Inventory is a tangible resource that is held for resale in

the normal course of operations.

Acquisition cost includes all costs incurred to get the inventory:
Delivered or Prepared for resale e.g.

Purchase price

Taxes paid for which no credit will be available

Costs for shipping the product

Insurance during transit

Labor required to assemble the product

Returns and allowances from the vendor

Purchase discounts from the vendor

Types of Inventory Systems
Perpetual–
Cost of Goods
Sold is updated
with each sale.

Periodic- Cost
of Goods Sold is
recorded only at
the end of a period.
Unlike a perpetual system a periodic inventory
system does not update the inventory and cost of
goods sold accounts during the period.

Instead, when purchases are made, they are

recorded in a temporary account called Purchases
and when sales are made, the resulting revenue is
recorded, but not the cost of goods sold.
 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 1. Recording Inventory Purchases
a. Periodic System
b. Perpetual System

Devon Gifts purchases `20,000 of inventory

on account on October 10 and records the
purchase as follows:
 1. Recording Inventory Purchases
a. Periodic System
b. Perpetual System

Devon Gifts purchases `20,000 of inventory

on account on October 10 and records the
purchase as follows:

GENERAL
JOURNAL
Date Description Debit Credit
2012
Oct. 10 Inventory 20,000

Accounts Payable 20,000

 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System

Suppose Devon pays a third-party carrier

`300 to transport the inventory to its
warehouse. Devon records the payment as
follows:
GENERAL
JOURNAL
Date Description Debit Credit
2010
Oct. 10 Transportation-in 300

Cash 300
 2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System

Suppose Devon pays a third-party carrier

`300 to transport the inventory to its
warehouse. Devon records the payment as
follows:
GENERAL
JOURNAL
Date Description Debit Credit
2012
Oct. 10 Inventory 300

Cash 300
 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 3. Recording Inventory Returns
a. Periodic System
b. Perpetual System

On October 12, Devon is granted a `1,000 reduction

in the cost of the merchandise due to blemishes on
the inventory. Devon records the reduction of the
inventory cost and payable as follows:

GENERAL
JOURNAL
Date Description Debit Credit
2010
Oct. 12 Accounts Payable 1,000

Purchase Returns &

Allowances 1,000
 3. Recording Inventory Returns
a. Periodic System
b. Perpetual System

On October 12, Devon is granted a `1,000 reduction

in the cost of the merchandise due to blemishes on
the inventory. Devon records the reduction of the
inventory cost and payable as follows:

GENERAL
JOURNAL
Date Description Debit Credit
2012
Oct. 12 Accounts Payable 1,000

Inventory 1,000
 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System

Devon pays its remaining `19,000 bill to the vendor

on October 15 and qualifies for a 1% early payment
discount (or `19,000 x 1% = `190), recorded as
follows:

GENERAL
JOURNAL
Date Description Debit Credit
2010
Oct. 15 Accounts Payable 19,000

Purchase Discounts 190

Cash 18,810
 4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System

Devon pays its remaining `19,000 bill to the vendor

on October 15 and qualifies for a 1% early payment
discount (or `19,000 x 1% = `190), recorded as
follows:

GENERAL
JOURNAL
Date Description Debit Credit
2012
Oct. 15 Accounts Payable 19,000

Inventory 190
Cash 18,810
 Summary of Net Purchases

Given the preceding activity, Devon’s net purchases

of inventory can be calculated as follows:
 Recording Inventory Transactions

1. Recording Inventory Purchases

a. Periodic System
b. Perpetual System
2. Recording Inventory Expenses
a. Periodic System
b. Perpetual System
3. Recording Inventory Returns
a. Periodic System
b. Perpetual System
4. Recording Inventory Discounts
a. Periodic System
b. Perpetual System
5. Recording Inventory Sales
a. Periodic System
b. Perpetual System
 5. Recording Inventory Sales
a. Periodic System
b. Perpetual System

The account Cost of Goods Sold or Cost of Sales is used to

capture the amount of inventory expensed during a
period. On Nov. 2, if Devon sells inventory costing `400
for `600 cash, the following entries would be recorded.

GENERAL
JOURNAL
Date Description Debit Credit
2012
Nov. 2 Cash 600
Sales 600
 5. Recording Inventory Sales
a. Periodic System
b. Perpetual System

The account Cost of Goods Sold or Cost of Sales is used to

capture the amount of inventory expensed during a
period. On Nov. 2, if Devon sells inventory costing `400
for `600 cash, the following entries would be recorded.

GENERAL
JOURNAL
Date Description Debit Credit
2012
Nov. 2 Cash 600
Sales 600
Cost of Goods Sold 400
Inventory 400
Example of Inventory and Cost of Goods
Sold
 Estimating
Ending Inventory
A company must sometimes estimate its
inventory balance. One example is when
inventory is destroyed by a natural catastrophe.
Another example is when a company prepares
interim financial statements.

