Accounting for Merchandise Inventory
Chapter Outline
Objective 3: Identify the income effects and the tax effects of the inventory costing methods
A. Because LIFO assigns the most recent costs to cost of goods sold, LIFO better matches the expenses with current revenue.
B. Because FIFO assigns the most recent prices to ending inventory, FIFO reports the current inventory value on the balance sheet.
D. FIFO produces inventory profits defined as the difference between gross profit under LIFO and FIFO.
E. LIFO net income can be manipulated (managed) by speeding up or delaying purchases of inventory.
F. LIFO inventories are subject to LIFO liquidation when the quantity of inventory declines. In this case, older (and cheaper) inventory costs are matched against current sale prices resulting in higher net income than normal.
G. Many countries allow the use of FIFO and weighted-average cost but do not allow the use of LIFO. (Exhibit 9-8 is a list of countries that do not permit LIFO.)
H. Perpetual inventory records can be maintained for each costing method.
1. The perpetual inventory record using FIFO is illustrated in Exhibit 9-9.
2. Few companies keep perpetual LIFO records because of the expense and the possibility of a LIFO liquidation. Instead, they may keep perpetual records in quantities only.
3. Several accounting principles relate to inventories:
a. The consistency principle requires businesses to use the same accounting methods from period to period. Inventory methods can be changed, but the change and the effect of the change must be disclosed.
b. The disclosure principle requires companies to report enough information for outsiders to make knowledgeable decisions. Information should be relevant, reliable, and comparable. Inventory methods must be disclosed.
c. The materiality concept states that a company must adhere to GAAP only for items and transactions that are significant (material) to the business’s financial statements.
d. Conservatism in accounting means to present the gloomiest possible figures in the financial statements when more than one possibility exists.
Objective 4: Apply the lower-of-cost-or-market rule to inventory
A. Inventory should be reported at the lower-of-cost-or-market (LCM); that is, the lower of its historical cost or its current replacement cost. (Exhibit 9-10 summarizes the effects of LCM.)
B. When inventory is written down to market (an example of conservatism), then cost of goods sold increases to reflect the loss in value as illustrated by the following entry:
Cost of Goods Sold XX
Inventory XX
Objective 5: Determine the effects of inventory errors on cost of goods sold and net income
A. Errors in ending inventory affect not only the balance of inventory but also cost of goods sold, gross profit, net income, and owner’s equity in the period that the error occurs (period 1). (Exhibit 9-11 is an example of inventory errors. Exhibit 9-12 summarizes the effects of an error on two periods.)
B. Inventory errors reverse (or counterbalance) in period 2 and have the opposite effect on cost of goods sold, gross profit, and net income.
C. Owner’s equity will be correctly stated at the end of period 2.
D. Unethical managers can overstate ending inventory or report dubious sales in order to overstate net income.
Objective 6: Estimate ending inventory by the gross profit method
A. The gross profit (or gross margin) method of estimating inventory is based on the cost of goods sold computation discussed in Chapter 5. That computation can be rearranged to solve for the ending inventory.
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Cost of Goods Sold Beginning inventory XX + Purchases XX = Cost of goods available for sale XX - Ending inventory (XX) = Cost of goods sold XX |
Computation Estimated Ending Inventory Beginning inventory XX + Purchases XX = Cost of goods available for sale XX - Cost of goods sold (estimated) (XX) = Estimated ending inventory XX |
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B. The cost of goods sold (above) is estimated using the following formula (Exhibit 9-13):
Net sales revenue (Sales revenue less returns, allowances, and discounts)
= Estimated cost of goods sold
C. Internal control over inventory is important because of the ease of misusing the inventory and its relative importance in the financial statements.
. 1. Inventory should be physically counted at least once a year.
2. Inventory should be stored to protect it against theft, damage, and decay.
3. Access to inventory should be limited to personnel who do not have access to the accounting records.
4. Avoid tying up money in unnecessary inventory.
D. Decision guidelines summarize various aspects of inventory management, such as which inventory system to use, which inventory method to use, and how to estimate the ending inventory.