Inventories: Prepared By: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University

Inventories
Chapter 7
Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting
Pepperdine University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objectives
1. Describe the importance of control over

inventory.
2. Describe three inventory cost flow assumptions
and how they impact the income statement and
balance sheet.
3. Determine the cost of inventory under the
perpetual inventory system, using the FIFO,
LIFO, and average cost methods.
4. Determine the cost of inventory under the
periodic inventory system, using the FIFO, LIFO,
and average cost methods.
Learning Objectives
 Compare and contrast the use of the three
inventory costing methods.
Learning Objectives
inventory costing method.
 Describe and illustrate the reporting of
merchandise inventory in the financial
statements.
Learning Objectives
statements.
 Describe and illustrate the inventory turnover
and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of
inventory management.
Learning Objective 1
 Describe the importance of control over

inventory.
LO 1
Control of Inventory
 Two primary objectives of control over inventory

are:
1. Safeguarding the inventory from damage or
theft.
2. Reporting inventory in the financial
statements.
LO 1
Safeguarding Inventory
 The purchase order authorizes the purchase of

the inventory from an approved vendor.
LO 1
 The receiving report establishes an initial record
of the receipt of the inventory.
LO 1
 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.
LO 1
 Controls for safeguarding inventory should

include security measures to prevent damage and
customer or employee theft. Some examples of
security measures include the following:
 Storing inventory in areas that are restricted to

only authorized employees.
 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags,
and guards.
LO 1
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.

inventories.
 Describe three inventory cost flow assumptions
balance sheet.
LO 2
Inventory Cost Flow Assumptions
LO 2
LO 2
Assume that one unit is sold on May 30 for $20.

Depending upon which unit was sold, the gross
profit varies from $11 to $6 as shown below:
LO 2
 Under the specific identification inventory cost

flow method, the unit sold is identified with a
specific purchase.
LO 2
 Under the first-in, first out (FIFO) inventory cost

flow method, the first units purchased are
assumed to be sold first and the ending inventory
is made up of the most recent purchases.
LO 2
 Under the last-in, first out (LIFO) inventory cost

flow method, the last units purchased are
assumed to be sold first and the ending inventory
is made up of the first units purchased.
LO 2
 Under the average inventory cost flow method,

the cost of the units sold and in ending inventory
is an average of the purchase costs.
LO 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. (continued)
LO 2
(continued)
LO 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. (concluded)
EE 7-1

inventory.
balance sheet.
 Determine the cost of inventory under the
LO 3
Inventory Costing Methods
 For purposes of illustration, the data for Item

127B are used, as shown below. We will
examine the perpetual inventory system first.
LO 3
First-In, First-Out Method
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(concluded)
EE 7-2
LO 3
Last-In, First-Out Method
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
LO 3
(continued)
EE 7-3
LO 3
Average Cost Method
 When the average cost method is used in a

perpetual system, an average unit cost for each
item is computed each time a purchase is made.
 This unit cost is then used to determine the cost of
each sale until another purchase is made and a
new average is computed. This averaging
technique is called a moving average.

inventories.
balance sheet.
periodic inventory system, using the FIFO, LIFO,
and average cost methods.
LO 4
 Using FIFO, the earliest batch purchased is

considered the first batch of merchandise sold.
The physical flow does not have to match the
accounting method chosen. This time we will be
examining the periodic inventory system.
LO 4
 Beginning inventory and purchases of Item

127B in January are as follows:
Cost of merchandise
available for sale
LO 4
 The physical count on January 31 shows that

150 units are on hand. (Conclusion: 130 units
were sold.) What is the cost of the ending
inventory?
LO 4
 Now we can calculate the cost of merchandise

sold as follows:
LO 4
LO 4
 Using LIFO, the most recent batch purchased is

considered the first batch of merchandise sold.
The actual flow of goods does not have to be
LIFO. For example, a store selling fresh fish
would want to sell the oldest fish first (which is
FIFO), even though LIFO is used for accounting
purposes.
LO 4
 Using the last-in, first-out method, the cost

of the ending inventory on January 31 is
determined as follows:
Inventory, January 31
LO 4
 Assume again that the physical count on

January 31 is 150 units (and that 130 units
were sold). What is the cost of the
merchandise sold?
LO 4
LO 4
Average Cost Method
 The average cost method is sometimes called the

weighted average method. It uses the average unit
cost for determining cost of merchandise sold and
the ending merchandise inventory.
LO 4
Average Cost Method

 The weighted average unit cost is determined as
follows:
Total Cost of Units Available for Sale

Average Unit Cost =
Units Available for Sale
$5,880
Average Unit Cost =
280 units
Average Unit Cost = $21 per unit
LO 4
Average Cost Method
Cost of merchandise
available for sale
Average cost
per unit
Ending
Inventory
LO 4
Average Cost Method
EE 7-4

inventory costing methods.
LO 5
Comparing Inventory Cost Methods
 Using the periodic inventory system illustration

with sales of $3,900 (130 units x $30), the
differences in ending inventory, cost of
merchandise sold, and gross profit are
illustrated in the next three slides.
LO 5
Partial Income Statements (FIFO)
LO 5
Partial Income Statements (Average Cost)
LO 5
Partial Income Statements (LIFO)
LO 5
Comparing Inventory Cost Methods

statements.
LO 6
Reporting Merchandise Inventory
 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:
 The cost of replacing items in inventory is
below the recorded cost.
 The inventory cannot be sold at normal
prices due to imperfections, style changes, or
other causes.
LO 6
Valuation at Lower of Cost or Market
Market, as used in lower-of-cost-or-market

method, is the cost to replace the merchandise on
the inventory date.
LO 6
 Cost and replacement cost can be determined for

the following:
 Each item in the inventory.
 Each major class or category of inventory.
 Total inventory as a whole.
LO 6
EE 7-5
LO 6
Valuation at Net Realizable Value
 Merchandise that is out of date, spoiled, or

damaged should be written down to its net
realizable value. This is the estimated selling price
less any direct costs of disposal, such as sales
commissions or special advertising.
LO 6
Valuation at Net Realizable Value

