7 Inventories
Accounting School ·Zhongnan
University of Economics & Law
ntermediate
Accounting
I
中级会计学
1,Classifications of inventory
Intermediate Accounting 7 Inventories
Inventories are the assets of a company
which are,
? held for sale in the ordinary course of business,
? in the process of production for sale,or
? held for use in the production of goods or services to be
made available for sale
Merchandise
Balance Sheet Items
Income
Statement
Items
Retailer
Cost of
Goods SoldSale
Manufacturer
Raw
Materials
Cost of
Goods Sold
Sale
Finished
Goods
Work in
Process
OverheadDirect
Labor
Intermediate Accounting 7 Inventories
Inventory Types
2,Alternative inventory systems
Intermediate Accounting 7 Inventories
A perpetual inventory system provides for a
continuous record of physical quantities in the
inventory,A company using a perpetual system
maintains a continuous record of the physical
quantities in its inventory.
A company using the periodic inventory system does
not maintain a continuous record of the physical
quantities (or costs) of inventory on hand.
Periodic Inventory Systems
Intermediate Accounting 7 Inventories
? Cost of Goods Sold is determined and Inventory
is adjusted to proper balance at period end.
? All purchases of inventoriable merchandise are
recorded in the Purchases account.
? Ending inventory is determined by physical count
of merchandise on hand.
Perpetual Inventory Systems
Intermediate Accounting 7 Inventories
? Cost of Goods Sold is determined and Inventory is
adjusted to proper balance each time inventory is
purchased or sold.
? All purchases of inventoriable goods are recorded
in the Inventory account.
Comparison of Systems
Intermediate Accounting 7 Inventories
Perpetual
Inventory System
Beginning inventory
+ Purchases (net)
- Goods Sold
= Ending Inventory
Periodic
Inventory System
Beginning inventory
+ Purchases (net)
- Ending Inventory
= Goods Sold
3,Items to be included in inventory
quantities
Intermediate Accounting 7 Inventories
Economic control at the balance
sheet date,and not legal ownership
or physical possession,determines
what items are to be included in the
ending inventory.
Whose Inventory Is It?
Intermediate Accounting 7 Inventories
?Goods in Inventory.
?Goods in Transit.
?FOB Shipping Point,buyer’s inventory from
time of shipment.
?FOB Destination,seller’s inventory until
receipt by buyer.
?Goods on Consignment,inventory of the
consignor,not the consignee.
4,Determination of inventory costs
Intermediate Accounting 7 Inventories
? Price paid or consideration given
? Freight-in
? Receiving
? Unpacking
? Inspecting
? Storage
? Insurance
? Sales and other applicable taxes
Inventory Cost is all expenditures related to inventory
acquisition,preparation,and placement for sale.
Inventory costs
Selling costs,which are not
associated with bringing the
inventory to its existing condition
and location,are never included in
inventory,
Intermediate Accounting 7 Inventories
Interest costs are not included in
the cost of inventory that is
routinely manufactured,
Inventory costs
?Material manufacturing costs which are
related directly or indirectly to the
production of inventory are costs of
inventory.
?Variable manufacturing overhead is
related directly and is always included in
inventory.
?The allocation of fixed manufacturing
overhead is difficult and may be
somewhat arbitrary,the costs incurred
must be traceable to the benefits.
Intermediate Accounting 7 Inventories
5,Inventory valuation methods
Intermediate Accounting 7 Inventories
? Specific
identification
? First-in,first-
out (FIFO)
? Average cost
? Last-in,first-
out (LIFO)
Specific Identification
Intermediate Accounting 7 Inventories
? Assigns the actual cost of the asset to Inventory
and Cost of Goods Sold.
? Provides a highly objective method of matching
costs because cost flow exactly matches physical
goods flow.
? Is almost impossible to implement cost
effectively.
First-in,First-out (FIFO) Method
Intermediate Accounting 7 Inventories
? Assigns historical unit cost to Cost of Goods
Sold in the order the costs are incurred.
? Provides a close match between physical
product flow and product cost flow.
? Results in the same inventory valuation and
Cost of Goods Sold regardless of whether
perpetual or periodic inventory is used.
