8

Inventories

Managing Inventories
OBJECTIVE 1: Explain the management
decisions related to inventory accounting,
evaluation of inventory level, and the effects
of inventory misstatements on income
measurement.

Key Ratios

Inventory turnover
Days inventory on hand

Figure 1: Management Choices in

Accounting for Inventories

Figure 2: Inventory Turnover for Selected

Industries

Figure 3: Days Inventory on Hand for

Selected Industries

Managing Inventories

Merchandise inventory is a current asset.

The matching principle is applied to inventory
valuation.
The higher the ending inventory, the lower the
cost of goods sold and the higher the gross
profit and net income.

Managing Inventories

Merchandise inventory is a current asset.

(cont.)
Management chooses an inventory system
(periodic or perpetual), an inventory costing
system (specific identification, average cost,
FIFO, or LIFO), and a method of valuing
inventory at market.

Managing Inventories

In managing inventory levels, it is important to

take into consideration both the costs of
handling, storing, and financing inventories and
the cost of lost sales.
Inventory turnover (cost of goods sold divided by
average inventory) is the number of times, on
average, inventory is sold during the period.
Days inventory on hand (365 divided by inventory
turnover) is the number of days it takes to sell
inventory.

Managing Inventories

In managing inventory levels, it is

important to take into consideration both
the costs of handling, storing, and financing
inventories and the cost of lost sales. (cont.)
Inventory levels are minimized by using
supply-chain management in a just-in-time
operating environment.

Managing Inventories

Beginning and ending inventory are an integral

part of the calculation of cost of goods sold
and, therefore, income before income taxes.
When ending inventory is under- or overstated,
income before income taxes will be under- or
overstated, respectively.
When beginning inventory is under- or overstated,
income before income taxes will be over- or
understated, respectively.

Managing Inventories

Beginning and ending inventory are an

integral part of the calculation of cost of
goods sold and, therefore, income before
income taxes. (cont.)
Inventory errors are counterbalancing because
their effects are reversed within two accounting
periods.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.

Inventory Cost and Valuation

OBJECTIVE 2: Define inventory cost,
contrast goods flow and cost flow, and
explain the lower-of-cost-or-market (LCM)
rule.

Figure 4: Merchandise in Transit

Inventory Cost and Valuation

Inventory cost includes purchase price less

discounts; freight-in and insurance in
transit; and taxes and tariffs.

Inventory Cost and Valuation

Goods flows and cost flows

Goods flow is the actual physical flow of
goods into and out of the company.
Cost flow is an assumption made about costs
for accounting purposes.

Inventory Cost and Valuation

Goods flows and cost flows (cont.)

Merchandise inventory also includes the
following costs:
Incoming goods shipped FOB shipping point
Outgoing goods shipped FOB destination
Goods consigned to another company

Inventory Cost and Valuation

Goods flows and cost flows (cont.)

Merchandise inventory would not include the
following costs:
Incoming goods shipped FOB destination
Outgoing goods shipped FOB shipping point
Goods held on consignment from another company

Inventory Cost and Valuation

Inventory should be valued at the lower of

cost or market.
First, cost is determined by historical, or
original, cost.
Market is defined as replacement cost.
Cost is compared with market.
Use of LCM can be an indicator that a
company is in trouble.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.

Inventory Cost Under the Periodic

Inventory System
OBJECTIVE 3: Calculate inventory cost
under the periodic inventory system using
various costing methods.

Figure 5: The Impact of Costing Methods on the

Income Statement and Balance Sheet Under the
Periodic Inventory System

Inventory Cost Under the Periodic

Inventory System

Under the specific identification method,

ending inventory can be identified as
having come from specific purchases.
The specific identification method is used
primarily for high-priced items such as
automobiles, furniture, and expensive jewelry.

Inventory Cost Under the Periodic

Inventory System

Under the average-cost method, an average

cost per unit is calculated on goods
available for sale to determine ending
inventory and cost of goods sold.
An advantage of the average-cost method is that
cost increases and decreases are leveled out.
A disadvantage of the average-cost method is
that the most current costs are not used in
income determination.

Inventory Cost Under the Periodic

Inventory System

Under FIFO, the first goods purchased are

assumed to be the first sold.
In a period of rising prices, FIFO will produce
the highest net income of the four methods.
FIFO is criticized for magnifying the effects of
the business cycle on income.

Inventory Cost Under the Periodic

Inventory System

Under LIFO, the goods purchased most

recently are assumed to be the first sold.
LIFO matches current costs with current revenues,
and the effects of the business cycle are smoothed
out.
Disadvantages of LIFO include reporting the
lowest net income of the four methods in
inflationary times, often an unrealistic inventory
valuation, and lack of acceptance in most other
countries.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.

