Chapter 6 Inventory Notes

Control of Inventory (Learning Objective 1)

Two primary objectives of control over inventory:
- Safeguarding the inventory from damage or theft.
- Reporting inventory in the financial statements.

Safeguarding Inventory

Controls begin when inventory is ordered.
Documents used for inventory control:
- Purchase order: authorizes the purchase from an approved vendor.
- Receiving report: records the receipt of inventory.
- Vendor’s invoice.
Subsidiary inventory ledger: records inventory amount and helps maintain proper levels.
Controls should include security measures.

Reporting Inventory

A physical inventory count should be taken near year-end to ensure accuracy.
The cost of inventory is assigned for financial statement reporting after the quantity is determined.

Inventory Cost Flow Assumptions (Learning Objective 2)

An accounting issue arises when identical units are acquired at different costs.
It’s necessary to determine the cost using a cost flow assumption and costing method when an item is sold.
Three identical units purchased during May:
- May 10: 1 unit at $9
- May 18: 1 unit at $13
- May 24: 1 unit at $14
- Total: 3 units for $36
- Average cost per unit: $12 (36 ÷ 3 units)
Assume one unit is sold on May 30 for $20. Gross profit varies depending on which unit was sold:
- May 10 Unit Sold:
  - Sales: $20
  - Cost of goods sold: ($14)
  - Gross profit: $6
  - Ending inventory: $23 (9 + $13)
- May 18 Unit Sold:
  - Sales: $20
  - Cost of goods sold: ($13)
  - Gross profit: $7
  - Ending inventory: $22 (9 + $14)
- May 24 Unit Sold:
  - Sales: $20
  - Cost of goods sold: ($9)
  - Gross profit: $11
  - Ending inventory: $27 (13 + $14)
Specific identification inventory cost flow method: the unit sold is identified with a specific purchase. Ending inventory consists of remaining units.
First-in, first-out (FIFO) inventory cost flow method: the first units purchased are assumed to be sold. Ending inventory consists of the most recent purchases.
Last-in, first-out (LIFO) inventory cost flow method: the last units purchased are assumed to be sold. Ending inventory consists of the first purchases.
Weighted average inventory cost flow method: the cost of goods sold and ending inventory is a weighted average of purchase costs.
- Purchase costs are weighted by the quantities purchased at each cost.

Inventory Costing Methods Under a Perpetual Inventory System (Learning Objective 3)

FIFO, LIFO, and weighted average cost methods are illustrated under a perpetual inventory system.
Illustration data for Item 127B:
- Jan. 1: Inventory: 1,000 units @ $20.00
- Jan. 4: Sale at $30 per unit: 700 units
- Jan. 10: Purchase: 500 units @ $22.40
- Jan. 22: Sale at $30 per unit: 360 units
- Jan. 28: Sale at $30 per unit: 240 units
- Jan. 30: Purchase: 600 units @ $23.30

Perpetual Inventory System: First-In, First-Out Method

FIFO method: costs are included in the cost of goods sold in the order purchased.
Often the same as the physical flow of goods.
Often provides similar results to the specific identification method.
Ending balance on January 31 is $18,460 . Made up of two inventory layers:
- Layer 1: Jan. 10: 200 units @ $22.40 = $4,480
- Layer 2: Jan. 30: 600 units @ $23.30 = $13,980
- Total: 800 units = $18,460

Perpetual Inventory System: Last-In, First-Out Method

LIFO method: the cost of units sold is the cost of the most recent purchases.
Originally used when units sold were from the most recently purchased units.
For tax purposes, LIFO is widely used even when it does not represent the physical flow of units.
Subsidiary inventory ledger is sometimes maintained in units only.
- Units are converted to dollars when financial statements are prepared.
The ending balance on January 31 is $17,980 . This balance is made up of two layers of inventory:
- Layer 1: Beg. inv. (Jan. 1): 200 units @ $20.00 = $4,000
- Layer 2: Jan. 30: 600 units @ $23.30 = $13,980
- Total: 800 units = $17,980

Perpetual Inventory System: Weighted Average Cost Method

A weighted average unit cost for each item is computed each time a purchase is made.
This unit cost determines the cost of each sale until another purchase is made and a new average is computed.
- This technique is called a moving average.

Knowledge Check Activity 1

Which inventory costing method results in the highest cost of goods sold during rising costs?
- Answer: c. LIFO (last-in, first-out)
- Rationale: In a period of rising costs, the latest purchased inventory would have the highest costs and thus, the highest cost of goods sold.

