Chapter 6 - Study

Objectives
After studying this chapter, you should be able to:
1.
Determine how to classify inventory and inventory
quantities.
2.
Explain the basis of accounting for inventories and
apply the inventory cost flow methods under a
periodic inventory system.
3.
Explain the financial statement and tax effects of each
of the inventory cost flow assumptions.
4.
Explain the lower-of-cost-or-market basis of accounting
for inventories.
5.
Compute and interpret the inventory turnover ratio.
6.
Describe the LIFO reserve and explain its importance
for comparing results of different companies.
Financial
Accounting Kimmel, 7th

Chapter 6

Classifying Inventory
Manufacturing
Company

Merchandising
Company

Three Classifications:

One Classification:

Merchandise
Inventory

Raw Materials

Work in Process

Finished Goods

Helpful Hint Regardless of the

classification, companies report
all inventories under Current
Assets on the balance sheet.
Financial
Accounting Kimmel, 7th

Chapter 6

Determining Inventory
Quantities
In a periodic system, no attempt is
made on date of sale to record
the cost of merchandise sold. A
physical count of inventory is
taken at end of period to
determine:

Cost of merchandise on hand;

Cost of goods sold.

Financial
Accounting Kimmel, 7th

Chapter 6

Inventory Costing
For the year-end F/S, you must determine how much of your total
inventory cost should be assigned to Cost of Goods Sold
(Expense) and how much should remain in Inventory (Asset).
Note the following:
CGS + Ending Inventory = Total Cost of Inventory Available for
Sale
Potential Problem: Determining the cost per unit of the
inventory you sold (or have left) is a major problem if you
bought identical inventory units at different cost prices. For
example, if you buy 3 lamps for the following costs:
Lamp #1 - $3 cost
Lamp #2 - $4 cost
Lamp #3 - $5 cost
$12 Total cost of inventory available for sale
If you sell 1 lamp for $10, what is the amount you assign to Cost
ofFinancial
Goods Sold? Also, what might be the potential methods of
Accounting computing
Cost of Ending
Inventory and the Cost of 4Goods
Kimmel, 7th
Chapter 6
Sold?

Process Used to
Determine CGS and
Ending Inventory

Determine the UNITS remaining (or sold).

Under both inventory systems (perpetual and periodic), a
physical count must be taken. In a perpetual system, a
physical inventory is taken to adjust inventory records for
shrinkage losses. In a periodic system, a physical inventory is
the basis for determining the cost of ending inventory and cost
of goods sold.
Potential Problem: The effect of goods in transit at the end
of the period.
Key Point - the company that owns goods during transit
should add them to the physical inventory they counted. To
determine who owns the goods in transit, remember the
following shipping terms:
FOB Shipping Point - title of goods passes at shipping point;
buyer owns during transit.

FOB Destination Point - title of goods passes at destination

Financial
point; seller owns during transit.
Accounting

Kimmel, 7th

Chapter 6

E6-1, p. 316
Columbia Bank and Trust is giving Gallup Company a loan. Before doing so, they
decide that further discussions with Gallups accountant may be desirable.
One area of particular concern is the inventory account, which has a year-end
balance of $275,000. Determine the correct inventory amount at Dec 31
based on the following information:
1.Gallup sold goods costing $55,000 to Bazil Company FOB shipping point on Dec
28. The goods are not expected to reach Bazil until Jan12. The goods were not
included in the physical inventory because they were not in the warehouse.
2.The physical count of the inventory did not include goods costing $95,000 that
were shipped to Gallup FOB destination on Dec 27 and were still in transit at
year-end.
3. Gallup received goods costing $25,000 on Jan 2. The goods were shipped FOB
shipping point on Dec 26 by Lynch Co. The goods were not included in the
physical count.
4. Gallup sold goods costing $51,000 to Lamey of Canada FOB destination on Dec
30. The goods were received in Canada on Jan 8. They were not included in
Gallup's physical inventory.
5. Gallup received goods costing $42,000 on Jan 2 that were shipped FOB
6
destination on Dec 29. The shipment was a rush order that was supposed to

