Chapter 6

Learning Objective
1. Show how to account for inventory
6-1
Copyright 2015 Pearson Education Inc. All rights reserved.
SHOW HOW TO ACCOUNT FOR INVENTORY

Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company
Merchandisers have two accounts that service entities dont need:
6-2
Cost of goods sold on the income statement

Inventory on the balance sheet
LO 1

Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company
Merchandisers have two accounts that service entities dont need:
6-3
Cost of goods sold on the income statement

Inventory on the balance sheet
LO 1

Exhibit 6-2 |
Inventory and Cost of
Goods Sold When
Inventory Cost Is Constant
Assume Family Dollar

Stores, Inc., has in stock
300 towels that cost $3
each.
Family Dollar Stores
marks each towel up by $2
and sells 200 of the towels
for $5 each.
6-4

The cost of inventory sold shifts from asset to expense when
the seller delivers goods to the buyer
6-5
LO 1
Sale Price vs. Cost of Inventory

Note the difference
6-6
Sales revenue based on sales price of inventory sold
Cost of goods sold based on cost of inventory sold
Inventory based on cost of inventory on hand
LO 1
Sale Price vs. Cost of Inventory

Number of Units of Inventory
Determined from accounting records
Evidenced by physical count at year-end
Consigned goods:
Does not include those held for another company
Does include those out on consignment
In transit goods
6-7
Depends on shipping terms
LO 1
Number of Units of Inventory

Shipping Terms Ownership Changes Hands
FOB
(free on board)
shipping point
At the point when the goods leave

the sellers shipping dock
FOB
(free on board)
destination
At the point of delivery to the

customer
Company with legal title to the goods while in

transit pays the transportation costs
6-8
LO 1
Accounting for Inventory in the

Perpetual System
Perpetual
Inventory System
6-9
Periodic
Inventory System
Used for all types of goods
Used for inexpensive goods
Keeps a running record of

all goods bought, sold, and
on hand
Does not keep a running

record of all goods bought,
sold, and on hand
Inventory counted at least

once a year
Inventory counted at least

once a year
LO 1
Accounting for Inventory in the

Perpetual System
How the Perpetual System Works
6-10
Optical scanner reads bar code, system
Records sale
Updates inventory records
Exhibit 6-4 | Bar Code for

Electronic Scanner
Two entries needed for each sale
Record revenue and asset received
Record cost of goods sold and reduction of inventory
LO 1
Recording Transactions (Perpetual System)

Exhibit 6-5 | Recording and Reporting InventoryPerpetual System
6-11
PANEL ARecording Transactions (amounts assumed)

LO 1

Exhibit 6-5 | Recording and Reporting InventoryPerpetual System
6-12
PANEL AT-accounts (amounts assumed)

LO 1
Recording
Transactions
(Perpetual
System)
Exhibit 6-5 |
Recording and
Reporting Inventory
Perpetual System
6-13
PANEL BReporting (amounts assumed)

LO 1

The cost of inventory is the net amount of purchases,
determined as follows (using assumed amounts):
6-14
LO 1

The journal entry to record a purchase return of merchandise
that cost $500 is as follows:
Account
Accounts payable
Debit
Credit
500
500
Inventory
To record purchase return
6-15
LO 1

The journal entry to record a purchase of $1,000 in
merchandise is as follows:
Account
Inventory
Debit
Credit
1,000
Accounts Payable
1,000
To record purchase of merchandise
6-16
LO 1

The journal entry to record the payment for merchandise
within 10 days when the discount terms are 2/10, n/30, is as
follows:
Account
Accounts Payable
Debit
Credit
1,000
20
Inventory
980
Cash
To record payment within discount period
Discount = $1,000 x 2% = $20
6-17
LO 1
Learning Objective
2. Apply and compare various inventory cost
methods
6-18
APPLY AND COMPARE VARIOUS

INVENTORY COST METHODS
Accounting method selected affects the
6-19
Profits to be reported
Amount of income tax to be paid
Values of inventory turnover and gross margin percentage

ratios derived from the financial statements
LO 2
What Goes into Inventory Cost?

