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ING 747 parts on behalf of GATX CORPORATION.



Ownership Transfer for Goods in Transit
exhibit 7-4



Seller Buyer


FOB FOB
Shipping Point Destination

• Seller owns
• Buyer owns
goods in transit
goods in transit

• Ownership changes
Ownership changes
at destination
at shipping point
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Operating Activities



business environment essay


Technology Is Changing the Way Com- The relationship between PROCTER & GAMBLE
panies View Inventory In the good old (P&G) and WAL-MART provides an example of how
days, a company would buy inventory, technology is being used to manage inventory. In
hold it for a while, and then sell it to a 1999, Wal-Mart was easily P&G s largest customer, ac-
customer. Businesses now realize that in- counting for 12% of its sales. Using electronic data in-
ventory sitting on a shelf costs money terchange (EDI), P&G has access to certain portions
money that is tied up in inventory cannot of Wal-Mart s inventory data. When Wal-Mart s in-
be used for other purposes. Technology ventory reaches a certain level, P&G automatically
now allows companies to shorten the processes and ships an order to the appropriate Wal-
time that money is tied up in inventory. Mart warehouse to ensure that Wal-Mart never is out
An entire discipline, supply-chain management, has de- of stock of P&G products. Companies are able to es-
veloped to determine the most cost-efficient method for tablish such mutually beneficial relationships because
procuring and moving raw materials, work in process, technology now allows the sharing of information at
finished goods, and items that have been sold from the a very low cost.
supplier to the producer to the eventual end user.




Ending Inventory and Cost of Goods Sold
Inventory purchased or manufactured during the period is added to beginning inventory, and
the total cost of this inventory is called the cost of goods available for sale. At the end of an
cost of goods available for
sale The cost of all mer- accounting period, total cost of goods available for sale must be allocated between inventory still
chandise available for sale
remaining (to be reported in the balance sheet as an asset) and inventory sold during the period
during the period; equal to
(to be reported in the income statement as an expense, Cost of Goods Sold).
the sum of beginning in-
This cost allocation process is extremely important because the more cost that is said to re-
ventory and net purchases.
main in ending inventory, the less cost is reported as cost of goods sold in the income statement.
This is why accurately determining who owns the inventory is such a big issue. Making a mis-
take with inventory ownership will result in misstating both the income statement and the bal-
ance sheet. For this reason, accountants must be careful of inventory errors because they directly
affect reported net income. The impact of inventory errors is illustrated later in the chapter.
The cost allocation process also involves a significant amount of accounting judgment. Iden-
tical inventory items are usually purchased at varying prices throughout the year, so to calculate
the amount of ending inventory and cost of goods sold, the accountant must determine which
items (the low cost or high cost) remain and which were sold. Again, this decision can directly
affect the amount of reported cost of goods sold and net income. The use of inventory cost flow
assumptions is discussed later in the chapter.




to summarize
Inventory is composed of goods held for sale in the normal course of busi-
ness. Cost of goods sold is the cost of inventory sold during the period. For
a manufacturing firm, the three types of inventory are raw materials, work
in process, and finished goods. All costs incurred in producing and getting
inventory ready to sell should be added to inventory cost. The costs associ-
ated with the selling effort itself are operating expenses of the period. In-
ventory should be recorded on the books of the company holding legal title.
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Inventory



At the end of an accounting period, the total cost of goods available for sale
during the period must be allocated between ending inventory and cost of
goods sold.




ACCOUNTING FOR INVENTORY PURCHASES
2
AND SALES
Account for inventory
purchases and sales using
both a perpetual and a To begin a more detailed study of inventory accounting, we must first establish a solid under-
periodic inventory system.
standing of the journal entries used to record inventory transactions. The accounting procedures
for recording purchases and sales using both a periodic and a perpetual inventory system are de-
tailed in this section.

Overview of Perpetual and Periodic Systems
Some businesses track changes in inventory levels on a continuous basis, recording each indi-
vidual purchase and sale to maintain a running total of the inventory balance. This is called a
perpetual inventory system. Other businesses rely on quarterly or yearly inventory counts to re-
veal which inventory items have been sold. This is called a periodic inventory system.

