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Learning Objective

1. Show how to account for inventory

6-1

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SHOW HOW TO ACCOUNT FOR INVENTORY


Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company

Merchandisers have two accounts that service entities dont need:

6-2

Cost of goods sold on the income statement


Inventory on the balance sheet
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LO 1

SHOW HOW TO ACCOUNT FOR INVENTORY


Exhibit 6-1 | Contrasting a Service Company with a Merchandising Company

Merchandisers have two accounts that service entities dont need:

6-3

Cost of goods sold on the income statement


Inventory on the balance sheet
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LO 1

SHOW HOW TO ACCOUNT FOR INVENTORY


Exhibit 6-2 |
Inventory and Cost of
Goods Sold When
Inventory Cost Is Constant

Assume Family Dollar


Stores, Inc., has in stock
300 towels that cost $3
each.
Family Dollar Stores
marks each towel up by $2
and sells 200 of the towels
for $5 each.

6-4
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SHOW HOW TO ACCOUNT FOR INVENTORY


The cost of inventory sold shifts from asset to expense when
the seller delivers goods to the buyer

6-5

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LO 1

Sale Price vs. Cost of Inventory


Note the difference

6-6

Sales revenue based on sales price of inventory sold

Cost of goods sold based on cost of inventory sold

Inventory based on cost of inventory on hand

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LO 1

Sale Price vs. Cost of Inventory


Number of Units of Inventory

Determined from accounting records

Evidenced by physical count at year-end

Consigned goods:

Does not include those held for another company

Does include those out on consignment

In transit goods

6-7

Depends on shipping terms

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LO 1

Number of Units of Inventory


Shipping Terms Ownership Changes Hands
FOB
(free on board)
shipping point

At the point when the goods leave


the sellers shipping dock

FOB
(free on board)
destination

At the point of delivery to the


customer

Company with legal title to the goods while in


transit pays the transportation costs
6-8

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LO 1

Accounting for Inventory in the


Perpetual System
Perpetual
Inventory System

6-9

Periodic
Inventory System

Used for all types of goods

Used for inexpensive goods

Keeps a running record of


all goods bought, sold, and
on hand

Does not keep a running


record of all goods bought,
sold, and on hand

Inventory counted at least


once a year

Inventory counted at least


once a year

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LO 1

Accounting for Inventory in the


Perpetual System
How the Perpetual System Works

6-10

Optical scanner reads bar code, system

Records sale

Updates inventory records

Exhibit 6-4 | Bar Code for


Electronic Scanner

Two entries needed for each sale

Record revenue and asset received

Record cost of goods sold and reduction of inventory

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LO 1

Recording Transactions (Perpetual System)


Exhibit 6-5 | Recording and Reporting InventoryPerpetual System

6-11

PANEL ARecording Transactions (amounts assumed)


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LO 1

Recording Transactions (Perpetual System)


Exhibit 6-5 | Recording and Reporting InventoryPerpetual System

6-12

PANEL AT-accounts (amounts assumed)


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LO 1

Recording
Transactions
(Perpetual
System)

Exhibit 6-5 |
Recording and
Reporting Inventory
Perpetual System

6-13

PANEL BReporting (amounts assumed)


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LO 1

Recording Transactions (Perpetual System)


The cost of inventory is the net amount of purchases,
determined as follows (using assumed amounts):

6-14

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LO 1

Recording Transactions (Perpetual System)


The journal entry to record a purchase return of merchandise
that cost $500 is as follows:
Account
Accounts payable

Debit

Credit

500
500

Inventory
To record purchase return

6-15

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LO 1

Recording Transactions (Perpetual System)


The journal entry to record a purchase of $1,000 in
merchandise is as follows:
Account
Inventory

Debit

Credit

1,000

Accounts Payable

1,000

To record purchase of merchandise

6-16

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LO 1

Recording Transactions (Perpetual System)


The journal entry to record the payment for merchandise
within 10 days when the discount terms are 2/10, n/30, is as
follows:
Account
Accounts Payable

Debit

Credit

1,000
20

Inventory

980

Cash
To record payment within discount period

Discount = $1,000 x 2% = $20

6-17

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LO 1

Learning Objective
2. Apply and compare various inventory cost
methods

6-18

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APPLY AND COMPARE VARIOUS


INVENTORY COST METHODS
Accounting method selected affects the

6-19

Profits to be reported

Amount of income tax to be paid

Values of inventory turnover and gross margin percentage


ratios derived from the financial statements

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LO 2

What Goes into Inventory Cost?


