Financial accounting 9th jamie pratt chapter 07

Chapter 7:
Merchandise Inventory


Merchandise Inventory
 What is inventory?
 Items held for resale to customers
 Who has inventory?
 Wholesaler or Retailer
o Merchandise Inventory

 Manufacturer

o Raw Materials
o Work in Process
o Finished Goods


The Relative Size of Inventories

Figure 7-1
Inventory as
a percentage
of total assets
and current
assets


Four Important Inventory Issues
1. Acquiring inventory: What costs to capitalize?

3. Recording inventory activity: Which

method?

5. Selling inventory: Which cost flow assumption?
7. Ending inventory: Lower-of-cost-or market

valuation.


Figure 7-2 Accounting for Inventory: Four Important Issues


Acquiring Inventory
 What items or units to include?
 General rule: complete and unrestricted ownership.

 Ownership is usually possession; however, there are

exceptions

 Consignment consignee takes physical possession

but does not take ownership
 Goods in transit
 FOB Shipping Point – seller is responsible for (owns) goods only until

they are loaded on the common carrier
 FOB Destination – seller is responsible for goods until they arrive at

the destination (buyer).


Acquired Inventory: Which costs to attach?
 Which costs are included in inventory?
 General rule: all costs associated with

manufacture, acquisition, storage or
preparation of inventory including shipping to
facility.

 Freight-in (transportation-in) adds to the cost of

inventory.

 Purchase returns reduce the cost of purchases

(contra) for returned inventory.

 Purchase allowances reduce the cost of

purchases (contra) for reduced prices due to
damage or errors.

 Purchase discounts from early cash payments

(contra) reduce the cost of purchases.


Carrying Value: Perpetual Method

Maintaining a continuous record

Figure 7.3: Perpetual Inventory


Exercise E7-6
Sales
Cost of Goods
Sold (COGS):
BI
Purchases
GAS
Less: EI
COGS
Gross Profit

2012
$1,443

$220
983
$1,203
244

2011
$1,369

$194
915
$1,109

220
959
$484

889
$480


E7-6
Assume that counting errors caused the ending
inventory (EI) in 2011 to be understated by $50
and the ending inventory in 2012 to be overstated
by $50.
a. Compute the impact of these errors on cost of
goods sold for the year ended December 31, 2011
and on the inventory balance as of December 31,
2011.


E7-6

a. Error in Ending Inventory in 2011: The $50
understated error in the Ending inventory means
that the Ending Inventory should have been
$220 + $50 = $270. This would change the Cost
of goods sold to $1,109 - $270 = $839 which
would then increase the Gross profit to $530
($1,369 - $839).

E7-6
b. Compute the impact of these errors on cost of
goods sold for the year ended December 31, 2012
and on the inventory balance as of December 31,
2012.
c. What is the impact of these errors on cost of
goods sold over the two-year period ended
December 31, 2012?


E7-6

b. Error in Ending Inventory in 2012: = The 2011
error in the Ending Inventory changes the Beginning
Inventory in 2012 and the Goods Available for sale
to $270 + $983 = $1,253. To calculate the Cost of
Goods Sold the Ending Inventory for 2012 is
deducted from the revised Goods Available for Sale:
$1,253 – ($244 - $50) = $1,059. The gross profit
would then be $1,443 - $1,059 = $384.


E7-6

c.
Original COGS
Corrected COGS

2011
$889

$839

2012
$959
$1,059


Cost Flow Assumptions
 Given: BI + P (net) = EI + COGS
 Management must decide how to assign costs of

inflows [BI + P(net)] to EI and COGS?

Methods:
 Specific identification
 Average for both COGS and EI
 FIFO - (first-in, first-out) for COGS
 and LISH (last-in, still here) for EI

 LIFO - (last-in, first-out) for COGS
 and FISH (first-in, still here) for EI


Cost Flows

Figure 7.7 Inventory
flow assumption:
Average, FIFO, and
LIFO

Cost Flows - Average


Cost Flows - FIFO


st Flows - LIFO


Effects on Financials/Taxes
In an inflationary period (rising prices) which most
periods are:
 FIFO has the highest inventory balance, lowest

COGS, and highest income

 LIFO has the lowest inventory balance, highest

COGS, and lowest income

 This means that LIFO pays the least taxes


Cost Flows – Effects on Financial Statements
Figure 7-8 Financial statement effects


Cost Flows – Effects on Federal Income Taxes

Figure 7-9 Income tax effects


Choosing an Inventory Cost Flow Assumption: Trade-Offs
 Income and Asset Measurement
 Economic Consequences
 Income Taxes and Liquidity
 Bookkeeping Costs
 LIFO Liquidation and Inventory Purchasing

Practices

 Debt and Compensation Practices
 The Capital Market


Ending Inventory: Applying the Lower-of-Cost-or-Market Rule

 Applying the lower-of-cost-or-market rule to

ending inventory is accomplished by
comparing the cost allocated to ending
inventory with the market value of the
inventory. If the market value exceeds the
cost, no adjustment is made and the
inventory remains at cost. If the market value
is less than the cost, the inventories are
written down to market value with an
adjusting journal entry.