Impact of Inventory Decisions

OBJECTIVE 4: Explain the effects of
inventory costing methods on income
determination and income taxes.

Table 1: Effects of Inventory Costing

Methods on Gross Margin

Figure 6: Inventory Costing Methods Used

by 600 Large Companies

Impact of Inventory Decisions

During periods of rising prices, FIFO

provides a higher gross margin than LIFO.
The average-cost method produces gross
margin that is between those of FIFO and
LIFO. No generalization can be made about
the specific identification method.
During periods of falling prices, LIFO
produces a higher gross margin than FIFO.

Impact of Inventory Decisions

Effects on the financial statements

In general, LIFO best follows the matching rule.
In general, FIFO provides a more up-to-date
ending inventory figure for balance sheet
purposes.
The inventory method chosen must be applied
consistently. When LIFO is used for tax
purposes, it must also be used for financial
reporting.

Impact of Inventory Decisions

A LIFO liquidation occurs when the quantity

of ending inventory is less than the quantity
of beginning inventory. This generally
produces higher income before taxes.
When ending inventory is understated, income
before income taxes for the period will be
understated.
When ending inventory is overstated, income
before income taxes for the period will be
overstated.

Impact of Inventory Decisions

A LIFO liquidation occurs when the quantity

of ending inventory is less than the quantity
of beginning inventory. This generally
produces higher income before taxes. (cont.)
When beginning inventory is understated,
income before income taxes for the period will
be overstated.
When beginning inventory is overstated, income
before income taxes for the period will be
understated.

Impact of Inventory Decisions

A companys choice of inventory method

will affect not only its profitability, but also
its liquidity and cash flows.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.

Inventory Cost Under the Perpetual

Inventory System
SUPPLEMENTAL OBJECTIVE 5: Calculate
inventory cost under the perpetual inventory
system using various costing methods.

Figure 7: The Impact of Costing Methods on the

Income Statement and Balance Sheet Under the
Perpetual Inventory System

Inventory Cost Under the Perpetual

Inventory System

The specific identification method is

applied the same way in the perpetual
system as in the periodic system and
produces the same results.
Using the average-cost method in a
perpetual system, a moving average is
computed after each purchase.

Inventory Cost Under the Perpetual

Inventory System

Using FIFO and LIFO in a perpetual

system, list each inventory layer separately.
FIFO will yield the same ending inventory
figure under the perpetual system as under
the periodic system.

Inventory Cost Under the Perpetual

Inventory System

LIFO will usually produce different figures

for ending inventory and cost of goods sold
in a perpetual system than in a periodic
system.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.

Valuing Inventory by Estimation

SUPPLEMENTAL OBJECTIVE 6: Use the
retail method and gross profit method to
estimate the cost of ending inventory.

Table 2: Retail Method of Inventory

Estimation

Table 3: Gross Profit Method of Inventory

Estimation

Valuing Inventory by Estimation

The retail method can be used when the

relationship between cost and selling price is
relatively constant. Applying this method is
complicated by retail prices that change during
the year, different markups that exist on different
types of merchandise, and sales volumes of
different types of merchandise that vary.
With the retail method, records must be kept at cost
and at retail.

Valuing Inventory by Estimation

The retail method can be used when the

relationship between cost and selling price
is relatively constant. Applying this method
is complicated by retail prices that change
during the year, different markups that exist
on different types of merchandise, and sales
volumes of different types of merchandise
that vary. (cont.)

Valuing Inventory by Estimation

Applying the retail method involves four steps.

Compute goods available for sale at cost and at
retail.
Compute a cost-to-retail ratio.
Subtract sales from goods available for sale at retail
to obtain ending inventory at retail.
Multiply ending inventory at retail by the cost-toretail ratio to determine ending inventory at cost.

Valuing Inventory by Estimation

The gross profit method can be used when

the gross profit ratio remains relatively
constant.
The gross profit method is used in place of the
retail method when records of retail prices of
beginning inventory and purchases are not
kept.
The gross profit method is generally used when
inventory is destroyed or stolen.

Valuing Inventory by Estimation

The gross profit method can be used when the

gross profit ratio remains relatively constant.
Applying the gross profit method involves three
steps.
Compute goods available for sale (at cost) by adding
purchases to beginning inventory.
Compute estimated cost of goods sold by deducting
the estimated gross margin from sales.
Subtract estimated cost of goods sold from cost of
goods available for sale to obtain estimated ending
inventory.

2011 Cengage Learning All Rights Reserved. May not be scanned, copied or duplicate, or posted to a publicly accessible website, in whole or in part.