Inventory

Inventory
Checklist
Chapter 11
Inventory Basics
Perpetual vs. Periodic Inventory Systems
Perpetual Purchase Transactions
Perpetual Sales Transactions and Closing Entries
Methods of Valuing Inventory
Methods of Estimating Inventory
Inventory Ratios
Inventory
Inventory represents physical goods

purchased/manufactured for resale to a customer.
Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Why is Inventory Important?
A reader of financial statements needs to know how much gross profit a

business is generating to make informed business decisions.
Examples include:
–Pricing policies
–Purchasing decisions
The Cost of Goods Sold is directly linked to the value of inventory used.
Two Types of Inventory Systems
1. Perpetual inventory system

2. Periodic inventory system
Perpetual Inventory System
When a product is sold, the item is instantly removed from the inventory
records and the cost of the product is immediately matched to the sale of the
product.
Example: Supermarket sales. A barcode is scanned and immediately records the sale
of inventory
Perpetual Inventory System
You are already familiar with this system. When an item is sold, the cost of the product
is immediately matched to the sale so that the gross profit is known each period.
CURRENT ASSETS
CASH
Jan Feb March

SHORT-TERM
INVESTMENTS
SALES REVENUE SALES REVENUE SALES REVENUE
$100 $150 $130
ACCOUNTS
RECEIVABLE COST OF GOODS SOLD COST OF GOODS SOLD COST OF GOODS SOLD
$20 $40 $60
INVENTORY GROSS PROFIT GROSS PROFIT GROSS PROFIT
$80 $90 $70
PREPAID
EXPENSES
Periodic Inventory System
Example: Restaurant
Under a periodic inventory system the value of inventory and cost of goods
sold is not known until it is physically counted.
When food is sold, the sale is recorded as revenue. However the cost of goods
sold and inventory value is not exactly known.
Quarterly Periods
At the end of the period, a physical count of ingredients (ending inventory)

will help calculate how much was sold, which is then matched to sales for the
period.
Inventory Systems - Question
True or False? A perpetual inventory system

continually tracks changes in inventory, and
matches COGS to revenue as the sale is
generated.
a. True
b. False
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Inventory Systems - Question
Which inventory system is more costly to

implement?
a. Perpetual
b. Periodic
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Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Inventory Purchase
Assume for the following transactions, that all inventory BALANCE SHEET
purchases were made on account. ASSETS LIABILITIES
CASH ACCOUNTS
PAYABLE
x 10,000 CR
JOURNAL
ACCOUNTS UNEARNED
ACCOUNT TITLE DEBIT CREDIT RECEIVABLE REVENUE
x
Inventory 10,000 x
BANK LOAN
INVENTORY
Accounts Payable 10,000
x
Record purchase of inventory 10,000 DR
STOCKHOLDERS’ EQUITY
PREPAID
COMMON STOCK
EXPENSES
PROPERTY, PLANT RETAINED

& EQUIPMENT EARNINGS
x
Purchase Returns
Goods that are purchased, often need to be returned.
Reasons can include:

• Incorrect products
• Over-shipments
• Inferior quality products
Purchase Returns
Entry to record the return of goods purchased on BALANCE SHEET
account to supplier ($300 worth of inventory returned): ASSETS LIABILITIES
CASH ACCOUNTS
PAYABLE
x 300 DR
ACCOUNTS UNEARNED
RECEIVABLE REVENUE
JOURNAL
x
x
ACCOUNT TITLE DEBIT CREDIT
BANK LOAN
INVENTORY
Accounts Payable 300 x
300 CR
Inventory 300 STOCKHOLDERS’ EQUITY
PREPAID
Goods returned to supplier COMMON STOCK
EXPENSES

x
Purchase Allowances (for Goods that have not been Sold)
Rather than returning goods, a business can offer an allowance. The buyer
agrees to keep undesirable goods at a reduced cost.
An allowance reduces the value of the inventory purchased and reduces the
amount owing to the supplier.
Purchase Allowances
Occurs when the buyer agrees to keep undesirable goods at a BALANCE SHEET
reduced cost. ASSETS LIABILITIES
CASH ACCOUNTS
PAYABLE
For example: x 60 DR
• Offer a 20% allowance for the company to keep the goods ACCOUNTS UNEARNED
RECEIVABLE REVENUE
rather than returning them x
x
• Calculation: $300 potential return x 20% allowance = $60 INVENTORY
BANK LOAN
x
60 CR
STOCKHOLDERS’ EQUITY
JOURNAL
PREPAID
COMMON STOCK
ACCOUNT TITLE DEBIT CREDIT EXPENSES
Accounts Payable 60 x

