CHAPTER 9
Accounting for Merchandise Inventory
Chapter Overview
Chapter 9 examines the accounting for merchandise inventory. The periodic and perpetual systems are compared. The chapter reviews entries in a perpetual system and illustrates how Inventory and Cost of Goods Sold are reported on the financial statements. Net purchases, cost of goods sold and gross profit are illustrated. How owners and managers use the cost-of-goods-sold model is discussed. Journal entries in the periodic system are reviewed. Students learn how to determine the quantity and cost of inventories by using the four inventory costing methods: specific unit cost, weighted-average cost, FIFO cost, and LIFO cost. The inventory methods are compared and the advantages and disadvantages of each are detailed. The income tax advantage of LIFO is emphasized. A mid-chapter summary problem allows students to practice using FIFO, LIFO, and weighted-average cost, and to test their understanding of the differences among the methods.
The chapter resumes with a discussion of perpetual inventory for FIFO, LIFO and weighted-average cost. Perpetual FIFO is illustrated. The accounting principles and concepts that affect inventory—the consistency principle, the disclosure principle, the materiality concept, and accounting conservatism—are explained. The lower-of-cost-or-market rule is defined, followed by an illustration of the effects of inventory errors. Ethical issues in inventory accounting are emphasized.
The chapter then illustrates how to estimate inventory using the gross profit method. After discussing the importance of internal control over inventory, the chapter concludes with the decision guidelines that provide guidance for inventory management. A summary problem reviews perpetual inventory entries, using the cost-of-goods-sold model, and preparing an income statement.
Learning Objectives
After studying Chapter 9, your students should be able to:
1. Account for inventory by the perpetual and periodic systems
2. Apply inventory costing methods: specific unit cost, weighted-average cost, FIFO, and LIFO
3. Identify the income effects and the tax effects of the inventory costing methods
4. Apply the lower-of-cost-or-market rule to inventory
5. Determine the effects of inventory errors on cost of goods sold and net income
6. Estimate ending inventory by the gross profit method
Chapter Outline
Objective 1: Account for inventory by the perpetual and periodic systems
B. The perpetual inventory system maintains a continuous record for each inventory item.
1. The quantity and cost of the inventory on hand is updated whenever inventory is purchased or sold. Some companies maintain only quantities perpetually.
2. The inventory records can easily be maintained on a computer. The perpetual inventory record is illustrated in Exhibit 9-2.
3. The journal entries in a perpetual system are the same as illustrated in Chapter 5. Those entries are illustrated again in Exhibit 9-3 along with and illustration of the reporting of inventory and cost of goods sold.
4. A physical count of inventory is still required.
5. The net amount of the purchases is determined as in Chapter 5.
Inventory
- Purchase returns and allowances
= Net purchase of inventory
+ Freight in
= Total cost of inventory
6. In the perpetual system, cost of goods sold is the sum of all debits to the Cost of Goods Sold account.
7. An alternative computation can be used to compute cost of goods sold.
Beginning inventory
+ Net purchases (including freight-in)
= Cost of goods available for sale
- Ending inventory
= Cost of goods sold
Beginning inventory
+ Net purchases (including freight-in)
= Cost of goods available for sale
= Ending inventory
9. The inventory quantity is determined by a physical count of the merchandise on hand.
a. Goods on consignment are goods transferred, not sold, to another business (consignee). For a fee, the consignee sells the consigned goods. Consignments are included in the inventory of the consignor.
b. The cost of the inventory is the inventory quantity times the unit cost. The cost includes the invoice price, less any discounts, plus sales tax, tariffs, freight, insurance, and any other costs needed to make the goods ready for sale.
C. In the periodic inventory system (or physical system), the business does not keep a continuous record of the inventory on hand.
1. A physical count of the quantity of inventory is made at the end of the period.
2. The business uses an account called Purchases to record the merchandise purchased.
3. The beginning inventory remains in the Inventory account until the physical inventory is counted at the end of the period and is replaced with the ending inventory value. Journal entries, T-accounts, and financial statement presentation of the periodic system are illustrated in Exhibit 9-4.
a. The purchase of inventory is recorded as follows:
Purchases XX
Accounts Payable XX
b. The sale of inventory only requires one entry under periodic system:
Accounts Receivable XX
Sales Revenue XX
c. At the end of the period, Inventory must be updated and Cost of Goods Sold recorded under the periodic system. Closing entries in a periodic system are presented in full in the Appendix to Chapter 5. Partial closing entries are provided below:
Cost of Goods Sold XX
Inventory (beg.) XX
Inventory (end.) XX
Cost of Goods Sold XX
Cost of Goods Sold XX
Purchases XX
Objective 2: Apply inventory costing methods: specific unit cost, weighted-average cost, FIFO, and LIFO
A. The four costing methods allowed by GAAP are specific unit cost; weighted-average cost; first-in, first-out (FIFO); and last-in, first-out (LIFO). Exhibit 9-5 shows the computation of the ending inventory and cost of goods sold under weighted-average, FIFO, and LIFO inventory methods.
1. The specific unit cost (specific identification) method assigns a specific invoice price to each specific item in the inventory. This method is best applicable to high-value, low-quantity items such as real estate and cars.
2. The weighted-average cost (average costs) method assigns an average cost to the units on hand.
a. The weighted-average cost per unit equals the weighted-average cost of goods available for sale divided by the number of units available for sale.
b. Ending inventory and cost of goods sold are computed by multiplying the number of units by the average cost per unit.
3. First-in, first-out (FIFO) cost method assumes that the first goods purchased are the first sold and, therefore, the most recent (the latest) prices should be assigned to the units on hand, and the earliest prices should be assigned to cost of goods sold.
4. Last-in, first-out (LIFO) cost method assumes that the latest goods purchased are the first sold and, therefore, the earliest prices should be assigned to the units on hand, and the most recent (latest) prices should be assigned to cost of goods sold.
B. When inventory unit costs are rising, LIFO ending inventory and net income are the lowest among the methods. (Exhibit 9-6 compares the income effects of the FIFO, LIFO, and weighted-average methods.)
C. LIFO and FIFO are the most popular inventory methods. Exhibit 9-7 shows the percentage of companies using each method.