CHAPTER

6 Inventories

Financial and
Managerial
Accounting
13e

human/iStock/360/Getty Images
Warren
Reeve
Duchac
Safeguarding Inventory
(slide 1 of 2)

• Controls for safeguarding inventory begin as soon as

the inventory is ordered.
• The purchase order authorizes the purchase of the
inventory from an approved vendor.
• The receiving report establishes an initial record of
the receipt of the inventory.
• The price, quantity, and description of the item on the
purchase order and receiving report are compared to
the vendor’s invoice before the inventory is recorded
in the accounting records.

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Safeguarding Inventory
(slide 2 of 2)

• Recording inventory using a perpetual inventory system is also

an effective means of control. The amount of inventory is
always available in the subsidiary inventory ledger.
• Controls for safeguarding inventory should include security
measures to prevent damage and customer or employee theft.

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Reporting Inventory

• A physical inventory or count of inventory should be

taken near year-end to make sure that the quantity of
inventory reported in the financial statements is
accurate.
• After the quantity of inventory on hand is determined,
the cost of the inventory is assigned for reporting in
the financial statements.
o Most companies assign costs to inventory using one of
three inventory cost flow assumptions.

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Inventory Cost Flow Assumptions
(slide 1 of 2)

• Under the specific identification inventory cost

flow method, the unit sold is identified with a
specific purchase.

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Inventory Cost Flow Assumptions
(slide 2 of 2)

• Under the first-in, first-out (FIFO) inventory cost flow

method, the first units purchased are assumed to be sold and
the ending inventory is made up of the most recent purchases.
• Under the last-in, first out (LIFO) inventory cost flow
method, the last units purchased are assumed to be sold and
the ending inventory is made up of the first purchases.
• Under the weighted average inventory cost flow method, the
cost of the units sold and in ending inventory is a weighted
average of the purchase costs.

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First-In, First-Out Method

• When the FIFO method is used in a perpetual

inventory system, costs are included in the cost of
merchandise sold in the order in which they were
purchased.
• This is often the same as the physical flow of the
merchandise.
• For example, grocery stores shelve milk and other
perishable products by expiration dates. Products
with early expiration dates are stocked in front. In this
way, the oldest products (earliest purchases) are sold
first.
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Entries and Perpetual Inventory Account (FIFO)

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Last-In, First-Out Method

• When the LIFO method is used in a perpetual

inventory system, the cost of the units sold is the cost
of the most recent purchases.
• The LIFO method was originally used in those rare
cases where the units sold were taken from the most
recently purchased units. However, for tax purposes,
LIFO is now widely used even when it does not
represent the physical flow of units.

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Entries and Perpetual Inventory Account (LIFO)

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Weighted Average Cost Method

• When the weighted average cost method is used in a

perpetual inventory system, a weighted average unit
cost for each item is computed each time a purchase
is made.
• This unit cost is used to determine the cost of each
sale until another purchase is made and a new average
is computed.
o This technique is called a moving average.

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Entries and Perpetual Inventory Account
(Weighted Average)

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Inventory Costing Methods Under a
Periodic Inventory System

• When the periodic inventory system is used, 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 merchandise sold.
• At the end of the accounting period, a physical
inventory is taken to determine the cost of the
inventory and the cost of the merchandise sold.
• Like the perpetual inventory system, a cost flow
assumption must be made when identical units are
acquired at different unit costs during a period.

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Weighted Average Cost Method
(slide 1 of 2)

• What is the average cost per unit and the ending

inventory?

Average cost
per unit

Ending
inventory

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Weighted Average Cost Method
(slide 2 of 2)

• The cost of merchandise sold is computed as follows:

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Comparing Inventory Costing Methods

• 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:
o Cost of merchandise sold
o Gross profit
o Net income
o Ending merchandise inventory
• Note that if costs (prices) remain the same, all three
methods would yield the same results. However, costs
(prices) normally do change.

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Reporting Merchandise Inventory
in the Financial Statements

• 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:
o The cost of replacing items in inventory is below the
recorded cost.
o The inventory cannot be sold at normal prices due to
imperfections, style changes, spoilage, damage,
obsolescence, or other causes.

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Valuation at Lower of Cost or Market
(slide 1 of 2)

• If the market is lower than the purchase cost, the

lower-of-cost-or-market (LCM) method is used to
value the inventory.
• Market, as used in lower of cost or market, is the net
realizable value of the merchandise. Net realizable
value is determined as follows:
Net Realizable Value = Estimated Selling Price – Direct Costs of Disposal
o Direct costs of disposal include selling expenses such as
special advertising or sales commissions.

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Valuation at Lower of Cost or Market
(slide 2 of 2)

• The lower-of-cost-or-market method can be applied

in one of three ways. The cost, market price, and any
declines could be determined for the following:
o Each item in the inventory
o Each major class or category of inventory
o Total inventory as a whole

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Merchandise Inventory on the Balance Sheet

• Merchandise inventory is usually reported in the

Current Assets section of the balance sheet.
• In addition to this amount, the following are reported:
o The method of determining the cost of the inventory
(FIFO, LIFO, or weighted average)
o The method of valuing the inventory (cost or the lower of
cost or market)

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Effect of Inventory Errors
on the Financial Statements
(slide 1 of 2)

• Any errors in merchandise inventory will affect the

balance sheet and income statement.
• Some reasons that inventory errors may occur include
the following:
o Physical inventory on hand was miscounted.
o Costs were incorrectly assigned to inventory.
o Inventory in transit was incorrectly included or excluded
from inventory.
o Consigned inventory was incorrectly included or excluded
from inventory.

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Effect of Inventory Errors
on the Financial Statements
(slide 2 of 2)

• Inventory errors often arise from consigned

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 is said to
be shipped on consignment to the retailer, called the
consignee.
• Any unsold merchandise at year-end is part of the
manufacturer’s (consignor’s) inventory, even though
the merchandise is in the hands of the retailer
(consignee).
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Financial Analysis and Interpretation: Inventory
Turnover

• Inventory turnover measures the relationship

between cost of merchandise sold and the amount of
inventory carried during the period.
• Inventory turnover is calculated as follows:
Cost of Merchandise Sold
Inventory Turnover =
Average Inventory

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Financial Analysis and Interpretation:
Number of Days’ Sales in Inventory

• The number of days’ sales in inventory measures

the length of time it takes to acquire, sell, and replace
the inventory.
• The number of days’ sales in inventory is computed
as follows:
Number of Days’ Average Inventory
=
Sales in Inventory Average Daily Cost of Merchandise
Sold

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Appendix: Estimating Inventory Cost

• A business may need to estimate the amount of

inventory for the following reasons:
o Perpetual inventory records are not maintained.
o A disaster such as a fire or flood has destroyed the
inventory records and the inventory.
o Monthly or quarterly financial statements are needed, but a
physical inventory is taken only once a year.
• Two widely used methods of estimating inventory
cost are the retail inventory method and gross profit
method.

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