Inventory 60
Allowance for damaged goods
x
(20% x $300)
Purchase Allowances - Question
When recording an allowance for inventory

that has been purchased from a supplier but
not yet sold to customers, what account
should the allowance reduce?
a. Inventory
b. Cost of Goods Sold
When product is still in inventory, the

adjustment must reduce inventory. 0% 0%
When the product has been sold, the
adjustment is recorded to COGS.
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Purchase Discounts
Companies often offer discounts
There are two types of purchase discounts

1. Trade discounts
2. Cash discounts
Trade Discounts
Given based on volume of goods purchased
For example: Receive 10% discount for ordering 15 or more products
Why are trade discounts useful?

• Encourages more volume of sales
Cash Discounts
A cash discount is used to encourage quick payment from the customer
Example: 2/10 net 30
A 2% discount if payment is received in 10 days. The remaining amount must be paid

within 30 days.
Why are cash discounts useful?

• Encourages quick payment, which increases cash flow
Cash Discounts
Example: 2/10, n/30
2% discount is applied if paid within 10 days. Net amount owing is due in 30 days
1. Original purchase of inventory for $4,200
JOURNAL
DATE ACCOUNT TITLE DEBIT CREDIT
Jan 10 Inventory 4,200
Accounts Payable 4,200
Purchased goods
2. Make full payment within the 10 day discount period

JOURNAL
DATE ACCOUNT TITLE DEBIT CREDIT
Jan 15 Accounts Payable 4,200
Cash 4,166
Inventory 84
Paid invoice owing less discount received for early
payment
Purchase Discounts - Question
If the payment terms of an invoice dated

May 1st are shown as “2/10 net 20”, on
which date does the discount expire?
a. May 3
b. May 21
c. May 11
0% 0% 0%
3
21
11
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Freight
FOB Shipping Point

Indicates that ownership of the items being purchased changes when the goods leave
the seller’s place of business. The buyer pays for the shipping costs.
FOB Destination Point

Indicates that ownership of the items being purchased changes when the goods arrive
at the buyer’s place of business. The seller pays for the shipping costs.
Freight
BALANCE SHEET
Freight –in:
ASSETS LIABILITIES
Freight-in costs are added to the cost of inventory
CASH ACCOUNTS
PAYABLE
100 CR 60 DR
JOURNAL
ACCOUNTS UNEARNED
RECEIVABLE REVENUE
x
Inventory 100 x
BANK LOAN
INVENTORY
Cash 100 x
100 DR
Record the payment of freight STOCKHOLDERS’ EQUITY
costs PREPAID COMMON STOCK

EXPENSES

x
Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Sales Transactions
Adjusting entries relating to sales are, for the most part, a mirror image of
those for purchases.
This section will address:

1. Reversing entries
2. Tracking merchandise returns
3. Allowances
4. Discounts allowed
Sales (Perpetual Method)
Two entries to record a cash sale under BALANCE SHEET INCOME STATEMENT
perpetual system: ASSETS LIABILITIES SALES REVENUE
1. Record sale
1. Record the sale CASH ACCOUNTS 15,000 CR
PAYABLE EXPENSES
JOURNAL
15,000 DR
ACCOUNT TITLE DEBIT CREDIT COST OF GOODS SOLD
ACCOUNTS UNEARNED
Cash 15,000 RECEIVABLE REVENUE 9,000 DR
Sales Revenue 15,000 x GROSS PROFIT

x
Record sale to customer BANK LOAN 2. Record
BADthe
DEBTS MAINTENANCE
INVENTORY
COGS x x
x
2. Record the COGS 9,000 CR DEPRECIATION MISCELLANEOUS
STOCKHOLDERS’ EQUITY x x
JOURNAL PREPAID EXPENSES
COMMON STOCK INCOME TAX PAYROLL
x x
x INSURANCE RENT
Cost of Goods Sold 9,000 x x
Inventory 9,000 EARNINGS INTEREST TELEPHONE
& EQUIPMENT x x
Record COGS for above sale
x NET INCOME (LOSS)
Tracking Returns
Customers can frequently return purchased goods.