Average Cost Method
Intermediate Accounting 7 Inventories
?Assigns the same average cost to each unit sold
and each item in inventory.
?For Periodic Inventory,the unit cost is the
weighted average for the entire period.
?For Perpetual Inventory,the unit cost is computed
as a moving average,which changes with each
new purchase of goods.
Last-in,First-out (LIFO) Method
Intermediate Accounting 7 Inventories
? Assigns the most recent historical costs to Cost of
Goods Sold and the oldest costs to Inventory.
? Is used primarily to minimize taxable income.
? Results in differences between Cost of Goods
Sold and Inventory for perpetual inventory versus
periodic inventory.
Un
it C
ost
of
Goods
Sol
d
Beginning of
Year End of Year
FIFO assumes
the old units are
sold
FIFO
LIFO assumes
the new units
are sold
LIFO
Intermediate Accounting 7 Inventories
LIFO and FIFO in Times of Inflation
FIFO Advantages and Disadvantages
Intermediate Accounting 7 Inventories
Advantages
?Corresponds with
physical flow of goods.
?Ending inventory
balance is close to
current replacement cost.
Disadvantages
?Matches older costs with
current revenues.
?Inventory holding gains
and losses are part of gross
profit.
?No income tax deferral.
LIFO Advantages and Disadvantages
Intermediate Accounting 7 Inventories
Advantages
?Matches current costs
with current revenues.
?Excludes inventory
holding gains from gross
profit.
?Income tax deferral.
Disadvantages
?Does not correspond with
the physical flow of goods.
?Potential LIFO liquidation
can draw old costs into cost
of goods sold.
?Ending inventory balance
can be much lower than
current replacement cost.
6,Inventory valuation at other than cost
Intermediate Accounting 7 Inventories
? Lower of cost
or market
(LCM)
? Gross profit
method
? Retail inventory
method
Lower of Cost or Market
Intermediate Accounting 7 Inventories
The lower of cost or market rule requires that a
company write down its inventory to market
value when the inventory’s utility has declined.
Lower of Cost or Market
Intermediate Accounting 7 Inventories
What is
market?
In lower of cost
or market,
market means
replacement cost
within limits.
Lower of Cost or Market
Intermediate Accounting 7 Inventories
What is the
replacement
cost limits?
Upper limit:
Net realizable
value.
Lower limit:
Net realizable
value minus a
normal profit.
Lower of Cost or Market
Selection of Market
Value
Ceiling (Net
Realizable Value)
Replacement Cost
Floor (Net
Realizable Value -
Normal Profit)
Comparison to
Cost
Use lower of
(a) cost or
(b) selected
market value
Reporting the
Results
Balance sheet,
Inventory at
LCM
Income
statement,Loss
(if recognized)
Intermediate Accounting 7 Inventories
Lower of Cost or Market
A company’s unit of
inventory has the following
characteristics:
Selling price $165
Packaging cost 10
Transportation cost 15
Profit margin 40
Intermediate Accounting 7 Inventories
Example
LCM Example
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Case 1
Intermediate Accounting 7 Inventories
Current
Replacement
Cost,$120
LCM Example
Cost
$110
Market
$120
Current
Replacement
Cost,$120
LCM is the
cost of
$110
Case 1 Selling price $165 Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Intermediate Accounting 7 Inventories
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$150
LCM is the
cost of
$110
Case 2
Mkt,= $140
Current
Replacement
Cost,$150
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Intermediate Accounting 7 Inventories
Current
Replacement
Cost,$75
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$75
LCM is the
cost of
$110
Case 3
Mkt,= $120
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling $140
Normal profit (20 )
Floor $120
Intermediate Accounting 7 Inventories
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$105
LCM is the
market of
$105
Case 4
Mkt,= $105
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Individual Items Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700 $ 700
Item 2 1,200 1,300 1,200
$2,200 $2,000
Category B:
Item 3 $2,000 $2,400 2,000
Item 4 2,500 2,200 2,200
$4,500 $4,600
Total $6,700 $6,600
Inventory valuation $6,100
Individual Items
Loss
recognition,
$600
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Category Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700
Item 2 1,200 1,300
$2,200 $2,000 $2,000
Category B:
Item 3 $2,000 $2,400
Item 4 2,500 2,200
$4,500 $4,600 4,500
Total $6,700 $6,600
Inventory valuation $6,500
Category
Loss
recognition,
$200
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Total Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700
