using both a perpetual and a periodic inventory system.

11. What are the Two Methods for Accounting for Inventory?
Perpetual
Records are updated when a purchase or sale is made.
Records reflect total items in inventory or sold at any given time.
Most often used when
each item has a relatively high value, or
the cost of running out of or overstocking an item is expensive.
Periodic
Records are not updated when a purchase or a sale is made.
Only the dollar amount of the sale is recorded.
Used when
inventory is composed of a large number of diverse items,
each with a relatively low value.

12. Example: Accounting for Inventory Purchases and Sales
Harper’s Hats recorded the following transactions for 2001:
Beginning inventory 10 $10 each = $100
March 1 Purchase 15 $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 $15 each = $ 45
May 2 Purchase 10 $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats $10, $15)
July 3 Sales return 1 $15 = $ 15
Ending inventory 13 hats 18

13. Example: 2001 Inventory Purchase Sale Balance `
Date Units Total Units Total Units Cost Total
Jan $10 $100
Mar $ $10 $ $15 $225 (3) ($45) 12 $15 $180
May 2 10 $ $10 $ $15 $ $20 $200
June $ $ $15 $ $20 $200
July 3 (1) ($15) 3 $15 $ $20 $200 19

14. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
All purchases are added directly to the inventory account.
Periodic
At end of period,
Inventory balance is updated using inventory count.
Temporary purchases account balance is closed to Inventory to compute COGS.

15. Example: Journal Entries for Purchases
Harper purchased 10 hats at $10 each on January 1. Record the entries for both the perpetual and the periodic systems.
Jan. 1 Inventory
Accounts Payable
Purchased 10 $10.
PERPETUAL
Jan. 1 Purchases
Accounts Payable
Purchased 10 $10.
PERIODIC 22

16. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
All costs are added directly to the inventory balance.
Periodic
At end of period, temporary freight in account balance is closed to Inventory to compute COGS.

17. Example: Journal Entries for Transportation Cost
Harper hired a trucking company to deliver its March 1 purchase of 15 hats. The trucking company charged $10. Record the entries for both the perpetual and the periodic systems.
Mar. 1 Inventory
Cash
Delivery charge on 15 hats.
PERPETUAL
Mar. 1 Freight In
Cash
Delivery charge on 15 hats.
PERIODIC 22

18. Perpetual & Periodic Journal Entries
Inventory is decreased.
Accounts Payable is decreased by same amount.
Periodic
If merchandise has been paid for, the supplier will reimburse (debit Cash).
At end of period, temporary purchase returns account balance is closed to Inventory to compute COGS.
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS

19. Example: Journal Entries for Purchase Returns
Of the 15 hats delivered on March 1, three were defective and Harper returned them the same day. Record the entries for both the perpetual and the periodic inventory systems.
Mar. 1 Accounts Payable (or Cash) 45
Inventory
Returned 3 $15.
PERPETUAL
Mar. 1 Accounts Payable (or Cash) 45
Purchase Returns
Returned 3 $15.
PERIODIC 22

20. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Subtract the discount amount from the inventory account.
Periodic
At end of period, temporary purchase discounts account balance is closed to Inventory to compute COGS.

21. Example: Journal Entries for Purchase Discounts
On May 2, Harper purchased 10 hats at $20 each. The supplier offered terms of 2/10, n/30. Record the entries for both the perpetual and the periodic inventory systems.
May 2 Accounts Payable (or Cash) 200
Inventory
Cash
Purchase discount on 10 hats.
PERPETUAL
May 2 Accounts Payable (or Cash) 200
Purchase Discounts
Cash
Purchase discount on 10 hats.
PERIODIC 22

22. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Perpetual
All adjustments are entered directly in the Inventory account.
Periodic
All adjustments are accumulated in an array of temporary holding accounts:
Purchases
Freight In
Purchase Returns
Purchase Discounts
The difference in terms of journal entries:

23. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Recognize sales and COGS on a transaction-by-transaction basis.
Periodic
Only total sales are known.

24. Example: Journal Entries for Sales
In June, Harper’s Hats sold 20 hats for $25 each (selling the old ones first). Record the entries for both the perpetual and the periodic systems.
Jun. 30 Accounts Receivable (or Cash) 500
Sales
Sold 20 $25.
Jun. 30 Cost of Goods Sold
Inventory $10; $15) 250
Record cost of goods sold.
PERPETUAL
Jun. 30 Accounts Receivable (or Cash) 500
Sales
Sold 20 $25.
No entry.
PERIODIC 22

25. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
Sales for returned items are canceled.
Cost of returned inventory is removed from COGS and restored to the inventory account.
Periodic
Sales for returned items are canceled.
No entry is made to adjust COGS.