It is important to track customer returns.
High return rate could indicate many problems.
To track sales returns and allowances a contra-revenue account is used.

Sales Return and Sales Allowance - Difference
Sales Return Sales Allowance

• Occurs when undesirable • Occurs when the customer
products are returned to the decides to keep such undesirable
seller products at a reduced price.
Sales Returns & Allowances
INCOME STATEMENT
In order to keep track of returns and allowances use a
SALES REVENUE
contra revenue account
SALES RETURNS AND ALLOWANCES
Sales Returns EXPENSES
Undesirable product is returned to seller COST OF GOODS SOLD
GROSS PROFIT
Sales Allowances DEPRECIATION MISCELLANEOUS
x x
Customer decides to keep undesirable products at a
MARKETING SALARIES
reduced price x x
INSURANCE RENT
x x
INTEREST TELEPHONE
x x
NET INCOME (LOSS)

Sales Returns and Allowances
Example: Sales Return
How should you record a merchandise BALANCE SHEET INCOME STATEMENT

1. Record
return assuming $4,000 worth of goods ASSETS sales return
LIABILITIES SALES REVENUE
from client
(i.e. its cost) were sold for $6,000? CASH ACCOUNTS
PAYABLE SALES RETURNS AND ALLOWANCES
100 CRdsdx100 60 DR 6,000 DR
EXPENSES
JOURNAL ACCOUNTS UNEARNED
RECEIVABLE REVENUE
COST OF GOODS SOLD
x
6,000 CR 4,000 CR
Sales Returns & Allowances 6,000
BANK LOAN GROSS PROFIT
INVENTORY
Accounts Receivable 6,000 2. Restock
x
inventory
DEPRECIATION MISCELLANEOUS
4,000 DR
Record sales return STOCKHOLDERS’ EQUITY x
returned from x
PREPAID client
COMMON STOCK INCOME TAX PAYROLL
EXPENSES x x
JOURNAL
x INSURANCE RENT
ACCOUNT TITLE DEBIT CREDIT x x
Inventory 4,000 & EQUIPMENT EARNINGS INTEREST TELEPHONE
x x
Cost of Goods Sold 4,000 x NET INCOME (LOSS)
Restock returned inventory

Sales Returns and Allowances
Example: Sales Allowance
A company sold $2,000 of goods on BALANCE SHEET INCOME STATEMENT
account. How should a sales allowance ASSETS LIABILITIES SALES REVENUE
of $100 be recorded? CASH ACCOUNTS

PAYABLE SALES RETURNS AND ALLOWANCES
100 DR
EXPENSES
ACCOUNTS UNEARNED
JOURNAL RECEIVABLE REVENUE COST OF GOODS SOLD
x
ACCOUNT TITLE DEBIT CREDIT 100 CR
Sales Returns & Allowances 100 INVENTORY
x
Accounts Receivable 100 DEPRECIATION MISCELLANEOUS
Record sales return PREPAID INCOME TAX PAYROLL
EXPENSES x x
COMMON STOCK
x INSURANCE RENT
Notice that there is no change to x x
COGS because the goods are not PROPERTY, PLANT
INTEREST TELEPHONE
returned. & EQUIPMENT RETAINED x x
EARNINGS
x NET INCOME (LOSS)
Sales Discount
On March 1st,Dorval sold $4,000 of BALANCE SHEET INCOME STATEMENT
services with payment terms of 2/10 ASSETS LIABILITIES SALES REVENUE
net 30. On March 5th, Dorval received CASH ACCOUNTS

PAYABLE SALES DISCOUNT
payment. How should Dorval record the 80 DR
3,920 DR 60 DR
receipt of payment? ACCOUNTS UNEARNED
EXPENSES
RECEIVABLE REVENUE
COST OF GOODS SOLD
What is the sales discount amount? 3,920 CR
x
$4,000 x 2% = $80 INVENTORY
x
DEPRECIATION MISCELLANEOUS
JOURNAL 100 DR
ACCOUNT TITLE DEBIT CREDIT PREPAID INCOME TAX PAYROLL