Item 2 1,200 1,300
$2,200 $2,000
Category B:
Item 3 $2,000 $2,400
Item 4 2,500 2,200
$4,500 $4,600
Total $6,700 $6,600 $6,600
Inventory valuation $6,600
Total
Loss
recognition,
$100
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Recording the Reduction of Inventory to Cost
Cost Market
December 31,2003 $20,000 $20,000
December 31,2004 25,000 22,000
December 31,2005 30,000 28,000
Assume the company uses a
periodic system.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Direct Method— December 31,2004
To close beginning inventory:
Income Summary 20,000
Inventory 20,000
To record ending inventory:
Inventory 22,000
Income Summary 22,000
An adjusting entry for the loss
is not required.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Direct Method— December 31,2005
To close beginning inventory:
Income Summary 22,000
Inventory 22,000
To record ending inventory:
Inventory 28,000
Income Summary 28000
An adjusting entry for the loss
is not required.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Allowance Method— December 31,2004
To close beginning inventory:
Income Summary 20,000
Inventory 20,000
To record ending inventory:
Inventory 25,000
Income Summary 25,000
To record inventory at market:
Loss Due to Market Valuation 3,000
Allow,to Reduce Inventory to Market 3,000
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Allowance Method— December 31,2005
To close beginning inventory:
Income Summary 25,000
Inventory 25,000
To record ending inventory:
Inventory 30,000
Income Summary 30,000
To record inventory at market:
Allowance to Reduce Inventory to Market 1,000
Loss Recovery Due to Market
Valuation 1,000
Intermediate Accounting 7 Inventories
Gross Profit Method
Intermediate Accounting 7 Inventories
Intermediate Accounting 7 Inventories
The gross profit method is an
estimation technique to determine
the inventory count...
? when a physical
count is not
practical,and
? as a validity check.
Gross Profit Method Steps
Intermediate Accounting 7 Inventories
① Calculate the historical gross profit rate by dividing the
gross profit (net sales minus cost of goods sold) of the
prior period(s) by the net sales of the prior period(s),
② Estimate current gross profit by multiplying the historical
gross profit rate by net sales for the period.
③ Subtract the estimated gross profit from the actual net
sales to determine the estimated cost of goods sold.
④ Subtract the estimated cost of goods sold from the actual
cost of goods available for sale to determine the estimated
cost of the ending inventory,
Estimated
Cost of
Goods Sold
Estimated
Cost of
Goods Sold
Estimated
Gross
Profit
Sales
Estimated
Ending
Inventory
Cost of Goods
Available for Sale
Intermediate Accounting 7 Inventories
Gross Profit Method
Enhancing the Accuracy of the Gross Profit
Method
Intermediate Accounting 7 Inventories
? A company should adjust the gross profit rate for known
changes in the relationship between its gross profit and
net sales.
? A company may use a separate gross profit rate for each
department or type of inventory that has a different
markup percentage.
? A company may use an average gross profit rate based on
several past periods to average out period-to-period
fluctuations.
Retail inventory method
Intermediate Accounting 7 Inventories
A company uses the retail inventory method to
determine the cost of its ending inventory based on
current-period estimates of the profit percentage.
① Determine goods available for sale at cost and retail.
② Determine cost percentage.
③ Determine ending inventory at retail.
④ Determine ending inventory at cost.
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
Goods Available
for Sale,At Retail
Estimated
Ending
Inventory
at Retail
Less
Sales
To calculation of cost
percentage
Intermediate Accounting 7 Inventories
Retail inventory method
Continued
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
Goods Available
for Sale,At Cost
To calculation of cost
percentage
Intermediate Accounting 7 Inventories
Retail inventory method
Continued
Cost Percentage:
Cost/Retail
x
Cost Percentage
Estimated Ending
Inventory at Retail
Estimated Ending
Inventory at Cost
Intermediate Accounting 7 Inventories
Retail inventory method
7,Effects of inventory errors
Intermediate Accounting 7 Inventories
Errors made by a company in the
valuation of inventory and the
recording of its purchases can
result in errors on the company's
balance sheet and income statement
for current and succeeding years.
