Chapter 7: Inventory

1
 Merchandise Inventory

 What is inventory?
– Items held for resale to customers

 Who has inventory?

– Wholesaler or Retailer  Merchandise
Inventory
– Manufacturer  Raw materials
Work in Process
Finished Goods
2
The Relative Size of Inventories

Figure 7-1
Inventory as
a percentage
of total assets
and current
assets 3
 Four Important Inventory Issues
1. Acquisition of inventory: What costs to
capitalize?
2. Recording inventory activity: Which
method?
3. Selling inventory: Which cost flow
assumption?
4. Ending inventory: Lower-of-cost-or market
valuation.

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Figure 7-2 Accounting for Inventory: Four Important Issues

5
 1. Acquiring Inventory
 What items or units to include?
– General rule: (1) held for sale and (2) complete
and unrestricted ownership.
– Ownership is usually possession; however, there
are exceptions
 Consignments: belong to consignor, ownership

not based on physical possession.

 Goods in transit

– FOB Shipping Point: belongs to the purchaser

while in transit (once inventory leaves seller’s
facilities).
– FOB Destination: belongs to seller while in transit
(until inventory reaches purchaser’s facilities).

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Exercise 7.1

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 Class Exercise E7.1
Error if Dallas includes in ending inventory at 12/31?
1. FOB Shipping Point (purchase):
No error
2. FOB Shipping Point (sale):
Yes - inventory overstated.
3. FOB Destination (sale):
No error
4. FOB Destination (purchase):
No error
5. FOB Destination (purchase):
Yes - inventory overstated

8
 Inventory Errors
 Inventory errors are unique in financial reporting
because they involve multiple accounts and
multiple periods.
 Because of the carryover nature of inventory,
some inventory errors reverse out by the end of
the second year involved.
 To analyze, use basic inventory formula.

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 Class Problem
Assume that the ending inventory of 20x4 was
undervalued by $9,000. If the error goes
undetected in 20x5, what effect would the
error have on the balance sheet and income
statement accounts for 20x4 and 20x5.
Analyze using the following relationships:
BI + P - EI = COGS NI A = L + SE
Note that the asset account in inventory error
analysis is ending inventory, and the
equity effect is retained earnings,
specifically the effect on net income. 10
 Class Problem
Analysis:
BI + P - EI = COGS NI A = L + SE

20x4: 9u 9o 9u 9u 9u
20x5: 9u 9u 9o X X
Why no effect on 20x5 ending SE?
NI 20x4 understated by $9,000
NI 20x5 overstated by $9,000
Both closed to RE, so no net effect at end.
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 Acquiring inventory - contd.
 What costs to attach? General rule: all costs
associated with purchase or manufacture,
including shipping to facility.
– Freight-in (transportation-in) adds to the
cost of inventory.
– Purchase returns reduce the cost of
purchases (contra) for returned inventory.
– Purchase allowances reduce the cost of
purchases (contra) for reduced prices due to
damage or errors.
– Purchase discounts from early cash
payments (contra) reduce the cost of
purchases.
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 2. Perpetual or Periodic Method
 Perpetual
– Up-to-date record in inventory account.
– Cost of goods sold computed for each sale.
 Periodic
– Inventory purchases are recorded as incurred.
– Inventory and cost of goods sold determined at the end
of each period through physical count.
 Costs and benefits
– Perpetual requires more bookkeeping but provides more
useful information.
– General application: Periodic used for external reporting;
perpetual used for internal tracking of units.
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 Figure 7.3, Perpetual System
December 10 Purchase of 100 units @ $20:
Inventory 2,000
Accts. Pay. 2,000
December 20 Sale of 50 units @ $30:
Cash 1,500
Sales 1,500
COGS 1,000
Inventory 1,000
December 30 AJE to recognize loss of 5 units @$20
each (170 on hand, books show 175)
Loss 100
Inventory 100

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Figure 7-4 Perpetual Inventory