EXPENSES x x
Cash 3,920 COMMON STOCK
x INSURANCE RENT
Sales Discount 80 x x
PROPERTY, PLANT
Accounts Receivable 4,000 & EQUIPMENT INTEREST TELEPHONE
RETAINED x x
EARNINGS
Record payment less discounts x NET INCOME (LOSS)
owed
Sales Returns and Allowances - Question
True or False? When a customer

returns a product, an entry to cost of
goods sold is not required.
a. True
b. False
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Sales Discount - Question
An invoice in the amount of $100 is dated

April 1, with payment terms “2/15 net 25”. If
it is paid on April 20, what is the total
discount?
a. $0 (i.e. no discount)
b. $2
c. $15
d. $25
0% 0% 0% 0%
$0 (i.e. no $2 $15 $25
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Income Statement
The multistep income statement can be prepared based on the sales

transactions that have occurred:
Sample Company
Income Statement
For the Period Ended mm/dd/yy
Separate tracking allows

for separate reporting
Gross Profit Margin
When a company tracks sales returns and discounts separately, gross profit
margin is calculated using net sales (not sales revenue).
Sample Company
Income Statement
Closing Entries in a Perpetual Inventory System
Step 1: Adjust Inventory*
*Assuming shrinkage = $200 (i.e. the balance

in the inventory account was $200 more than
the physical count)
ABC Inc.*
Adjusted Trial Balance
Step 2: Close revenue accounts
*A corporation
ABC Inc.
Adjusted Trial Balance
Step 3: Close expense and debit balance accounts
New
additions
to the
usual list
Step 4: Close income summary to retained earnings*
*The debit and credit amount for this entry

is equal to the net income for the period.
Income summary is closed to retained

earnings since ABC Inc. is a corporation.
Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Four Methods of Valuing Inventory
1. Specific Identification
2. First-In-First-Out (FIFO)
3. Weighted Average Cost
4. Last-In-First- Out (LIFO)
Specific Identification
When items are sold, they can be specifically identified.
For example:
• 3 products are ordered at different times and prices.
• Each unit has its own serial number and can be specifically identified.
• When 2 units are sold, the sales are specifically identified
$50 $50 $51

$52
$50 $51
Opening inventory
Cost of Goods sold = $102 Ending Inventory

= $50+$50+$51+$51
$50 $52
Sales = $202
First-In First-Out (FIFO)
Identifies the value of inventory that was delivered first, as the ones to be
sold first.
Purchased Jan 1st Purchased Jan 5th Purchased Jan 7th

Suppose you placed
3 orders for a $50 $50 $52
$50 $51 $51
product at different
times and prices.
$150 $102 $52
Management wants oldest inventory

$50 $50
sold first. Therefore when a sale is
made, the product that is first in, is the
product that is first out. Cost of Goods Sold
= 2 x $50 = $100
Management wants oldest inventory

$50 $50
sold first. Therefore when a sale is
made, the product that is first in, is the
product that is first out. Cost of Goods Sold
= 2 x $50 = $100
The Cost of Goods Sold for the sale is matched to the cost of the first item purchased in
inventory (Jan 1st ). The Ending Inventory is made up of the last items purchased.
Ending Inventory = + + = $204

$50 $51 $51 $52
(4 units)
Weighted Average Cost
Calculates the value of inventory using an average cost for all units of
inventory.
Weighted Average Cost
$50 $50 $51

$50 $51 $52
Weighted Average Total Cost of Goods Available for Sale ($150 + $102+ $52 )
Cost per unit
Total number of units available for Sale (6 units)
= $304 = $50.67 average
Calculate the Cost of Goods Sold and the Value of Ending Inventory using the
Weighted Average Cost method.
Cost of Goods Sold = 2 x $50.67 = $101

Ending Inventory = 4 x $50.67 = $203
Last-In First-Out (LIFO)
Identifies the value of inventory that was delivered last, as the ones to be
sold first.
Last in First out (LIFO) (2 items were sold)
Purchased Jan 1st Purchased Jan 5th Purchased Jan 7th

Suppose you placed
3 orders for a $50 $50 $52
$50 $51 $51
product at different
times and prices.
$150 $102 $52
Inventory that is purchased last is sold

$50 $50
first.
Cost of Goods Sold

= 51+ 52 = $103
Last in First out (LIFO) (2 items were sold)
Inventory that is purchased last is sold

$50 $50
first.
Cost of Goods Sold

= 51+ 52 = $103
The Cost of Goods Sold for the sale is matched to the cost of the last items purchased in
inventory (Jan 1st ). The Ending Inventory is made up of first items purchased
Ending Inventory = $50 $50 $50 + $51 = $201

