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Chapter 6
Inventories
Learning Objectives
After studying this chapter, you should be able to:
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1.
Describe the steps in determining inventory quantities.
2.
Explain the accounting for inventories and apply the inventory cost
flow methods.
3.
Explain the financial effects of the inventory cost flow assumptions.
4.
Explain the lower-of-cost-or-market basis of accounting for inventories.
5.
Indicate the effects of inventory errors on the financial statements.
6.
Compute and interpret the inventory turnover ratio.
Preview of Chapter 6
Financial Accounting
Eighth Edition
Weygandt Kieso Kimmel
6-3
Classifying Inventory
Merchandising
Company
One Classification:

Inventory
Manufacturing
Company
Three Classifications:

Raw Materials

Work in Process

Finished Goods
Regardless of the classification, companies report all inventories under
Current Assets on the balance sheet.
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Determining Inventory Quantities
Physical Inventory taken for two reasons:
Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw materials,
shoplifting, or employee theft).
Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
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LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
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
when the business is closed or business is slow.

at end of the accounting period.
LO 1 Describe the steps in determining inventory quantities.
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Determining Inventory Quantities
Determining Ownership of Goods
Goods in Transit

Purchased goods not yet received.

Sold goods not yet delivered.
Goods in transit should be included in the inventory of the company
that has legal title to the goods. Legal title is determined by the
terms of sale.
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LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Goods in Transit
Illustration 6-1
Terms of sale
Ownership of the goods
passes to the buyer when the
public carrier accepts the
goods from the seller.
Ownership of the goods
remains with the seller until the
goods reach the buyer.
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LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Question
Goods in transit should be included in the inventory of the
buyer when the:
a. public carrier accepts the goods from the seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
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LO 1 Describe the steps in determining inventory quantities.
Determining Inventory Quantities
Determining Ownership of Goods
Consigned Goods
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
Goods held for sale by one party.

Ownership of the goods is retained by another party.
LO 1 Describe the steps in determining inventory quantities.
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Inventory Costing
Unit costs can be applied to quantities on hand using the
following costing methods:
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
Specific Identification

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Average-cost
Cost Flow
Assumptions
LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Illustration: Assume that Crivitz TV Company purchases
three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200
each. These facts are summarized below.
Illustration 6-2
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Illustration 6-3
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of
the ending inventory.

Practice is relatively rare.

Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Cost Flow
Assumptions
do not need to match the
physical movement of
goods
Illustration 6-11
Use of cost flow methods in
major U.S. companies
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Illustration: Data for Houston Electronics’ Astro
condensers.
Illustration 6-4
Houston Electronics
Astro Condensers
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
First-In-First-Out (FIFO)

Earliest goods purchased are first to be sold.

Often parallels actual physical flow of merchandise.

Generally good business practice to sell oldest units
first.
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5
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LO 2
Inventory Costing
First-In-First-Out (FIFO)
Illustration 6-5
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Last-In-First-Out (LIFO)

Latest goods purchased are first to be sold.

Seldom coincides with actual physical flow of
merchandise.

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Includes goods stored in piles, such as coal or hay.
LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Last-In-First-Out (LIFO)
Illustration 6-7
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LO 2
Inventory Costing
Last-In-First-Out (LIFO)
Illustration 6-7
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost

Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

Assumes goods are similar in nature.

Applies weighted-average unit cost to the units on
hand to determine cost of the ending inventory.
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost
Illustration 6-10
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Average Cost
Illustration 6-10
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LO 2 Explain the basis of accounting for inventories
and apply the inventory cost flow methods.
Inventory Costing
Financial Statement and Tax Effects
Illustration 6-12
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LO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
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LO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.
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LO 3 Explain the financial effects of the inventory cost flow assumptions.
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Inventory Costing
Using Cost Flow Methods Consistently

Method should be used consistently, enhances
comparability.

Although consistency is preferred, a company may change
its inventory costing method.
Illustration 6-14
Disclosure of change in cost flow method
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LO 3 Explain the financial effects of the inventory cost flow assumptions.
Inventory Costing
Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
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
Companies can “write down” the inventory to its market
value in the period in which the price decline occurs.