Effects of Inventory Errors
Intermediate Accounting 7 Inventories
A purchase on credit is omitted from both the
Purchases account and ending inventory and
is not recorded in the succeeding year.
Current Year
Income Statement
Income is correct.
Balance Sheet
Ending inventory and
Accounts Payable are
understated.
A purchase on credit is omitted from both the
Purchases account and ending inventory and
is not recorded in the succeeding year.
Succeeding Year
Income Statement
Income is overstated and
cost of goods sold is
understated.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
A purchase on credit is omitted
from the Purchases account but
ending inventory is correct.
Current Year
Income Statement
Income is overstated and
cost of goods sold is
understated.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
A purchase on credit is omitted
from the Purchases account but
ending inventory is correct.
Succeeding Year
Income Statement
No effect.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
Ending inventory is over(under)stated
due to quantity and/or costing errors,
but the Purchases account is correct.
Current Year
Income Statement
Income is over(under)stated
and cost of goods sold is
under(over)stated.
Balance Sheet
Ending inventory and
Retained Earnings are
over(under)stated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
Succeeding Year
Income Statement
Income is under(over)stated
and cost of goods sold is
over(under)stated.
Balance Sheet
No effect.
Ending inventory is over(under)stated
due to quantity and/or costing errors,
but the Purchases account is correct.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
The End
Intermediate Accounting 7 Inventories
Accounting School ·Zhongnan
University of Economics & Law
ntermediate
Accounting
I
中级会计学
1,Classifications of inventory
Intermediate Accounting 7 Inventories
Inventories are the assets of a company
which are,
? held for sale in the ordinary course of business,
? in the process of production for sale,or
? held for use in the production of goods or services to be
made available for sale
Merchandise
Balance Sheet Items
Income
Statement
Items
Retailer
Cost of
Goods SoldSale
Manufacturer
Raw
Materials
Cost of
Goods Sold
Sale
Finished
Goods
Work in
Process
OverheadDirect
Labor
Intermediate Accounting 7 Inventories
Inventory Types
2,Alternative inventory systems
Intermediate Accounting 7 Inventories
A perpetual inventory system provides for a
continuous record of physical quantities in the
inventory,A company using a perpetual system
maintains a continuous record of the physical
quantities in its inventory.
A company using the periodic inventory system does
not maintain a continuous record of the physical
quantities (or costs) of inventory on hand.
Periodic Inventory Systems
Intermediate Accounting 7 Inventories
? Cost of Goods Sold is determined and Inventory
is adjusted to proper balance at period end.
? All purchases of inventoriable merchandise are
recorded in the Purchases account.
? Ending inventory is determined by physical count
of merchandise on hand.
Perpetual Inventory Systems
Intermediate Accounting 7 Inventories
? Cost of Goods Sold is determined and Inventory is
adjusted to proper balance each time inventory is
purchased or sold.
? All purchases of inventoriable goods are recorded
in the Inventory account.
Comparison of Systems
Intermediate Accounting 7 Inventories
Perpetual
Inventory System
Beginning inventory
+ Purchases (net)
- Goods Sold
= Ending Inventory
Periodic
Inventory System
Beginning inventory
+ Purchases (net)
- Ending Inventory
= Goods Sold
3,Items to be included in inventory
quantities
Intermediate Accounting 7 Inventories
Economic control at the balance
sheet date,and not legal ownership
or physical possession,determines
what items are to be included in the
ending inventory.
Whose Inventory Is It?
Intermediate Accounting 7 Inventories
?Goods in Inventory.
?Goods in Transit.
?FOB Shipping Point,buyer’s inventory from
time of shipment.
?FOB Destination,seller’s inventory until
receipt by buyer.