(4 units)
The Effect of Different Valuation Methods
4 inventory methods produced Summary of Results*

different results
Inventory Method Inventory Value
Specific Identification $202
Changing the value of COGS FIFO $203
Weighted Average Cost $204
LIFO $202
Significantly affecting company’s *Although the values shown above are not materially
different from one another, in the real world, they often are.
financial records This is because large companies often deal with millions of
units and dollars worth of inventory.
Once a method of valuing inventory is chosen it must be consistently followed

according to GAAP rules.
The Effect of Different Valuation Methods
Other Conclusions:
1.In times where product cost are increasing, FIFO will result in the highest
value of ending inventory and LIFO will result in the highest value of cost of
goods sold.
2.While specific identification provides the true value of ending inventory and
cost of goods sold, it is costly to implement and therefore not practical for
items of small value.
Inventory Valuation Methods - Question
Company ABC manufactures identical steel nails

for construction. What inventory method is the
most logical to use?
a. Specific Identification
b. Weighted Average Cost
c. First in First Out (FIFO)
d. Last in First Out (LIFO)
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Inventory Valuation Methods - Question
What inventory method is most suitable to

value used cars at a dealership?
a. Specific Identification
b. Weighted Average Cost
c. First in First Out (FIFO)
d. Last in First Out (LIFO)
Values specific items individually. 0% 0% 0% 0%
Example: High value items such as cars,

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Controls Related to Inventory
• Use controls to comply with plans, policies, procedures, regulations and

laws
• Use controls to safeguard inventory

• Physically protect assets. The facilities storing the inventory must be
easily accessible for shipping, but also needs to protect against theft.
• Use alarm systems, security guards and/or inventory custodian
• Use controls to ensure the economical and efficient use of resources

Ethics and Inventory
What kind of impact does inventory have on a business?
• Inflating closing inventory reduces the cost of goods sold and increases
profit for the current year.
• Inventory values significantly effect financial statements and profitability
of companies.
• For this reason, manipulating inventory is illegal.
• It is management’s ethical responsibility to ensure manipulation does not
happen.
• Inventory fraud can happen from the top down and also from the bottom
up.
Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Estimating Inventory
In a perpetual inventory system, a company can track the cost of an inventory

item from purchase to sale.
Therefore, at any given point in time, a company can value their inventory,
cost of goods sold and ending inventory.
However, when a periodic system is used, accountants do not have this

information. Accountants estimate the value of inventory using two methods:
1. Gross Profit Method

2. Retail Method
Basic Calculations
To calculate a line item, you need two pieces of information.
Sales 125,000
Cost of Goods Sold
Opening Inventory 5,000
Purchases 65,000
Cost of Goods Available
for Sale 70,000
Closing Inventory 50,000
Cost of Goods Sold 20,000
Gross Profit ?
Estimating Inventory - Question
What is the value of cost of goods available for sale?

Sales 125,000
Cost of Goods Sold
Purchases 65,000
Cost of Goods Available
for Sale 70,000
Cost of Goods Sold
Gross Profit
a. 55,000
b. 60,000
c. 70,000 0% 0% 0% 0%
d. 195,000
00
0
0
00
00
00
50
55
60
70
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What is the value of closing inventory?

Sales 125,000
Cost of Goods Sold
Purchases 65,000
Cost of Goods Available 70,000
for Sale
Cost of Goods Sold 20,000
Gross Profit
a. 50,000
b. 55,000
0% 0% 0% 0%
c. 75,000
d. 90,000
0
0
00
00
00
00
50
55
75
90
What is the value of gross profit given a gross profit margin of 50%
Sales 100,000 50%

Cost of Goods Sold
Purchases 65,000
Cost of Goods Available 70,000
for Sale
Closing Inventory
Cost of Goods Sold
Gross Profit 50,000
a. 70,000 0% 0% 0% 0%
b. 50,000
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Inventory Valuation at the Lower of Cost or Market
• GAAP Principle of Conservatism asserts the use of the accounting method that
produces the lowest value for assets must always be used
• Lower of Cost or Market (LCM) principle must be used when valuing inventory
• When inventory is sold below cost, it is the selling price that is used to value
inventory, not the purchase price
• Inventory items can never be valued at more than their purchase price
We will demonstrate how this is done by using Elan’s Camera Shop as an example.
The chart on the next slide details the cost and selling price of all their inventory.
Lower of Cost or Market Applied at Three Levels
Lower of Cost or Market Example

