Chapter 6
Inventories
1. Define and identify the items included in inventory at the reporting date
2. Determine the costs to be included in the value of inventory
3. Describe the four inventory costing methods and identify the three inventory costing methods that are based on cost flow assumptions
4. Determine the cost of goods sold and ending inventory under the perpetual inventory system
Learning objectives
5. Compare the financial statement effects of the three inventory cost flow assumptions
6. Explain the characteristics of each inventory costing method
7. Record returns of merchandise using inventory cards for each of the three inventory cost flow assumptions (perpetual inventory)
8. Explain the lower of cost or market (LCM) rule 9. Explain the effect of inventory errors on the
Learning objectives
Define and identify the items
included in inventory at
the reporting date
Learning objective 1
▪ Inventory can represent a significant item in the financial statements
▪ Inventory can differ between business types and can include:
▪ We focus on merchandise inventory held for sale
Defining inventory
Business Type Type of inventory held Retailer Merchandise held for sale Wholesaler Merchandise held for sale Manufacturer Raw materials / Supplies
Work in process
Finished goods (Merchandise held for sale)
▪ When inventory is held in the retail store or
warehouse of the business it is easy to identify who is to report the goods at the reporting date
▪ But what happens when the goods are being
delivered from the seller to the buyer at reporting date?
▪ Or if the goods are shipped on consignment to an agent to be sold on behalf of the owner?
Identifying inventory
▪ Party that owns the goods at the reporting date reports them as part of their inventory
▪ Ownership determined by shipping terms
FOB shipping point:
▪ Buyer owns goods and reports them in inventory
FOB destination:
▪ Seller owns goods and reports them in inventory
Goods in transit
▪ Goods owned by one party but held by another party who sells the goods on their behalf
▪ Consignor (owner)
▪ Consignee (agent)
▪ Consignor owns the goods and reports them in inventory, even though the consignee may have physical custody of the goods
Goods on consignment
Determine the costs
to be included in the
value of inventory
Learning objective 2
▪ Cost of inventory includes any expenditure incurred, directly or indirectly, in bringing the inventory to the condition and location where it is able to be sold.
▪ Includes:
– Purchase price (list price less any trade discount) – Less purchase discounts
– Plus incidental costs
• transportation charges
• import duties
Determining inventory costs
Describe the four inventory costing
methods and identify the
three inventory costing methods
that are based on cost flow
assumptions
Learning objective 3
▪ Consider the situation where a business has a storage container half full of liquid chocolate
▪ Next, they purchased more liquid chocolate to fill up the container, purchased at a higher price
▪ During the period one third of the liquid chocolate was sold
▪ Because the chocolate at the higher price was
mixed in with the lower priced chocolate, how do we determine the cost to assign to cost of goods
Inventory cost flow assumptions
▪ There are four inventory costing methods used to assign the cost of goods available for sale to cost of goods sold and ending inventory.