The cost of any asset, such as inventory, is the sum of all
the costs incurred to bring the asset to its intended use,
less any discounts.

Cost includes:

Purchase price

Freight in

6-20

Insurance while in transit

Fees or taxes paid to get


the inventory ready to sell

Less returns, allowances,


and discounts

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LO 2

Apply Various Inventory Costing Methods


Accounting uses four generally accepted inventory
methods:
1. Specific unit cost
2. Average cost
3. First-in, first-out (FIFO) cost
4. Last-in, first-out (LIFO) cost

Company can use any of


these methods
Methods can have very
different effects on
reported
profits,
income taxes, and
cash flow

6-21

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LO 2

Apply Various Inventory Costing Methods


Specific
unit

6-22

Average

First-in,
first-out

Last-in,
first-out

Used for businesses with unique inventory items

Automobiles, antique furniture, jewels, and real estate

Businesses cost their inventories at the specific cost of the


particular unit

Too expensive for inventories with common characteristics

Also called the specific identification method


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LO 2

Apply Various Inventory Costing Methods


Specific
unit

6-23

Average

First-in,
first-out

Last-in,
first-out

Sometimes called the weighted-average method

Based on the average cost of inventory during the period

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LO 2

Illustration
Exhibit 6-6 | Inventory Data Used to Illustrate the Various Inventory Costing
Methods

In Exhibit 6-6, Family Dollar began the period with 10 lamps that
cost $10 each; the beginning inventory was therefore $100. During
the period, Family Dollar bought 50 more lamps, sold 40 lamps,
and ended the period with 20 lamps.
6-24

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LO 2

Illustration

6-25

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Exhibit 6-6

LO 2

Illustration

Exhibit 6-6

Accounting questions are:


1. What is the cost of goods sold for the income statement?
2. What is the cost of the ending inventory for the balance
sheet?
Answer depends on
cost method used
6-26
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LO 2

Average Cost
Exhibit 6-6

Average cost per unit =


Number of units sold
40 units

Cost of goods available


$900
=
= $15
Number of units available
60
X Average cost per unit = Cost of good sold
X

$15

$600

Number of units on hand X Average cost per unit = Ending inventory


20 units
6-27

$15

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$300
LO 2

Average Cost
Exhibit 6-6

The following T-account shows the effects of average costing:

Cost of goods sold (40 units


@ average cost of $15 per unit)
End bal

6-28

(20 units @ average


cost of $15 per unit)

600

300

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LO 2

Apply Various Inventory Costing Methods


Specific
unit

6-29

Average

First-in,
first-out

Last-in,
first-out

First costs into inventory are first costs assigned to cost of


goods sold (oldest items assumed to be sold first)

Ending inventory is based on latest costs incurred

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LO 2

40 units sold
20 units on hand

FIFO Cost
Inventory (at FIFO cost)
Beg bal

(10 units @ $10)

100

Purchases:
No. 1
No. 2
End bal

(25 units @ $14)


350
(25 units @ $18)
450
(20 units @ $18)

(10 units @$10)


100
(25 units @$14)
350
(5 units @$18)

360

90

Cost of Good Sold


(10 units @$10)
100
(25 units @$14)
350
(5 units @$18)
90
End bal (40 units)
6-30

540

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LO 2

Apply Various Inventory Costing Methods


Specific
unit

6-31

Average

First-in,
first-out

Last-in,
first-out

Costing is the opposite of FIFO

Last costs into inventory go to cost of goods sold (most


recent items purchased are assumed to be sold first)

Oldest costs in ending inventory

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LO 2

40 units sold
20 units on hand

LIFO Cost
Inventory (at LIFO cost)
Beg bal

(10 units @ $10)

100

Purchases:
No. 1
No. 2
End bal

(25 units @ $14)


