ACTG 2110

Chapter 7 –Inventories

Control of Inventories

• Controls– Physically safeguard the inventory– Financially – make sure all of the inventories

are properly recorded

Inventory Cost Flow Assumptions

• Four Methods:– 1 - Specific Unit Cost– 2 - First-in, First out (FIFO)– 3 - Last-in, First out (LIFO)– 4 - Average cost

Specific Unit Cost

• Units can be specifically identified

• Cost of goods sold and items in ending inventory can be identified

• Can be manipulated

First-in, First out (FIFO)

• First items in, first items sold

• COGS reflects first items

• Ending inventory reflects last items purchased

• In times of inflation, FIFO– Has highest net income– Has highest asset amount for inventory

Last-in, First out (LIFO)

• Last items in, first items sold• COGS reflects last items• Ending inventory reflects first items

purchased• In times of inflation, LIFO

– Has lowest net income– If you use LIFO for tax purposes, you MUST

use it for financial reporting purposes– Has lowest asset amount for inventory

Average Cost

• Weighted average of inventory is calculated each time a purchase is made

• Items sold are recorded at the most recent weighted average cost

• When a new purchase is made, a NEW weighted average is calculated.

Periodic Inventory System

• Cost of goods sold:

• Beginning Inventory

• Plus net purchases

• Cost of goods available for sale

• Less ending inventory

• COST OF GOODS SOLD

Periodic Inventory System

• COGS and ending inventory often different from perpetual system due to timing differences

• FIFO – no difference• LIFO

– Could be different if you sold items before buying items. – Periodic disregards WHEN you bought the items. – All sold items are costed using the very latest costs, regardless

of when purchased.

• Average cost– Only ONE weighted average cost is calculated– All items in ending inventory and those items sold are costed

using the weighted average cost per unit.

Lower of Cost or Market Rule

• Lower-of-cost-or-market rule– If market value of inventory has decreased

below COST, we must write down the inventory to market value

• Some items are damaged, some are old, some are out-of-style, obsolete (software), etc.

Inventory Errors

• Overstatement or understatement of inventory affects COGS, net income and the inventory account

• Overstatements of ending inventory cause COGS to be too low, Net income to be too high, and ending inventory to be too high

• Understatements of ending inventory cause COGS to be too high, net income to be too low, and ending inventory to be too low

• Last period’s ending inventory becomes next period’s beginning inventory so the error will reverse in the next year

Estimating Inventory

• Used when there is a natural disaster that destroys inventory

• Used when an estimate of inventory is all that is needed – monthly or quarterly reports

• Used to see if cost of goods sold is relatively consistent from prior periods

• Retail method• Gross Profit method

Retail Method of Inventory

1. Determine merchandise available for sale at cost AND at retail prices

2. Divide cost/retail prices = cost to retail ratio

3. Subtract sales at retail price from cost of merchandise available at retail

4. Remainder is the inventory at retail price

5. Convert the inventory at retail price to inventory at cost by multiplying the cost to retail ratio determined in step (2).

Estimating Inventory

• Gross Profit Method– Gross profit percentage is estimated from

looking at previous records and years– Gross profit percentage is multiplied by net

sales to derive the estimated gross profit– Gross profit is then subtracted from net sales

to get the estimated COGS

Estimating Inventory

• Gross Profit MethodCost of goods available for sale (Beginning

inventory + Net purchases from records)

-- COGS just estimated

= Ending inventory

• This method is also used as a test to see if COGS is about right on the financial statements for interim financial statements

Evaluating Performance

• Inventory turnover– Tells us how many times we sell our inventory during

the year– Cost of goods sold/average inventory– Higher the number, generally the more profitable a

business– Inventory turnover and gross profit percentage often

go together• High gross profit percentage (Harris Teeter) often means you

won’t turn over the inventory as many times• Low gross profit percentage (Target, WalMart, Kroger) often

means you can sell your inventory more times/much quicker

Evaluating Performance

• Number of days’ sales in inventory =

Average inventory

Average daily cost of merchandise sold

Lower the number of days, the less time it takes to sell the inventory