The cost of any asset, such as inventory, is the sum of all
the costs incurred to bring the asset to its intended use,
less any discounts.
Cost includes:
Purchase price
Freight in
6-20
Insurance while in transit
Fees or taxes paid to get

the inventory ready to sell
Less returns, allowances,

and discounts
LO 2
Apply Various Inventory Costing Methods

Accounting uses four generally accepted inventory
methods:
1. Specific unit cost
2. Average cost
3. First-in, first-out (FIFO) cost
4. Last-in, first-out (LIFO) cost
Company can use any of

these methods
Methods can have very
different effects on
reported
profits,
income taxes, and
cash flow
6-21
LO 2

Specific
unit
6-22
Average
First-in,
first-out
Last-in,
first-out
Used for businesses with unique inventory items
Automobiles, antique furniture, jewels, and real estate
Businesses cost their inventories at the specific cost of the

particular unit
Too expensive for inventories with common characteristics
Also called the specific identification method

LO 2

Specific
unit
6-23
Average
First-in,
first-out
Last-in,
first-out
Sometimes called the weighted-average method
Based on the average cost of inventory during the period
LO 2
Illustration
Exhibit 6-6 | Inventory Data Used to Illustrate the Various Inventory Costing
Methods
In Exhibit 6-6, Family Dollar began the period with 10 lamps that
cost $10 each; the beginning inventory was therefore $100. During
the period, Family Dollar bought 50 more lamps, sold 40 lamps,
and ended the period with 20 lamps.
6-24
LO 2
Illustration
6-25
Exhibit 6-6
LO 2
Illustration
Exhibit 6-6
Accounting questions are:

1. What is the cost of goods sold for the income statement?
2. What is the cost of the ending inventory for the balance
sheet?
Answer depends on
cost method used
6-26
LO 2
Average Cost
Exhibit 6-6
Average cost per unit =

Number of units sold
40 units
Cost of goods available

$900
=
= $15
Number of units available
60
X Average cost per unit = Cost of good sold
X
$15
$600
Number of units on hand X Average cost per unit = Ending inventory

20 units
6-27
$15
$300
LO 2
Average Cost
Exhibit 6-6
The following T-account shows the effects of average costing:
Cost of goods sold (40 units

@ average cost of $15 per unit)
End bal
6-28
(20 units @ average

cost of $15 per unit)
600
300
LO 2

Specific
unit
6-29
Average
First-in,
first-out
Last-in,
first-out
First costs into inventory are first costs assigned to cost of

goods sold (oldest items assumed to be sold first)
Ending inventory is based on latest costs incurred
LO 2
40 units sold
20 units on hand
FIFO Cost
Inventory (at FIFO cost)
Beg bal
(10 units @ $10)
100
Purchases:
No. 1
No. 2
End bal
(25 units @ $14)

350
(25 units @ $18)
450
(20 units @ $18)
(10 units @$10)

100
(25 units @$14)
350
(5 units @$18)
360
90
Cost of Good Sold

(10 units @$10)
100
(25 units @$14)
350
(5 units @$18)
90
End bal (40 units)
6-30
540
LO 2

Specific
unit
6-31
Average
First-in,
first-out
Last-in,
first-out
Costing is the opposite of FIFO
Last costs into inventory go to cost of goods sold (most

recent items purchased are assumed to be sold first)
Oldest costs in ending inventory
LO 2
40 units sold
20 units on hand
LIFO Cost
Inventory (at LIFO cost)
Beg bal
(10 units @ $10)
100
Purchases:
No. 1
No. 2
End bal
(25 units @ $14)

350
(25 units @ $18)
450
(10 units @ $10)
(10 units @ $14)
(15 units @$14)

210
(25 units @$18)
450
240
Cost of Good Sold

(25 units @$18)
450
(15 units @$14)
210
End bal
6-32
(40 units)
660
LO 2
Illustration
Hazelwood Surplus began March with 75 tents that cost $16 each.
During the month, Hazelwood Surplus made the following purchases
at cost:
March 3
95 tents @ $18 = $1,710
17
165 tents @ $20 = 3,300
23
35 tents @ $21 =
735
Hazelwood Surplus sold 318 tents, and at March 31 the ending
inventory consists of 52 tents. The sale price of each tent was $45.
Requirements
Determine the cost of goods sold and ending inventory amounts for
March under the average cost, FIFO cost, and LIFO cost. Round
average cost per unit to two decimal places.
6-33
LO 2
Illustration
Goods Available
LO 2
6-34
318 tents sold

