Chapter One

Inventories
 1.1. Classification of Inventories
Inventories are asset items held for sale in the ordinary course
of business, or goods to be used in the production of goods to be
sold.
Classifying Inventory
Merchandising Company Manufacturing Company
One Classification: Three Classifications:
 Merchandise Inventory  Raw Materials

Helpful Hint: Regardless of  Work in Process

the classification, companies
report all inventories under
 Finished Goods
Current Assets on the SoFP.
6-2
 1.2. Determining Inventory Quantities

No matter whether they are using a periodic or perpetual

inventory system, all companies need to determine inventory
quantities at the end of the accounting period.
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.

6-3
4. Determine the cost of goods sold for the period.
 Cont’d
Determining inventory quantities involves two steps:
(1) taking a physical inventory of goods on hand and
(2) determining the ownership of goods.

Taking a Physical Inventory

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

6-4
 Cont’d

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.
6-5
 Cont’d
Goods In Transit Illustration 6-2 Terms of sale

Ownership of the goods

passes to the buyer when
the public carrier accepts
the goods from the seller.

Ownership of the goods

remains with the seller
until the goods reach the
buyer.
6-6
 Cont’d

Question # 1:
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.

6-7
 Cont’d

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?

6-8
 > DO IT!
Deng Yaping Company 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 Yaping 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 inventory
that had been sold with a cost of ¥12,000, which
6-9
was in transit (terms: FOB shipping point).
 1.3. Inventory Costing Methods
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 compute the
total cost of the inventory and the cost of goods
sold using the following costing methods:
► Specific identification
► First-in, first-out (FIFO)
Cost Flow
► Average-cost Assumptions

6-10
 Cont’d
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.
Illustration 6-3: Data for Inventory Costing Example
1.3.1. Specific Identification

If Crivitz sold the TVs it purchased on February 3 and May

22, then its cost of goods sold is £1,500 (£700 + £800),
and its ending inventory is £750.
Illustration 6-4: Specific Identification Method
 Cont’d
Actual physical flow 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.

6-13
1.3.2. 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.
 Cont’d
Data for Lin Electronics’ Astro condensers. Illustration 6-5

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

6-15
 Cont’d
FIRST-IN, FIRST-OUT (FIFO)
 Costs of the earliest goods purchased are the
first to be recognized in determining cost of
goods sold.
 Often parallels actual physical flow of
merchandise.
 Companies obtain the cost of the ending inventory
by taking the unit cost of the most recent
purchase and working backward until all units of
6-16 inventory have been costed.
 Cont’d
Illustration 6-6: Allocation of costs—FIFO method

6-17
 Cont’d
Illustration 6-6: Allocation of costs—FIFO method

• HELPFUL HINT
Another way of thinking about the calculation of FIFO
ending inventory is the LISH assumption—last in still here.
6-18
 Cont’d
AVERAGE-COST
 Allocates cost of goods available for sale on the
basis of weighted-average unit cost incurred.
 Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
Illustration 6-8: Formula for weighted-average unit cost

6-19
 Cont’d
Illustration 6-9 Allocation of costs—Average-Cost Method

6-20
 Cont’d
Illustration 6-9 Allocation of costs—Average-Cost Method
Illustration 6-11

6-21
 > DO IT!
The accounting records of Shumway Ag Implement
show the following.

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.
6-22
 Cont’d

6-23
1.3.3. Inventory CF Methods in Perpetual Inventory Systems
Data for Lin Electronics’ Astro condensers. Illustration 6A-1

Assuming the Perpetual Inventory System, compute CGS and

Ending Inventory under FIFO and Average-cost.
First-In-First-Out (FIFO)
Illustration 6A-2: Perpetual System—FIFO

Cost of Goods Sold Ending Inventory

Average-Cost
Illustration 6A-3: Perpetual System—Average-cost method

Cost of Goods Sold Ending Inventory

Cont’d
FS and Tax Effects of Cost Flow Methods

Either of the two cost flow assumptions is acceptable for

use. For example,
 adidas (DEU) and Lenovo (CHN) use the average-cost
method, whereas
 Syngenta Group (CHE) and Nokia (FIN) use FIFO.
A recent survey of IFRS companies, approximately
► 60% use the average-cost method,
► 40% use FIFO, and
► 23% use both for different parts of their
inventory.
6-28
INCOME STATEMENT EFFECTS
Illustration 6-10: Comparative effects of cost flow methods

6-29
SoFP EFFECTS

 A major advantage of the FIFO method is that in

a period of inflation, the costs allocated to ending
inventory will approximate their current cost.
 A major shortcoming of the average-cost method
is that in a period of inflation, the costs allocated
to ending inventory may be understated in terms
of current cost.