You own a discount appliance superstore. Your biggest-selling items are wash-
PERPETUAL
ers, dryers, refrigerators, microwaves, and dishwashers. You advertise your weekly sale items on
local TV stations, and your sales volume is quite heavy. You have 50 salespeople who work in-
dependently of one another. You have found that customers get very upset if they come to buy
an advertised item and you have run out. In this business environment, would it make sense to
keep a running total of the quantity remaining of each inventory item and update it each time a
sale is made? Yes, the benefit of having current information on each inventory item would make
it worthwhile to spend a little extra time to update the inventory records when a sale is made.
This appliance store would probably use a perpetual inventory system. With a perpetual
perpetual inventory system
A system of accounting for system, inventory records are updated whenever a purchase or a sale is made. In this way, the
inventory in which detailed
inventory records at any given time reflect how many of each inventory item should be in the
records of the number of
warehouse or out on the store shelves. A perpetual system is most often used when each indi-
units and the cost of each
vidual inventory item has a relatively high value or when there are large costs to running out of
purchase and sales transac-
or overstocking specific items.
tion are prepared through-
out the accounting period.
You operate a newsstand in a busy metropolitan subway station. Almost all of your
PERIODIC
sales occur during the morning and the evening rush hours. You sell a diverse array of items
newspapers, magazines, pens, snacks, and other odds and ends. During rush hour, your business
is a fast-paced pressure cooker; the longer you take with one customer, the more chance that the
busy commuters waiting in line for service will tire of waiting and you will lose sales. In this busi-
ness environment, would it make sense to make each customer wait while you meticulously check
off on an inventory sheet exactly which items were sold? No, the delay caused by this detailed
bookkeeping would cause you to lose customers. It makes more sense to wait until the end of the
day, count up what inventory you still have left, compare that to what you started with, and use
those numbers to deduce how many of each inventory item you sold during the day.
This subway newsstand scenario is an example of a situation where a periodic inven-
periodic inventory system
A system of accounting for tory system is appropriate. With a periodic system, inventory records are not updated when
inventory in which cost of a sale is made; only the dollar amount of the sale is recorded. Periodic systems are most of-
goods sold is determined
ten used when inventory is composed of a large number of diverse items, each with a rela-
and inventory is adjusted at
tively low value.
the end of the accounting
period, not when merchan-
dise is purchased or sold. Over the past 25 years, advances in infor-
IMPACT OF INFORMATION TECHNOLOGY
mation technology have lowered the cost of maintaining a perpetual inventory system. As a re-
sult, more businesses have adopted perpetual systems so that they can more closely track inven-
299
f300 Part 2 Inventory
Operating Activities


A newsstand will wait un-
til the end of the day to
count inventory by com-
paring what items it
started with to what is
left. This is an example of
a periodic inventory sys-
tem.




tory levels. The most visible manifestation of this trend is in supermarkets. Twenty years ago,
the checkout clerk rang up the price of each item on a cash register. After the customers walked
out of the store with their groceries, the store knew the total amount of the purchase but did
not know which individual items had been sold. This was a periodic inventory
If you buy your groceries
system. Now, with laser scanning equipment tied into the supermarket s com-
with a credit card or a bank debit card, puter system, most supermarkets operate under a perpetual system. The store
what kind of information can the supermar- manager knows exactly what you bought and exactly how many of each item
should still be left on the store shelves.
ket accumulate about you?