Description Category Cost Selling Price Individual Category Total
Film Type 1 Supplies $100 $90 $90

Film Type 2 Supplies 500 520 500
Total Supplies 600 610 $600
Camera A Cameras 1,000 1,000 1,000

Camera B Cameras 2,000 2,200 2,000
Total 3,000 3,200
3,000
Cameras
Accessory 1 Accessories 3,000 2,900 2,900
Accessory 2 Accessories 4,000 3,500 3,500
Total 7,000 6,400 6,400
Accessory
Total $10,600 $10,210 $9,990 $10,000 $10,210
Lower of Cost or Market Transaction
The cost of the inventory is over-stated by $610. To adjust this amount, the following
journal entry should be recorded.
JOURNAL

Cost of Goods Sold 610
Inventory 610
To adjust inventory to LCM on an individual item basis

Gross Profit Method
Based on previous years, a figure of 50% for gross profit margin will be used to
estimate inventory.
Three steps of estimating closing inventory
1 What is the value of Gross
Profit? Sales 100,000
= Sales x Gross Profit Margin Cost of Goods Sold
= 100,000 x 50% Opening Inventory 4,000 Given
= 50,000 Purchases 65,000 Given
2 What is the value of COGS? Cost of goods available for Sale 69,000 Given
= Sales – Gross Profit Closing Inventory 3 ?
19,000
=100,000 – 50,000 Cost of Goods Sold ?
2 50,000
=50,000 ?
Gross Profit 1 50,000 50%
3 What is the value of closing inventory?
= Cost of goods available for sale – COGS Use 50% Gross Profit
= Inventory minus what was sold Margin
= 69,000 – 50,000
= 19,000
What is the value of closing inventory using a 45% Gross Profit Margin?
Sales 125,000
Cost of Goods Sold
Opening Inventory 5,000 Given
Purchases 65,000 Given
Cost of Goods
Available for Sale ?
Closing Inventory ?
Cost of Goods Sold ?
Gross Profit ? ?
a. 1,875 0% 0% 0% 0%
b. -8,750
c. 1,250
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Estimating Inventory - Solution
Sales 125,000
Cost of Goods Sold
1 Use 45% Gross Profit Margin Opening Inventory 5,000 Given
Purchases 65,000 Given
2 Gross Profit: Cost of Goods 4 70,000
= Sales x 45% Gross Profit Margin Available for Sale
Closing Inventory 5 1,250
3 COGS
Cost of Goods Sold 3 68750
= Sales – gross profit
Gross Profit 2 56,250 1 45%
4 Cost of goods available for sale
= Opening inventory + purchases
5 Closing Inventory
= COGS available for sale – COGS
Gross Margin Method
If gross margin varies significantly from year to year, using a historical average
of Gross Profit Margin to estimate ending inventory may be inaccurate.
The second method of estimating inventory is the Retail Method.

Retail Method
Retail businesses track both the selling price and the purchase cost of goods
sold.
Selling
Price
This information provides another way to estimate ending inventory.

Estimating Ending Inventory
Suppose a retail store wants to estimate the cost of ending inventory

using the information shown below.
Cost Retail
Beginning Inventory $70,000 140,000
Purchases 240,000 480,000
Cost of Goods Available for Sale $ 310,000 620,000
Net Sales $ 400,000 First step:
Ending Inventory $220,000
?
calculate the retail value
of ending inventory
Subtract net sales from the retail value of goods available for sale.
Second step: calculate the cost-to-retail ratio
Cost Retail
Purchases 240,000 480,000
Second step:
Cost of Goods Available $ 310,000 620,000
calculate the
for Sale
cost-to-retail ratio.
Net Sales $ 400,000
Ending Inventory 220,000
Cost of Goods Available for Sale at cost $ 310,000

50%
620,000
Cost Goods Available for Sale at retail
Third step: Estimate the cost of ending inventory using cost-to-retail ratio.
Cost Retail
Purchases 240,000 480,000
Cost of Goods Available for Sale $ 310,000 620,000
Net Sales $ 400,000 Third step:
Ending Inventory ?
$110,000 220,000 Apply the cost-to-retail
ratio of 50%.
Ending Inventory (cost) = cost-to-retail ratio x retail value