– specific identification – first-in, first-out (FIFO) – last-in, first-out (LIFO) – average cost
▪ The last three are known as inventory cost flow
assumptions because they assume a flow of costs through inventory to COGS
Inventory costing methods
▪ Assigns the actual purchase cost of the item to COGS and ending inventory
▪ As each item is purchased, some form of
identification is attached to track the cost of that item from purchase to sale
▪ Uses actual costs to calculate:
– COGS
– Ending inventory
Specific identification
▪ Assumes the first units purchased are the first units sold
▪ Assigns:
– Earliest costs to COGS
– Most recent costs to ending inventory
First-in, first-out (FIFO)
▪ Assumes the last units purchased are the first units sold
▪ Assigns:
– Most recent costs to COGS
– Earliest costs to ending inventory
Last-in, first-out (LIFO)
▪ Assigns an average cost of inventory available for sale to both:
– COGS
– Ending inventory
▪ The average cost method is called the
– Moving average method under perpetual inventory – Weighted average method under periodic inventory
(Appendix 6A)
Average cost
Determine the cost of goods sold and
ending inventory under the
perpetual inventory system for
each of the four inventory costing
methods
Learning objective 4
▪ We now illustrate how to calculate the cost of goods sold and ending inventory under the perpetual
inventory system for each of the four inventory costing methods using the following data:
Illustration of inventory costing methods
Purchases Sales Inventory
Date Description Units Unit
cost Total
cost Units Selling
price Sales
revenues Units
Nov. 1 Beginning inventory 50 x $1 = $50 50
7 Purchases 75 x $2 = $150 125
17 Purchases 15 x $3 = $45 140
27 Sales 60 x $5 = $300 80
Specific identification - (perpetual)
▪ Of the 60 units sold on November 27, the
business specifically
identified the number of units sold at each unit cost
▪ Allocates actual costs to COGS & ending inventory
Units identified as sold, Nov. 27 Units Unit cost Total cost
35 1 35
20 2 40
5 3 15
60 90
Specific identification - (perpetual)
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 50 1 50
7 75 2 150 50 1 50
75 2 150
17 15 3 45 50 1 50
75 2 150
15 3 45
27 35 1 35 15 1 15
20 2 40 55 2 110
5 3 15 10 3 30
Specific identification - (perpetual)
▪ Ending inventory
= the sum of the items in the
inventory balance (total cost) column for the last entry only
▪ COGS = the sum of all items in the cost of goods sold (total cost) column (i.e. all sales)
Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total cost
35 1 35 15 1 15
20 2 40 55 2 110
5 3 15 10 3 30
60 90 80 155
▪ Assumes the first units purchased are the first units sold
▪ Assigns:
– Earliest costs to COGS
– Most recent costs to end inventory
First-in, first-out (FIFO) - (perpetual)
First-in, first-out (FIFO) - (perpetual)
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 50 1 50
7 75 2 150 50 1 50
75 2 150
17 15 3 45 50 1 50
75 2 150
15 3 45
27 50 1 50 65 2 130
10 2 20 15 3 45
First-in, first-out (FIFO) - (perpetual)
▪ Ending inventory
= the sum of the items in the
inventory balance (total cost) column for the last entry only
▪ COGS = the sum of all items in the cost of goods sold (total cost) column (i.e. all sales)
Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total cost
50 1 50 65 2 130
10 2 20 15 3 45
60 70 80 175
▪ Assumes the last units purchased are the first units sold
▪ Assigns:
– Most recent costs to COGS – Earliest costs to end inventory
Last-in, first-out (LIFO) - (perpetual)
Last-in, first-out (LIFO) - (perpetual)
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 50 1 50
7 75 2 150 50 1 50
75 2 150
17 15 3 45 50 1 50
75 2 150
15 3 45
27 15 3 45 50 1 50
45 2 90 30 2 60
Last-in, first-out (LIFO) - (perpetual)
▪ Ending inventory
= the sum of the items in the
inventory balance (total cost) column for the last entry only
▪ COGS = the sum of all items in the cost of goods sold (total cost) column (i.e. all sales)
Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total cost
15 3 45 50 1 50
45 2 90 30 2 60
60 135 80 110
▪ Assigns an average cost of inventory available for sale to both:
– COGS
– Ending inventory
▪ The average cost method is called the moving average method under perpetual inventory
because a new average cost of goods available for sale is calculated after each purchase
Average cost - (perpetual)
Inventory Balance:
Nov. 7 = ($50 + $150) ÷ (50 + 75) units = $200 ÷ 125 = $1.60
Average cost - (perpetual)