?Goods on Consignment,inventory of the
consignor,not the consignee.
4,Determination of inventory costs
Intermediate Accounting 7 Inventories
? Price paid or consideration given
? Freight-in
? Receiving
? Unpacking
? Inspecting
? Storage
? Insurance
? Sales and other applicable taxes
Inventory Cost is all expenditures related to inventory
acquisition,preparation,and placement for sale.
Inventory costs
Selling costs,which are not
associated with bringing the
inventory to its existing condition
and location,are never included in
inventory,
Intermediate Accounting 7 Inventories
Interest costs are not included in
the cost of inventory that is
routinely manufactured,
Inventory costs
?Material manufacturing costs which are
related directly or indirectly to the
production of inventory are costs of
inventory.
?Variable manufacturing overhead is
related directly and is always included in
inventory.
?The allocation of fixed manufacturing
overhead is difficult and may be
somewhat arbitrary,the costs incurred
must be traceable to the benefits.
Intermediate Accounting 7 Inventories
5,Inventory valuation methods
Intermediate Accounting 7 Inventories
? Specific
identification
? First-in,first-
out (FIFO)
? Average cost
? Last-in,first-
out (LIFO)
Specific Identification
Intermediate Accounting 7 Inventories
? Assigns the actual cost of the asset to Inventory
and Cost of Goods Sold.
? Provides a highly objective method of matching
costs because cost flow exactly matches physical
goods flow.
? Is almost impossible to implement cost
effectively.
First-in,First-out (FIFO) Method
Intermediate Accounting 7 Inventories
? Assigns historical unit cost to Cost of Goods
Sold in the order the costs are incurred.
? Provides a close match between physical
product flow and product cost flow.
? Results in the same inventory valuation and
Cost of Goods Sold regardless of whether
perpetual or periodic inventory is used.
Average Cost Method
Intermediate Accounting 7 Inventories
?Assigns the same average cost to each unit sold
and each item in inventory.
?For Periodic Inventory,the unit cost is the
weighted average for the entire period.
?For Perpetual Inventory,the unit cost is computed
as a moving average,which changes with each
new purchase of goods.
Last-in,First-out (LIFO) Method
Intermediate Accounting 7 Inventories
? Assigns the most recent historical costs to Cost of
Goods Sold and the oldest costs to Inventory.
? Is used primarily to minimize taxable income.
? Results in differences between Cost of Goods
Sold and Inventory for perpetual inventory versus
periodic inventory.
Un
it C
ost
of
Goods
Sol
d
Beginning of
Year End of Year
FIFO assumes
the old units are
sold
FIFO
LIFO assumes
the new units
are sold
LIFO
Intermediate Accounting 7 Inventories
LIFO and FIFO in Times of Inflation
FIFO Advantages and Disadvantages
Intermediate Accounting 7 Inventories
Advantages
?Corresponds with
physical flow of goods.
?Ending inventory
balance is close to
current replacement cost.
Disadvantages
?Matches older costs with
current revenues.
?Inventory holding gains
and losses are part of gross
profit.
?No income tax deferral.
LIFO Advantages and Disadvantages
Intermediate Accounting 7 Inventories
Advantages
?Matches current costs
with current revenues.
?Excludes inventory
holding gains from gross
profit.
?Income tax deferral.
Disadvantages
?Does not correspond with
the physical flow of goods.
?Potential LIFO liquidation
can draw old costs into cost
of goods sold.
?Ending inventory balance
can be much lower than
current replacement cost.
6,Inventory valuation at other than cost
Intermediate Accounting 7 Inventories
? Lower of cost
or market
(LCM)
? Gross profit
method
? Retail inventory
method
Lower of Cost or Market
Intermediate Accounting 7 Inventories
The lower of cost or market rule requires that a
company write down its inventory to market
value when the inventory’s utility has declined.
Lower of Cost or Market
Intermediate Accounting 7 Inventories
What is
market?
In lower of cost
or market,
market means
replacement cost
within limits.
Lower of Cost or Market
Intermediate Accounting 7 Inventories
What is the
replacement
cost limits?
Upper limit:
Net realizable
value.