52 tents on hand
Average Cost
Beg bal
(75 units @ $16)
1,200
Mar 3
(95 units @ $18)
1,710
Mar 17
(165 units @ $20)
3,300
Mar 23
(35 units @ $21)
End bal
(370 units)
735
6,945
Average cost per unit

$6,945 370 = $18.77
Cost of Good Sold
6-35
LO 2
318 tents sold

52 tents on hand
Average Cost
Beg bal
(75 units @ $16)
1,200
Mar 3
(95 units @ $18)
1,710
Mar 17
(165 units @ $20)
3,300
Mar 23
(35 units @ $21)
735
End bal
(52 units @ $18.77)
976
(318 units @$18.77)

5,969
Average cost per unit

$6,945 370 = $18.77
Cost of Good Sold

(318 units @$18.77)
5,969
6-36
LO 2
318 tents sold

52 tents on hand
FIFO Cost
Beg bal
(75 units @ $16)
1,200
Mar 3
(95 units @ $18)
1,710
Mar 17
(165 units @ $20)
3,300
Mar 23
(35 units @ $21)
End bal
(52 units)
735
(75 units @$16)

1,200
(95 units @$18)
1,710
(148 units @$20)
2,960
1,075
Cost of Good Sold

(75 units @$16)
1,200
(95 units @$18)
1,710
(148 units @$20)
2,960
End bal (318 units)
6-37
5,870
LO 2
318 tents sold

52 tents on hand
LIFO Cost
Beg bal
(75 units @ $16)
1,200
Mar 3
(95 units @ $18)
1,710
Mar 17
(165 units @ $20)
3,300
Mar 23
(35 units @ $21)
End bal
(52 units)
735
(23 units @$16)

368
(95 units @$18)
1,710
(165 units @$20)
3,300
(35 units @$21)
832
735
Cost of Good Sold

(35 units @$21)
735
(165 units @$20)
3,300
(95 units @$18)
1,710
(23 units @$16)
End bal
6-38
368
(318 units)
6,113
LO 2
Illustration
Inventory Cost Summary by Method
FIFO
Inventory
Cost of goods sold
Goods available
Average
$1,075
$ 832
$ 976
5,870
6,113
5,969
$6,945
$6,945
$6,945
LIFO
LO 2
6-39
Effects of FIFO, LIFO, and Average Cost

Panel AWhen Inventory Costs Are Increasing
6-40
Exhibit 6-8
Cost of Goods Sold (COGS)
Ending Inventory (EI)
FIFO
FIFO COGS is lowest

because its based on the
oldest costs, which are low.
Gross profit is, therefore, the
highest.
FIFO EI is highest because

its based on the most recent
costs, which are high.
LIFO
LIFO COGS is highest

most recent costs, which are
high. Gross profit is,
therefore, the lowest.
LIFO EI is lowest because its

based on the oldest costs,
which are low.
LO 2
Effects of FIFO, LIFO, and Average Cost

Panel BWhen Inventory Costs Are Decreasing
6-41
Exhibit 6-8
Cost of Goods Sold (COGS)
Ending Inventory (EI)
FIFO
FIFO COGS is highest

oldest costs, which are high.
Gross profit is, therefore, the
lowest.
FIFO EI is lowest because its

based on the most recent
costs, which are low.
LIFO
LIFO COGS is lowest

most recent costs, which are
low. Gross profit is, therefore,
the highest.
LIFO EI is highest because

its based on the oldest costs,
which are high.
LO 2
Keeping Track of Perpetual Inventories
6-42
Impossible to apply LIFO unit costs to units purchased

and sold as transactions are happening
Weighted-average cost can be quite challenging,

requiring sophisticated computer software
Many companies track only inventory quantities during

the period, making adjusting journal entries at the end
of the period to apply either LIFO or weighted-average
LO 2
The Tax Advantage of LIFO

When prices are rising
Results in lowest taxable income
Results in lowest income taxes
Increases cash available
6-43
LO 2
Comparing FIFO and LIFO

Cost of Goods Sold
6-44
Ending Inventory
LIFO provides more

realistic net income figure
FIFO provides a more up-todate inventory cost
Most recent costs are

assigned to Cost of Goods
Sold
More recent costs on the

Balance Sheet
LO 2
LIFO and Managing Reported Income
Allows manipulation of net income
Liquidation can occur
6-45
When inventory prices are rising, large quantities

purchased at end of year to lower taxes
Quantities decrease from last year, companies must

dip into older inventory layers
Not allowed under International Financial Reporting