 Assume the following data about an item of
damaged merchandise:
Original cost $1,000
Estimated selling price 800
Selling expenses 150
 The merchandise should be valued at its net
realizable value of $650 ($800 – $150).
LO 6
Merchandise Inventory on the Balance Sheet
 Merchandise inventory is usually presented in the

Current Assets section of the balance sheet,
following receivables.
LO 6
 The method of determining the cost of the

inventory (FIFO, LIFO, or weighted average) and
the method of valuing the inventory (cost or the
lower of cost or market) should be shown.
LO 6
LO 6
Inventory Errors
 Some reasons that inventory errors may occur

include the following:
 Physical inventory on hand was miscounted.
 Costs were incorrectly assigned to inventory.
 Inventory in transit was incorrectly included
or excluded from inventory.
 Consigned inventory was incorrectly
included or excluded from inventory.
LO 6
Inventory Errors
 Inventory errors often arise from consigned

inventory. Manufacturers sometimes ship
merchandise to retailers who act as the
manufacturer’s agent.
LO 6
Inventory Errors
 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.
LO 6
Inventory Errors
LO 6
LO 6
Balance Sheet Effects
EE 7-6

statements.
 Describe and illustrate the inventory turnover
and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of
inventory management.
LO 7
Inventory Turnover
 Inventory turnover measures the relationship

between cost of merchandise sold and the amount
of inventory carried during the period. It is
calculated as follows:
Cost of Merchandise Sold

Inventory Turnover =
Average Inventory
LO 7
Inventory Turnover
 Inventory turnover for Best Buy is shown
below (in millions).
LO 7
Inventory Turnover
 The number of days’ sales in inventory measures
the length of time it takes to acquire, sell, and
replace the inventory. It is computed as follows:
Number of Days’ = Average Inventory

Sales in Inventory Average Daily Cost of
Merchandise Sold
LO 7
Inventory Turnover
 The number of days’ sales in inventory for Best
Buy is computed below (in millions).
EE 7-7
EE 7-7
PE 7-7A, PE 7-7B
Appendix
Estimating
Inventory
Cost Prepared by: C. Douglas Cloud
Appendix
Retail Method of Inventory Costing
 The retail inventory method of estimating

inventory cost requires costs and retail prices to
be maintained for the merchandise available for
sale.
 A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the
ending inventory cost.
Appendix
Retail Method of Inventory Costing
Appendix
Gross Profit Method of Inventory Costing
 The gross profit method uses the estimated gross

profit for the period to estimate the inventory at
the end of the period.
Appendix
Gross Profit Method of Inventory Costing
Inventories
The End
Prepared by: C. Douglas Cloud


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Inventories

Prepared by: C. Douglas Cloud

1. Describe the importance of control over

 Describe the importance of control over

 Two primary objectives of control over inventory

 The purchase order authorizes the purchase of

 Controls for safeguarding inventory should

 Storing inventory in areas that are restricted to

 A physical inventory or count of inventory should

 Describe the importance of control over

Assume that one unit is sold on May 30 for $20.

 Under the specific identification inventory cost

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

 Under the last-in, first out (LIFO) inventory cost

 Under the average inventory cost flow method,

 Describe the importance of control over

 For purposes of illustration, the data for Item

 When the average cost method is used in a

 Describe the importance of control over

 Using FIFO, the earliest batch purchased is

 Beginning inventory and purchases of Item

 The physical count on January 31 shows that

 Now we can calculate the cost of merchandise

First-In, First-Out Method

 Using LIFO, the most recent batch purchased is

 Using the last-in, first-out method, the cost

 Assume again that the physical count on

Last-In, First-Out Method

 The average cost method is sometimes called the

Average Cost Method

Total Cost of Units Available for Sale

Average Unit Cost = $21 per unit

Average Cost Method

Average Cost Method

 Compare and contrast the use of the three

 Using the periodic inventory system illustration

Partial Income Statements (FIFO)

Partial Income Statements (Average Cost)

 Compare and contrast the use of the three

 Cost is the primary basis for valuing and

Market, as used in lower-of-cost-or-market

 Cost and replacement cost can be determined for

 Merchandise that is out of date, spoiled, or

Valuation at Net Realizable Value

 Merchandise inventory is usually presented in the

 The method of determining the cost of the

 Some reasons that inventory errors may occur

 Inventory errors often arise from consigned

 Compare and contrast the use of the three

 Inventory turnover measures the relationship

Cost of Merchandise Sold

Number of Days’ = Average Inventory

Retail Method of Inventory Costing

 The retail inventory method of estimating

Retail Method of Inventory Costing

Gross Profit Method of Inventory Costing

 The gross profit method uses the estimated gross

Gross Profit Method of Inventory Costing

Prepared by: C. Douglas Cloud