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CHAPTER 6
Inventories
MRes Uyen Nguyen

Learning Objective 1
Discuss How to Classify and Determine
Inventory
Copyright ©2019 John Wiley & Sons, Inc. 2

Classifying and Determining Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
• Merchandise • Raw Materials
Inventory • Work in Process
• Finished Goods
Helpful Hint
Regardless of the classification, companies report all inventories
under Current Assets on the statement of financial position.
Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted
raw materials, shoplifting, or employee theft.
Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

Taking a Physical Inventory
Involves counting, weighing, or measuring each kind
of inventory on hand.
Taken,
• when the business is closed or business is slow
• at the end of the accounting period

Determining Ownership of Goods (1 of 5)
Goods In Transit
• Purchased goods not yet received
• Sold goods not yet delivered
Goods in transit should be included in the inventory of
the company that has legal title to the goods.
Legal title is determined by the terms of sale.

Freight Costs (2 of 5)
Ownership of the goods Ownership of the goods

passes to the buyer when the remains with the seller until
public carrier accepts the the goods reach the buyer.
goods from the seller.

Review Question
Goods in transit should be included in the inventory of
the buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.

Consigned Goods
To hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of
the goods.
Many car, boat, and antique dealers sell goods on
consignment. Why?

Do It! 1: Rules of Ownership (1 of 2)
Deng Imports completed its inventory count. It arrived at a total
inventory value of ¥200,000. You have been given the
information listed below. Discuss how this information affects the
reported cost of inventory.
1. Deng included in the inventory goods held on consignment for
Falls Co., costing ¥15,000.
2. The company did not include in the count purchased goods of
¥10,000, which were in transit (terms: F O B shipping point).
3. The company did not include in the count inventory that had
been sold with a cost of ¥12,000, which was in transit (terms:
F O B shipping point).

Apply Inventory Cost Flow Methods
and Discuss Their Financial Effects

Inventory Methods and Financial Effects
Inventory is accounted for at cost.
• Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale
• Unit costs are applied to quantities to determine the
total cost of inventory and cost of goods sold using
the following costing methods:
§ Specific identification
§ Cost flow assumptions (First-in first-out and
Average-cost)

Specific Identification (1 of 3)
Illustration: Crivitz TV Company purchases three identical 50-
inch TVs on different dates at costs of £700, £750, and £800.
During the year Crivitz sold two sets at £1,200 each. These
facts are summarized below.
Purchases
February 3 1 TV at £700
March 5 1 TV at £750
May 22 1 TV at £800
Sales
June 1 2 TVs for £2,400 (£1,200 × 2)

If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is £1,520 (£720 + £800), and its
ending inventory is £750.
Cost of Goods Sold
Ending Inventory
£720
£750
£1,520
£800
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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
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Cost Flow Assumptions (1 of 6)
There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost
Cost flow does not need be consistent with the physical
movement of the goods.

Illustration: Data for Lin Electronics’ Astro condensers.
Date Explanation Units Unit Cost Total Cost

Jan. 1 Beginning inventory 10 HK$100 HK$1,000
Apr. 15 Purchase 20 110 2,200
Aug. 24 Purchase 30 120 3,600
Nov. 27 Purchase 40 130 5,200
Total units available for sale 100 HK$12,000
Units in ending inventory (45)
Units sold 55
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

First-In, First-Out (FIFO)
• Costs of earliest goods purchased are first to be
recognized in determining cost of goods sold
• Often parallels actual physical flow of merchandise
• Companies determine cost of ending inventory by
taking unit cost of most recent purchase and working
backward until all units of inventory have been costed

First-In, First-Out (FIFO) (1 of 2)
COST OF GOODS AVAILABLE FOR SALE
Apr. 15 Purchase 20 110 2,200
Aug. 24 Purchase 30 120 3,600
Nov. 27 Purchase 40 130 5,200
Total 100 HK$12,000
STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

Unit Total
Date Units Cost Cost
Nov. 27 40 HK$130 HK$5,200 Cost of goods available for sale HK$12,000
Aug. 24 5 120 600 Less : Ending inventory 5,800
Total 45 HK$5,800 Cost of goods sold HK$ 6,200

Average-Cost
• Allocates cost of goods available for sale on basis of
weighted-average unit cost incurred
• Applies weighted-average unit cost to units on hand
to determine cost of ending inventory

Average-Cost (1 of 2)
Apr. 15 Purchase 20 110 2,200
Aug. 24 Purchase 30 120 3,600
Nov. 27 Purchase 40 130 5,200
Total 100 HK$12,000

Unit Total
Units Cost Cost
HK$12,000 ÷ 100 = HK$120 Cost of goods available for sale HK$12,000
Cost of goods sold 5,400
45 HK$120 HK$5,400 Less : Ending inventory HK$ 6,600

