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CHAPTER 5
ACCOUNTING FOR INVENTORIES
Key Terms and Concepts to Know
Ownership: Ownership includes all inventory owned by the purchaser, regardless of location or possession. The following items are included in inventory: Owned inventory at the company’s location Inventory purchased FOB Shipping Point and still in-transit from the seller Inventory sold FOB Destination and still in-transit to the seller Owned inventory on consignment to others
Physical Inventory: Inventory is physically counted to determine the actual quantity on hand. The units of inventory physical counted are then valued at cost to determine the value of inventory that SHOULD be recorded in the general ledger. Any difference between the general ledger balance and the value of the physical inventory is recorded as shrinkage.
Inventory Methods: There are two basic methods used to account for inventory: Periodic and Perpetual. Periodic Inventory: o A separate general ledger account is used for each type of inventory transaction. o Cost of goods sold transactions are ignored during the period and recorded only at the end of the period. o Merchandise inventory balance in the general ledger is not updated until the end of the period and does NOT represent the value of inventory on hand. Perpetual Inventory: o All inventory transactions are recorded in a single merchandise inventory account in the general ledger. o Cost of goods sold transactions are recorded as incurred throughout the period.
o All inventory transactions are recorded as incurred, constantly updating the value of inventory in the general ledger which represents the value of inventory on hand.
Inventory Cost: Cost is the total resources given up to acquire inventory and move it to the purchaser’s place of business. Cost may be assigned to units of inventory in one of four ways: o Specific identification o First-In, First Out (FIFO) o Last-In, First-Out (LIFO) o Weighted Average Cost The actual application of these methods will vary depending on whether a perpetual or periodic inventory system is used.
Lower of Cost or Market: As with all assets, inventory is recorded at cost when acquired. Over time, however, the cost of replacing the inventory with the same type of inventory (market cost) may fall below purchase cost. The lower-of-cost-or-market principle may be applied in one of three ways: o To the entire inventory taken as a whole o By group or class or type of product o To each item individually This situation requires a journal entry to record the decline in the value of the inventory on hand:
Cost of Goods Sold xxx Merchandise Inventory xxx
Inventory Turnover ratio and Days Sales in Inventory ratio
actually sold. The most recent or last-in unit costs are used to calculate cost of goods sold; remaining unit costs are assigned to the units in ending inventory. Under Average Cost, an average cost for all units cost for all units in inventory is calculated and used to value the units in both cost of goods sold and ending inventory.
Following are examples of these methods under the periodic inventory method (Examples #1, #2 and #3) and under the perpetual inventory method (Examples #4, #5 and #6). There are 50 units in ending inventory.
Transaction Type # of Units Unit Cost Beginning Inventory 10 $ Purchased 40 $ Sold 20 Purchased 50 $ Sold 20 Sold 30 Purchased 40 $ Sold 20
Example #1: FIFO/Periodic Note that the costs of the 50 units purchased at $130 have been split between the units sold and the units remaining in inventory.
Cost of Goods Sold Ending Inventory Units Cost/unit Units Cost/unit Total 10 $120 $1, 40 $125 5, 40 $130 5,200 10 $130 $1, 40 $132 5, $11,400 $6,
Example #2: LIFO/Periodic
Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 50 $130 $6,500 10 $120 $1, 40 $132 5,280 40 $125 5, $11,780 $6,
Example #3: Average Cost/Periodic
Transaction Type # of Units Unit Cost Value Beginning Inventory 10 $120 $1, Purchased 40 $125 5, Purchased 50 $130 6, Purchased 40 $132 5, Total 140 $128.43 $17,
Average Cost: $17,980 / 140 total units = $128.43/unit (rounded). Average cost is calculated at the end of the period.
Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 90 $128.43 $11,558.50 50 $128.43 $6,421.
Example #4: FIFO/Perpetual
Transaction Type
Purchases Cost of Goods Sold
Balance
Beginning Inventory
Purchased 40@$125=$5,000 10@$120=$1, 40@$125=$5, Sold 10@$120=$1, 10@$125=$1,250 30@$125=$3, Purchased 50@$130=$6,500 30@$125=$3, 50@$130=$6, Sold 20@$125=$2,500 10@$125=$1, 50@$130=$6, Sold 10@$125=$1, 20@$130=$2,600 30@$130=$3, Purchased 40@$132=$5,280 30@$130=$3, 40@$132=$5, Sold 20@$130=$2,600 10@$130=$1, 40@$132=$5, Total/Balance $11,400 $6,
Average cost (highlighted in red) is calculated after each purchase and is used to value both cost of goods sold and inventory until the next purchase is made.