The gross profit method of estimating inventory uses

a company’s gross profit percentage to estimate cost
of goods sold and then ending inventory.
 Example
1

3
Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
 LCM Rule
Cost < Market
No
Adjustment

Market < Cost

Adjust inventory
down to the lower
market value
Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis

Inventories in total

Major Groups of Inventories

Individual Inventory
Items
 1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
Dryden has four types of inventory (A,B,C,&D) in 2 groups. Cost and market values
are computed for each inventory type, each inventory group, and total inventory.
The three right columns show the value that should be reported for inventory when
applying LCM to total inventories, to the two groups of inventory, and to each
individual inventory item.
 1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
No journal adjustment needed if Dryden uses
the total inventories cost approach or the
inventory group approach because
LCM = Cost
 1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
However, if Dryden applies LCM to individual inventory
items, it will need to adjust its inventory by $120.
 Inventory Costing Methods
To determine the cost of
inventory sold, companies can
use the following methods:

Moving
LIFO Average

FIFO

Specific
Identification
Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Specific
Sep.10 Sale (65) Identification

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Specific
Sep.30 Sale (50) Identification
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
30@`12
Sep.10 Sale (65) 35@`13

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) 10@`12
20@`13
10@`14
10@`15
 2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
Cost of Goods Sold

Ending Inventory
 2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
At the end of the month Nell counts 60 units on hand.
5 x `13 units
20 x `14 units
35 x `15 units
Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) FIFO

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) FIFO
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) 40@`12
25@`13

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) 35@`13
15@`14
 3. Costing by FIFO
a. Perpetual System
b. Periodic System
Cost of Goods Sold

Ending Inventory
 3. Costing by FIFO
a. Perpetual System
b. Periodic System

At the end of the month Nell counts 60 units on hand.

Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) LIFO

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) LIFO
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) 60@`13
05@`12

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) 05@`14
45@`15
 4. Costing by LIFO
a. Perpetual System
b. Periodic System
Cost of Goods Sold

Ending Inventory
 4. Costing by LIFO
a. Perpetual System
b. Periodic System

At the end of the month Nell counts 60 units on hand.

Lower of Cost or Net Realizable Value

1. Valuation of Inventory
a. Aggregate Basis
b. Group Basis
c. Individual Basis
2. Costing by Specific Identification
a. Perpetual System
b. Periodic System
3. Costing by FIFO
a. Perpetual System
b. Periodic System
4. Costing by LIFO
a. Perpetual System
b. Periodic System
5. Costing by Moving Average
a. Perpetual System
b. Periodic System
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) MA

Sep.15 Purchase 30 `14 `420

Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) MA
 Net Income Units Unit Cost Total
Sep.1 Begin Inventory 40 `12 `480
Sep.4 Purchase 60 `13 `780
Sep.10 Sale (65) 65@`12.6
0
Sep.15 Purchase 30 `14 `420
Sep.23 Purchase 45 `15 `675
Sep.30 Sale (50) 50@`13.9
6
 5. Costing by Moving Average
a. Perpetual System
b. Periodic System
Cost of Goods Sold

Ending Inventory
 5. Costing by Moving Average
a. Perpetual System
b. Periodic System

At the end of the month Nell counts 60 units on hand.

`13.46 x 60 = `807.60 (or

approximately `808)
 Comparing Inventory
Costing Methods
Because inventory costing methods affect both income
statement and balance sheet accounts, a company must
disclose the method that it uses. It must also use the same
method consistently.
Relationships Summarized
 LIFO and Tax Deferral
Tax deferral is a temporary delay in the
payment of income taxes.

Tax deferrals are beneficial because a company

can keep and use its cash for a longer period of
time.

While companies can use any of the four

costing methods, some choose the LIFO
method because of the resulting tax deferral.
 LIFO Reserve
LIFO reserve is the difference between the
inventory reported on the balance sheet and what
inventory would be if reported on a FIFO basis.

The reserve is cumulative and can be

calculated by multiplying the reserve by the
company’s tax rate.

EXAMPLE (from Safeway’s 2010 financial footnotes):

Inventories valued at FIFO: $1,720M
Inventories valued at LIFO: $1,685M
Difference: ($1,720 - $1,685 = $35M). Assuming a tax
rate of 30%, the taxes that Safeway has deferred as of
the end of 2010 are $35 M ($35 X 30%).
 Inventory Errors
Inventory errors affect the following:
 Inventory Errors
If inventory is understated If inventory is overstated

Current Next Current Next

Period Period Period Period
Inventory Understated Correct Overstated Correct

Cost of Overstated Understated Understated Overstated

goods sold
Net Understated Overstated Overstated Understated

income
Total Understated Correct Overstated Correct

assets
 Evaluating a Company’s
Management of Inventory

How well is Target managing its

inventory?
 Assessing Inventory Using
Horizontal & Vertical Analysis
Target’s Analysis
Comparative Analysis
 Inventory Turnover Ratio
This ratio compares the cost of goods sold during a
period to the average inventory balance during that
period and measures the ability to sell inventory.

Target’s 2010 Inventory

Turnover Ratio:
 Days-in-Inventory Ratio
This ratio converts the inventory turnover ratio
into a measure of days by dividing the turnover
ratio into 365 days.

Target’s 2008 Days-

In-Inventory Ratio:
Learning Objectives
1. Describe inventory and how it is
recorded, expensed, and reported.
2. Calculate the cost of goods sold using
different inventory costing methods.
3. Understand the income and tax effects
of inventory cost flow assumptions.
4. Analyze the effects of inventory errors.
5. Demonstrate how inventory is
estimated.
Learning Objectives

6. Apply the lower-of-cost-or-market rule

to inventory.
7. Evaluate inventory through the
calculation of horizontal, vertical, and
ratio analyses.
8. Appendix: Record purchases and
calculate the cost of goods sold under a
periodic system.