Perpetual and Periodic Journal Entries
The following transactions for Grantsville Clothing Store will be used to illustrate the differ-
ences in bookkeeping procedures between a business using a perpetual inventory system and one
using a periodic inventory system:


a. Purchased on account: 1,000 shirts at a cost of $10 each for a total of $10,000.
b. Purchased on account: 300 pairs of pants at a cost of $18 each for a total of $5,400.
c. Paid cash for separate shipping costs on the shirts purchased in (a), $970. The sup-
plier of the pants purchased in (b) included the shipping costs in the $18 purchase
price.
d. Returned 30 of the shirts (costing $300) to the supplier because they were stained.
e. Paid for the shirt purchase. A 2% discount was given on the $9,700 bill [(1,000 pur-
chased 30 returned) $10] because of payment within the ten-day discount pe-
riod (payment terms were 2/10, n/30).
f. Paid $5,400 for the pants purchase. No discount was allowed because payment was
made after the discount period.
g. Sold on account: 600 shirts at a price of $25 each for a total of $15,000.
h. Sold on account: 200 pairs of pants at a price of $40 each for a total of $8,000.
i. Accepted return of 50 shirts by dissatisfied customers.
300 f301
Inventory Chapter 7
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The journal entries for the perpetual inventory system should seem familiar to you a per-
petual system has been assumed in all earlier chapters of the text. A perpetual system was as-
sumed because it is logical and is the system all companies would choose if there were no cost
to updating the inventory records each time a sale or purchase is made. As mentioned, a peri-
odic inventory system is sometimes a practical necessity.

With a perpetual system, all purchases are added (debited) directly to In-
PURCHASES
ventory. With a periodic system, the inventory balance is only updated using an inventory
count at the end of the period; inventory purchases during the period are recorded in a tem-
porary holding account called Purchases. As will be illustrated later, at the end of the period,
the balance in Purchases is closed to Inventory in connection with the computation of cost
of goods sold.
Entries (a) and (b) to record the shirt and pants purchases are given below:

Perpetual Periodic
a. Inventory 10,000 Purchases 10,000
Accounts Payable 10,000 Accounts Payable 10,000
b. Inventory 5,400 Purchases 5,400
Accounts Payable 5,400 Accounts Payable 5,400



The cost of transporting the inventory is an additional in-
TRANSPORTATION COSTS
ventory cost. Sometimes, as with the pants in the Grantsville Clothing example, the shipping
cost is already included in the purchase price, so a separate entry to record the transportation
costs is not needed. When a separate payment is made for transportation costs, it is recorded as
follows:

Perpetual Periodic

c. Inventory 970 Freight In 970
Cash 970 Cash 970


With a perpetual inventory system, transportation costs are added directly to the inventory
balance. With a periodic inventory system, another temporary holding account, Freight In, is
created, and transportation costs are accumulated in this account during the period. Like the
purchases account, Freight In is closed to Inventory at the end of the period in connection with
the computation of cost of goods sold.

With a perpetual system, the return of unsatisfactory merchandise
PURCHASE RETURNS
to the supplier results in a decrease in Inventory. In addition, since no payment will have to be
made for the returned merchandise, Accounts Payable is reduced by the same amount. With a
periodic system, the amount of the returned merchandise is recorded in yet another temporary
holding account called Purchase Returns. Purchase Returns is a contra account to Purchases and
is also closed to Inventory as part of the computation of cost of goods sold.

Perpetual Periodic

d. Accounts Payable 300 Accounts Payable 300
Inventory 300 Purchase Returns 300


If the returned merchandise had already been paid for, the supplier would most likely re-
turn the purchase price. In this case, the debit would be to Cash instead of to Accounts Payable.
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Operating Activities


As discussed in Chapter 6, sellers sometimes offer inducements
PURCHASE DISCOUNTS
for credit customers to pay quickly. In this example, Grantsville Clothing takes advantage of
purchase discounts to save money on the payment for the shirts. The amount of the purchase
discount is $194 ($9,700 0.02), so the total payment for the shirts is $9,506 ($9,700
$194). The amount recorded for inventory should reflect the actual amount paid to purchase
the inventory. With a perpetual inventory system, this is shown by subtracting the purchase dis-
count amount from the inventory account. With a periodic inventory system, another holding
account is created to accumulate purchase discounts taken during the period.