26. Example: Journal Entries for Sales Returns
On July 3, one hat was returned from a late June purchase. Record the entries for both the perpetual and the periodic inventory systems.
Jul. 3 Sales Returns
Accounts Receivable
1 hat returned from June purchase.
Jul. 3 Inventory
Cost of Goods sold
Placed returned hat back into inventory.
PERPETUAL
Jul. 3 Sales Returns
Accounts Receivable
1 hat returned from June purchase.
No entry.
PERIODIC 22

27. Perpetual & Periodic Journal Entries
Purchases
Transportation costs
Purchase returns
Purchase discounts
Sales
Sales returns
Closing entries for COGS
Perpetual
All journal entries are posted to the ledger.
Results in new balances for Inventory and COGS.
Numbers are verified by physical count.
Periodic
Temporary holding accounts are accumulated and added to Inventory.
Inventory account balance is reduced by the amount of COGS.

28. Example: Accounting for Inventory Purchases and Sales
Harper’s Hats recorded the following transactions for 2001:
Beginning inventory 10 $10 each = $100
March 1 Purchase 15 $15 each = $225
March 1 Freight in $10
March 1 Purchase return 3 $15 each = $ 45
May 2 Purchase 10 $20 each = $200
May 2 Purchase discount 2/10, n/30
June 30 Sales 20 hats $10, $15)
July 3 Sales return 1 $15 = $ 15
Ending inventory 13 hats 18

29. Example: Closing Entries for Cost of Goods Sold
Perpetual: the inventory account will have an ending balance of $255.
Inventory
COGS
1/1 100
3/ /1 45
3/1 10
5/2 200
6/30 250
7/3 15
Bal. 255
6/30 250
7/3 15
Bal. 235

30. Example: Closing Entries for Cost of Goods Sold
Periodic: the inventory account will be debited by $386, which represents the net purchases for the year.
Jul. 31 Inventory
Purchase Returns
Purchase Discounts
Freight In
Purchases

31. Periodic Inventory
With a periodic system, a physical count is the only way to get the information necessary to compute COGS:
Beginning Inventory, January 1, 2001
+ Purchases for the year
= Cost of goods available for sale during 2001
– Ending Inventory, December 31, 2001
= Cost of Goods Sold for 2001 30

32. Learning Objective 3
Calculate cost of goods sold using the results of an inventory count and understand the impact of errors in ending inventory on reported cost of goods sold.

33. Physical Count of Inventory
Essential to maintaining reliable inventory accounting records.
Perpetual
Physical count either confirms records are accurate or highlights shortages and clerical errors.
Periodic
The only way to get information necessary to compute COGS:
Quantity count.
Inventory costing (assigning a unit cost to each type of merchandise).
Ending inventory = quantity of each type x its unit cost.

34. COGS Computation Periodic Perpetual
The accounting records yield the COGS for the period as well as the amount of inventory that should be found with a physical count.
The difference between the records and actual count = inventory lost, stolen, or spoiled.
Periodic
Company does not know what ending inventory should be.
Assumes physical count is the difference between cost of goods available for sale and ending inventory.
Cannot tell whether goods were sold, lost, stolen, or spoiled.

35. What is the Income Effect of an Error in Ending Inventory?
An error in inventory results in COGS being overstated or understated.
The inventory error has the opposite effect on gross margin and net income.
Any uncorrected error will affect the financial statements for two years. 8

36. Effects of Inventory Errors
Understate Ending Inventory
Sales OK
Beginning inventory OK
Net purchases OK
Goods available OK
Ending inventory LOW
Cost of goods sold HIGH
Gross margin LOW
Expenses OK
Net income LOW
Understate
Purchases
Beginning
Inventory
Understate Sales OK
LOW
HIGH OK
LOW
HIGH
LOW OK 12

37. Learning Objective 4
Apply the four inventory cost flow alternatives: specific identification, FIFO, LIFO, and average cost.

38. Inventory Cost Flow
Kernel King buys and sells corn and had the following transactions for 2002:
June 10 Purchased 10 tons at $6 per ton.
July 28 Purchased 10 tons at $9 per ton.
October 10 Sold 10 tons at $11 per ton.
How much did Kernel King make in 2002?
Case #1 Case #2 Case #3
Sold Sold Sold
Old Corn New Corn Mixed Corn
Sales ($11 x 10 tons) $110 $110 $110
COGS (10 tons)
Gross margin $ 50 $ $ 35

39. Specific Identification Cost Flow
Specifically identify the cost of each unit sold.
The individual cost of each unit is charged against revenue as COGS.
To compute COGS and ending inventory, a firm must know each unit sold and its cost.