Inventory Costing Methods Under a Periodic Inventory System (Learning Objective 4)

Only revenue is recorded each time a sale is made.
- No entry is made at the time of the sale to record the cost of the goods sold.
At the end of the accounting period, a physical inventory is taken to determine the cost of inventory and cost of goods sold.
A cost flow assumption must be made when identical units are acquired at different unit costs during a period.
- FIFO, LIFO, or weighted average cost method is used.

Periodic Inventory System: First-In, First-Out Method

Using the same data for Item 127B as in the perpetual inventory example.
Beginning inventory and purchases of Item 127B in January:
- Jan. 1: Inventory: 1,000 units @ $20.00 = $20,000
- Jan. 10: Purchase: 500 units @ $22.40 = $11,200
- Jan. 30: Purchase: 600 units @ $23.30 = $13,980
- Total available for sale: 2,100 units, $45,180
The physical count on January 31 shows that 800 units are on hand. Using the FIFO method, the cost of the goods on hand at the end of the period is made up of the most recent costs.
The cost of the 800 units in the ending inventory on January 31 is determined as follows:
- Most recent costs, January 30 purchase: 600 units at $23.30 = $13,980
- Next most recent costs, January 10 purchase: 200 units at $22.40 = $4,480
- Inventory, January 31: 800 units = $18,460
Deducting the cost of the January 31 inventory of $18,460 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $26,720 , computed as follows:
- Beginning inventory, January 1: $20,000
- Purchases ( $11,200 + $13,980 ): $25,180
- Cost of goods available for sale in January: $45,180
- Ending inventory, January 31: ( $18,460 )
- Cost of goods sold: $26,720

Periodic Inventory System: Last-In, First-Out Method

When the LIFO method is used, the cost of goods on hand at the end of the period is made up of the earliest costs.
Based on the same data for Item 127B as in the FIFO example, the cost of the 800 units in ending inventory on January 31 is $16,000 , which consists of 800 units from the beginning inventory at a cost of $20.00 per unit.
Deducting the cost of the January 31 inventory of $16,000 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $29,180 , computed as follows:
- Beginning inventory, January 1: $20,000
- Purchases ( $11,200 + $13,980 ): $25,180
- Cost of goods available for sale in January: $45,180
- Ending inventory, January 31: ( $16,000 )
- Cost of goods sold: $29,180

Periodic Inventory System: Weighted Average Cost Method

The weighted average cost method uses the weighted average unit cost for determining the cost of goods sold and the ending inventory.
If purchases are relatively uniform during a period, the weighted average cost method provides results that are similar to the physical flow of goods.
The weighted average unit cost is determined as follows:

Weighted Average Unit Cost = \frac{Total Cost of Units Available for Sale}{Units Available for Sale}

To illustrate, the data for Item 127B are used as follows:

Weighted Average Unit Cost = \frac{$45,180}{2,100 units} = $21.51

The cost of the January 31 ending inventory is as follows:
- Inventory, January 31: $17,208 (800 units × $21.51 )
Deducting the cost of the January 31 inventory of $17,208 from the cost of goods available for sale of $45,180 yields the cost of goods sold of $27,972 , computed as follows:
- Beginning inventory, January 1: $20,000
- Purchases ( $11,200 + $13,980 ): $25,180
- Cost of goods available for sale in January: $45,180
- Ending inventory, January 31: ( $17,208 )
- Cost of goods sold: $27,972

Knowledge Check Activity 2

Which of the following statements regarding inventory costing under the periodic inventory system is correct?
- Answer: a. At the time of sale, no entry is made to cost of goods sold.
- Rationale: When the periodic inventory system is used, only revenue is recorded each time a sale is made. At the end of the accounting period, a physical inventory is taken to determine the cost of the inventory and the cost of the goods sold.

Comparing Inventory Costing Methods (Learning Objective 5)

A different cost flow is assumed for the FIFO, LIFO, and weighted average inventory cost flow methods.
As a result, the three methods normally yield different amounts for the following:
- Cost of goods sold
- Gross profit
- Net income
- Ending inventory
Using the perpetual inventory system illustration with sales of $39,000 (1,300 units × $30 ), the following differences among partial income statements are apparent:
- Sales: $39,000 across all methods
- Cost of goods sold:
  - FIFO: ($26,720)
  - Weighted Average Cost: ($26,900)
  - LIFO: ($27,200)
- Gross profit:
  - FIFO: $12,280
  - Weighted Average Cost: $12,100
  - LIFO: $11,800
- Inventory, Jan. 31:
  - FIFO: $18,460
  - Weighted Average Cost: $18,280
  - LIFO: $17,980
The preceding differences show the effect of increasing costs (prices).
If costs (prices) remain the same, all three methods would yield the same results.
- However, costs normally do change.