Financial Statement and Tax Effects
of Cost Flow Methods
Either of the two cost flow assumptions is acceptable for
use.
• Lenovo (CHN) uses the average-cost method
• Yingli Solar (CHN) uses average-costing for key raw
materials and FIFO for the remainder of its inventories

Income Statement Effects
Lin Electronics
Condensed Income Statements
FIFO Average-Cost
Sales revenue HK$11,500 HK$11,500
Beginning inventory 1,000 1,000
Purchases 11,000 11,000
Cost of goods available for sale 12,000 12,000
Ending inventory 5,800 5,400
Cost of goods sold 6,200 6,600
Gross profit 5,300 4,900
Operating expenses 2,000 2,000
Income before income taxes 3,300 2,900
Income tax expense (30%) 990 870
Net income HK$ 2,310 HK$ 2,030

Statement of Financial Position Effects (1 of 2)
• A major advantage of the FIFO method is that in a
period of inflation, costs allocated to ending
inventory will approximate their current cost
• A shortcoming of the average-cost method is that in a
period of inflation, costs allocated to ending
inventory may be understated in terms of current
cost

Tax Effects
• Both inventory and net income are higher when
companies use FIFO in a period of inflation
• Average-cost results in lower income taxes (because
of lower net income) during times of rising prices

Using Inventory Cost Flow Methods
Consistently
• Method should be used consistently, enhances
comparability
• Although consistency is preferred, a company may
change its inventory costing method

The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method
b. LIFO method
c. average cost method
d. gross profit method

DO IT! 2: Cost Flow Methods
The accounting records of Shumway Implements show the
following data.
Beginning inventory 4,000 units at € 3
Purchases 6,000 units at € 4
Sales 7,000 units at €12
Determine the cost of goods sold during the period under a
periodic inventory system using (a) the FIFO method, and (b)
the average-cost method.

Indicate the Effects of Inventory Errors
on the Financial Statements

Effects of 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 the
statement of financial position

Income Statement Effects (1 of 5)
Inventory errors affect the computation of cost of goods sold
and net income in two periods.
Cost of Cost of
Beginning Ending
+ Goods - = Goods
Inventory Inventory
Purchased Sold
Cost of
When Inventory Error: Goods Sold Is: Net Income Is:
Understates beginning inventory Understated Overstated
Overstates beginning inventory Overstated Understated
Understates ending inventory Overstated Understated
Overstates ending inventory Understated Overstated

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

2019 2020
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income € 22,000 € 25,000 € 13,000 € 10,000
Combined income
for 2-year period is (€3,000) €3,000
correct. Understated Overstated

Understating ending inventory will overstate:
a. assets
b. cost of goods sold
c. net income
d. stockholders’ equity

Statement of Financial Position Effects (2 of 2)
Effect of inventory errors on the statement of financial
position is determined by using the basic accounting
equation: Assets = Liabilities + Equity.
Errors in the ending inventory have the following effects.
Ending
Inventory Error Assets Liabilities Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated

DO IT! 3: Inventory Errors
Visual Designs overstated its 2019 ending inventory by
NT$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and owner’s equity in 2019 and
2020.
Solution 2019 2020
Ending inventory NT$22,000 overstated No effect
Cost of goods sold NT$22,000 understated NT$22,000 overstated
Owner’s equity NT$22,000 overstated No effect

Explain the Statement Presentation
and Analysis of Inventory

Statement Presentation and Analysis (1 of 2)
Presentation
Statement of Financial Position - Inventory classified as
current asset.
Income Statement - Cost of goods sold subtracted from
sales.
There also should be disclosure of
1. major inventory classifications
2. basis of accounting (cost or LCNRV)
3. costing method (FIFO, or average-cost)
Lower-of-Cost-or-Net Realizable Value (1 of 2)
When the value of inventory is lower than its cost
• Companies must “write down” inventory to its net
realizable value
• Net realizable value: Amount that company expects
to realize (receive from the sale of inventory)
• Example of conservatism

Lower-of-Cost-or-Net Realizable Value (2 of 2)
Illustration: Assume that Gao TVs has the following lines of
merchandise with costs and net realizable values as indicated.
Net
Cost Realizable Lower-of-Cost-or-Net
Units per Unit Value per Unit Realizable Value
Flat-screen TVs 100 NT$600 NT$550 NT$ 55,000 (NT$550 x 100)
Satellite radios 500 90 104 45,000 (NT$90 x 500)
DVD recorders 850 50 48 40,800 (NT$48 x 850)
DVDs 3,000 5 6 15,000 (NT$5 x 3,000)
Total inventory NT$155,800

Statement Presentation and Analysis (2 of 2)
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying
costs (e.g., investment, storage, insurance,
obsolescence, and damage).
2. Low Inventory Levels – may lead to stock-outs and
lost sales.