350
(25 units @ $18)
450
(10 units @ $10)
(10 units @ $14)

(15 units @$14)


210
(25 units @$18)
450
240

Cost of Good Sold


(25 units @$18)
450
(15 units @$14)
210
End bal
6-32

(40 units)

660

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LO 2

Illustration
Hazelwood Surplus began March with 75 tents that cost $16 each.
During the month, Hazelwood Surplus made the following purchases
at cost:
March 3
95 tents @ $18 = $1,710
17
165 tents @ $20 = 3,300
23
35 tents @ $21 =
735
Hazelwood Surplus sold 318 tents, and at March 31 the ending
inventory consists of 52 tents. The sale price of each tent was $45.
Requirements
Determine the cost of goods sold and ending inventory amounts for
March under the average cost, FIFO cost, and LIFO cost. Round
average cost per unit to two decimal places.
6-33

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LO 2

Illustration
Goods Available

LO 2

6-34
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318 tents sold


52 tents on hand

Average Cost
Inventory (at FIFO cost)
Beg bal

(75 units @ $16)

1,200

Mar 3

(95 units @ $18)

1,710

Mar 17

(165 units @ $20)

3,300

Mar 23

(35 units @ $21)

End bal

(370 units)

735
6,945

Average cost per unit


$6,945 370 = $18.77

Cost of Good Sold

6-35

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LO 2

318 tents sold


52 tents on hand

Average Cost
Inventory (at FIFO cost)
Beg bal

(75 units @ $16)

1,200

Mar 3

(95 units @ $18)

1,710

Mar 17

(165 units @ $20)

3,300

Mar 23

(35 units @ $21)

735

End bal

(52 units @ $18.77)

976

(318 units @$18.77)


5,969

Average cost per unit


$6,945 370 = $18.77

Cost of Good Sold


(318 units @$18.77)
5,969
6-36

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LO 2

318 tents sold


52 tents on hand

FIFO Cost
Inventory (at FIFO cost)
Beg bal

(75 units @ $16)

1,200

Mar 3

(95 units @ $18)

1,710

Mar 17

(165 units @ $20)

3,300

Mar 23

(35 units @ $21)

End bal

(52 units)

735

(75 units @$16)


1,200
(95 units @$18)
1,710
(148 units @$20)
2,960

1,075

Cost of Good Sold


(75 units @$16)
1,200
(95 units @$18)
1,710
(148 units @$20)
2,960
End bal (318 units)
6-37

5,870

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LO 2

318 tents sold


52 tents on hand

LIFO Cost
Inventory (at FIFO cost)
Beg bal

(75 units @ $16)

1,200

Mar 3

(95 units @ $18)

1,710

Mar 17

(165 units @ $20)

3,300

Mar 23

(35 units @ $21)

End bal

(52 units)

735

(23 units @$16)


368
(95 units @$18)
1,710
(165 units @$20)
3,300
(35 units @$21)

832

735

Cost of Good Sold


(35 units @$21)
735
(165 units @$20)
3,300
(95 units @$18)
1,710
(23 units @$16)
End bal
6-38

368
(318 units)

6,113

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LO 2

Illustration
Inventory Cost Summary by Method
FIFO
Inventory
Cost of goods sold
Goods available

Average

$1,075
$ 832

$ 976

5,870
6,113

5,969

$6,945
$6,945

$6,945

LIFO

LO 2

6-39
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Effects of FIFO, LIFO, and Average Cost


Panel AWhen Inventory Costs Are Increasing

6-40

Exhibit 6-8

Cost of Goods Sold (COGS)

Ending Inventory (EI)

FIFO

FIFO COGS is lowest


because its based on the
oldest costs, which are low.
Gross profit is, therefore, the
highest.

FIFO EI is highest because


its based on the most recent
costs, which are high.

LIFO

LIFO COGS is highest


because its based on the
most recent costs, which are
high. Gross profit is,
therefore, the lowest.

LIFO EI is lowest because its


based on the oldest costs,
which are low.

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LO 2

Effects of FIFO, LIFO, and Average Cost


Panel BWhen Inventory Costs Are Decreasing

6-41

Exhibit 6-8

Cost of Goods Sold (COGS)

Ending Inventory (EI)

FIFO

FIFO COGS is highest


because its based on the
oldest costs, which are high.
Gross profit is, therefore, the
lowest.