Reporting Inventory in the Financial Statements (Learning Objective 6)

Cost is the primary basis for valuing and reporting inventories in the financial statements.
However, inventory may be valued at other than cost in the following cases:
- The cost of replacing items in inventory is below the recorded cost.
- The inventory cannot be sold at normal prices due to imperfections, style changes, spoilage, damage, obsolescence, or other causes.

Valuation at Lower of Cost or Market

If the market value is lower than the purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory.
Market is the net realizable value of the inventory.
Net realizable value is determined as follows:

Net Realizable Value = Estimated Selling Price – Direct Costs of Disposal

Direct costs of disposal include selling expenses such as special advertising or sales commissions.
Illustration:
- Original cost: $1,000
- Estimated selling price: $800
- Estimated selling expenses: $150
- Market Value (Net Realizable Value) = $800 – $150 = $650
- Therefore, the inventory would be valued at $650 , which is the lower of its cost of $1,000 and its market value of $650 .
The lower-of-cost-or-market method can be applied in one of three ways:
1. Each item in the inventory
2. Each major class or category of inventory
3. Total inventory as a whole
The amount of any price decline is included in the cost of goods sold.
This reduces gross profit and net income in the period in which the price declines occur.
This matching of price declines to the period in which they occur is the primary advantage of using the lower-of-cost-or-market method.
Assume the following data for 400 identical units of Item A in inventory on December 31:
- Cost per unit: $10.25
- Market value (net realizable value) per unit: $9.50

Inventory on the Balance Sheet

Inventory is usually reported in the “Current assets” section of the balance sheet.
In addition to this amount, the following are reported on the balance sheet or in the accompanying notes:
- The method of determining the cost of the inventory (FIFO, LIFO, or weighted average)
- The method of valuing the inventory (cost or the lower of cost or market)

Effects of Inventory Errors on the Financial Statements

Any errors in inventory will affect the balance sheet and income statement.
Some reasons that inventory errors may occur:
- Physical inventory on hand was miscounted.
- Costs were incorrectly assigned to inventory using an inventory costing method that was incorrectly applied.
- Inventory in transit was incorrectly included or excluded from inventory.
- Consigned inventory was incorrectly included or excluded from inventory.
Inventory errors often arise when conducting the end-of-year “physical” inventory.
- For example, merchandise that was ordered FOB shipping point may be in transit at the end of the year and thus, not counted as part of the physical inventory.
- Even though the inventory has not been received, the title to the merchandise passed to the buyer at the time of shipment and should be included in the buyer’s physical inventory.
Manufacturers sometimes ship merchandise to retailers who act as the manufacturer’s selling agent.
- The manufacturer, called the consignor, retains title until the goods are sold.
- Such merchandise, called consigned inventory, is said to be shipped on consignment to the retailer, called the consignee.
Any unsold merchandise at year-end is a part of the manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the retailer (consignee).

Knowledge Check Activity 3

Lakeview Forest Products, Inc., sells an item that originally cost $1,500 . Due to obsolescence, its estimated selling price is now $1,200 with $200 of estimated selling expenses. Using the lower-of-cost-or-market (LCM) method, what would be the adjusted value of the inventory?
- Answer: d. $1,000
- Rationale: Market Value (net realizable value) = $1,200 - $200 = $1,000 . The inventory would be valued at $1,000 , which is the lower of its cost of $1,500 and its market value of $1,000 .

Analysis for Decision Making: Inventory Turnover and Days’ Sales in Inventory (Learning Objective 7)

A retail business should keep enough inventory on hand to meet its customers’ needs.
Two measures to analyze inventory management:
- Inventory turnover
- Days’ sales in inventory
Inventory turnover measures the relationship between the cost of goods sold and the amount of inventory carried during the period.
- It measures the number of times inventory is turned into sold goods during the year.

Inventory Turnover = \frac{Cost of Goods Sold}{Average Inventory}

Generally, the larger the inventory turnover, the more efficient and effective the company is in managing inventory.
The days’ sales in inventory measures the length of time it takes to acquire, sell, and replace the inventory.

Days' Sales in Inventory = \frac{Average Inventory}{Average Daily Cost of Goods Sold}

The average daily cost of goods sold is determined by dividing the cost of goods sold by 365.
As with most financial ratios, differences exist among industries.
To illustrate, The Kroger Co. (KR) is the world’s largest grocery store chain.
- Because food is perishable, it will sell more rapidly than Best Buy’s consumer electronics.
- Thus, Kroger’s inventory management should be significantly more efficient than Best Buy’s.
For a recent year, this is confirmed as follows:
- Best Buy Kroger
Inventory turnover 6.9 12.8
Days’ sales in inventory 52.7 days 28.5 days