Market value = Replacement Cost

Example of conservatism.
LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.
Inventory Costing
Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as
indicated.
Illustration 6-15
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LO 4 Explain the lower-of-cost-or-market basis of accounting for inventories.
Inventory Errors
Common Cause:
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
Failure to count or price inventory correctly.

Not properly recognizing the transfer of legal title to goods
in transit.

Errors affect both the income statement and balance sheet.
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods sold
and net income.
Illustration 6-16
Illustration 6-17
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LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Income Statement Effects
Inventory errors affect the computation of cost of goods
sold and net income in two periods.
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
An error in ending inventory of the current period will have a
reverse effect on net income of the next accounting
period.

Over the two years, the total net income is correct because
the errors offset each other.

Ending inventory depends entirely on the accuracy of taking
and costing the inventory.
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Illustration 6-18
Sales
2014
Incorrect
Correct
$
$
80,000
$
80,000
90,000
$
90,000
Beginning inventory
20,000
20,000
12,000
15,000
Cost of goods purchased
40,000
40,000
68,000
68,000
Cost of goods available
60,000
60,000
80,000
83,000
Ending inventory
12,000
15,000
23,000
23,000
Cost of good sold
48,000
45,000
57,000
60,000
Gross profit
32,000
35,000
33,000
30,000
Operating expenses
10,000
10,000
20,000
20,000
Net income
$
Combined income for 2year period is correct.
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2013
Incorrect
Correct
22,000
$
25,000
($3,000)
Net Income
understated
$
13,000
$
10,000
$3,000
Net Income
overstated
LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Question
Understating ending inventory will overstate:
a. assets.
b. cost of goods sold.
c. net income.
d. owner's equity.
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LO 5 Indicate the effects of inventory errors on the financial statements.
Inventory Costing
Balance Sheet Effects
Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:
Illustration 6-16
Illustration 6-19
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LO 5 Indicate the effects of inventory errors on the financial statements.
LCM Basis; Inventory Errors
(a) Tracy Company sells three different types of home heating stoves
(wood, gas, and pellet). The cost and market value of its inventory of
stoves are as follows.
Solution
The total inventory value is the sum of these amounts, $430,000.
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LO 5 Indicate the effects of inventory errors on the financial statements.
LCM Basis; Inventory Errors
(b) Visual Company overstated its 2013 ending inventory by $22,000.
Determine the impact this error has on ending inventory, cost of
goods sold, and stockholders’ equity in 2013 and 2014.
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LO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Presentation
Balance Sheet - Inventory classified as current asset.
Income Statement - Cost of goods sold subtracted from
sales.
There also should be disclosure of
1) major inventory classifications,
2) basis of accounting (cost or LCM), and
3) costing method (FIFO, LIFO, or average).
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LO 5 Indicate the effects of inventory errors on the financial statements.
Statement Presentation and Analysis
Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).
2. Low Inventory Levels – may lead to stockouts and lost
sales.
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LO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Inventory turnover measures the number of times on average
the inventory is sold during the period.
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
Days in inventory measures the average number of days
inventory is held.
Days in
Inventory
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Days in Year (365)
=
Inventory Turnover
LO 6 Compute and interpret the inventory turnover ratio.
Statement Presentation and Analysis
Illustration: Wal-Mart reported in its 2011 annual report a beginning
inventory of $32,713 million, an ending inventory of $36,318 million, and
cost of goods sold for the year ended January 31, 2011, of $315,287
million. The inventory turnover formula and computation for Wal-Mart are
shown below.
Illustration 6-21
Days in Inventory: Inventory turnover of 9.13 times divided into 365
is approximately 40 days. This is the approximate time that it takes a
company to sell the inventory.
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LO 6 Compute and interpret the inventory turnover ratio.
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APPENDIX 6A
PERPETUAL INVENTORY SYSTEMS
Illustration 6A-1
Assuming the Perpetual Inventory System, compute Cost of Goods
Sold and Ending Inventory under FIFO, LIFO, and Average cost.
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LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6A
PERPETUAL INVENTORY SYSTEMS
First-In-First-Out (FIFO)
Cost of Goods
Sold
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Illustration 6A-2
Ending Inventory
LO 7
APPENDIX 6A
PERPETUAL INVENTORY SYSTEMS
Last-In-First-Out (LIFO)
Cost of Goods
Sold
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Illustration 6A-3
Ending Inventory
LO 7
APPENDIX 6A
PERPETUAL INVENTORY SYSTEMS
Average Cost
Illustration 6A-4
Cost of Goods
Sold
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Ending Inventory
LO 7 Apply the inventory cost flow methods to perpetual inventory records.
APPENDIX 6B
ESTIMATING INVENTORIES
Gross Profit Method
Estimates the cost of ending inventory by applying a gross profit
rate to net sales.
Illustration 6B-1
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LO 8 Describe the two methods of estimating inventories.
APPENDIX 6B
ESTIMATING INVENTORIES
Illustration: Kishwaukee Company’s records for January show net
sales of $200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. The company expects to earn a 30% gross profit
rate. Compute the estimated cost of the ending inventory at January 31
under the gross profit method.
Illustration 6B-2
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LO 8
APPENDIX 6B
ESTIMATING INVENTORIES
Retail Inventory Method
Company applies the cost-to-retail percentage to ending inventory
at retail prices to determine inventory at cost.
Illustration 6B-3
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LO 8 Describe the two methods of estimating inventories.
APPENDIX 6B
ESTIMATING INVENTORIES
Illustration:
Illustration 6B-4
Note that it is not necessary to take a physical inventory to estimate
the cost of goods on hand at any given time.
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LO 8 Describe the two methods of estimating inventories.
Key Points
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
The requirements for accounting for and reporting inventories are
more principles-based under IFRS. That is, GAAP provides more
detailed guidelines in inventory accounting.