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 50 1.00 50
7 75 2.00 150 125 1.60 200
17 15 3.00 45 140 1.75 245
27 60 1.75 105 80 1.75 140
Average cost - (perpetual)
▪ Ending inventory
= the balance reported in the
inventory balance (total cost) column for the last entry only
▪ COGS = the sum of all items in the cost of goods sold (total cost) column (i.e. all sales)
Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total cost
60 1.75 105 80 1.75 140
60 105 80 140
Compare the financial statement
effects of the three
inventory cost flow
assumptions
Learning objective 5
▪ When prices are constant throughout the period each method yields the same results
▪ When prices change throughout the accounting period, each method almost always assigns
different costs to COGS and ending inventory
Financial statement effects
Financial statement effects
Specific
identification FIFO LIFO Moving
average
Income statement $ $ $ $
Sales Revenues 300 300 300 300
Cost of goods sold 90 70 135 105
Gross profit 210 230 165 195
Expenses 100 100 100 100
Net income 110 130 65 95
Balance sheet
Inventory 155 175 110 140
▪ When prices are rising we can generalize the effects on the financial statement items
▪ The opposite effect occurs when prices are falling
(The effects of the specific identification method can not be generalized. Therefore this method is excluded from the
Financial statement effects
FIFO Moving
average LIFO
Cost of goods sold Lowest Middle Highest
Gross profit Highest Middle Lowest
Net income Highest Middle Lowest
Ending balance of inventory Highest Middle Lowest
Explain the characteristics of each
inventory costing method
Learning objective 6
Specific identification:
▪ Accurately matches sales revenues to the actual costs incurred to earn those revenues
– Reports actual gross profit
– Reports actual cost of ending inventory
▪ Can be costly to implement
Characteristics of costing methods
First-in, first-out (FIFO)
▪ Ending inventory is reported in the balance sheet closest to its current replacement cost
▪ When prices rise:
– Reports lower COGS
– Reports higher gross profit (and higher net income) – So can overstate income
Characteristics of costing methods
Last-in, first-out (LIFO)
▪ Matches sales revenues to the current costs incurred to earn those revenues
▪ Taxation advantages for corporations when prices are rising
▪ When prices rise:
– Inventory not reported at current replacement costs
Characteristics of costing methods
Average cost
▪ Tends to smooth out net income and inventory
▪ Neither cost of goods sold or ending inventory are reported at their current costs
▪ Under perpetual inventory, a new average cost is calculated each time a purchase is made, which can be time consuming and difficult to track
Characteristics of costing methods
Record returns of merchandise using
inventory cards for each of the
three inventory cost flow
assumptions
(perpetual inventory)
Learning objective 7
▪ The perpetual inventory system tracks the movement of inventory at the time it occurs
▪ Therefore purchase returns and sales returns must also be tracked at the time of the return
▪ But what cost do we use when recording the return?
Recording returns
▪ The specific identification method uses the actual cost of the items returned for both purchase and sales returns, so will not be illustrated
▪ The difficulty is deciding what cost to record the return under the three inventory cost flow
assumptions
– FIFO – LIFO
– Moving average
▪ Let’s start with purchase returns
Recording returns
▪ Purchase returns are always recorded using the actual value of the refund, regardless of the cost flow assumption
▪ The return is to be recorded as a negative entry into the Purchases column for all inventory cost flow assumptions
Purchase returns
For example:
▪ A business purchased 300 units at $2 each on November 5
▪ The business then returned 100 of these units purchased at $2 on November 8
Purchase returns
FIFO purchase return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 450 1 450
5 300 2 600 450 1 450
300 2 600
6 150 1 150 300 1 300
300 2 600
8 (100) 2 (200) 300 1 300
200 2 400
LIFO purchase return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 450 1 450
5 300 2 600 450 1 450
300 2 600
6 150 2 300 450 1 450
150 2 300
8 (100) 2 (200) 450 1 450
50 2 100
▪ A new moving average cost is calculated after each purchase and after each purchase return
Moving average purchase return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 450 1.00 450