Summary of Examples #1 through #6:
Cost of Goods Sold Ending Inventory Units Value Units Value Periodic Example #1 90 $11,400 50 $6, Example #2 90 $11,780 50 $6, Example #3 90 $11,558 50 $6, Perpetual Example #4 90 $11,400 50 $6, Example #5 90 $11,640 50 $6, Example #6 90 $11,471 50 $6,
Six different inventory methods, five different costs of goods sold and five different ending inventory vales and all of them are GAAP. Periodic and perpetual FIFO will always produce the same cost of goods sold and ending inventory.
Practice Problem #
Transaction # of Units Unit Cost Beginning Inventory 20 $2, Purchase 25 $2, Sold 10 Sold 14 Purchase 15 $2, Sold 26 Purchase 20 $2,
According to the table above, there are 30 units in the ending inventory.
Required: What is the cost of these units under each of the following assumptions? a. FIFO/Periodic b. FIFO/Perpetual c. LIFO/Periodic d. LIFO/Perpetual e. Average Cost/Periodic f. Average Cost/Perpetual
Practice Problem #2: For each item below, indicate whether FIFO or LIFO will generally result in a higher reported amount when inventory costs are rising versus falling.
Inventory Costs
Higher Total Assets
Higher Cost of Goods Sold
Higher Net Income
Rising ___________ ___________ ___________
Falling ___________ ___________ ___________
Practice Problem #3: During 2012, a company sells 200 units of inventory for $50 each. The company has the following inventory purchase transactions for 2012:
Date Transaction Units Unit Cost Total Cost Jan 1 Beginning Inventory 50 $39 $1, May 5 Purchase 100 38 3, Nov 3 Purchase 80 37 2, 230 $8,
Actual sales by the company include its entire beginning inventory, 80 units of inventory from the May 5 purchase, and 70 units from the November 3 purchase.
Required: Calculate cost of goods sold and ending inventory for 2012 assuming the company uses specific identification.
Practice Problem #4: A company reports inventory using the lower-of-cost-or-market method. Below is information related to its year-end inventory:
Inventory Quantity Cost Market Item A 100 $25 $ Item B 50 30 20
Required: Calculate ending inventory under lower-of-cost-or-market and record any necessary adjustment to inventory.
True False
- Understating ending inventory in the current year causes cost of goods sold in the current year to be understated. True False
- Using the first-in, first-out method (FIFO), the first units purchased are assumed to be the first ones sold. True False
- For most companies, actual physical flow of their inventory follows LIFO. True False
- One of the primary benefits of using FIFO when inventory costs are rising is that it results in greater tax savings. True False
- At the time inventory is sold, cost of goods sold is recorded under the perpetual inventory system. True False
- Using a perpetual inventory system, the purchase of inventory is recorded with a debit to the Purchases account, which is a temporary account closed to cost of goods sold at the end of the period. True False
- When the value of inventory falls below its cost, companies have the option of recording the inventory at cost or the lower market value. True False
- The adjustment to write down inventory from cost to its lower market value includes a debit to Cost of Goods Sold and a credit to Inventory. True False
- The inventory turnover ratio equals cost of goods sold divided by average inventory. True False
- Using LIFO, the amount reported for ending inventory does not differ depending on whether a company uses a periodic system or a perpetual system. True False
- During periods of rising costs, LIFO generally results in a higher cost of goods sold. True False
- If the cost of an item of inventory is $50, the current replacement cost is $45, and the sales price is $65, the amount included in inventory according to the lower of cost or market is: a) $ b) $ c) $ d) $
- Merchandise Inventory is reported on the balance sheet in the section entitled: a) current liabilities b) plant assets c) current assets d) owner’s equity
- The number of days’ sales in inventory a) Measures the length of time it takes to acquire, sell, and replace the inventory. b) Is computed by dividing the cost of merchandise sold by 365. c) Measures the length of time it takes to sell the merchandise on credit and collect the account receivable. d) Is about the same for all industries.
