Fundamentals of Accounting II

AcFn 2012

Chapter 1
Inventories
 Chapter Outline:
• Nature and definition of inventories
• Internal control of inventories
• The effects of inventory errors on the financial statements
• The inventory cost flow methods/assumptions and their financial
effects
• Inventory costing methods under the periodic and perpetual
inventory systems
• Valuation of inventory at other than cost
• Estimating inventory costs
• Presentation of inventory in the financial statements
2
Nature and definition of inventories
Inventories are assets:
• held for sale in the ordinary course of business
• in the process of production for such sale or
• in the form of materials or supplies to be consumed in
the production process or the rendering of services.

3
Nature and definition of inventories
Merchandising Company Manufacturing 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.
4
Control of Inventory

• Two primary objectives of control over inventory are :

• Safeguarding the inventory from damage or theft.
• Reporting inventory in the financial statements.
• Controls for safeguarding inventory begin as soon as the
inventory is ordered.
• The following documents are often used for inventory control:
• Purchase order
• Receiving report
• Vendor’s invoice
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.

6
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

7
Determining Ownership of Goods
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.

8
Freight Costs

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.

9
Determining Ownership of Goods
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.

10
Determining Ownership of Goods (4 of 5)
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.

11
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?

12
Do It! 1: Rules of Ownership
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).

13
Do It! 1: Rules of Ownership
Solution
1. Goods of ¥15,000 held on consignment should be deducted from
the inventory count.
2. The goods of ¥10,000 purchased F O B shipping point should be
added to the inventory count.
3. Item 3 was treated correctly

Inventory should be ¥195,000

(¥200,000 − ¥15,000 + ¥10,000)

14
Exercise
 Inventory Methods and Financial Effects
 After the quantity of inventory on hand is determined,
the cost of the inventory is assigned for reporting in the
financial statements
Inventory is accounted for at cost.
• Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale
• The cost of inventory includes:
1. all costs of purchase less trade discounts and rebates
2. costs of conversion and
3. other costs incurred in bringing the inventories to their
present location and condition.
16
Inventory Methods and Financial Effects

• 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)

17
 Specific Identification
Costing method in which
• the unit sold is identified with a specific purchase.
• 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

LO 2 18
 Specific Identification
Illustration: Crivitz TV Company 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)
If Crivitz sold the TVs it purchased on February 3 and May 22, then what is its
cost of goods sold and its ending inventory? 19
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

20
Cost Flow Assumptions
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.

21
Cost Flow Assumptions
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

22
Cost Flow Assumptions
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

23
 First-In, First-Out (FIFO)
COST OF GOODS AVAILABLE FOR SALE
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 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

24
Cost Flow Assumptions
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

25
 Average-Cost
COST OF GOODS AVAILABLE FOR SALE
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 100 HK$12,000

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

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

LO 2 26
Financial Statement and Tax Effects
of Cost Flow Methods

Either of the two cost flow assumptions is acceptable for

use.

27
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

28
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

29
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

30
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
 Should disclose the change and its effect on net
income

31
Cost Flow Assumptions (5 of 6)
Review Question
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

32
Cost Flow Assumptions (6 of 6)
Review Question
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

33
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.

34
DO IT! 2: FIFO Method
Determine cost of goods sold under a periodic inventory.
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
Beginning inventory 4,000 €3 €12,000
Purchase 6,000 4 24,000
Total 10,000 €36,000

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

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

35
DO IT! 2: Average-Cost
Determine cost of goods sold under a periodic inventory.
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
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
STEP 1: ENDING INVENTORY STEP 2: COST OF GOODS SOLD
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

36
Exercise 1
Exercise 2

2.
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

39
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

40
Income Statement Effects (2 of 5)
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
41
Income Statement Effects (3 of 5)
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

42
 Income Statement Effects (4 of 5)
Review Question
Understating ending inventory will overstate:
a. assets
b. cost of goods sold
c. net income
d. stockholders’ equity

LO 3 43
 Income Statement Effects (5 of 5)
Review Question
Understating ending inventory will overstate:
a. assets
b. cost of goods sold
c. net income
d. stockholders’ equity

LO 3 44
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

45
 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

46
Exercise
Exercise…
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)
49
 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

LO 4 50
 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

51
Exercise
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.

53
Analysis (1 of 2)
Inventory turnover measures the number of times on
average the inventory is sold during the period.

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Days in inventory measures the average number of

days inventory is held.
Days in Days in Year (365)
=
Inventory Inventory Turnover
54
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

55
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.
56
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
Beginning inventory 290,000 210,000
Ending inventory 210,000 50,000
Determine the inventory turnover and days in inventory for 2019
and 2020.

57
 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
Beginning inventory 290,000 210,000
Ending inventory 210,000 50,000

2019 2020
Inventory NT$1,000,000 NT$910,000
turnover =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

58
Inventory Cost Flow Methods in the
case of Perpetual Inventory System

59
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.

60
 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)

61
 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

62
Exercise
Methods of Estimating Inventories

o Until now we assumed that a company would be

able to physically count its inventory.
o What if it cannot? What if the inventory were
destroyed by fire or flood, for example?
o In that case, the company would use an estimate.

64
Estimating Inventories
 Two circumstances explain why companies sometimes
estimate inventories.
• First, a casualty such as fire, flood, or earthquake
may make it impossible to take a physical inventory.
• Second, managers may want monthly or quarterly
financial statements, but a physical inventory is
taken only annually.
 The need for estimating inventories occurs primarily
with a periodic inventory system because of the
absence of perpetual inventory records.
Estimating Inventories
There are two widely used methods of estimating
inventories:
1. the gross profit method, and
2. the retail inventory method.
 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

67
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.

68
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
69
Exercise
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

71
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

72
Exercise
Apply the LIFO Inventory Costing
Method

74
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.

75
 Last-In, First-Out (LIFO)
COST OF GOODS AVAILABLE FOR SALE
Date Explanation Units Unit Cost Total Cost
Jan. 1 Beginning inventory 10 HK$100 $1,000
Apr. 15 Purchase 20 110 2,200
Aug. 24 Purchase 30 120 3,600
Nov. 27 Purchase 40 130 5,200
Total 1000 HK$12,000

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

Unit Total
Date Units Cost Cost
Jan. 1 10 HK$100 HK$1,000 Cost of goods available for sale HK$12,000
Apr. 15 20 110 2,200 Less : Ending inventory 5,000
Aug. 24 15 120 1,800 Cost of goods sold HK$ 7,000
Total 45 HK$5,000

76