5 300 2.00 600 750 1.40 1050
6 150 1.40 210 600 1.40 840
8 (100) 2.00 (200) 500 1.28 640
▪ Sales returns are recorded following the same
inventory cost flow assumption used in their original sale
▪ The return is to be recorded as a negative entry into the Cost of Goods Sold column for all
inventory costing methods
Sales returns
For example:
▪ A different business sold 195 units on November 13
▪ The customer then returned 100 of these units on November 19
▪ Each cost flow assumption will record a different value for cost of goods sold for the sale and for the sales return
Sales returns
▪ FIFO assumes that the cost of the goods returned are the most recent costs assigned to inventory
when the sale was made
FIFO sales return
FIFO sales return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 120 3 360
180 4 720
13 120 3 360 105 4 420
75 4 300
18 385 5 1925 105 4 420
385 5 1925
19 (75) 4 (300) 25 3 75
(25) 3 (75) 180 4 720
▪ LIFO assumes the cost of the goods returned to be the oldest costs assigned to the goods at the time the sale was made
LIFO sales return
LIFO sales return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 120 3 360
180 4 720
13 180 4 720 105 3 315
15 3 45
18 385 5 1925 105 3 315
385 5 1925
19 (15) 3 (45) 120 3 360
(85) 4 (340) 85 4 340
▪ The moving average method records the sales
return at the moving average cost of the inventory at the time of the return rather than at the time of the original sale
Moving average sales return
Moving average sales return
Date
Purchases Cost of Goods Sold Inventory Balance Units Unit
cost Total
cost Units Unit
cost Total
cost Units Unit
cost Total cost
Nov. 1 300 3.60 1080
13 195 3.60 702 105 3.60 378
18 385 5.00 1925 490 4.70 2303
19 (100) 4.70 (470) 590 4.70 2773
Explain the
lower of cost or market
(LCM) rule
Learning objective 8
▪ Inventories are initially accounted for on a cost basis
▪ Inventories may subsequently be valued at less than cost if:
– Purchase price decreases
– Can not sell goods at normal selling prices – Damaged goods
– Obsolete goods
▪ To test if this is the case, businesses are required to
Lower of cost or market rule
▪ The lower of cost or market (LCM) rule requires inventories to be reported at current market value when the market value is lower than the cost
recorded for the item
Lower of cost or market rule
▪ The market value of an item is defined as the current replacement cost of the inventory item provided that:
a) market value is not to be greater than net realizable value
b) market value is not to be lower than the net realizable value less an allowance for a normal profit margin
▪ The net realizable value of an item is the selling price less costs incurred to sell the item
Lower of cost or market rule
▪ The lower of cost or market rule can be applied to one of the following:
1. Items
2. Categories
3. Entire balance
▪ Each of the three methods results in a different amount to be reported in ending inventory and a different loss recognized in the income statement
▪ See your textbook for a detailed example
Lower of cost or market rule
▪ Calculate the amount to be adjusted
– (Current cost – Market value)
▪ Record the journal entry
▪ fds
▪ Alternatively, a specific account can be debited,
Date Account and explanation Post
Ref. Debit Credit 2011
Nov. 30 Cost of Goods Sold 2,000
Inventory 2,000
(To adjust inventory from cost to market value.)
Journal entry to adjust inventory to LCM
▪ The written down value becomes the new cost of the item for subsequent accounting periods
▪ Even if the market value of the goods rises in
subsequent accounting periods, the goods are not to be revalued upward to the old higher cost
▪ This is consistent with the lower of cost or market rule
Lower of cost or market
Explain the effect of inventory errors
on the financial statements
Learning objective 9
▪ Inventory errors can occur in many ways, e.g.
– Taking inventory
– Using an inventory costing method
– Applying the lower of cost or market rule – Transcription errors
▪ Affects both the income statement and the balance sheet
Effects of inventory errors
Income statement:
▪ Affects the current period, and has an equal and opposite effect in the following period
– ending balance of inventory is used in determining COGS – ending balance of inventory in one period becomes the
opening balance of inventory in the following period
▪ Affects:
– Cost of goods sold – Gross profit
Effects of inventory errors
Balance sheet:
▪ Affects the current period only
▪ Affects:
– Inventory