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 Figure 7-4, Periodic System
December 10 Purchase of 100 units @ $20:
Purchases 2,000
Accts. Pay. 2,000
December 20 Sale of 50 units @ $30:
Cash 1,500
Sales 1,500
(no COGS entry until the end of the period)
December 31 AJE/CJE to recognize EI and COGS:
(Note: BI given at $2,500 and EI of 175 units (125 BI + 100
Purchase -50 Sold) valued at $20 per unit, or $3,500)
Inventory (end) 3,500
COGS 1,000
Purchases 2,000
Inventory (begin) 2,500
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 Figure 7-4, Periodic System
 What if only 170 units in Ending Inventory

December 31 AJE/CJE to recognize EI and COGS:

(Note: BI given at $2,500 and EI of 170 units (125 BI + 100
Purchase -170 EI; Would assume COGS = 55) valued at
$20 per unit, or $3,500)
Inventory (end) 3,400
COGS 1,100
Purchases 2,000
Inventory (begin) 2,500

 Drawbacks of Parodic System

– Without up-to-date inventory information
– Without knowledge of missing inventory
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This AJE under periodic system follows
the formula for COGS:
BI + Purchases (net) - EI = COGS
2,500 + 2,000 - 3,500 = 1,000
(Alternative: BI + P(net) = EI + COGS)
Note that Purchases (net) =
Purchases
+ Freight-in
- Purchase Discounts (see next slide)
- Purchase Returns
- Purchase Allowances
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 Purchase Discounts - Gross Method
Assume purchase of $100 on account on 6/1/x5,
terms 2/15 (2% discount if paid within15 days), n/30.
GJE to record purchase on 6/1/x5:
Purchases 100
Accounts Payable 100
GJE to record payment, if on or before 6/16/x5:
Accounts Payable 100
Purchase Discounts 2
Cash 98
GJE to record payment, if after 6/16/x5:
Accounts Payable 100
Cash 100
(Purch Disc. is contra to Purchases; part of COGS calc.) 19
E7.3

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 Class Problem: E7-3 (Periodic)
March 3 purchase:
Purchases 50,000
A/P 50,000

March 10 purchase:
Purchases 140,000
A/P 140,000

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 Class Problem: E7-3 (Periodic)
March 20 payment (3% discount taken):
A/P 140,000
Purchase discounts 4,200
Cash 135,800

April 25 payment (no discount taken):

A/P 50,000
Cash 50,000

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E7.4

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 Class Exercise: Exercise 7-4

Note:

Cost of goods available for sale = GAS, and

GAS = Beginning inventory + Purchases (net)
GAS = EI + COGS

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 Class Exercise: Exercise 7-4
for 2017
12/31/17
Find Ending Inventory (2017):
COGS = GAS - EI
$16,055 = $20,089 - EI
$4,034 = EI

12/31/18
Find GAS 2018:
GAS = COGS + EI
GAS = $16,682 + $4,366
GAS = $21,048
12/31/18
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 Class Exercise: Exercise 7-4
for 2018
12/31/18
Find GAS 2018:
GAS = COGS + EI
GAS = $16,682 + $4,366
GAS = $21,048
Purchases:
Purchases = GAS - BI
Purchases = $21,048 - $4,304
Purchases = $17,014

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 Class Exercise: Exercise 7-4
for 2019
12/31/19
Find GAS 2019:
GAS = BI + Purchases
GAS = $4,366 + $16,094
GAS = $21,270
Ending Inventory (EI):
EI = GAS - COGS
EI = $21,270 - $17,136
EI = $4,134

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3. Cost Flow Assumptions
 Given: BI + P (net) = EI + COGS
 How to assign costs of inflows [BI + P(net)]
to EI and COGS?
Methods:
 Specific identification
 Average for both COGS and EI
 FIFO - (first-in, first-out) for COGS
– and LISH (last-in, still here) for EI
 LIFO - (last-in, first-out) for COGS
– and FISH (first-in, still here) for EI

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 Class Problem - Cost Flows
Given the following activity for January:
Cost Total
Units per Unit Cost
Begin Inventory 20 $ 9.00 $180
Purchase 1/10 40 10.00 400
Purchase 1/22 30 11.00 330
Total available 90 units $910
Sales - 55 units
Ending inventory 35 units
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 Class Problem - Cost Flows
 Note that, for illustrative purposes, only
the periodic system is shown here.
 The perpetual system give similar
results, but is more cumbersome to
illustrate.
 In fact, using the FIFO method, the
perpetual and periodic systems yield
exactly the same results.