Analysis (1 of 2)
Inventory turnover measures the number of times on
average the inventory is sold during the period.
Cost of Goods Sold
Inventory
=
Turnover Average Inventory
Days in inventory measures the average number of

days inventory is held.
Days in Year (365)
Days in
=
Inventory Inventory Turnover
Analysis (2 of 2)
Illustration: Esprit Holdings (HKG) reported in a recent annual
report a beginning inventory of HK$3,209 million, an ending
inventory of HK$3,254 million, and cost of goods sold for the year
ended of HK$12,071 million. Illustration 6.16 shows the inventory
turnover formula and computation for Esprit Holdings.
Cost of
÷ Average Inventory = Inventory Turnover
Goods Sold
HK$3,209 + HK$3,254
HK$12,071 ÷ = 3.7 Times
2
365 ÷ 3.7 = 98.6 Days

DO IT! 4: LCNRV and Inventory Turnover
Poon Heaters sells three different types of home heating stoves
(gas, wood, and pellet). The cost and net realizable value of its
inventory of stoves are as follows.
Cost Net Realizable Value
Gas NT$ 84,000 NT$ 79,000
Wood 250,000 280,000
Pellet 112,000 101,000
Determine the value of the company’s inventory under the lower-
of-cost-or-net realizable value approach.
Solution: The lowest value for each inventory type is gas
NT$79,000, wood NT$250,000, and pellet NT$101,000. The total
inventory value is the sum of these amounts, NT$430,000.
DO IT! 4: Inventory Turnover (1 of 2)
Early in 2020, Westmoreland Company switched to a just-in-time
inventory system. Its sales revenue, cost of goods sold, and
inventory amounts for 2019 and 2020 are shown below.
2019 2020
Sales revenue NT$2,000,000 NT$1,800,000
Cost of goods sold 1,000,000 910,000
Determine the inventory turnover and days in inventory for 2019
and 2020.

DO IT! 4: Inventory Turnover (2 of 2)
2019 2020
Sales revenue NT$2,000,000 NT$1,800,000
Cost of goods sold 1,000,000 910,000
2019 2020
Inventory
turnover NT$1,000,000 NT$910,000 =7
=4
(NT$290,000 + NT$210,000)/2 (NT$210,000 + NT$50,000)/2
Days in 365 ÷ 4 = 91.3 Days 365 ÷ 7 = 52.1 Days
inventory

Apply the Inventory Cost Flow Methods
to Perpetual Inventory Records

Appendix 6A Inventory Cost Flow Methods in
Perpetual Inventory Systems
LIN ELECTRONICS
Balance
Date Explanation Units Unit Cost Total Cost in Units
1/1 Beginning inventory 10 $100 HK$ 1,000 10
4/15 Purchase 20 110 2,200 30
8/24 Purchase 30 120 3,600 60
9/10 Sale 55 5
11/27 Purchase 40 130 5,200 45
HK$12,000
Illustration: Compute Cost of Goods Sold and Ending Inventory under

FIFO and average-cost.

First-In, First-Out (FIFO) (2 of 2)
Cost of
Date Purchases Goods Sold Inventory Balance
January 1 (10 @ HK$100) HK$1,000
April 15 (20 @ $110) HK$2,200 (10 @ HK$100)
HK$3,200
(20 @ HK$110)
August 24 (30 @ $120) HK$3,600 (10 @ HK$100)
(20 @ HK$110) HK$6,800
(30 @ HK$120)
September 10 (10 @ HK$100)
(20 @ HK$110)
(25 @ HK$120) (5 @ HK$120) HK$600
HK$6,200
November 27 (40 @ $13) HK$5,200 (5 @ HK$120)
HK$5,800
(40 @ HK$130)

Average-Cost (2 of 2)
Cost of
Date Purchases Goods Sold Inventory Balance
January 1 (10 @ HK$100) HK$ 1,000
April 15 (20 @ HK$110) HK$2,200 (30 @ HK$106.667) HK$ 3,200
August 24 (30 @ HK$120) HK$3,600 (60 @ HK$113.333) HK$ 6,800
September 10 (55 @ HK$113.333) (5 @ HK$113.333) HK$ 567
HK$6,233
November 27 (40 @ HK$130) HK$5,200 (45 @ HK$128.156) HK$5,767

Describe the Two Methods of
Estimating Inventories

Appendix 6B Estimating Inventories
Gross Profit Method
A method of estimating the cost of ending inventory by
applying a gross profit rate to net sales.
Estimated Estimated
Step 1: Net Sales - Gross = Cost of
Profit Goods Sold
Cost of Goods Estimated Estimated

Step 2: - Cost of = Cost of
Available
for Sale Goods Sold Ending Inventory

Gross Profit Method (1 of 2)
Illustration: Kishwaukee Company records show net sales of
$200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. In the preceding year, the company
realized a 30% gross profit rate. It expects to earn the same
rate this year. Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.

