CHAPTER 6

INVENTORIES

Accounting Principles, Eighth Edition

Chapter 6-1

Reporting and Analyzing Inventory

Classifying Inventory

Determining Inventory Quantities

Taking a physical inventory Determining ownership of goods

Inventory Costing

Inventory Errors

Statement Presentation and Analysis

Presentation

Finished goods Work in process Raw materials

Specific identification Cost flow assumptions Financial statement and tax effects Consistent use

Income statement effects Balance sheet effects

Analysis

Chapter 6-2

Lower-ofcost-ormarket

Classifying Inventory
Merchandising Company
One Classification: Merchandise Inventory

Manufacturing Company
Three Classifications: Raw Materials

Work in Process
Finished Goods

Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
Chapter 6-3

Inventory Costing
Unit costs can be applied to quantities on hand using the following costing methods: Specific Identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Average-cost
Cost Flow Assumptions

Chapter 6-4

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing
Specific Identification Method
An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. Practice is relatively rare.

Most companies make assumptions (Cost Flow Assumptions) about which units were sold.

Chapter 6-5

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Cost Flow Assumptions

Cost Flow Assumption
does not need to equal

Physical Movement of Goods

Illustration 6-11 Use of cost flow methods in major U.S. companies
Chapter 6-6

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Cost Flow Assumptions

First-In-First-Out (FIFO)
Earliest goods purchased are first to be sold. Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units first.

Chapter 6-7

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Cost Flow Assumptions

Last-In-First-Out (LIFO)
Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of merchandise.

Exceptions include goods stored in piles, such as coal or hay.

Chapter 6-8

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Cost Flow Assumptions

Average-Cost
Allocates cost of goods available for sale on the basis of weighted average unit cost incurred. Assumes goods are similar in nature.

Applies weighted average unit cost to the units on hand to determine cost of the ending inventory.
Chapter 6-9

LO 2 Explain the accounting for inventories and apply the inventory cost flow methods.

Inventory Costing Cost Flow Assumptions

Comparative Financial Statement Summary
FIFO Average LIFO

Sales

$90

$90

$90

Cost of goods sold

Gross profit Admin. & selling expense

10
80 33

15
75 33

20
70 33

Income before taxes

Income tax expense Net income

47
14 $33

42
13 $29

37
11 $26

Inventory balance
Chapter 6-10

$35

$30

$25

LO 3 Explain the financial effects of the inventory cost flow assumptions.

Inventory Errors
Common Cause:
Failure to count or price inventory correctly.
Not properly recognizing the transfer of legal title to goods in transit. Errors affect both the income statement and balance sheet.

Chapter 6-11

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income. Illustration 6-16

Illustration 6-17

Chapter 6-12

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Income Statement Effects
Inventory errors affect the computation of cost of goods sold and net income in two periods.
An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period. Over the two years, the total net income is correct because the errors offset each other. The ending inventory depends entirely on the accuracy of taking and costing the inventory.
Chapter 6-13

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Illustration 6-18

2008 Incorrect $ 80,000 20,000 40,000 60,000 12,000 48,000 32,000 10,000 $ 22,000 Correct $ 80,000 20,000 40,000 60,000 15,000 45,000 35,000 10,000 $ 25,000

2009 Incorrect $ 90,000 12,000 68,000 80,000 23,000 57,000 33,000 20,000 $ 13,000 Correct $ 90,000 15,000 68,000 83,000 23,000 60,000 30,000 20,000 $ 10,000

Sales Beginning inventory Cost of goods purchased Cost of goods available Ending inventory Cost of good sold Gross profit Operating expenses Net income

Combined income for 2-year period is correct.

Chapter 6-14

($3,000) Net Income understated

$3,000 Net Income overstated

LO 5 Indicate the effects of inventory errors on the financial statements.

Inventory Errors
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:.
Illustration 6-16

Illustration 6-19

Chapter 6-15

LO 5 Indicate the effects of inventory errors on the financial statements.

Statement Presentation and Analysis

Inventory turnover measures the number of times on average the inventory is sold during the period. Inventory Turnover
=

Cost of Goods Sold Average Inventory

Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in = Inventory Inventory Turnover
Chapter 6-16

LO 6 Compute and interpret the inventory turnover ratio.

Statement Presentation and Analysis

BE6-9 At December 31, 2008, the following information was available for J. Graff Company: ending inventory $40,000, beginning inventory $60,000, cost of goods sold $270,000, and sales revenue $380,000. Calculate inventory turnover and days in inventory for J. Graff Company.

Inventory Turnover Days in Inventory

Chapter 6-17

$270,000 ($60,000 + 40,000) / 2 365 5.4

5.4

67.59 days

LO 6 Compute and interpret the inventory turnover ratio.