CH 06

Chapter 6
Inventories
Chapter Outline
Learning Objectives
LO 1 Discuss how to classify and determine inventory.
LO 2 Apply inventory cost flow methods and discuss
their financial effects.
LO 3 Indicate the effects of inventory errors on the
financial statements.
LO 4 Explain the statement presentation and analysis of
inventory.
Copyright ©2019 John Wiley & Son, Inc. 3

Classifying and Determining Inventory
Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
• Inventory • Raw Materials
• Work in Process
• Finished Goods
LO 1 Copyright ©2019 John Wiley & Son, Inc. 4

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
3. Determine the inventory on hand.
4. Determine the cost of goods sold for the period.

Taking a Physical Inventory
Involves counting, weighing, or measuring each kind
of inventory on hand.
Companies often “take inventory”
when business is closed or business is slow
at the end of accounting period

Determining Ownership of Goods
Goods in Transit
Purchased goods not yet received
Sold goods not yet delivered
Included in inventory of company that has legal title
to goods

Goods in Transit
Ownership of goods
passes to buyer when
public carrier accepts
goods from seller.
Ownership of goods
remains with seller until
the goods reach buyer.
ILLUSTRATION 6.2
Terms of sale
Freight costs incurred by the seller are an operating expense.

Goods in Transit
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

Determining Ownership of Goods
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
Deng Imports completed its inventory count. It arrived at a total
inventory value of ¥200,000 (amounts in thousands). As a new
member of Deng’s accounting department, 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: FOB shipping point).
3. The company did not include in the count sold inventory with a
cost of ¥12,000 which was in transit (terms: FOB shipping point).
Inventory = ¥200,000 - ¥15,000 + ¥10,000 = ¥195,000
Inventory Methods and Financial Effects
Inventory is accounted for at cost
Includes all expenditures necessary to acquire goods and
place them in a condition ready for sale
Unit costs are applied to quantities to compute total cost of
inventory and cost of goods sold using the following
costing methods:
 Specific identification
 First-in, first-out (FIFO)
Cost Flow
 Average-cost Assumptions

Inventory Methods and Financial Effects
Illustration: Crivitz Home Entertainment purchases three
identical 50-inch TVs on different dates at costs of £720, £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 £720
March 5 1 TV at £750
May 22 1 TV at £800
Sales
June 1 2 TVs for £2,400 (£1,200 × 2)
Specific Identification
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

Specific Identification
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

Cost Flow Assumptions
Cost flow assumptions DO NOT
need to 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
ILLUSTRATION 6.5
(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) ILLUSTRATION 6.6
Allocation of costs—FIFO method
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 ILLUSTRATION 6.9
Allocation of costs—average-cost
method

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

Last in-first out ILLUSTRATION 6.9
Allocation of costs—LIfo method

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
Cost of goods available for sale HK$12,000
Cost of goods sold 5,400
10 20110 Less : Ending inventory HK$ 5000
Cost of good sold 7000

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 ILLUSTRATION 6.10
Comparative effects of cost
flow methods
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

Comparative effects of cost
flow methods
Lin Electronics
Condensed Income Statements
FIFO Average-Cost LIfo
HK
Sales revenue ( 1) HK$11,500 HK$11,500 $11,500
1,0
Beginning inventory 1,000 1,000 00
11,
Purchases 11,000 11,000 000
Cost of goods available for 12,
sale 12,000 12,000 000
50
Ending inventory (5,800) 5,400 00
70
Cost of goods sold (2) 6,200 6,600 00
4,5
Gross profit (1-2)=3 5,300 4,900 00
2,0
Operating expenses 2,000 2,000 00
25
Income before income taxes 3,300 2,900 00
75
Income tax expense (30%) 990 870 0
HK$ HK
Net income HK$ 2,310 2,030 $ 1750

Statement of Financial Position Effects
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.

DO IT! 2 FIFO Method
Determine cost of goods sold under a periodic inventory.