E6-1, p. 316
Determine the correct inventory amount at December 31.
Ending inventory: physical count ............................................. $275,000
1. No effecttitle passes to purchaser upon shipment
when terms are FOB shipping point..................................................... 0
2. No effecttitle does not transfer to Gallup until
goods are received ............................................................................ 0
3. Add to inventory: Title passed to Gallup when
goods were shipped ................................................................... 25,000
4. Add to inventory: Title remains with Gallup until
purchaser receives goods............................................................ 51,000
5. The goods did not arrive prior to year-end. The goods,
therefore, cannot be included in the inventory............................ (42,000)
Correct inventory..................................................................... $309,000
7

Farley Company had beginning inventory of $15,000 at

March 1, 2007. During the month, the company made
purchases of $40,000. The inventory at the end of the
month is $17,300. What is cost of goods sold for the month
of March?
A.
B.
C.
D.

$37,700
$40,000
$55,000
$57,300

Financial
Accounting Kimmel, 7th

Chapter 6

Farley Company had beginning inventory of $15,000 at

March 1, 2007. During the month, the company made
purchases of $40,000. The inventory at the end of the
month is $17,300. What is cost of goods sold for the month
of March?
A.
B.
C.
D.

$37,700
$40,000
$55,000
$57,300

Financial
Accounting Kimmel, 7th

Chapter 6

Process Used to Determine CGS

and Ending Inventory
(continued)

Determine the cost amount to assign to each unit left

(or sold) - by selecting one of the following Inventory Cost
Flow Methods:
Specific Identification - the actual cost of the specific units
sold are transferred from inventory to cost of goods sold.
Properly matches costs to revenues but can be cumbersome
when inventory consists of identical units.
Average-Cost Method - the average cost of all units in
inventory are computed and assigned to ending inventory and
cost of goods sold. It is the middle ground taken and it does
not properly reflect current replacement inventory costs.
First-In, First-Out (FIFO) - the first units purchased are the
first ones sold, and ending inventory consists of its most
recent purchases. During periods of rising prices, inventory is
valued at its most recent (current replacement) costs, but net
income could be overstated.
Last-In, First-Out (LIFO) - the most recent units purchased
are the first ones sold, and that the older units remain in
ending inventory. Proponents argue that sales revenue is
offset by the current cost of the items sold. Inventories
10 can
have layers of items purchased many periods ago.

If the unit price of inventory is increasing during

a period, a company using the LIFO inventory
method will show less gross profit for the period,
than if it had used the FIFO inventory method.
A.
B.

True
False

Financial
Accounting Kimmel, 7th

Chapter 6

11

If the unit price of inventory is increasing during

a period, a company using the LIFO inventory
method will show less gross profit for the period,
than if it had used the FIFO inventory method.
A.
B.

True
False

Financial
Accounting Kimmel, 7th

Chapter 6

12

Inventory Costing
Cost Flow Assumption

does not need to be

consistent with the
physical movement of
goods

Illustration 6-12
Use of cost flow methods in
major U.S. companies

Financial
Accounting Kimmel, 7th

Chapter 6

13

Inventory Cost Flow

Examples
Compute the cost of Ending Inventory and CGS using
the data below assuming the Periodic Inventory
System.

Jan
Jan
Jan
Jan
Jan

Units
Units
Total
Purchased
Sold Cost
Per Unit
1 - Beg Inventory
50
$2.00 $100
12 - Purchase
200
$4.00 $800
15 - Sale
150
16 - Purchase
100
$5.00 $500
19 - Sale
10

Average Cost = $1,400/350 = $4.00 per unit

Amount in Ending Inventory = 190 units @ $4.00 = $760
Cost of Goods Sold = $1,400 - $760 = $640 or 160 units @ $4.00
= $640
14

Inventory Cost Flow

Examples
Compute the cost of Ending Inventory and CGS using
the data below assuming the Periodic Inventory
System.

Jan
Jan
Jan
Jan
Jan
2.