FIFO EI is lowest because its


based on the most recent
costs, which are low.

LIFO

LIFO COGS is lowest


because its based on the
most recent costs, which are
low. Gross profit is, therefore,
the highest.

LIFO EI is highest because


its based on the oldest costs,
which are high.

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LO 2

Keeping Track of Perpetual Inventories

6-42

Impossible to apply LIFO unit costs to units purchased


and sold as transactions are happening

Weighted-average cost can be quite challenging,


requiring sophisticated computer software

Many companies track only inventory quantities during


the period, making adjusting journal entries at the end
of the period to apply either LIFO or weighted-average

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LO 2

The Tax Advantage of LIFO


When prices are rising
Results in lowest taxable income
Results in lowest income taxes
Increases cash available

6-43

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LO 2

Comparing FIFO and LIFO


Cost of Goods Sold

6-44

Ending Inventory

LIFO provides more


realistic net income figure

FIFO provides a more up-todate inventory cost

Most recent costs are


assigned to Cost of Goods
Sold

More recent costs on the


Balance Sheet

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LO 2

LIFO and Managing Reported Income

Allows manipulation of net income

Liquidation can occur

6-45

When inventory prices are rising, large quantities


purchased at end of year to lower taxes

Quantities decrease from last year, companies must


dip into older inventory layers

Not allowed under International Financial Reporting


Standards (IFRS)

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LO 2

Learning Objective
3. Explain and apply underlying GAAP for inventory

6-46

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UNDERLYING GAAP FOR INVENTORY


Accounting Principles Relevant to Inventory
Disclosure

6-47

Representational
Faithfulness

Consistency

Financial statement should report enough information for


outsiders to make informed decisions

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LO 3

UNDERLYING GAAP FOR INVENTORY


Accounting Principles Relevant to Inventory
Disclosure

6-48

Representational
Faithfulness

Consistency

Company should report relevant and representationally


faithful information about itself

Properly disclosing

Inventory accounting methods

Substance of all material transactions impacting


inventory
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LO 3

UNDERLYING GAAP FOR INVENTORY


Accounting Principles Relevant to Inventory
Disclosure

6-49

Representational
Faithfulness

Consistency

Requires the use of comparable methods for consistency


of presentation from period to period

Financial statements contain a footnote describing

Inventory costing method used

Inventory was valued at the lower of the costing


method or market
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LO 3

Lower-of-Cost-or-Market Rule
Requires that inventory be reported in the financial
statements at whichever is lower

Inventorys historical cost or

Market value

Generally means current replacement cost

If replacement cost is below historical cost, inventory is


written down to market value

Ending inventory is reported at LCM value on the


balance sheet

LO 3

6-50
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Lower-of-Cost-or-Market Rule
Suppose Family Dollar, Inc., paid $3,000 for inventory on June 26.
By August 25, its fiscal year-end, the inventory can be replaced for
$2,000. Family Dollars year-end balance sheet must report this
inventory at the LCM value of $2,000. An LCM write-down decreases
Inventory and increases Cost of Goods Sold:

Account
Cost of Goods Sold

Debit

Credit

1,000
1,000

Inventory
Wrote inventory down to market value

6-51

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LO 3

Lower-of-Cost-or-Market Rule

6-52

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Exhibit 6-9 | Lower-ofCost-or-Market (LCM)


Effects on Inventory and
Cost of Goods Sold

LO 3

Under IFRS, market is always defined as net


realizable value, which, for inventories, is current
market value.
Under U.S. GAAP, once the LCM rule is applied to write
inventories down to current replacement cost, the write-downs
may never be reversed. In contrast, under IFRS, some LCM
write-downs may be reversed, and inventory may be
subsequently written up again, not to exceed original cost.

