Chapter 6 Merchandise Inventorylrbrasher.com/images/Chapter_6_Powerpoint.pdfChapter 6 Learning...

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© 2018 Pearson Education, Inc.

Chapter 6Merchandise Inventory


Chapter 6 Learning Objectives

1. Identify accounting principles and controls related to merchandise inventory

2. Account for merchandise inventory costs under a perpetual inventory system

3. Compare the effects on the financial statements when using the different inventory costing methods

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4. Apply the lower-of-cost-or-market rule to merchandise inventory

5. Measure the effects of merchandise inventory errors on the financial statements

6. Use inventory turnover and days’ sales in inventory to evaluate business performance

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7. Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

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Learning Objective 1

Identify accounting principles and controls related to merchandise inventory

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WHAT ARE THE ACCOUNTING PRINCIPLES AND CONTROLS THAT RELATE TO

MERCHANDISE INVENTORY?

• Accounting principles help accountants classify and report items on the financial statements.

• The accounting principles associated with merchandise inventory are:– Consistency– Disclosure– Materiality– Accounting conservatism

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Consistency Principle

• The consistency principle states that a business should use the same accounting methods and procedures from period to period.

• Consistency helps investors and creditors compare financial statements from one period to the next.

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If changes are made in

accounting methods, these

changes must be reported,

generally in the notes to the

financial statements.


Disclosure Principle

• The disclosure principle states that financial statements should report enough information for outsiders to make knowledgeable decisions about the company.

• Information should be relevant and have faithful representation.

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Materiality Concept

• The materiality concept states that a company must perform strictly proper accounting only for items that are significant to the business’s financial situation.

• Information is significant when it would cause someone to change a decision.

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For example, $10,000 is material to a small business

with sales of $100,000.

However, $10,000 isn’t material to a

large company with annual sales of

$1 billion.


Conservatism

• Conservatism means a business should report the least favorable figures in the financial statements when two or more possible options are presented.– Anticipate no gains, but provide for all probable

losses.– Record an asset at the lowest reasonable amount

and a liability at the highest reasonable amount. – When there’s a question, record an expense rather

than an asset. – Choose the option that undervalues, rather than

overvalues, your business.

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Control Over Merchandise Inventory

• Good inventory controls ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system by: – Ensuring inventory is purchased with proper

authorization.– Tracking and documenting receipt of inventory.– Recording damaged inventory properly. – Performing physical counts of inventory annually. – Recording and removing inventory from

Merchandise Inventory when sold.

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Account for merchandise inventory costs under a perpetual inventory system

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HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED UNDER A

PERPETUAL INVENTORY SYSTEM?

• At the end of the period, count the units in ending inventory and assign dollar amounts to the account.

• At the end of the period, determine the units sold during the period and assign dollar amounts to Cost of Goods Sold.

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• Note: Each unit originally cost $350• Ending Inventory = Units on hand × Unit cost

= 4 units × $350 per unit = $1,400

• COGS = Units sold × Unit cost= 14 units × $350 per unit = $4,900

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When the costs are different for different groups of inventory, it is more difficult to decide which dollar amounts to assign to the ending inventory.

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• An inventory costing method approximates the flow of inventory costs in a business that is used to determine the amount of cost of goods sold and ending merchandise inventory.

• Four basic inventory costing methods are allowable by GAAP:1. Specific identification2. First-in, first-out (FIFO)3. Last-in, first-out (LIFO)4. Weighted-average

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Specific Identification Method

• The specific identification method is an inventory costing method based on the specific cost of particular units of inventory.

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Used for inventories that include:

Automobiles

Jewels

Real estate


Specific Identification Method

On August 15, 1 tablet sold had a cost $350 and 3 cost $360 each. On August 31, 1 cost $350, and 9 cost $380.

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First-In, First-Out (FIFO) Method

• The first-in, first-out method (FIFO) assumes the first units purchased are the first to be sold. • Cost of Goods Sold is based on the oldest

purchases.• Ending Inventory closely reflects current

replacement cost.• Cost of goods available for sale is the total

cost spent on inventory that was available to be sold during a period.

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Journal Entries

Under FIFO

Amounts unique to FIFO are shown in blue.

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Last-In, First-Out (LIFO) Method

• Last-in, first-out (LIFO) method is the opposite of FIFO.

• As inventory is sold, the cost of the newest item in inventory is assigned to each unit as Cost of Goods Sold.• Cost of Goods Sold closely reflects current

replacement cost.• Ending Inventory contains the oldest costing

units.

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Journal Entries

Under LIFO

Amounts unique to LIFO are shown in blue.


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Weighted-Average Method

• The weighted-average method computes a new weighted-average cost per unit after each purchase.

• Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available.

• Ending Inventory and Cost of Goods Sold are based on the same weighted-average cost per unit.