Gross Profit Method (2 of 2)
Illustration: Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Step 1:
Net sales $200,000
Less: Estimated gross profit (30% × $200,000) 60,000
Estimated cost of goods sold $140,000
Step 2:
Beginning inventory $ 40,000
Cost of goods purchased 120,000
Cost of goods available for sale 160,000
Less: Estimated cost of goods sold 140,000
Estimated cost of ending inventory $ 20,000
Retail Inventory Method (1 of 2)
• Retail companies establish a relationship between cost
and sales price
• Applies cost-to-retail percentage to ending inventory at
retail prices to determine inventory at cost
Goods Available Ending Inventory

Step 1: - Net Sales =
for Sale at Retail at Retail
Step 2: Goods Available Goods Available Cost-to-

÷ =
for Sale at Cost for Sale at Retail Retail Ratio
Step 3: Ending Cost-to- Estimated Cost of

x =
Inventory at Retail Retail Ratio Ending Inventory

Retail Inventory Method (2 of 2)
Illustration: It is not necessary to take a physical inventory to
determine the estimated cost of goods on hand.
At Cost At Retail
Beginning inventory $14,000 $ 21,500
Goods purchased 61,000 78,500
Goods available for sale $75,000 100,000
Less: Net sales 70,000
Step (1) Ending inventory at retail = $ 30,000
Step (2) Cost-to-retail ratio = $75,000 ÷ $100,000 = 75%
Step (3) Estimated cost of ending inventory = $30,000 x 75% = $22,500

Apply the LIFO Inventory Costing
Method

Cost Flow Assumptions
Last-In, First-Out (LIFO)
• Costs of latest goods purchased are first to be
recognized in determining cost of goods sold
• Seldom coincides with actual physical flow of
merchandise
• Exceptions include goods stored in piles, such as coal
or hay

Last-In, First-Out (LIFO)
Jan. 1 Beginning inventory 100 HK$10 $1,000
Apr. 15 Purchase 200 11 2,200
Aug. 24 Purchase 300 12 3,600
Nov. 27 Purchase 400 13 5,200
Total 1,000 HK$12,000

Unit Total
Date Units Cost Cost
Jan. 1 100 HK$10 HK$1,000 Cost of goods available for sale HK$12,000
Apr. 15 200 11 2,200 Less : Ending inventory 5,000
Aug. 24 150 12 1,800 Cost of goods sold HK$ 7,000
Total 450 HK$5,000

Compare the Accounting for
Inventories Under IFRS and U.S. GAAP

A Look at U.S. GAAP (1 of 4)
Key Points
Similarities
• The definitions for inventory are essentially similar under GAAP and
IFRS. Both define inventory as assets held-for-sale in the ordinary
course of business, in the process of production for sale (work in
process), or to be consumed in the production of goods or services
(e.g., raw materials).
• Who owns the goods—goods in transit or consigned goods—as well
as the costs to include in inventory are essentially accounted for the
same under IFRS and GAAP.
• Except for LIFO under GAAP, both IFRS and GAAP use the lower-of-
cost-or-net realizable value for inventory valuation.

Key Points
Differences
• Both GAAP and IFRS permit specific identification where appropriate.
IFRS actually requires that the specific identification method be used
where the inventory items are not interchangeable (i.e., can be
specifically identified). If the inventory items are not specifically
identifiable, a cost flow assumption is used. GAAP does not specify
situations in which specific identification must be used.
• A major difference between IFRS and GAAP relates to the LIFO cost
flow assumption. GAAP permits the use of LIFO for inventory
valuation. IFRS prohibits its use. FIFO and average-cost are the only
two acceptable cost flow assumptions permitted under IFRS.

Key Points
Differences
• IFRS generally requires pre-harvest inventories of agricultural
products (e.g., growing crops and farm animals) to be reported at fair
value less cost of disposal. GAAP generally requires these items to be
recorded at cost.

Looking to the Future
One convergence issue that will be difficult to resolve relates to the use
of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits
its use. Conversely, the LIFO cost flow assumption is widely used in the
United States because of its favorable tax advantages. In addition, many
argue that LIFO from a financial reporting point of view provides a better
matching of current costs against revenue and, therefore, enables
companies to compute a more realistic income.

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CHAPTER 6

MRes Uyen Nguyen

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Ownership of the goods Ownership of the goods

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Date Explanation Units Unit Cost Total Cost

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STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

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STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD

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Days in inventory measures the average number of

365 ÷ 3.7 = 98.6 Days

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Illustration: Compute Cost of Goods Sold and Ending Inventory under

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Cost of Goods Estimated Estimated

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Goods Available Ending Inventory

Step 2: Goods Available Goods Available Cost-to-