Standards (IFRS)
LO 2
Learning Objective
3. Explain and apply underlying GAAP for inventory
6-46
UNDERLYING GAAP FOR INVENTORY

Accounting Principles Relevant to Inventory
Disclosure
6-47
Representational
Faithfulness
Consistency
Financial statement should report enough information for

outsiders to make informed decisions
LO 3

Disclosure
6-48
Representational
Faithfulness
Consistency
Company should report relevant and representationally

faithful information about itself
Properly disclosing
Inventory accounting methods
Substance of all material transactions impacting

inventory
LO 3

Disclosure
6-49
Representational
Faithfulness
Consistency
Requires the use of comparable methods for consistency

of presentation from period to period
Financial statements contain a footnote describing
Inventory costing method used
Inventory was valued at the lower of the costing

method or market
LO 3
Lower-of-Cost-or-Market Rule
Requires that inventory be reported in the financial
statements at whichever is lower
Inventorys historical cost or
Market value
Generally means current replacement cost
If replacement cost is below historical cost, inventory is

written down to market value
Ending inventory is reported at LCM value on the

balance sheet
LO 3
6-50
Suppose Family Dollar, Inc., paid $3,000 for inventory on June 26.
By August 25, its fiscal year-end, the inventory can be replaced for
$2,000. Family Dollars year-end balance sheet must report this
inventory at the LCM value of $2,000. An LCM write-down decreases
Inventory and increases Cost of Goods Sold:
Account
Cost of Goods Sold
Debit
Credit
1,000
1,000
Inventory
Wrote inventory down to market value
6-51
LO 3
6-52
Exhibit 6-9 | Lower-ofCost-or-Market (LCM)

Effects on Inventory and
Cost of Goods Sold
LO 3
Under IFRS, market is always defined as net

realizable value, which, for inventories, is current
market value.
Under U.S. GAAP, once the LCM rule is applied to write
inventories down to current replacement cost, the write-downs
may never be reversed. In contrast, under IFRS, some LCM
write-downs may be reversed, and inventory may be
subsequently written up again, not to exceed original cost.
6-53
LO 3
Learning Objective
4. Compute and evaluate gross profit (margin)
percentage and inventory turnover
6-54
COMPUTE AND EVALUATE GROSS PROFIT

(MARGIN) PERCENTAGE AND INVENTORY
TURNOVER
Gross Profit Percentage
Gross profitsales minus cost of goods soldkey

indicator of a companys ability to sell inventory at a profit
Markup stated as a percentage of sales
Watched carefully by managers and investors
Gross profit percentage =
6-55
Gross profit
Net sales revenue
LO 4
Inventory Turnover
6-56
Ratio of cost of goods sold to average inventory
Indicates how rapidly inventory is sold
Varies from industry to industry
Inventory turnover =
LO 4
Illustration
Cola Company made sales of $35,376 million during 2014. Cost of
goods sold for the year totaled $15,437 million. At the end of 2013,
Colas inventory stood at $1,672 million, and Cola ended 2014 with
inventory of $1,908 million. Compute Colas gross profit percentage
and rate of inventory turnover for 2014.
6-57
Gross profit
Net sales revenue
$35,376 - $15,437
$35,376
= 56.4%
LO 4
Illustration
Cola Company made sales of $35,376 million during 2014. Cost of
goods sold for the year totaled $15,437 million. At the end of 2013,
Colas inventory stood at $1,672 million, and Cola ended 2014 with
inventory of $1,908 million. Compute Colas gross profit percentage
and rate of inventory turnover for 2014.
6-58
Cost of goods sold

Average inventory
$15,437
($1,672 + $1,908) 2
= 8.6 times
Every 42.4 days (365 days 8.6 times)

LO 4
Learning Objective
5. Use the cost-of-goods-sold (COGS) model to
make management decisions
6-59
USE THE COGS MODEL TO MAKE