Use the following information to answer questions 8-10: Acme Company just started business in August and they use the periodic inventory system. They made the following purchases during August: August 01 300 units $1,560 total cost August 12 400 units 2,340 total cost August 24 400 units 2,520 total cost August 30 300 units 1,980 total cost
- A physical count of the inventory on August 31 reveals that there are 500 units on hand. Using a FIFO cost flow assumption, the value of the ending inventory on August 31 is: a) $2, b) $5, c) $5, d) $3,
- A physical count of the inventory on August 31 reveals that there are 500 units on hand. Using a LIFO cost flow assumption, the value of the ending inventory on August 31 is: a) $3, b) $2, c) $5, d) $5,
- A physical count of the inventory on August 31 reveals that there are 500 units on hand. Using the average cost method, the cost of goods sold for August is: a) $5, b) $8, c) $2, d) $3,
Use the following information to answer questions 11-13:
Cole, Inc. uses perpetual inventory procedures and made the following sales and purchases during the month of September: September 1 Balance 200 units $150/unit September 5 Sold 110 units September 8 Purchased 400 units $155/unit September 10 Sold 320 units September 15 Purchased 400 units $160/unit September 20 Sold 240 units September 25 Sold 230 units September 30 Purchased 300 units $165/unit
- A^ physical count of the inventory on September 30 reveals that there are 400 units on hand. Using a FIFO cost flow assumption, the value of the ending inventory on August 31 is: a) $60, b) $66, c) $65, d) $64,
- Inventory records for Dunbar Incorporated revealed the following:
Dunbar sold 700 units of inventory during the month. Ending inventory assuming weighted-average cost would be (round weighted-average unit cost to four decimals if necessary): a) $ b) $ c) $ d) $
- During periods when inventory costs are rising, cost of goods sold will most likely be: a) Higher under FIFO than LIFO. b) Higher under FIFO than average cost. c) Lower under average cost than LIFO. d) Lower under LIFO than FIFO.
- Niva Company has the following information for their inventories A, B, C, and D:
The necessary adjustment associated with the lower-of-cost-or- market method would be: a) Inventory 675 Cost of Goods Sold 675 b) Cost of Goods Sold 675 Inventory 675 c) Inventory 475 Cost of Goods Sold 475 d) Cost of Goods Sold 475 Inventory 475
- Under the principle of lower-of-cost-or-market, when a company has 10 units of inventory A with market value of $50 and a cost of $60, what is the adjustment? a) Debit Inventory $100; credit Cost of Goods Sold $100. b) Debit Inventory $500; credit Cost of Goods Sold $500. c) Debit Cost of Goods Sold $100; credit Inventory $100. d) Debit Cost of Goods Sold $500; credit Inventory $500.
- At the end of a reporting period, Gamble Corporation determines that its ending inventory has a cost of $300,000 and a market value of $230,000. What would be the effect(s) of the adjustment to write down inventory to market value? a) Decrease total assets b) Decrease net income c) Increase retained earnings d) Both a) and b)
c) LIFO/Periodic
Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 15 $2,250 $33.750 20 $2,200 $44, 15 $2,300 34,500 10 $2,250 22, 20 $2,350 47, $115,250 $66,
d) LIFO/Perpetual
Transaction Type
Cost of Goods Sold Balance
Beginning Inventory
Purchased 20@$2,200=$44, 25@$2,250=$56, Sold 10@$2,250=$22,500 20@$2,200=$44, 15@$2,250=$33, Sold 14@$2,250 = $31,
Purchased 20@$2,200=$44, 1@$2,250 = $2, 15@$2,300=$34, Sold 10@$2,200 = $22, 1@$2,250=$2, 15@$2,300 = $34,
Purchased 10@$2,200=$22, 20@$2,350 =$47, Total/Balance $112,750 $69,
e) Average Cost/Periodic
Transaction Type # of Units Unit Cost Value Beginning Inventory 20 $2,200 $44, Purchased 25 $2,250 56, Purchased 15 $2,300 34, Purchased 20 $2,350 47, Total 80 $2,271.88 $181,
Cost of Goods Sold Ending Inventory Units Cost/unit Total Units Cost/unit Total 50 $2,271.88 $113,593.25 30 $2,271.88 $68,156.
f) Average Cost/Perpetual
Transaction Type
Purchases Cost of Goods Sold Balance
Beginning Inventory
Purchased 25@$2,250=$56,250 45@$2,227.78=$100, Sold 10@$2,227.78=$22,278 35@$2,227.78=$77,972. Sold 14@$2,227.78=$31,189 21@$2,227.78=$46, Purchased 15@$2,300=$34,500 36@$2,257.86=$81, Sold 26@$2,257.86=$58,704 10@$2,257.86=$22, Purchased 20@$2,350=$47,000 30@$2,319.30=$69, Total/Balance $112,171 $69,
Practice Problem #2:
Inventory Costs
Higher Total Assets
Higher Cost of Goods Sold
Higher Net Income Rising FIFO LIFO FIFO Falling LIFO FIFO LIFO