The definitions for inventory are essentially similar under IFRS and
GAAP. Both define inventory as assets held-for-sale in the ordinary
course of business, in the process of production for sale (work in
process), or to be consumed in the production of goods or services
(e.g., raw materials).

Who owns the goods—goods in transit or consigned goods—as well
as the costs to include in inventory, are accounted for the same
under IFRS and GAAP.
Key Points
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
Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific identification
method be used where the inventory items are not interchangeable
(i.e., can be specifically identified). If the inventory items are not
specifically identifiable, a cost flow assumption is used. GAAP does
not specify situations in which specific identification must be used.

A major difference between IFRS and GAAP relates to the LIFO cost
flow assumption. GAAP permits the use of LIFO for inventory
valuation. IFRS prohibits its use. FIFO and average-cost are the only
two acceptable cost flow assumptions permitted under IFRS.
Key Points
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
IFRS requires companies to use the same cost flow assumption
for all goods of a similar nature. GAAP has no specific
requirement in this area.

In the lower-of-cost-or-market test for inventory valuation, IFRS
defines market as net realizable value. Net realizable value is the
estimated selling price in the ordinary course of business, less the
estimated costs of completion and estimated selling expenses. In
other words, net realizable value is the best estimate of the net
amounts that inventories are expected to realize. GAAP, on the
other hand, defines market as essentially replacement cost.
Key Points

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Under GAAP, if inventory is written down under the lower-of-costor-market valuation, the new value becomes its cost basis. As a
result, the inventory may not be written back up to its original cost
in a subsequent period. Under IFRS, the write-down may be
reversed in a subsequent period up to the amount of the previous
write-down. Both the write-down and any subsequent reversal
should be reported on the income statement as an expense. An
item-by-item approach is generally followed under IFRS.
Key Points
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
Unlike property, plant, and equipment, IFRS does not permit the
option of valuing inventories at fair value. As indicated above,
IFRS requires inventory to be written down, but inventory cannot
be written up above its original cost.

Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.
Looking to the Future
One convergence issue relates to the use of the LIFO cost flow
assumption. IFRS specifically prohibits its use. Conversely, the LIFO
cost flow assumption is widely used in the United States because of its
favorable tax advantages. With a new conceptual framework being
developed, it is highly probable that the use of the concept of
conservatism will be eliminated. Similarly, the concept of “prudence” in
the IASB literature will also be eliminated. This may ultimately have
implications for the application of the lower-of-cost-or-net realizable
value.
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IFRS Self-Test Questions
Which of the following should not be included in the inventory of a
company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB shipping
point.
d) None of the above.
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IFRS Self-Test Questions
Which method of inventory costing is prohibited under IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.
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IFRS Self-Test Questions
Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.
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