MANAGEMENT DECISIONS
Exhibit 6-13 | The Cost-of-Goods-Sold-Model
Beginning inventory
$2,100
+ Purchases 6,300
= Cost of goods available for sale
- Ending inventory
7,500
-1,500
= Cost of goods sold $6,000
COGS model is used by all companies regardless of their

accounting systems
6-60
LO 5
Computing Budgeted Purchases

Rearrange the COGS formula using amounts from Exhibit 6-13
Cost of goods sold (based on the plan for the next period) $6,000
+ Ending inventory (based on the plan for the next period)
= Cost of goods available as planned
-
1,500
7,500
Beginning inventory (actual amount left over from prior period)

-1,200
= Purchases (how much inventory the manager needs to buy)$6,300
Manager should buy $6,300 of merchandise to work his plan for

the upcoming period
6-61
LO 5
Estimating Inventory by the Gross Profit

Method
Gross profit method
6-62
Also known as gross margin method
Widely used to estimate ending inventory
Uses COGS model
LO 5
Gross Profit Method

Exhibit 6-14 shows the calculations for the gross profit method,
with new amounts assumed for the illustration.
Exhibit 6-14
6-63
LO 5
Learning Objective
6. Analyze effects of inventory errors
6-64
ANALYZE EFFECTS OF INVENTORY

ERRORS
6-65
Error in ending inventory creates errors for two accounting

periods
Inventory errors counterbalance in two consecutive

periods
Beginning inventory and ending inventory have opposite

effects on cost of goods sold
Beginning inventory is added; ending inventory is

subtracted
After two periods an inventory error counterbalances

LO 6
EFFECTS OF INVENTORY ERRORS
6-66
LO 6
EFFECTS OF INVENTORY ERRORS
6-67
LO 6
Accounting For
Inventory
6-68
Advance slide in presentation mode to reveal answers.

LO 6
Accounting For
Inventory
6-69
Advance slide in presentation mode to reveal answers.

LO 6
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who rely on these materials.
6-70

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Learning Objective

1. Show how to account for inventory

Copyright 2015 Pearson Education Inc. All rights reserved.

SHOW HOW TO ACCOUNT FOR INVENTORY

Merchandisers have two accounts that service entities dont need:

Cost of goods sold on the income statement

SHOW HOW TO ACCOUNT FOR INVENTORY

Merchandisers have two accounts that service entities dont need:

Cost of goods sold on the income statement

SHOW HOW TO ACCOUNT FOR INVENTORY

Assume Family Dollar

SHOW HOW TO ACCOUNT FOR INVENTORY

Copyright 2015 Pearson Education Inc. All rights reserved.

Sale Price vs. Cost of Inventory

Sales revenue based on sales price of inventory sold

Cost of goods sold based on cost of inventory sold

Inventory based on cost of inventory on hand

Copyright 2015 Pearson Education Inc. All rights reserved.

Sale Price vs. Cost of Inventory

Determined from accounting records

Evidenced by physical count at year-end

Does not include those held for another company

Does include those out on consignment

Depends on shipping terms

Copyright 2015 Pearson Education Inc. All rights reserved.

Number of Units of Inventory

At the point when the goods leave

At the point of delivery to the

Company with legal title to the goods while in

Copyright 2015 Pearson Education Inc. All rights reserved.

Accounting for Inventory in the

Used for all types of goods

Used for inexpensive goods

Keeps a running record of

Does not keep a running

Inventory counted at least

Inventory counted at least

Copyright 2015 Pearson Education Inc. All rights reserved.

Accounting for Inventory in the

Optical scanner reads bar code, system

Updates inventory records

Exhibit 6-4 | Bar Code for

Two entries needed for each sale

Record revenue and asset received

Record cost of goods sold and reduction of inventory

Copyright 2015 Pearson Education Inc. All rights reserved.

Recording Transactions (Perpetual System)

PANEL ARecording Transactions (amounts assumed)

Recording Transactions (Perpetual System)

PANEL AT-accounts (amounts assumed)

PANEL BReporting (amounts assumed)

Recording Transactions (Perpetual System)

Copyright 2015 Pearson Education Inc. All rights reserved.

Recording Transactions (Perpetual System)

Copyright 2015 Pearson Education Inc. All rights reserved.

Recording Transactions (Perpetual System)

To record purchase of merchandise

Copyright 2015 Pearson Education Inc. All rights reserved.

Recording Transactions (Perpetual System)

Discount = $1,000 x 2% = $20

Copyright 2015 Pearson Education Inc. All rights reserved.

Copyright 2015 Pearson Education Inc. All rights reserved.

APPLY AND COMPARE VARIOUS