Chapter 6: Merchandise Inventory

Chapter 6: Merchandise Inventory

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Learning Objectives

  • 6.1: Identify accounting principles and controls related to merchandise inventory.
  • 6.2: Account for merchandise inventory costs under a perpetual inventory system.
  • 6.3: Compare the effects on the financial statements when using different inventory costing methods.
  • 6.4: Apply the lower-of-cost-or-market rule to merchandise inventory.
  • 6.5: Measure the effects of merchandise inventory errors on the financial statements.
  • 6.6: Use inventory turnover and days’ sales in inventory to evaluate business performance.
  • 6.7: Account for merchandise inventory costs under a periodic inventory system (Appendix 6A).

Learning Objective 6.1: Accounting Principles and Controls Related to Merchandise Inventory

What Are the Accounting Principles?

  • Accounting principles assist in classifying and reporting items on financial statements.
  • Key accounting principles related to merchandise inventory include:
    • Consistency
    • Disclosure
    • Materiality
    • Accounting Conservatism

Consistency Principle

  • States that a business must use the same accounting methods and procedures consistently from period to period.
  • Ensures comparability of financial statements over time.
  • If accounting methods change, this must be disclosed, generally in the notes to the financial statements.

Disclosure Principle

  • Financial statements must provide sufficient information for outsiders to make informed decisions.
  • Information should be both relevant and reliably represented.

Materiality Concept

  • A company must apply strict accounting only to items significant to its financial situation.
  • Information is deemed significant when altering decisions made about financial statements.
    • Example: $10,000 is material for a small business with $100,000 in sales, but not for a large corporation with $1 billion in sales.

Conservatism Principle

  • States that when presented with two or more options, a business should select the least favorable financial outcome.
  • Guidelines include:
    • Anticipate no gains, but record all probable losses.
    • Report assets at their lowest reasonable value and liabilities at their highest reasonable value.
    • If in doubt, record an expense instead of an asset.
    • Choose the option that undervalues the business rather than overvalues it.

Control Over Merchandise Inventory

  • Good inventory controls ensure proper authorization and accounting for inventory purchases and sales.
  • Key controls include:
    • Proper authorization for inventory purchases.
    • Tracking and documenting inventory receipt.
    • Proper recording of damaged inventory.
    • Conducting annual physical counts of inventory.
    • Correctly recording and removing sold inventory from Merchandise Inventory accounts.

Data Analytics in Accounting

  • Inventory is crucial for merchandising and manufacturing firms.
  • Data analytics tools assist in inventory evaluation.
    • Example: Airbnb analyzes 1.5 petabytes of customer data to identify inadequate listings in cities.
    • Example: Dickey’s Barbecue Pit analyzes inventory data every 20 minutes across 500 locations to manage inventory effectively and minimize spoilage.

Learning Objective 6.2: Merchandise Inventory Costs Under a Perpetual Inventory System

Determination of Merchandise Inventory Costs

  1. At period’s end, count units in ending inventory and assign dollar values to the account.
  2. Determine units sold throughout the period and assign their costs to the Cost of Goods Sold (COGS).

Inventory Costing Methods

  • An inventory costing method estimates inventory cost flow and determines COGS and ending merchandise inventory.
  • GAAP allows the following four inventory costing methods:
    1. Specific identification
    2. First-in, first-out (FIFO)
    3. Last-in, first-out (LIFO)
    4. Weighted-average

Specific Identification Method

  • This method bases inventory costing on the specific cost of individual inventory units.
  • Typically used for:
    • Automobiles
    • Jewels
    • Real estate

First-In, First-Out (FIFO) Method

  • FIFO assumes that the first units purchased are the first units sold.
    • COGS is derived from the oldest purchases.
    • Ending Inventory closely reflects current replacement costs.
  • COGS available for sale is the total cost incurred for inventory available for sale during the period.