= 50% x $220,000
= $110,000
Using the retail method of valuing inventory, what is the value of ending
inventory at cost?
a. 50% cost-to-retail, Closing inventory $50,000
b. 62.5% cost-to-retail, Closing inventory
$62,500
c. 55% cost-to-retail, inventory $55,000
Cost Retail
Purchases 50,000 80,000
Goods Available for Sale $ 110,000 200,000
Net Sales $ 100,000
0% 0% 0% 0%
Ending Inventory ?
$55,000 100,000 50% cost-to- 62.5% cost-to- 55% cost-to- None of the
re... ... re... ab...
Retail Method
A store's cost-to-retail ratio may vary significantly from one type of item to
another.
If the items that actually sold have a cost-to-retail ratio that differs
significantly from the simple ratio used in the calculation, the estimate will be
inaccurate.
Checklist
Chapter 11
Inventory Basics
Inventory Ratios
Inventory Ratios
What is the purpose of analyzing inventory ratios?
A company can measure how well inventory is being managed by using

inventory ratios.
• Too much inventory means capital is tied up.

• Too little inventory means that customer demand is not being
met.
Inventory Ratios
*Note* When insufficient

Inventory turnover = Cost of Goods Sold information is available to
Average Inventory* calculate averages, use
ending the inventory.
Inventory turnover ratio:

Estimates how many times a year a company is selling inventory.
Inventory Ratios - Question
What is the formula for Inventory Turnover?
a. Inventory / COGS
b. Avg. Inventory / COGS
c. COGS / Inventory
d. COGS / Avg. Inventory
0% 0% 0% 0%
..
..
...
y..
n.
o.
CO
or
nt
I
Inventory
g.
COGS
nt
y/
ve
Av
ve
In
or
=
In
/
/
nt
GS
g.
GS
ve
Turnover
Av
CO
Avg. Inventory
CO
In
Average = Beginning inventory + Ending Inventory
Inventory 2
What is the inventory turnover ratio for company ABC?

a. 0.11
b. 0.10
c. 10.00
d. 11.11
Beginning Inventory $100,000

0% 0% 0% 0%
Cost of goods sold $1,000,000
1
.
1
.1
10
.1
.1
11
Inventory COGS 1,000,000
= = = 11.11
Turn over 90,000
Avg. Inventory
This means company ABC on average sells inventory 11
times a year
Which company has a better inventory turnover?

a. Company A
b. Company B
Company A
Cost of goods sold $275,000
Inventory Turnover Ratio 5
Company B
0% 0%
B
Cost of goods sold $1,400,000 A
ny
ny
pa
pa
m
m
Co
Co

A low inventory turnover rate could mean a company is overstocking their

inventory. True or false?
a. True
b. False
A low inventory rate of say 3 times per year means a

company sells out inventory 3 times per year (not
often). This could mean the company is
overstocking inventory depending on the industry.
0% 0%
Inventory cost money to hold. Companies need to
pay attention to this ratio and stock the correct Tr
ue l se
Fa
amount of inventory.
Inventory Days on Hand
The inventory turnover ratio measures the number of times a company sells
its inventory during the year.
Inventory Days on Hand estimates how many days it takes to move items out
of inventory. In other word's, how many days inventory will last given the
current rate of sales.
# of days in fiscal period

365
Inventory Days on Hand =
Inventory Turnover
Avg. Inventory
or x 365
Cost of Goods Sold
What is the formula for Inventory Days on Hand?
a. 365 / Average Sales

b. 365 / Inventory Turnover
c. Inventory Turnover / 365
d. Sales / 365
0% 0% 0% 0%
..
..
...
5
n.
36
e.
or
ur
ag
nt
/
yT
es
er
ve
Av
l
or
In
Sa
nt
5/
5/
ve
36
36
In
What is the Inventory Days on Hand for company XYZ?

a. 0.04 days
b. 19.01 days
c. 22.26 days
d. 25.56 days
0% 0% 0% 0%
ys
ys
ys
y s
Average inventory $30,500
da
da
da
da
6
04
.0
.2
.5
0.
19
22
25
Cost of goods sold $500,000
Inventory Days on Average Inventory

Hand = x 365 =
COGS
30,500
= x 365 = 22.26 days
500,000
This means company ABC on average sells out their
inventory every 22.26 days.
Which company sells inventory quicker?

