ACCT 1235: Introduction to Financial

Accounting I & II

Chapter 6

Reporting and Analyzing Inventory

Copyright ©2020 John Wiley & Sons, Inc.

Learning Objectives
LO 1: Describe the steps in determining inventory quantities.
LO 2: Apply cost formulas using specific identification, FIFO,
and average cost under a perpetual inventory system.
LO 3: Explain the effects on the financial statements of
choosing each of the inventory cost formulas.
LO 4: Identify the effects of inventory errors on the financial
statements.
LO 5: Demonstrate the presentation and analysis of inventory.
LO 6: Apply the FIFO and average cost formulas under a
periodic inventory system (Appendix 6A).
Determining Inventory Quantities
• Whether companies use a periodic or perpetual system,
physical inventory must still be counted at the end of
each accounting period:
o To check the accuracy of the perpetual inventory
records
o To determine the amount of inventory lost to shrinkage
or theft
Determining Ownership
• Ownership of goods must be considered when taking inventory
• Goods in transit at the end of the period make the determination of
ownership more complicated:
o Determine who has legal title to goods in transit
o Include in inventory if company has legal title
o Apply freight/shipping concepts from Chapter 5: FOB shipping point
versus FOB destination
• Ownership of consigned goods remains with the owner (the
consignor), not the holder of the goods (the consignee)
• Goods taken home “on approval” by a customer are still owned by the
company
Taking Inventory
• To ensure inventory is properly counted, companies
must have a good system of internal control
• Internal control systems include control activities, such
as review and reconciliation
o Counting inventory is a control activity
o Allows reconciliation to information in company’s
inventory system
Inventory Cost Formulas
• Once inventory quantities are counted, must apply unit
costs to determine total cost of inventory
o Journal entries used to record purchases of inventory
only show the total cost, not the per unit cost
o Units of the same inventory can be purchased at
different prices
• Which costs should be used?
Specific Identification
• Tracks physical flow of goods
o Each unit of inventory is tagged with its specific cost
• Used in perpetual system only
• Can only be used where
o Actual costs of each item can be determined
o Goods are easily distinguishable (not easily
interchangeable)
o Goods produced and segregated for specific projects
Cost Formulas
• Cost formulas assume a flow of costs that may not be
the same as the actual flow of goods
• FIFO (First-in, first-out)
o Oldest goods are sold first, then next oldest, etc.
o Cost of first item purchased is cost of first item sold
o Inventory is made up of the newest goods
• Average Cost
o Cost is determined using a moving (weighted) average
of the unit cost of the items purchased
First-in, First-out (FIFO)
• Merchandise inventory is recorded at most recent
(current) cost in the current assets section of statement
of financial position
• Cost of goods sold is recorded as an expense at oldest
inventory cost on the statement of income
• Ending inventory and cost of goods sold under FIFO
are the same for periodic and perpetual inventory
systems
Perpetual Inventory Schedule - FIFO
Average Cost
• Used when physical flow of inventory cannot
specifically be measured
• Under a perpetual inventory system, a new weighted
(moving) average unit cost is calculated after each
purchase
o Used to record cost of goods sold and ending inventory
Perpetual Inventory Schedule –
Average Cost
Choice of Inventory Cost Formula
• Choose a formula that best
o Represents as closely as possible the physical flow of
goods,
o Reports ending inventory at recent cost, and
• Use the same formula for inventories of similar nature
and usage
Summary of Financial Statement Effects

Rising Prices: Rising Rising Falling Prices: Falling Falling

Specific Prices: Prices: Specific Prices: Prices:
Identification FIFO Average Identification FIFO Average
Cost Cost
Statement of Income
Cost of goods sold Variable Lower Higher Variable Higher Lower
Gross profit and Net Variable Higher Lower Variable Lower Higher
income
Statement of
financial position
Cash Same Same Same Same Same Same
Ending inventory Variable Higher Lower Variable Lower Higher
Retained earnings Variable Higher Lower Variable Lower Higher
Summary of Advantages of Cost Formulas

Specific Identification FIFO Average Cost

• Exactly matches costs • Ending inventory on the • Cost of goods sold on
and revenues on the statement of financial the income statement
income statement. position includes the most includes more current
• Tracks the actual current costs (closet to cost than FIFO.
physical flow. replacement cost). • Smooths the effects of
• Approximates the physical price changes by
flow of most retailers. assigning all units the
same average cost.
Inventory Errors
• Errors can occur in accounting for inventory
o Quantity or costs assigned to inventory are incorrect
o Errors made when recording goods in transit at the end
of accounting period
• Errors affect both
o Statement of financial position – through merchandise
inventory
o Statement of income– through cost of goods sold
Effect of Inventory Errors on Income
Statement & Statement of Financial
Position

Then Income
Then Cost of Then Gross Then Retained
If Inventory Is: Before Income
Goods Sold Is: Profit Is: Earnings Are:
Tax Is:
Overstated Understated Overstated Overstated Overstated
Understated Overstated Understated Understated Understated
Summary of Effect of Errors
• If inventory is counted correctly in the next period,
then there is no longer an error in ending inventory
• The current period error will have a reverse effect on
net income in the next accounting period
Valuing Inventory at the Lower of
Cost and Net Realizable Value
• When the net realizable (fair) value is less than cost, the
value is written down
o Called the lower of cost and net realizable value (LCNRV)
rule
• Net realizable value is selling price less any costs to make
goods ready for sale
LCNRV Rule - Application
• Apply rule to individual inventory items
• Reduce inventory by crediting it for the amount of
write-down, debit is to cost of goods sold
• Reverse write-down if value subsequently recovers
o When conditions that caused the write-down have
changed
Reporting Inventory
• In the statement of financial position:
o At the lower of cost and NRV
• In the notes to the statements
o Total amount of inventory
o Cost of goods sold
o Cost formula(s) used
o Amount of write-downs to NRV or reversals
• No significant differences between IFRS and ASPE
Inventory Turnover
• How much inventory should a company have?
• Two ratios to help manage:
o Inventory turnover ratio – measures the number of
times, on average, inventory is sold in a period
o Days in inventory ratio – converts inventory turnover
ratio into number of days inventory is held
Inventory Ratios
• In general, the higher the inventory turnover and the
lower the days in inventory ratios, the better

Cost of goods sold

Inventory Turnover =
Average inventory

365 days
Days in Inventory =
Inventory turnover