Last-In, First-Out (LIFO) Method

  • LIFO operates on the opposite principle to FIFO.
    • As inventory is sold, the cost of the latest item is assigned to each unit sold as COGS.
    • COGS reflects the current replacement cost, while ending inventory comprises older item costs.

Weighted-Average Method

  • This method computes a new weighted-average cost per unit for every inventory purchase.
  • The weighted-average cost per unit is determined by:
    \text{Weighted-Average Cost per Unit} = \frac{\text{Cost of Goods Available for Sale}}{\text{Number of Units Available}}
  • Both COGS and ending inventory values are based on this average cost per unit.

Learning Objective 6.3: Effects on Financial Statements by Different Inventory Costing Methods

Impact on Financial Statements

  • Income Statement:
    • COGS is typically higher under LIFO than under FIFO when prices are rising.
    • Net income is lower under LIFO than FIFO during rising prices.
  • Balance Sheet:
    • FIFO results in higher inventory values than LIFO when costs increase.

Comparative Income Statement Effects

  • Higher gross profit observed under FIFO.
  • Highest COGS is noted under LIFO.

Comparative Balance Sheet Effects

  • Comprehensive representation of inventory values across different methods during varying price trends.
  • Implications of rising and declining inventory costs showcased in updated exhibits.

Learning Objective 6.4: Lower-of-Cost-or-Market Rule for Merchandise Inventory

Valuation of Merchandise Inventory

  • The Lower-of-Cost-or-Market (LCM) rule mandates that inventory be reported at the lower value between historical cost and market value, with market value typically equating to current replacement cost.

Adjusting Journal Entry for Merchandise Inventory

  • For instance, if Smart Touch Learning purchased inventory for $3,000 but finds its replacement cost at $2,200, an adjusting entry is necessary due to the permanent decline in value.

Learning Objective 6.5: Effects of Merchandise Inventory Errors

Effects of Inventory Errors

  • Inventory errors can cause ripple effects on related financial accounts.
  • Ending inventory numbers directly influence:
    • COGS
    • Gross Profit
    • Net Income

Example of Overstatement Effects

  • Overstating ending inventory affects COGS, gross profit, and net income in a specific manner which needs proper diagrammatic representation.

Understatement Effects

  • Illustration involving a $1,200 understatement of inventory demonstrates the resulting financial implications effectively.

Inventory Error Reconciliation

  • Inventory errors counterbalance after two reporting periods.

Learning Objective 6.6: Inventory Turnover and Days’ Sales in Inventory

Inventory Turnover

  • Measures how rapidly a business sells its inventory.
  • Evaluated against industry averages.
    • High turnover indicates efficient selling.
    • Low turnover suggests difficulty in moving products.

Days’ Sales in Inventory

  • Measures average days inventory remains unsold.
  • Critical for perishable goods.

Evaluating Pepsico Corporation

  • Financial data exhibited:
    • Cost of goods sold: $37,075
    • Beginning inventory: $4,172
    • Ending inventory: $4,347
  • Pepsico's inventory turnover calculated as:
    \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}
  • Days’ sales calculated:
    \text{Days’ Sales in Inventory} = \frac{365}{\text{Inventory Turnover}}

Learning Objective 6.7: Merchandise Inventory Costs Under a Periodic Inventory System

Determining Inventory Costs Periodically

  • A periodic inventory system does not update inventory levels continuously.
  • Beginning balance held until the end of the period, purchases accumulate, and ending inventory replaces the beginning balance at period end.

Inventory Calculation in Periodic System

  • End merchandise inventory and COGS calculations performed at the end using the COGS formula.

FIFO, LIFO, and Weighted-Average in Periodic System

  • FIFO requires calculating ending inventory with newer items.
  • LIFO utilizes the oldest items in the ending inventory and newest in COGS calculations.
  • Weighted-average cost is used uniformly across calculations.

Conclusion

  • This chapter comprehensively covers the principles and methods related to merchandise inventory. The importance of accurate accounting practices and the implications of inventory inaccuracies on financial statements has been emphasized.