Units
Units
Total
Purchased
Sold Cost
Per Unit
1 - Beg Inventory
50
$2.00 $100
12 - Purchase
200
$4.00 $800
15 - Sale
150
16 - Purchase
100
$5.00 $500
19 - Sale
10
First-In, First-Out (FIFO)

15

First-In, First-Out
(FIFO)
Amount in Ending Inventory
Units Available = 350
Units Sold
= 160
Units Left 190
100 units @ $5.00 = $500
90 units @ $4.00 = $360
190 units
$860
Cost of Goods Sold
$1,400 $860 = $540
or 50 units @ $2.00 = $100
110 units @ $4.00 = $440
160 units
$540
16

Inventory Cost Flow

Examples
Compute the cost of Ending Inventory and CGS using
the data below assuming the Periodic Inventory
System.

Jan
Jan
Jan
Jan
Jan
3.

Units
Units
Purchased
Sold
1 - Beg Inventory
50
12 - Purchase
200
15 - Sale
150
16 - Purchase
100
19 - Sale
10
Last-In, First-Out (LIFO)

Cost Total
Per UnitCost
$2.00 $100
$4.00 $800
$5.00 $500

17

Last-In, First-Out (LIFO)

Amount in Ending Inventory
Units Available = 350
Units Sold
= 160
Units Left 190
50 units @ $2.00 = $100
140 units @ $4.00 = $560
190 units
$660
Cost of Goods Sold
$1,400 $660 = $740
or
100 units @ $5.00 =
$500
60 units @ $4.00 = $240
160 units
$740
18

Effects of Inventory Method

Choice on F/S assuming Inflation
1.

2.

If a company uses FIFO

Lower CGS (oldest, lowest costs go to I/S)
Higher Net Income
Ending Inventory is close to current
replacement cost.
If a company uses LIFO
Higher CGS (newest costs go to I/S)
Lower Net Income
Ending Inventory is lower than current
replacement cost on the B/S.

Note: Average Cost and Specific Identification usually

produce numbers between LIFO and FIFO.
Financial
Accounting Kimmel, 7th

Chapter 6

19

Understanding F/S using

FIFO
The quality of earnings is considered lower because
some of the gross margin must be used to replace
goods sold at prices higher than is reflected in the CGS
section. For example, you buy two lamps for the
following costs:
Lamp #1 $3 cost
Lamp #2 $5 cost
Sell 1 lamp for $11
FIFO I/S: Sales $11
Replacement cost$5
CGS
-3
CGS
-3
G/M
$ 8
Inventory profit
$2

Some of the gross margin will be needed to replace the item sold.
The above amount is called inventory profit, and it is the
amount not available to owners.

FIFO B/S: Inventory is at $5. This should usually be at or

Financial
near
replacement cost.
Accounting Kimmel, 7th

Chapter 6

20

Understanding F/S using

LIFO
The quality of earnings is considered higher because
CGS is near replacement cost and very little of the gross
margin will be needed to replace the sold inventory at
current year-end prices. For example, you buy two
lamps for the following costs:
Lamp #1 $3 cost
Lamp #2 $5 cost
Sell 1 lamp for $11
LIFO I/S: Sales $11
Replacement cost$5
CGS
-5 CGS
-5
G/P
$ 6 Inventory profit
$0
Note this N/I is $2 lower than FIFO N/I with no real economic
differences having occurred. The above calculation shows no
inventory profit.

LIFO B/S: Inventory is at $3. This is understating its value

Financial
by
$2. The company must show the $5 replacement
Accounting cost
for ending inventory
in the footnotes.
Kimmel, 7th
Chapter 6
21

Points about LIFO

During periods of rising prices, LIFO is considered the most
conservative of the inventory pricing methods
because it results in the lowest valuation in ending
inventory and income measurement. However,
companies using LIFO must disclose current
replacement cost of the inventory in the notes.
1.
LIFO Conformity Rule - the IRS requires you to use
LIFO on your F/S issued to the public if you use LIFO on
your tax return.

Note: You are allowed to chose different methods for

use on your F/S versus those you use on your tax
return.
2.
Generally, it is better to use LIFO even though your F/S
show lower profits. This is because the only economic
affect of the inventory method you choose is the tax
outflow. LIFO will reduce your taxes, thus increasing
Financial
your cash
flows.
Accounting
Kimmel, 7th

Chapter 6

22

If the unit price of inventory is increasing during

a period, a company using the LIFO inventory
method will show less gross profit for the period,
than if it had used the FIFO inventory method.
A.
B.

