Merchandise Inventory

Chapter 6

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 Objective 1

Account for inventory by the FIFO,

LIFO, and average cost methods.

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 Inventory Costing Methods
• Specific Unit Cost
• FIFO
• LIFO
• Average Cost

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 Specific Unit Cost
• When units are sold, the specific cost of
the unit sold is added to cost of goods sold
First-In, First-Out (FIFO)

Oldest Cost of Goods

Costs Sold

Recent Ending
Costs Inventory
 First-In, First-Out (FIFO)
Then we sell 4 shirts for $20 each.
Beginning Inventory What costs should be assigned to
Cost of Goods Sold?

First-In, First-Out

Purchase 5 shirts

Inventory = $48 Cost of good sold = $42

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

Recent Cost of Goods

Costs Sold

Oldest Ending
Costs Inventory

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 Last-In, First-Out (LIFO)
Then we sell 4 shirts for $20 each.
Beginning Inventory What costs should be assigned to
Cost of Goods Sold?

Last-In, First-Out

Purchase 5 shirts

Inventory = $42 Cost of good sold = $48

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 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

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

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 Average Cost
The average cost of each unit in inventory
is assigned to cost of goods sold

Cost of Inventory Number of Units

on Hand ÷ on Hand = Average Cost

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 Average Cost
Then we sell 4 shirts for $20 each.
Beginning Inventory What costs should be assigned to
Cost of Goods Sold?

Compute the Average Cost

Units Cost
Beginning inventory 3 $30
Purchases 5 60
Total 8 $90

Average = $90/8 = $11.25

Purchase 5 shirts

Inventory = $11.25 x 4 = $45 Cost of good sold = $11.25 x 4 = $45

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 Average Cost
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

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

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 Objective 2

Compare the effects of FIFO,

LIFO, and average cost

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 Comparison

FIFO LIFO Average

Ending Inventory $48 $42 $45
Gross Profit $38 $32 $35

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 Advantage of Each Method
Weighted First-In, Last-In,
Average First-Out First-Out

Smoothes out Ending inventory Better matching of

price changes approximates current costs in
current cost of goods sold
replacement cost with revenues

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Use of Inventory Methods in
Practice

FIFO
LIFO 46%
31%

Avg
20%
Other
3%
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 Notice: We keep
Notice: This is not the
selling price, but the
E6-13 separate cost layers
as inventory is
cost of goods sold acquired

Per petual Inventor y Recor d

FIFO
ITEM:
Purchases Cost of Goods Sold Inventory on Hand
UNIT TOTAL UNIT TOTAL UNIT TOTAL
DATE QTY. COST COST QTY. COST COST QTY. COST COST
Nov 1 Bal. 5 $70 $350
6 3 $70 $210 2 70 140
8 10 $79 $790 2 70 140
10 79 790
17 2 $70 140
2 79 158 8 79 632
30 5 79 395 3 79 237
Total cost of goods sold for November = $903

Cost of ending inventory for November = $237

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 E6-14
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
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The last inventory costs
incurred are the first
inventory costs to be
assigned to cost of
E6-15
goods sold

Per petual Inventor y Recor d

LIFO
ITEM:
Purchases Cost of Goods Sold Inventory on Hand
UNIT TOTAL UNIT TOTAL UNIT TOTAL
DATE QTY. COST COST QTY. COST COST QTY. COST COST
Nov 1 Bal. 5 $70 $350
6 3 $70 $210 2 70 140
8 10 $79 $790 2 70 140
10 79 790
17 4 79 316 2 70 140
6 79 474
30 5 79 395 2 70 140
1 79 79
Total cost of goods sold for November = $921

Cost of ending inventory for November = $219

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 Every time the company purchases inventory,
E6-16
a new average price per unit is computed:
Total cost of goods available for sale
Total number of units available for sale

$140 + $790
P e r/p12
e tunits
u a l I=n $77.50
ventor y Recor d
Average Cost
ITEM:
Purchases Cost of Goods Sold Inventory on Hand
UNIT TOTAL UNIT TOTAL UNIT TOTAL
DATE QTY. COST COST QTY. COST COST QTY. COST COST
Nov 1 Bal. 5 $70.00 $350.00
6 3 $70.00 $210.00 2 70.00 140.00
8 10 $79 $790 12 77.50 930.00
17 4 77.50 310.00 8 77.50 620.00
30 5 77.50 387.50 3 77.50 232.50
Total cost of goods sold for November = $907.50

Cost of ending inventory for November = $232.50

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 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 $1,200 $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
* Rounded
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 Analysis of E6-13, 15, 16
How about the balance sheet?

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

* Rounded
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 Accounting Principles
• Consistency Principle
• Disclosure Principle
• Materiality Concept
• Accounting Conservatism

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

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 Disclosure Principle
• Report enough information for outsiders to
make wise decisions about the company

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 Materiality Concept
• A company must perform strictly proper
accounting only for significant items

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 Accounting Conservatism
• Exercise caution in reporting items in the
financial statements
• Report realistic figures

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

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 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

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

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When market value of inventory is
below cost, you must decrease the
inventory account. The
corresponding debit increases cost
E6-22
of goods sold
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

14,000 72,000
1,000 1,000

Bal 13,000 Bal 73,000

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 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

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 Objective 4

Measure the effects of inventory errors.

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 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

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 Hint: Remember, the
two I’s are affected the
Inventory Errors same way
I – Inventory
I – Income
• 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

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 E6-25
Whole Foods Grocery
Income Statements
Year Ended September 30, 2006 and 2005
2006 2005
Sales revenue $137,000 $120,000
Cost of Goods Sold
Beginning inventory $14,000
$11,000 $12,000
Net purchases 72,000 66,000
Cost of goods available $83,000
$86,000 $78,000
Ending inventory (16,000) (11,000)
(14,000)
Cost of goods sold 70,000
67,000 64,000
67,000
Gross profit $70,000
$67,000 $56,000
$53,000
Operating expenses 25,000 20,000
Net income $45,000
$42,000 $33,000
$36,000

Notice:
Net income for the two years combined is the same in both cases.
The error in 2006 counterbalances the error in 2005
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 Objective 5

Estimate ending inventory by the gross profit

method

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

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 Things to Remember
Compute Gross Profit:
Sales
- Cost of Goods Sold
Gross Profit

Compute Gross Profit Percent:

Gross Profit / Net Sales

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 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

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 E6-26
Sales 100%
- Cost of Goods Sold 60%
Gross Profit 40%

Sales $1,000,000
- Cost of Goods Sold ????
600,000
Gross Profit 400,000

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 E6-25
Beginning inventory $150,000
+ Purchases 800,000
Goods available for sale $950,000
- Ending inventory 350,000
????

Cost of goods sold $600,000

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End of Chapter 6

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