Beginning inventory 4,000 €3 €12,000
Purchase 6,000 4 24,000
Total 10,000 €36,000

Unit Total Cost of goods available for sale €36,000
Units Cost Cost Less : Ending inventory 12,000
3,000 €4 €12,000 Cost of goods sold € 24,000

DO IT! 2 Average-Cost Method
Determine cost of goods sold under a periodic inventory.

Beginning inventory 4,000 €3.00 €12,000
Purchase 6,000 4.00 24,000
Total 10,000 €3.60 €36,000
Average Cost Per Unit
Unit Total Cost of goods available for sale €36,000
Units Cost Cost Less : Ending inventory 10,800
3,000 €3.60 €10,800 Cost of goods sold € 25,200

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

Effects of Inventory Errors
Inventory errors affect the computation of cost of goods sold
and net income in two periods. ILLUSTRATION 6.11
Formula for cost of goods sold
Beginning Cost of Ending Cost of

+ Goods - = Goods
Inventory Purchased Inventory 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
ILLUSTRATION 6.12
Effects of inventory errors on current year’s income statement

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 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
Effects of inventory errors on
two years’ income statements
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

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

Statement of Financial Position Effects
Effect of inventory errors on the statement of
financial position is determined by using the basic
accounting equation: Assets = Liabilities + Owner's
Equity.
Errors in the ending inventory have the following
Ending
effects.
Inventory Error Assets Liabilities Owner's Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated
ILLUSTRATION 6.14
Effects of ending inventory errors on statement of financial position

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

Statement Presentation and Analysis
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 LCM)
3. costing method (FIFO, or average-cost)
Lower-of-Cost-or-Net Realizable Value
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
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
ILLUSTRATION 6.15
Computation of lower-of-cost-or-net realizable value

Statement Presentation and Analysis
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
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
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
Goods Sold ÷ Average Inventory = Inventory Turnover
HK$3,209 + HK$3,254
HK$12,071 ÷ = 3.7 Times
2
ILLUSTRATION 6.16
Inventory turnover formula and computation for Esprit Holdings (in
millions)
365 ÷ 3.7 = 98.6 Days
DO IT! 4 LCNRV and Inventory Turnover
Poon Heaters sells three different types of home heating stoves
(gas, wood, and pellet). The cost and net realizable value of its
inventory of stoves are as follows.
Cost Net Realizable Value
Gas NT$ 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
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
2019 2020
Sales revenue NT$2,000,000 NT$1,800,000
Cost of goods sold 1,000,000 910,000
2019 2020
Inventory NT$1,000,000 NT$910,000
turnover =4 =7
(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

Appendix 6A Inventory Cost Flow Methods in
Perpetual Inventory Systems ILLUSTRATION 6A.1
Inventoriable units and costs
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) ILLUSTRATION 6A.2
Perpetual system—FIFO
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 ILLUSTRATION 6A.3
Perpetual system—average-cost method
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
11/27 (40 @ HK$130) HK$5,200 (45 @ HK$128.156) HK$5,767

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. ILLUSTRATION 6B.1
Gross profit method formulas
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
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 ILLUSTRATION 6B.2
Examples of gross profit method
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
• 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 = at Retail
for Sale at Retail
Step 2: Goods Available Goods Available Cost-to-

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

Inventory at Retail Retail Ratio Ending Inventory
ILLUSTRATION 6B.3
Retail inventory method formulas
Retail Inventory Method
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
ILLUSTRATION 6B.4
Application of retail inventory method

A Look at U.S. GAAP
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.

A Look at U.S. GAAP
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.

A Look at U.S. GAAP
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.

Copyright
Copyright © 2019 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Act without the express written permission of the
copyright owner is unlawful. Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the use of these programs or
from the use of the information contained herein.
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Chapter 6

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COST OF GOODS AVAILABLE FOR SALE

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

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COST OF GOODS AVAILABLE FOR SALE

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

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COST OF GOODS AVAILABLE FOR SALE

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

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Yingli Solar (CHN) uses average-costing for key raw materials

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COST OF GOODS AVAILABLE FOR SALE

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

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COST OF GOODS AVAILABLE FOR SALE

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Beginning Cost of Ending Cost of

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Days in inventory measures the average number of

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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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