True
False

Financial
Accounting Kimmel, 7th

Chapter 6

23

If the unit price of inventory is increasing during

a period, a company using the LIFO inventory
method will show less gross profit for the period,
than if it had used the FIFO inventory method.
A.
B.

True
False

Financial
Accounting Kimmel, 7th

Chapter 6

24

In periods of rising prices, the inventory method

which results in the inventory value on the
balance sheet that is closest to current cost is
the
A.
B.
C.
D.

FIFO method.
LIFO method.
average cost method.
tax method.

Financial
Accounting Kimmel, 7th

Chapter 6

25

In periods of rising prices, the inventory method

which results in the inventory value on the
balance sheet that is closest to current cost is
the
A.
B.
C.
D.

FIFO method.
LIFO method.
average cost method.
tax method.

Financial
Accounting Kimmel, 7th

Chapter 6

26

Lower-of-Cost-or-Market
(LCM)
After your cost of ending inventory is established, you
must perform one more step - the Lower of Cost or
Market to get the inventory number for the year-ending
balance sheet.
This analysis is done after an Ending Inventory at Cost and
Cost of Goods Sold have been computed per the
inventory flow method used by the company.
Only the Ending Inventory number (for the B/S) is
involved in LCM. The Cost of Goods Sold is computed
by the inventory flow method and is not affected by
LCM.
Financial
Accounting Kimmel, 7th

Chapter 6

27

Lower-of-Cost-or-Market
(LCM)
LCM Method - at the end of the period you compare
Ending Inventory to Market Value
Cost
of Ending Inventory
If Cost is Lower - Leave your Ending Inventory at Cost
If Market Value is Lower - need to record the loss and
reduce the amount you will show for Ending Inventory
on the B/S to that lower Market value. Market value
generally means Current Replacement Cost.
The method used to apply the LCM rule are the following:
a. LCM on each item.
b. LCM on major category or group totals.
c. LCM on the entire inventory.
Financial
Accounting Kimmel, 7th

Chapter 6

28

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 6-16

Financial
Accounting Kimmel, 7th

Chapter 6

29

Analysis of Inventory
Used to monitor the age and size of your inventory and
computed as follows:
Inventory Turnover = Cost of Goods Sold
(times)
Average Inventory
where average = Beg Inventory + End. Inventory
2
Days in Inventory =
365
Inventory Turnover
Benefits of quick inventory turnover:
Less cash tied up in inventory and the need for
inventory financing
Less chance of inventory obsolescence or spoilage
Negative side - inventory stockouts could lead to lost sales.
Financial
Accounting Kimmel, 7th

Chapter 6

30

Analysis of Inventory
Illustration: Data available for Wal-Mart.

Illustration 6-17

31

A low number of days in inventory

may indicate all of the following
except:
Sales opportunities may be lost
because of inventory shortages.
B. There is less chance of having obsolete
inventory items.
C. The company has fewer funds tied up
in inventory.
D. Management has achieved the best
balance between too much and too
little inventory levels.
Financial
A.

Accounting Kimmel, 7th

Chapter 6

32

A low number of days in inventory

may indicate all of the following
except:
Sales opportunities may be lost
because of inventory shortages.
B. There is less chance of having obsolete
inventory items.
C. The company has fewer funds tied up
in inventory.
D. Management has achieved the best
balance between too much and too
little inventory levels.
Financial
A.

Accounting Kimmel, 7th

Chapter 6

33

LIFO Reserve and

Reporting Requirements
Accounting standards require firms using LIFO to
report the amount by which inventory would
be increased/decreased if the firm had instead
been using FIFO.
This amount is referred to as the LIFO
reserve. Reporting the LIFO reserve enables
analysts to make adjustments to compare
companies that use different cost flow
methods.
To convert inventory from LIFO to FIFO, the
LIFO reserve is added to the LIFO inventory.
Financial
Accounting Kimmel, 7th