Lower limit:
Net realizable
value minus a
normal profit.
Lower of Cost or Market
Selection of Market
Value
Ceiling (Net
Realizable Value)
Replacement Cost
Floor (Net
Realizable Value -
Normal Profit)
Comparison to
Cost
Use lower of
(a) cost or
(b) selected
market value
Reporting the
Results
Balance sheet,
Inventory at
LCM
Income
statement,Loss
(if recognized)
Intermediate Accounting 7 Inventories
Lower of Cost or Market
A company’s unit of
inventory has the following
characteristics:
Selling price $165
Packaging cost 10
Transportation cost 15
Profit margin 40
Intermediate Accounting 7 Inventories
Example
LCM Example
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Case 1
Intermediate Accounting 7 Inventories
Current
Replacement
Cost,$120
LCM Example
Cost
$110
Market
$120
Current
Replacement
Cost,$120
LCM is the
cost of
$110
Case 1 Selling price $165 Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Intermediate Accounting 7 Inventories
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$150
LCM is the
cost of
$110
Case 2
Mkt,= $140
Current
Replacement
Cost,$150
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Intermediate Accounting 7 Inventories
Current
Replacement
Cost,$75
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$75
LCM is the
cost of
$110
Case 3
Mkt,= $120
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling $140
Normal profit (20 )
Floor $120
Intermediate Accounting 7 Inventories
LCM Example
Cost
$110
What is
market?
Current
Replacement
Cost,$105
LCM is the
market of
$105
Case 4
Mkt,= $105
Selling price $165
Cost of completion (10 )
Transportation cost (15 )
Ceiling (NRV) $140
Ceiling (NRV) $140
Normal profit (40 )
Floor $100
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Individual Items Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700 $ 700
Item 2 1,200 1,300 1,200
$2,200 $2,000
Category B:
Item 3 $2,000 $2,400 2,000
Item 4 2,500 2,200 2,200
$4,500 $4,600
Total $6,700 $6,600
Inventory valuation $6,100
Individual Items
Loss
recognition,
$600
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Category Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700
Item 2 1,200 1,300
$2,200 $2,000 $2,000
Category B:
Item 3 $2,000 $2,400
Item 4 2,500 2,200
$4,500 $4,600 4,500
Total $6,700 $6,600
Inventory valuation $6,500
Category
Loss
recognition,
$200
Intermediate Accounting 7 Inventories
Approaches to implementing LCM—
Total Base
Inventory Cost Market
Category A:
Item 1 $1,000 $ 700
Item 2 1,200 1,300
$2,200 $2,000
Category B:
Item 3 $2,000 $2,400
Item 4 2,500 2,200
$4,500 $4,600
Total $6,700 $6,600 $6,600
Inventory valuation $6,600
Total
Loss
recognition,
$100
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Recording the Reduction of Inventory to Cost
Cost Market
December 31,2003 $20,000 $20,000
December 31,2004 25,000 22,000
December 31,2005 30,000 28,000
Assume the company uses a
periodic system.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Direct Method— December 31,2004
To close beginning inventory:
Income Summary 20,000
Inventory 20,000
To record ending inventory:
Inventory 22,000
Income Summary 22,000
An adjusting entry for the loss
is not required.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Direct Method— December 31,2005
To close beginning inventory:
Income Summary 22,000
Inventory 22,000
To record ending inventory:
Inventory 28,000
Income Summary 28000
An adjusting entry for the loss
is not required.
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Allowance Method— December 31,2004
To close beginning inventory:
Income Summary 20,000
Inventory 20,000
To record ending inventory:
Inventory 25,000
Income Summary 25,000
To record inventory at market:
Loss Due to Market Valuation 3,000
Allow,to Reduce Inventory to Market 3,000
Intermediate Accounting 7 Inventories
Lower of Cost or Market
Allowance Method— December 31,2005
To close beginning inventory:
Income Summary 25,000
Inventory 25,000
To record ending inventory:
Inventory 30,000
Income Summary 30,000
To record inventory at market:
Allowance to Reduce Inventory to Market 1,000
Loss Recovery Due to Market
Valuation 1,000
Intermediate Accounting 7 Inventories
Gross Profit Method
Intermediate Accounting 7 Inventories
Intermediate Accounting 7 Inventories
The gross profit method is an
estimation technique to determine
the inventory count...
