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 Cost of goods sold ! number of units sold x unit cost

$he perpetual inventory record maintains a continuous record for each inventory item. $he quantity of the inventory on hand is updated whenever inventory is purchased or sold. (%ee Exhibit 6-" $he four costing methods allowed by &AA' are specific unit cost( average cost ( first-in) first-out (*+*, ( and last-in) first-out (-+*, . Exhibit 6-. compares the cost flows of the three most popular methods. 1. $he specific unit cost (specific identification !ethod assigns a specific invoice cost to each item in the inventory. $his method can be used for items that differ from unit to unit) such as real estate and automobiles but is seldom used in practice. $he avera"e cost !ethod assigns an average cost to the units on hand and sold. /nder the first#in$ first#out (%I%& cost !ethod$ the oldest costs are assigned to cost of goods sold. /nder the last#in$ first#out ('I%& cost !ethod$ the most recent costs are assigned to cost of goods sold.

C.

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Objective 1: Account for inventory using FIFO, LIFO, and average cost.
A. /nder %I%&) cost of goods sold comes from the first costs incurred each period. *+*, is consistent with the physical flow of goods. 1. *+*, leaves in ending inventory the most recent costs incurred during the period.

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%ee Exhibit 6-0 for an illustration of a perpetual inventory record and the related 1ournal entries.

/nder 'I%&) the cost of goods sold recorded always comes from the last costs incurred each period. -+*, is favored by many companies because it often results in the highest cost of goods sold and the lowest income tax. 1. ". -+*, leaves in ending inventory the oldest costs of the period.

C.

%ee Exhibit 6-2 for an illustration of a perpetual inventory record and the related 1ournal entries. /nder avera"e costin") a new unit cost is computed after each purchase. $his unit price is applied to the number of units sold. 1. ". $he ending inventory is the number of units multiplied by this average cost. %ee Exhibit 6-6 for an illustration of a perpetual inventory record and the related 1ournal entries.

Objective2: Co pare the effects of FIFO, LIFO, and average cost

A. #. *+*, is the most popular method) followed by -+*,) and then average cost. (Exhibit 6-3 4uring a period of rising prices) *+*, produces the lowest cost of goods sold) the highest gross profit) and highest net income. 5igher net income may help companies to attract investors and to borrow on favorable terms. (6efer to Exhibit 6-7 4uring a period of rising prices) -+*, results in the highest cost of goods sold) the lowest gross profit) and the lowest net income. -ower income results in lower taxes and higher cash flow. Average cost results fall between -+*, and *+*,. %everal accounting principles relate to inventories8 1. $he consistency principle re9uires businesses to use the same accounting methods and procedures from period to period. +nventory methods can be changed) but the change and the effect of the change must be disclosed. $he disclosure principle re9uires companies to report enough information for outsiders to ma:e :nowledgeable decisions. +nformation should be relevant) reliable) and comparable. +nventory methods must be disclosed.

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$he !ateriality concept states that a company must adhere to &AA' only for items and transactions that are significant to the business;s financial statements. +nformation is significant or material when its presentation in the financial statements would cause someone to change a decision. Conservatis! in accounting means reporting items in the financial statements at amounts that lead to the most cautious immediate results. %ome guidelines are8 a. b. c. 4o not anticipate gains) but provide for all probable losses. +f in doubt) record an asset at the lowest reasonable amount and a liability at the highest possible amount. <hen there;s a 9uestion) record an expense rather than an asset.

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Objective !: App"y the "o#er$of$cost$or$ ar%et ru"e to inventory

A. +nventory should be reported at the lo(er#of#cost#or#!ar)et ('CM * that is) the lower of its historical cost or its current replacement cost. $his is an example of accounting conservatis!. <hen inventory is written down to mar:et) then cost of goods sold increases to reflect the loss in value as illustrated by the following entry8 Cost of &oods %old +nventory == ==

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Objective &: 'eter ine 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-> is an example of an inventory error. Exhibit 6-1? summari@es the effects of an error on two periods. +nventory errors reverse (or counter+alance in period " and have the opposite effect on cost of goods sold) gross profit) and net income. /nethical managers can overstate ending inventory or report dubious sales in order to overstate net income.

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Objective (: )sti ate ending inventory by the gross profit

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ethod

$he "ross profit !ethod of estimating inventory is based on the cost of goods sold computation . $hat computation can be rearranged to solve for the ending inventory. Cost of ,oods -old #eginning inventory == A 'urchases == ! Cost of goods available for sale == - Ending inventory (== ! Cost of goods sold == Co!putation of Esti!ated Endin" Inventory #eginning inventory == A 'urchases == ! Cost of goods available for sale == - Cost of goods sold (estimated (== ! Ending inventory (estimated ==

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$he cost of goods sold (above is estimated using the following formula (Exhibit 6-11 8 .et sales revenue (-ales revenue less returns$ allo(ances$ and discounts - Esti!ated "ross profit (-ales revenue / "ross profit rate 0 Esti!ated cost of "oods sold

C.

1ecision ,uidelines summari@e various aspects of inventory such as which inventory system to use) which inventory method to use) and how to estimate the ending inventory.

A**)+'I,: Accounting for inventory in a periodic inventory syste

A. +n the periodic inventory syste!) the business does not :eep a daily running record of the inventory on hand. A physical count of the 9uantity of inventory is made at the end of the year. Cost of "oods sold is computed by using this formula. A ! ! C. #eginning inventory (the inventory on hand at the end of the preceding period Bet purchases (often abbreviated as 'urchases C Cost of goods available for sale Ending inventory (the inventory on hand at the end of the current period Cost of goods sold

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.et purchases is determined by using this formula8 'urchases 'urchase discounts 6-0

- 'urchase returns and allowances A $ransportation-in ! Bet purchases 4. E. +n the periodic system) the purchase of inventory is recorded in an account called Purchases instead of the +nventory account. Dournal entries) $-accounts) and financial statement presentation of both the perpetual and periodic system are illustrated in Exhibit 6 A-1. 1. $he purchase of inventory is recorded as follows8 Perpetual +nventory == Accounts 'ayable == ". Periodic 'urchases == Accounts 'ayable ==

$he sale of inventory only re9uires one entry under periodic system but two under the perpetual8 Perpetual Accounts 6eceivable == %ales 6evenue == Cost of &oods %old == +nventory == Periodic Accounts 6eceivable %ales 6evenue == ==

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At the end of the period) +nventory must be updated and Cost of &oods %old recorded under the periodic system. Bo entries are re9uired under the perpetual system. Perpetual Periodic Cost of &oods %old +nventory (beg. == ==

+nventory (end. == Cost of &oods %old == Cost of &oods %old 'urchases == ==

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