CHAPTER 6 … Merchandise Inventory

Chapter Introduction

A. Companies determine the number of units sold and the units in inventory from perpetual inventory records. (Exhibit 6-1 shows the financial statements and how inventory appears on the balance sheet and cost of goods sold appears on the income statement.)

1. Ending inventory = number of units on hand x unit cost

2. Cost of goods sold = number of units sold x unit cost

B. The perpetual inventory record maintains a continuous record for each inventory item. The quantity of the inventory on hand is updated whenever inventory is purchased or sold. (See Exhibit 6-2)

C. The four costing methods allowed by GAAP are specific unit cost; average cost ; first-in, first-out (FIFO); and last-in, first-out (LIFO). Exhibit 6-3 compares the cost flows of the three most popular methods.

1. The specific unit cost (specific identification) method assigns a specific invoice cost to each item in the inventory. This method can be used for items that differ from unit to unit, such as real estate and automobiles but is seldom used in practice.

2. The average cost method assigns an average cost to the units on hand and sold.

3. Under the first-in, first-out (FIFO) cost method, the oldest costs are assigned to cost of goods sold.

4. Under the last-in, first-out (LIFO) cost method, the most recent costs are assigned to cost of goods sold.

Objective 1: Account for inventory using FIFO, LIFO, and average cost.

A. Under FIFO, cost of goods sold comes from the first costs incurred each period. FIFO is consistent with the physical flow of goods.

1. FIFO leaves in ending inventory the most recent costs incurred during the period.

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2. See Exhibit 6-4 for an illustration of a perpetual inventory record and the related journal entries.

B. Under LIFO, the cost of goods sold recorded always comes from the last costs incurred each period. LIFO is favored by many companies because it often results in the highest cost of goods sold and the lowest income tax.

1. LIFO leaves in ending inventory the oldest costs of the period.

2. See Exhibit 6-5 for an illustration of a perpetual inventory record and the related journal entries.

C. Under average costing, a new unit cost is computed after each purchase. This unit price is applied to the number of units sold.

1. The ending inventory is the number of units multiplied by this average cost.

2. See Exhibit 6-6 for an illustration of a perpetual inventory record and the related journal entries.

Objective2: Compare the effects of FIFO, LIFO, and average cost

A. FIFO is the most popular method, followed by LIFO, and then average cost. (Exhibit 6-7)

B. During a period of rising prices, FIFO produces the lowest cost of goods sold, the highest gross profit, and highest net income. Higher net income may help companies to attract investors and to borrow on favorable terms. (Refer to Exhibit 6-8)

C. During a period of rising prices, LIFO results in the highest cost of goods sold, the lowest gross profit, and the lowest net income. Lower income results in lower taxes and higher cash flow.

D. Average cost results fall between LIFO and FIFO.

E. Several accounting principles relate to inventories:

1. The consistency principle requires businesses to use the same accounting methods and procedures from period to period. Inventory methods can be changed, but the change and the effect of the change must be disclosed.

2. The disclosure principle requires companies to report enough information for outsiders to make knowledgeable decisions. Information should be relevant, reliable, and comparable. Inventory methods must be disclosed.

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3. The materiality concept states that a company must adhere to GAAP only for items and transactions that are significant to the business’s financial statements. Information is significant or material when its presentation in the financial statements would cause someone to change a decision.

4. Conservatism in accounting means reporting items in the financial statements at amounts that lead to the most cautious immediate results. Some guidelines are:

a. Do not anticipate gains, but provide for all probable losses.

b. If in doubt, record an asset at the lowest reasonable amount and a liability at the highest possible amount.

c. When there’s a question, record an expense rather than an asset.

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

A. Inventory should be reported at the lower-of-cost-or-market (LCM); that is, the lower of its historical cost or its current replacement cost. This is an example of accounting conservatism.

B. When inventory is written down to market, then cost of goods sold increases to reflect the loss in value as illustrated by the following entry:

Cost of Goods Sold XXInventory XX

Objective 4: Determine the effects of inventory errors

A. Errors in ending inventory affect not only the balance of inventory but also cost of goods sold, gross profit, and net income in the period that the error occurs (period 1). (Exhibit 6-9 is an example of an inventory error. Exhibit 6-10 summarizes the effects of an error on two periods.)

B. Inventory errors reverse (or counterbalance) in period 2 and have the opposite effect on cost of goods sold, gross profit, and net income.

C. Unethical managers can overstate ending inventory or report dubious sales in order to overstate net income.

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Objective 5: Estimate ending inventory by the gross profit method

A. The gross profit method of estimating inventory is based on the cost of goods sold computation . That computation can be rearranged to solve for the ending inventory.

Cost of Goods SoldBeginning inventory XX

+ Purchases XX = Cost of goods available for saleXX- Ending inventory (XX)= Cost of goods sold XX

Computation ofEstimated Ending Inventory

Beginning inventory XX+ Purchases XX = Cost of goods available for sale XX - Cost of goods sold (estimated) (XX)=Ending inventory (estimated) XX

B. The cost of goods sold (above) is estimated using the following formula (Exhibit 6-11):

Net sales revenue (Sales revenue less returns, allowances, and discounts)- Estimated gross profit (Sales revenue x gross profit rate) = Estimated cost of goods sold

C. Decision Guidelines summarize various aspects of inventory such as which inventory system to use, which inventory method to use, and how to estimate the ending inventory.

APPENDIX: Accounting for inventory in a periodic inventory system

A. In the periodic inventory system, the business does not keep a daily running record of the inventory on hand. A physical count of the quantity of inventory is made at the end of the year.

B. Cost of goods sold is computed by using this formula.

Beginning inventory (the inventory on hand at the end of the preceding period)+ Net purchases (often abbreviated as Purchases)*= Cost of goods available for sale- Ending inventory (the inventory on hand at the end of the current period)= Cost of goods sold

C. Net purchases is determined by using this formula:

Purchases- Purchase discounts

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- Purchase returns and allowances+ Transportation-in= Net purchases

D. In the periodic system, the purchase of inventory is recorded in an account called Purchases instead of the Inventory account.

E. Journal entries, T-accounts, and financial statement presentation of both the perpetual and periodic system are illustrated in Exhibit 6 A-1.

1. The purchase of inventory is recorded as follows:

Perpetual PeriodicInventory XX Purchases XX

Accounts Payable XX Accounts Payable XX

2. The sale of inventory only requires one entry under periodic system but two under the perpetual:

Perpetual PeriodicAccounts Receivable XX Accounts Receivable XX

Sales Revenue XX Sales Revenue XX

Cost of Goods Sold XXInventory XX

3. At the end of the period, Inventory must be updated and Cost of Goods Sold recorded under the periodic system. No entries are required under the perpetual system.

Perpetual PeriodicCost of Goods Sold XX

Inventory (beg.) XX

Inventory (end.) XXCost of Goods Sold XX

Cost of Goods Sold XXPurchases XX

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