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 FIFO(LISH)
 FIFO for COGS (top down)
55 units
20 @ $9 = $180
35 @ $10 = $350
Total = $530
 LISH for EI (bottom up)
35 units
30 @ $11 = $330
5 @ $10 = $ 50
Total $380
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 LIFO(FISH)
 LIFO for COGS (bottom up)
55 units
30 @ $11 = $330
25 @ $10 = $250
Total = $580
 FISH for EI (top down)
35 units
20 @ $ 9 = $180
15 @ $10 = $150
Total = $330
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 Average
 First
calculate average:
Goods available cost = $910
Goods available units = 90 units
Avg. = $10.11 per unit
 Now COGS:

55 units x $10.11 per unit = $ 556

 Now EI:

35 units x $10.11 per unit = $354

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Cost Flows
Figure 7-5 Inventory
flow assumption:
Average, FIFO, and
LIFO

34
Cost Flows - Average

35
Cost Flows - FIFO

36
Cost Flows - LIFO

37
Effects on Financials/Taxes
In an inflationary period (rising prices) which most
periods are:

FIFO has the highest inventory balance, lowest

COGS, and highest income

LIFO has the lowest inventory balance, highest

COGS, and lowest income
This means that LIFO pays the least taxes

38
Cost Flows – Effects on Financial Statements
Figure 7-8 Financial statement effects

39
Cost Flows – Effects on Federal Income Taxes

40
 Comparison of FIFO, LIFO, and
Average
 In times of rising prices:
LIFO highest COGS:
FIFO lowest COGS
FIFO highest EI
LIFO lowest EI
FIFO highest Net Income
LIFO lowest Net Income

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 Choosing an Inventory Cost Flow
Assumption: Trade-Offs
 Income and Asset Measurement

 Economic Consequences
– Income Taxes and Liquidity
– Bookkeeping Costs
– LIFO Liquidation and Inventory Purchasing
Practices
– Debt and Compensation Practices
– The Capital Market

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 Additional LIFO issues:
 LIFO and taxes
– Why use LIFO for taxes?
– Why use FIFO for financial statements?
 LIFO and market valuation
– Should market value a company higher or
lower if they use LIFO?
 LIFO liquidation
– What happens to net income with liquidation
of an old LIFO layer?
 LIFO reserve
– what information is contained in this
disclosure?
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 4. Ending Inventory:Applying the
Lower-of-Cost-or-Market Rule
 Based on conservatism, ending inventory is
valued at cost or market value, whichever is
lower.
 Problem: can create hidden reserves
– Recognizes price decreases immediately
– Defers price increase recognition until sold
 USGAAP and IFRS use different market values
when applying LCM. US GAAP  replacement
cost; IFRS  the realizable value.
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International Perspective –
Cost Flow Assumptions
– Under IFRS the LIFO method is prohibited.
– This poses an important potential impediment
to the adoption of IFRS in the US. Most LIFO
users in the US have chosen LIFO because it
results in an income tax savings.
– DuPont, for example, has saved over $150
million in income taxes because it uses LIFO.
– A shift to IFRS could impose a huge and
immediate tax burden on LIFO users in the
US.

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International Perspective:
Japanese Business and
Inventory Accounting
– Just-in-time (JIT) inventory systems, which
reduce the costs of carrying large amounts of
inventory without jeopardizing customer
service, have long been a characteristic of
this Japanese system and have given the
Japanese a definite advantage when
competing against U.S. industry.

– Japan has adopted international reporting

standards (IFRS), which does not allow the
use of LIFO.
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ID7.4

47
Class Issues for Discussion: ID7-4
a. AJE (in millions)- reduce EI and recognize loss:
Loss on Inventory 12
Inventory 12

b. Sale next year (new basis = 40):

Cash (or A/R) 48
Sales 48
COGS 40
Inventory 40

c. Loss of $12 in first year; gain of $8 in second

year:
- overestimate?
- or creating hidden reserve?
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