6-30
TAX EFFECTS

 Both inventory and net income are higher when

companies use FIFO in a period of inflation.
 Average-cost results in the lower income taxes
(because of lower net income) during times of
rising prices.

6-31
Using Cost Flow Methods Consistently

 Method should be used consistently, enhances

comparability.
 Although consistency is preferred, a company
may change its inventory costing method.

6-32
 Cont’d

Question # 2:
In periods of rising prices, average-cost will produce:
a. higher net income than FIFO.
b. the same net income as FIFO.
c. lower net income than FIFO.
d. NI equal to the specific identification method.

6-33 LO 3
 Cont’d

Question # 3:
Factors that affect the selection of an inventory costing
method do not include:
a. tax effects.
b. statement of financial position effects.
c. income statement effects.
d. perpetual vs. periodic inventory system.

6-34
1.3.4. Lower-of-Cost-or-Net Realizable Value

When the value of inventory is lower than its cost

 companies must “write down” the inventory to
its net realizable value.

Net realizable value: Amount that a company

expects to realize (receive from the sale of
inventory).

6-35
 Cont’d

Illustration: Assume that Gao TV has the following lines of

merchandise with costs and market values as indicated.
Illustration 6-11: Computation of lower-of-cost-or-net realizable value

6-36
 > DO IT!

LCNRV Basis
Tracy Company sells three different types of home heating
stoves (wood, gas, and pellet). The cost and net realizable
value of its inventory of stoves are as follows.

Determine the value of the company’s inventory under the

lower-of-cost-or-net realizable value approach.
Total inventory value is the sum of these amounts, NT$430,000.
1.4. Inventory Errors

 Unfortunately, errors occasionally occur in

accounting for inventory.
 In some cases, errors are caused by failure to
count or price inventory correctly.
 In other cases, errors occur because companies
do not properly recognize the transfer of legal
title to goods that are in transit.
 When errors occur, they affect both the
Income Statement and SoFP.
Income Statement Effects
Inventory errors affect the computation of Cost of Goods Sold and
Net Income in two periods.
Illustration 6-12: Formula for cost of goods sold

Illustration 6-13: Effects of inventory errors on current year’s income statement

 Cont’d
 An error in ending inventory of the current
period will have a reverse effect on net income
of the next accounting period.
 Over the two years, the total net income is
correct because the errors offset each other.
 Ending inventory depends entirely on the
accuracy of taking and costing the inventory.
 Illustration 6-13 shows this effect.
Illustration 6-13: Effects of Inventory Errors on Two Years’ Income Statements
 Cont’d

 As you study the illustration, you will see that the

reverse effect comes from the fact that
understating ending inventory in 2013 results in
understating beginning inventory in 2014 and
overstating net income in 2014.
 Over the two years, though, total net income is
correct because the errors offset each other.
 Notice that total income using incorrect data is
€35,000 (€22,000 + €13,000), which is the same as
the total income of €35,000 (€25,000 + €10,000)
using correct data.
 Cont’d
 Also note in this example that an error in the
beginning inventory does not result in a
corresponding error in the ending inventory
for that period.
 The correctness of the ending inventory
depends entirely on the accuracy of taking
and costing the inventory at the SoFP date
under the periodic inventory system.
 Cont’d

Question # 4:
Atlantis Company’s ending inventory is understated by
NT$122,000. The effects of this error on the current
year’s CGS and Net Income, respectively, are:
a. understated, overstated.
b. overstated, understated.
c. overstated, overstated.
d. understated, understated.
SoFP Effects
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.
Illustration 6-15: Effects of ending inventory errors on SoFP
 > DO IT!

Inventory Errors
Visual Company overstated its 2016 ending inventory by
NT$22,000. Determine the impact this error has on ending
inventory, cost of goods sold, and equity in 2016 and 2017.
2016 2017
Ending inventory NT$22,000 overstated No effect
Cost of goods sold NT$22,000 understated NT$22,000
overstated
Equity
Equity NT$22,000 overstated No effect
 1.5. Estimating Inventories
Gross Profit Method
Estimates the cost of ending inventory by applying a gross
profit rate to net sales.

Illustration 6B-1: Gross profit Method Formulas

 Cont’d
Illustration: Kishwaukee Company’s records for January show
net sales of $200,000, beginning inventory $40,000, and cost of
goods purchased $120,000. The company expects to earn a 30%
gross profit rate. Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Illustration 6B-2: Example of Gross Profit Method
Retail Inventory Method
Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.
Illustration 6B-3: Retail Inventory Method Formulas
 Cont’d
Illustration 6B-4: Application of Retail Inventory Method

Note that it is not necessary to take a physical inventory

to estimate the cost of goods on hand at any given time.
The End of Chapter 1
Thank You!!!