? when a physical
count is not
practical,and
? as a validity check.
Gross Profit Method Steps
Intermediate Accounting 7 Inventories
① Calculate the historical gross profit rate by dividing the
gross profit (net sales minus cost of goods sold) of the
prior period(s) by the net sales of the prior period(s),
② Estimate current gross profit by multiplying the historical
gross profit rate by net sales for the period.
③ Subtract the estimated gross profit from the actual net
sales to determine the estimated cost of goods sold.
④ Subtract the estimated cost of goods sold from the actual
cost of goods available for sale to determine the estimated
cost of the ending inventory,
Estimated
Cost of
Goods Sold
Estimated
Cost of
Goods Sold
Estimated
Gross
Profit
Sales
Estimated
Ending
Inventory
Cost of Goods
Available for Sale
Intermediate Accounting 7 Inventories
Gross Profit Method
Enhancing the Accuracy of the Gross Profit
Method
Intermediate Accounting 7 Inventories
? A company should adjust the gross profit rate for known
changes in the relationship between its gross profit and
net sales.
? A company may use a separate gross profit rate for each
department or type of inventory that has a different
markup percentage.
? A company may use an average gross profit rate based on
several past periods to average out period-to-period
fluctuations.
Retail inventory method
Intermediate Accounting 7 Inventories
A company uses the retail inventory method to
determine the cost of its ending inventory based on
current-period estimates of the profit percentage.
① Determine goods available for sale at cost and retail.
② Determine cost percentage.
③ Determine ending inventory at retail.
④ Determine ending inventory at cost.
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
Goods Available
for Sale,At Retail
Estimated
Ending
Inventory
at Retail
Less
Sales
To calculation of cost
percentage
Intermediate Accounting 7 Inventories
Retail inventory method
Continued
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
Goods Available
for Sale,At Cost
To calculation of cost
percentage
Intermediate Accounting 7 Inventories
Retail inventory method
Continued
Cost Percentage:
Cost/Retail
x
Cost Percentage
Estimated Ending
Inventory at Retail
Estimated Ending
Inventory at Cost
Intermediate Accounting 7 Inventories
Retail inventory method
7,Effects of inventory errors
Intermediate Accounting 7 Inventories
Errors made by a company in the
valuation of inventory and the
recording of its purchases can
result in errors on the company's
balance sheet and income statement
for current and succeeding years.
Effects of Inventory Errors
Intermediate Accounting 7 Inventories
A purchase on credit is omitted from both the
Purchases account and ending inventory and
is not recorded in the succeeding year.
Current Year
Income Statement
Income is correct.
Balance Sheet
Ending inventory and
Accounts Payable are
understated.
A purchase on credit is omitted from both the
Purchases account and ending inventory and
is not recorded in the succeeding year.
Succeeding Year
Income Statement
Income is overstated and
cost of goods sold is
understated.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
A purchase on credit is omitted
from the Purchases account but
ending inventory is correct.
Current Year
Income Statement
Income is overstated and
cost of goods sold is
understated.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
A purchase on credit is omitted
from the Purchases account but
ending inventory is correct.
Succeeding Year
Income Statement
No effect.
Balance Sheet
Accounts Payable is
understated and Retained
Earnings is overstated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
Ending inventory is over(under)stated
due to quantity and/or costing errors,
but the Purchases account is correct.
Current Year
Income Statement
Income is over(under)stated
and cost of goods sold is
under(over)stated.
Balance Sheet
Ending inventory and
Retained Earnings are
over(under)stated.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
Succeeding Year
Income Statement
Income is under(over)stated
and cost of goods sold is
over(under)stated.
Balance Sheet
No effect.
Ending inventory is over(under)stated
due to quantity and/or costing errors,
but the Purchases account is correct.
Intermediate Accounting 7 Inventories
Effects of Inventory Errors
The End
Intermediate Accounting 7 Inventories