Chapter 6

34

E6-11, p. 318-319
Deere & Company is a global manufacturer and distributor of
agricultural, construction, and forestry equipment. It reported
the following information in its 2014 annual report (amounts in
millions):
2014 2013
Inventories
(LIFO)
$ 2,397
3,042
Current assets
30,857
Current liabilities
12,753
LIFO reserve
1,367
Cost of goods sold 16,255
a) Compute Deeres 2014 inventory turnover ratio and days in
inventory.
b) Compute Deeres Current Ratio using 2014 data as presented,
and then again after adjusting for the LIFO reserve.
Financial
c)
Comment
on how ignoring the LIFO reserve might affect your
Accounting - of Deeres liquidity.
evaluation
Kimmel, 7th

Chapter 6

35

E6-11, p. 318-319
a) Inventory Turnover = $16,255 / (($3,042 + $2,397) / 2)
= 5.98 times
Days in Inventory = 365 / 5.98
= 61 days
b) Current ratio as presented
= 2.42:1

= $30,857 / $12,753

Current ratio after adjusting for LIFO = ($30,857 + $1,367) /

12,753
= 2.53:1
c) Deeres liquidity looks better after the adjustment.
36

Another Example
The X Company had the following inventory data for the
month of January 2010. Compute CGS and Ending
Inv.
Units
Units
Purchased
Sold
Beginning Inventory
10
Jan 5 - Purchase
20
Jan 6 - Sale
5
Jan 7 - Purchase
30
Jan 9 - Sale
1
Totals
60
6
A.

Cost
Total
Per Unit Cost
$6.00 $ 60
$15.00 $300
$17.50

$525

$885

Specific Identification Method - the inventory count

reveals that the 54 units left were from the following - 10
from Beg Inv, 15 from the Jan 5 purchase, and 29 from the
Jan 7 purchase.
37

Specific Identification
Method
Amount in Ending Inventory
Units Available = 60
Units Sold
= 6
Units Left 54
10 units @ $6.00 = $60.00
15 units @ 15.00 = 225.00
29 units @ 17.50 = 507.50
54 units
$792.50
Cost of Goods Sold
$885 $792.50 = $92.50
38

Another Example
The X Company had the following inventory data for the
month of January 2010. Compute CGS and Ending
Inv.
Units
Units
Purchased
Sold
Beginning Inventory
10
Jan 5 - Purchase
20
Jan 6 - Sale
5
Jan 7 - Purchase
30
Jan 9 - Sale
1
Totals
60
6
B.

Cost
Total
Per Unit Cost
$6.00 $ 60
$15.00 $300
$17.50

$525

$885

Average Cost

39

Average Cost
Average cost = $885/60 = $14.75/unit
Amount in Ending Inventory
54 units @ $14.75 = $796.50
Cost of Goods Sold
$885 $796.50 = $88.50

40

Another Example
The X Company had the following inventory data for the
month of January 2010. Compute CGS and Ending
Inv.
Units
Units
Purchased
Sold
Beginning Inventory
10
Jan 5 - Purchase
20
Jan 6 - Sale
5
Jan 7 - Purchase
30
Jan 9 - Sale
1
Totals
60
6
C.

Cost
Total
Per Unit Cost
$6.00 $ 60
$15.00 $300
$17.50

$525

$885

First-In, First-Out (FIFO)

41

First-In, First-Out
(FIFO)
Amount in Ending Inventory
Units Available = 60
Units Sold
= 6
Units Left 54
30 units @ $17.50 = $525.00
20 units @ 15.00 = 300.00
4 units @ 6.00 =
24.00
54 units
$849.00
Cost of Goods Sold
$885 $849 = $36
42

Another Example
The X Company had the following inventory data for the
month of January 2010. Compute CGS and Ending
Inv.
Units
Units
Purchased
Sold
Beginning Inventory
10
Jan 5 - Purchase
20
Jan 6 - Sale
5
Jan 7 - Purchase
30
Jan 9 - Sale
1
Totals
60
6
D.

Cost
Total
Per Unit Cost
$6.00 $ 60
$15.00 $300
$17.50

$525

$885

Last-In, First-Out (LIFO)

43

Last-In, First-Out (LIFO)

Amount in Ending Inventory
Units Available = 60
Units Sold
= 6
Units Left 54
10 units @ $ 6.00 = $ 60.00
20 units @ 15.00 = 300.00
24 units @ 17.50 = 420.00
54 units
$780.00
Cost of Goods Sold
$885 $780 = $105
44