6-53

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LO 3

Learning Objective
4. Compute and evaluate gross profit (margin)
percentage and inventory turnover

6-54

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COMPUTE AND EVALUATE GROSS PROFIT


(MARGIN) PERCENTAGE AND INVENTORY
TURNOVER

Gross Profit Percentage

Gross profitsales minus cost of goods soldkey


indicator of a companys ability to sell inventory at a profit

Markup stated as a percentage of sales

Watched carefully by managers and investors

Gross profit percentage =

6-55

Gross profit
Net sales revenue

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LO 4

Inventory Turnover

6-56

Ratio of cost of goods sold to average inventory

Indicates how rapidly inventory is sold

Varies from industry to industry

Inventory turnover =

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LO 4

Illustration
Cola Company made sales of $35,376 million during 2014. Cost of
goods sold for the year totaled $15,437 million. At the end of 2013,
Colas inventory stood at $1,672 million, and Cola ended 2014 with
inventory of $1,908 million. Compute Colas gross profit percentage
and rate of inventory turnover for 2014.

Gross profit percentage =

Gross profit percentage =

6-57

Gross profit
Net sales revenue
$35,376 - $15,437
$35,376

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= 56.4%

LO 4

Illustration
Cola Company made sales of $35,376 million during 2014. Cost of
goods sold for the year totaled $15,437 million. At the end of 2013,
Colas inventory stood at $1,672 million, and Cola ended 2014 with
inventory of $1,908 million. Compute Colas gross profit percentage
and rate of inventory turnover for 2014.

Inventory turnover =

Inventory turnover =

6-58

Cost of goods sold


Average inventory
$15,437
($1,672 + $1,908) 2

= 8.6 times

Every 42.4 days (365 days 8.6 times)


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LO 4

Learning Objective
5. Use the cost-of-goods-sold (COGS) model to
make management decisions

6-59

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USE THE COGS MODEL TO MAKE


MANAGEMENT DECISIONS
Exhibit 6-13 | The Cost-of-Goods-Sold-Model

Beginning inventory

$2,100

+ Purchases 6,300
= Cost of goods available for sale
- Ending inventory

7,500
-1,500

= Cost of goods sold $6,000

COGS model is used by all companies regardless of their


accounting systems

6-60

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LO 5

Computing Budgeted Purchases


Rearrange the COGS formula using amounts from Exhibit 6-13
Cost of goods sold (based on the plan for the next period) $6,000
+ Ending inventory (based on the plan for the next period)
= Cost of goods available as planned
-

1,500

7,500

Beginning inventory (actual amount left over from prior period)


-1,200

= Purchases (how much inventory the manager needs to buy)$6,300

Manager should buy $6,300 of merchandise to work his plan for


the upcoming period

6-61

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LO 5

Estimating Inventory by the Gross Profit


Method
Gross profit method

6-62

Also known as gross margin method

Widely used to estimate ending inventory

Uses COGS model

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LO 5

Gross Profit Method


Exhibit 6-14 shows the calculations for the gross profit method,
with new amounts assumed for the illustration.
Exhibit 6-14

6-63

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LO 5

Learning Objective
6. Analyze effects of inventory errors

6-64
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ANALYZE EFFECTS OF INVENTORY


ERRORS

6-65

Error in ending inventory creates errors for two accounting


periods

Inventory errors counterbalance in two consecutive


periods

Beginning inventory and ending inventory have opposite


effects on cost of goods sold

Beginning inventory is added; ending inventory is


subtracted

After two periods an inventory error counterbalances


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LO 6

EFFECTS OF INVENTORY ERRORS

6-66

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LO 6

EFFECTS OF INVENTORY ERRORS

6-67

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LO 6

Accounting For
Inventory

6-68

Advance slide in presentation mode to reveal answers.


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LO 6

Accounting For
Inventory

6-69

Advance slide in presentation mode to reveal answers.


Copyright 2015 Pearson Education Inc. All rights reserved.

LO 6

Copyright
This work is protected by United States copyright law and is
provided solely for the use of instructors in teaching their courses
and assessing student learning. Dissemination or sale of any part of
this work (including on the World Wide Web) will destroy the integrity
of the work and is not permitted. The work and materials from it
should never be made available to students except by instructors
using the accompanying text in their classes. All recipients of this
work are expected to abide by these restrictions and to honor the
intended pedagogical purposes and the needs of other instructors
who rely on these materials.

6-70

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