40. Inventory Cost Flow Methods
FIFO
The oldest units are sold and the newest units remain in inventory.
The cost of the oldest units purchased is transferred to COGS.
LIFO
The newest units are sold and the oldest units remain in inventory.
The cost of the most recent units purchased is transferred to COGS.
Average Cost
An average cost is computed for all inventory available for sale during the period.
COGS is computed by multiplying the number of units sold by the average cost per unit.

41. Comparison of Inventory Methods
LIFO gives a better reflection of COGS in the income statement.
Therefore, LIFO is a better measure of income.
FIFO gives a better measure of inventory on the balance sheet.
Therefore, FIFO is a better measure of inventory value.

42. Learning Objective 5
Use financial ratios to evaluate a company’s inventory level.

43. Why Use JIT Inventory Management?
Money tied up in inventory cannot be used for other purposes.
JIT attempts to have exactly enough inventory arrive “just in time” for sale.
Its purpose is to minimize investment in inventories while at the same time having enough inventory on hand to meet customer demand.

44. Evaluating Inventory Levels
Cost of goods sold
Average inventory
Inventory Turnover
Measures how many times a company turns over (or replenishes) its inventory.
Average inventory = average of the beginning and ending inventory balances.
Number of Days’ Sales in Inventory
365 days
Inventory turnover 58

45. Example: Evaluating Inventory Management
Buster Boots had cost of goods sold of $60,000 during The inventory account decreased by $1,000 to $4,000 during the same time. Calculate the inventory turnover ratio and number of days’ sales in inventory.
Cost of goods sold
Average inventory =
$60,000
$4,500
13.33
Inventory turnover ratio
Number of days’ sales in inventory
365 days
Inventory turnover =
365
13.33
27.38 22

46. Expanded Material Learning Objective 6
Analyze the impact of inventory errors on reported cost of goods sold.

47. What Is the Effect of These Inventory Errors?
If a sale is recorded but the merchandise remains in inventory and is counted in ending inventory,
> COGS Ô understated
> gross margin Ô overstated
> net income Ô overstated
If a sale is not recorded, but inventory is shipped and not counted in ending inventory,
> COGS Ô overstated
> gross margin Ô understated
> net income Ô understated

48. Expanded Material Learning Objective 7
Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system.

49. Using Average Cost or LIFO with a Perpetual System
Using average cost or LIFO with perpetual leads to complications.
The average cost of units available for sale changes every time a purchase is made.
The identification of the “last in” units also changes with every purchase.
With periodic,
One overall average cost is used for all goods available for sale during the period.
The “last in” units are identified at the end of the period.

50. Describe the Similarities of Using FIFO for Perpetual and Periodic Systems.
No complications arise as no matter when sales occur, the “first in” units are always the same in both systems.
FIFO periodic and FIFO perpetual yield the same numbers for COGS and ending inventory.

51. Expanded Material Learning Objective 8
Apply the lower-of-cost-or-market method of accounting for inventory.

52. When Do You Report Inventory Below Cost?
All inventory costing alternatives report inventory at cost.
Inventory is reported at less than cost when:
the future value of the inventory is in doubt (damaged, used, or obsolete), or
it can be replaced new at a price less than the original cost.

53. When Do You Report Inventory at Net Realizable Value (NRV)?
When inventory is damaged, used, or obsolete, it should be reported at no more than its net realizable value (the amount it can be sold for, less any selling costs).
NRV should be recognized as soon as a firm determines that an economic loss has occurred.
Loss is recognized when inventory is written down, not when inventory is finally sold.
Therefore, assets are not being reported at more than their future economic benefit.

54. Lower of Cost or Market (LCM)
Ceiling: the maximum market amount at which inventory can be carried on the books; equal to net realizable value (selling price less estimated selling costs).
LCM: A basis for valuing inventory at the lower of original cost or current market value.
Floor: the minimum market amount at which inventory can be carried on the books; equal to net realizable value less a normal profit.

55. Example: LCM
Market
Inventory Replacement NRV
Item Cost Floor Cost Ceiling A B C D
Define market value as:
replacement cost, if it falls between the ceiling and the floor.
the floor, if the replacement cost is less than the floor.
the ceiling, if the replacement cost is higher than the ceiling.
When replacement cost, ceiling, and floor are compared, market is always the middle value.
Compare the defined market value with the original cost and choose the lower amount.
110

56. Expanded Material Learning Objective 9
Explain the gross margin method of estimating inventories.

57. Gross Margin Method beginning inventory purchases
There are times when a physical count of inventory is either impossible or impractical.
If perpetual is used, the inventory account balance is assumed to be correct.
If periodic is used, an estimate of the inventory balance must be made.
Gross margin method.
COGS and ending inventory are estimated using available information:
beginning inventory
purchases
historical gross margin percentage