a. Company A
b. Company B
Company A
Cost of goods sold 600,000
Inventory Days on Hand = 365 / 5 =73
Company B
Inventory Turnover Ratio 8 0% 0%
Cost of goods sold 400,000
B
A
Inventory Days on Hand = 365/8 = 45.6
ny
ny
pa
pa
m
m
Co
Co
This means company A on average sells out inventory every
73 days compared to Company B who sells out every 45.6
days
A manager at Company ABC has performed a ratio analysis to determine how

effective inventory is being managed. He has found a decreasing trend in
inventory days on hand and is very worried that capital is being tied up in
overstocking. Are his worries justified?
a. Yes
b. No
Inventory Days on Hand estimates how many days it

takes to move items out of inventory. A decreasing
trends means stock is being sold more quickly.
If inventory days on hand gets too low, however, 0% 0%

the manager should be worried that they are under-
stocking inventory.
No
s
Ye
Do you think a very high inventory turnover is always good?
a. Yes
b. No
A very high inventory may result in lack of customer

service, stock-outs, increased purchasing costs.
Its all in the balance. Hence the importance of

trend and forecast analysis.
0% 0%
No
Ye
Application of Ratio Analysis
• Simply memorizing equations and calculating a ratio is not as critical as

understanding what the ratio demonstrates.
• Yearly trends determine the direction a company is moving towards,

allowing managers to draw sound conclusions.
• Always try to ask “so what?”

– What is the implication of a ratio?
– What is the trend?
– How does this effect profitability?
– What changes can be made to improve these ratios?
End of Chapter 11

Inventory

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Inventory represents physical goods

A reader of financial statements needs to know how much gross profit a

1. Perpetual inventory system

Jan Feb March

At the end of the period, a physical count of ingredients (ending inventory)

True or False? A perpetual inventory system

Which inventory system is more costly to

purchases were made on account. ASSETS LIABILITIES

PROPERTY, PLANT RETAINED

Goods that are purchased, often need to be returned.

Reasons can include:

Entry to record the return of goods purchased on BALANCE SHEET

account to supplier ($300 worth of inventory returned): ASSETS LIABILITIES

PROPERTY, PLANT RETAINED

PROPERTY, PLANT RETAINED

When recording an allowance for inventory

When product is still in inventory, the

Companies often offer discounts

There are two types of purchase discounts

Given based on volume of goods purchased

For example: Receive 10% discount for ordering 15 or more products

Why are trade discounts useful?

A cash discount is used to encourage quick payment from the customer

Example: 2/10 net 30

A 2% discount if payment is received in 10 days. The remaining amount must be paid

Why are cash discounts useful?

2. Make full payment within the 10 day discount period

If the payment terms of an invoice dated

FOB Shipping Point

FOB Destination Point

costs PREPAID COMMON STOCK

PROPERTY, PLANT RETAINED

This section will address:

Sales Revenue 15,000 x GROSS PROFIT

Customers can frequently return purchased goods.

To track sales returns and allowances a contra-revenue account is used.

Sales Return Sales Allowance

Sales Returns EXPENSES

Undesirable product is returned to seller COST OF GOODS SOLD

NET INCOME (LOSS)

How should you record a merchandise BALANCE SHEET INCOME STATEMENT

Restock returned inventory

A company sold $2,000 of goods on BALANCE SHEET INCOME STATEMENT

account. How should a sales allowance ASSETS LIABILITIES SALES REVENUE

of $100 be recorded? CASH ACCOUNTS

On March 1st,Dorval sold $4,000 of BALANCE SHEET INCOME STATEMENT

services with payment terms of 2/10 ASSETS LIABILITIES SALES REVENUE

net 30. On March 5th, Dorval received CASH ACCOUNTS

ACCOUNT TITLE DEBIT CREDIT PREPAID INCOME TAX PAYROLL

True or False? When a customer

An invoice in the amount of $100 is dated

The multistep income statement can be prepared based on the sales

Separate tracking allows

Step 1: Adjust Inventory*

*Assuming shrinkage = $200 (i.e. the balance

Step 4: Close income summary to retained earnings*

*The debit and credit amount for this entry

Income summary is closed to retained

When items are sold, they can be specifically identified.

$50 $50 $51

Cost of Goods sold = $102 Ending Inventory

Note When insufficient