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After each purchase, Smart Touch Learning computes a new weighted-average cost per unit. For example, on August 5:

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The goods sold on August 15 are then costed out at $356.67 per unit. On August 26 when the next purchase is made, the new weighted-average unit cost is as follows:

The weighted-average cost summary at August 31 is as follows:• Cost of goods sold: 14 units that cost a total of $5,193.• Ending inventory: 4 units that cost a total of $1,507.

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Journal Entries Under

Weighted-Average

Amounts unique to the weighted-average method are shown in blue.




Compare the effects on the financial statements when using the different inventory costing methods

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HOW ARE FINANCIAL STATEMENTS AFFECTED BY USING DIFFERENT INVENTORY COSTING METHODS?

• Income statement– Cost of Goods Sold is higher under LIFO than

under FIFO when costs are rising.– Net income is lower under LIFO than under

FIFO when costs are rising.• Balance sheet

– When costs are increasing, FIFO inventory will be the highest, and LIFO inventory will be the lowest.

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Income Statement

Note that FIFO results in the highest gross profit, while LIFO shows the highest cost of goods sold.

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Balance Sheet

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Apply the lower-of-cost-or-market rule to merchandise inventory

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HOW IS MERCHANDISE INVENTORY VALUED WHEN USING THE LOWER-OF-

COST-OR-MARKET RULE?

• The lower-of-cost-or-market (LCM) rule requires that inventory be reported in the financial statements at the lower of the inventory’s historical cost or its market value.

• Market value generally means the current replacement cost.

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Recording the Adjusting Journal Entry to Adjust Merchandise Inventory

Smart Touch Learning paid $3,000 for its TAB0503 inventory. By December 31, it can be replaced for only $2,200, and the decline in value appears permanent.

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Recording the Adjusting Journal Entry to Adjust Merchandise Inventory

Smart Touch Learning’s balance sheet would report this inventory as follows:

Footnote Disclosure:

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Measure the effects of merchandise inventory errors on the financial statements

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WHAT ARE THE EFFECTS OF MERCHANDISE INVENTORY ERRORS ON

THE FINANCIAL STATEMENTS?

• An error in inventory can lead to errors in other related accounts.

• Because the ending inventory number is used in other computations, when ending inventory is incorrect, other numbers will also be incorrect, such as:• Cost of goods sold• Gross profit• Net income

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• An inventory error cancels out after two periods. • The overstatement of cost of goods sold in Period 2

counterbalances the understatement for Period 1. 6-44

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Use inventory turnover and days’ sales in inventory to evaluate business performance

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Inventory Turnover

• The inventory turnover ratio measures how rapidly inventory is sold.

• The ratio should be evaluated against industry averages.– A high turnover rate indicates ease of selling.– A low turnover rate indicates difficulty of

selling.

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Days’ Sales in Inventory

• The days’ sales in inventory ratiomeasures the average number of days inventory is held by the company.

• Some types of inventory will move faster than others.

• For inventory with an expiration date, this measure is very important.

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HOW DO WE USE INVENTORY TURNOVER AND DAYS’ SALES IN INVENTORY TO EVALUATE BUSINESS PERFORMANCE?

From Kohl’s Corporation’s 2016 financial statements:

Kohl’s inventory turnover is 3.12 times per year and is calculated as:

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HOW DO WE USE INVENTORY TURNOVER AND DAYS’ SALES IN INVENTORY TO EVALUATE BUSINESS PERFORMANCE?

From Kohl’s Corporation’s 2016 financial statements:

Kohl’s days’ sales in inventory is 117 days and is calculated as:

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Account for merchandise inventory costs under a periodic inventory system (Appendix 6A)

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HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED UNDER A PERIODIC

INVENTORY SYSTEM?

• Under a periodic inventory system: • Inventory is not tracked in the accounting

system continuously.• The beginning inventory balance is carried

until the end of the period.• Purchases are accumulated during the period.• The ending inventory balance replaces the

beginning inventory balance.

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HOW ARE MERCHANDISE INVENTORY COSTS DETERMINED UNDER A PERIODIC

INVENTORY SYSTEM?

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• Ending Inventory will be calculated using the newest items in inventory.

• Cost of Goods Sold will include the oldest unit costs.

• Note: Amounts for Cost of Goods Sold and Ending Inventory are always the same for FIFO perpetual and FIFO periodic.

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• Ending Inventory will be calculated using the oldest items in inventory.

• Cost of Goods Sold will include the newest unit costs.

• Note: Amounts for Cost of Goods Sold and Ending Inventory are usually different for LIFO perpetual and LIFO periodic.

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• Ending Inventory and Cost of Goods sold are calculated using the average cost per unit.

• Note: Amounts for Cost of Goods Sold and Ending Inventory are usually different for perpetual and periodic weighted average.

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Chapter 6 Merchandise Inventorylrbrasher.com/images/Chapter_6_Powerpoint.pdfChapter 6 Learning...

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