Perpetual Periodic

e. Accounts Payable 9,700 Accounts Payable 9,700
Inventory 194 Purchase Discounts 194
Cash 9,506 Cash 9,506
f. Accounts Payable 5,400 Accounts Payable 5,400
Cash 5,400 Cash 5,400


Note that the payment for the pants is made after the discount period, so the full
fyi
amount must be paid. Since this transaction had no impact on Inventory, the entry is the
In practice, this same inventory
same for both the perpetual and the periodic system.
adjustment information (e.g., In terms of journal entries, you should recognize that the difference between a per-
Freight In, Purchase Returns, petual and a periodic inventory system is that all adjustments to inventory under a per-
petual system are entered directly in the inventory account; with a periodic system, all in-
etc.) would be maintained in
ventory adjustments are accumulated in an array of temporary holding accounts: Purchases,
supplemental records under a
Freight In, Purchase Returns, and Purchase Discounts.
perpetual inventory system.
Such information is useful to
management in evaluating The sales of shirts and pants would be recorded as follows:
SALES
company purchasing practices.

Perpetual Periodic

g. Accounts Receivable 15,000 Accounts Receivable 15,000
Sales (600 $25) 15,000 Sales 15,000
Cost of Goods Sold 6,000
Inventory (600 $10) 6,000
h. Accounts Receivable 8,000 Accounts Receivable 8,000
Sales (200 $40) 8,000 Sales 8,000
Cost of Goods Sold 3,600
Inventory (200 $18) 3,600


These entries reflect the primary difference between a perpetual and a periodic inventory
system with a periodic system, no attempt is made to recognize cost of goods sold on a trans-
action-by-transaction basis. In fact, with a periodic system, Grantsville Clothing would not even
know how many shirts and how many pairs of pants had been sold. Instead, only total sales of
$23,000 ($15,000 $8,000) would be known.
For simplicity, we have recorded the cost of goods sold for the shirts as $10 each. The actual
cost per shirt, after adjusting for freight in and purchase discounts, is $10.80, computed as follows:
Total purchase price (1,000 shirts) $10,000
Plus: Freight in 970
Less: Purchase returns (30 shirts) (300)
Less: Purchase discounts (194)
Total cost of shirts (970 shirts) $10,476
Total cost $10,476 970 shirts $10.80 per shirt

In practice, it is unlikely that a firm using a perpetual inventory system would bother to
adjust unit costs for the effects of freight cost and purchase discounts on an ongoing basis. The
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cost of doing these calculations could easily outweigh any resulting improvement in the quality
of cost information.

As discussed in Chapter 6, dissatisfied customers sometimes return their
SALES RETURNS
purchases. The journal entries to record the return of 50 shirts are as follows:


Perpetual Periodic

i. Sales Returns (50 $25) 1,250 Sales Returns 1,250
Accounts Receivable 1,250 Accounts Receivable 1,250
Inventory (50 $10) 500
Cost of Goods Sold 500


Should the returned in- Under the perpetual system, not only are the sales for the returned items
canceled, but the cost of the returned inventory is also removed from Cost of
ventory be recorded at its original cost of
Goods Sold and restored to the inventory account.
$10 per shirt?

After all of the journal entries are posted to the ledger, the T-accounts
CLOSING ENTRIES
for Inventory and Cost of Goods Sold, under a perpetual system, would appear as follows:

Inventory Cost of Goods Sold

(a) 10,000 (d) 300 (g) 6,000 (i) 500
(b) 5,400 (e) 194 (h) 3,600
(c) 970 (g) 6,000
(i) 500 (h) 3,600
Bal. 6,776 Bal. 9,100


These numbers, after being verified by a physical count of the inventory (as described in
the next section), would be reported in the financial statements the $6,776 of Inventory in the
balance sheet and the $9,100 of Cost of Goods Sold in the income statement.
Review the journal entries (a) through (i) under the periodic inventory system and notice
that none of the amounts have been entered in either Inventory or Cost of Goods Sold. As a
result, both of these accounts will have zero balances at year-end. Actually, the inventory ac-
count would have the same balance it had at the beginning of the period, which, in this exam-
ple, we will assume to be zero.
With a periodic inventory system, the correct balances are recorded in Inventory and Cost
of Goods Sold through a series of closing entries. Two entries are made:
1. Transfer all the temporary holding accounts to the inventory account balance. At this point,
the inventory account balance is equal to the cost of goods available for sale (beginning in-
ventory plus the net cost of purchases for the period).
2. Reduce Inventory by the amount of Cost of Goods Sold. At this point, the inventory ac-
count balance is equal to the ending inventory amount, and the appropriate cost of goods
sold amount is also recognized.
To illustrate, the information for Grantsville Clothing will be used. The entry to transfer
all the temporary holding accounts to the inventory account is as follows:


Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,876
Purchase Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Purchase Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Freight In . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 970
Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,400
Closing of temporary inventory accounts for periodic system.
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Operating Activities


The inventory debit of $15,876 is the amount of net purchases for the period. Notice that,
net purchases The net cost
of inventory purchased dur- after this entry has been posted, the balances in all the temporary holding accounts will have
ing a period, after adding been reduced to zero. As mentioned, after the addition of net purchases, the inventory account
the cost of freight in and
balance represents cost of goods available for sale (the sum of beginning inventory and net pur-
subtracting returns and dis-
chases). Remember that, in this example, beginning inventory is assumed to be zero.
counts.
The second closing entry involves the adjustment of Inventory to its appropriate ending
balance and the creation of the cost of goods sold account. This cost of goods sold account
would be closed when other nominal accounts (e.g., Sales Salaries, Interest Expense, etc.) are
closed. If the year-end physical count indicates that the ending inventory balance should be
$6,776, the appropriate entry is as follows:

Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,100
Inventory ($15,876 $6,776) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,100
Adjustment of inventory account to appropriate ending balance.


In this example, the values for both ending inventory ($6,776) and cost of goods sold
($9,100) are the same with either a perpetual or a periodic inventory system. So, what is the
practical difference between the two systems? One difference is that a perpetual system can tell
you the inventory balance and the cumulative cost of goods sold at any time during the period.
With a periodic system, on the other hand, you must wait until the inventory is counted at the
end of the period to compute the amount of inventory or cost of goods sold. Another differ-
ence is that, with a perpetual system, you can compare the inventory records to the amount of
inventory actually on hand and thus determine whether any inventory has been lost or stolen.
As described in the next section, this comparison is not possible with a periodic system.



to summarize
With a perpetual inventory system, the amount of inventory and cost of goods
sold for the period are tracked on an ongoing basis. With a periodic inven-
tory system, inventory and cost of goods sold are computed using an end-
of-period inventory count. With a periodic system, inventory-related items are
recorded in temporary holding accounts that are transferred to the inventory
account at the end of the period.




3 COUNTING INVENTORY AND CALCULATING
COST OF GOODS SOLD
Calculate cost of goods
sold using the results of an
inventory count and
Regular physical counts of the existing inventory are essential to maintaining reliable inventory
understand the impact of
accounting records. With a perpetual system, the physical count can be compared to the recorded
errors in ending inventory
on reported cost of goods inventory balance to see whether any inventory has been lost or stolen. With a periodic system,
sold.
a physical count is the only way to get the information necessary to compute cost of goods sold.

Taking a Physical Count of Inventory
No matter which inventory system a company is using, periodic physical counts are a necessary and
important part of accounting for inventory. With a perpetual inventory system, the physical count
either confirms that the amount entered in the accounting records is accurate or highlights short-
ages and clerical errors. If, for example, employees have been stealing inventory, the theft will show
up as a difference between the balance in the inventory account and the amount physically counted.
A physical count of inventory involves two steps:
1. Quantity count. In most companies, physically counting all inventory is a time-consuming
activity. Because sales transactions and merchandise deliveries can complicate matters, in-
304 f305
Inventory Chapter 7
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ventory is usually counted on holidays or after the close of business on the inventory day.
Special care must be taken to ensure that all inventory owned, wherever its location, is
counted and that inventory on hand but not owned (consignment inventory) is not
counted.
2. Inventory costing. When the physical count has been completed, each type of merchandise
is assigned a unit cost. The quantity of each type of merchandise is multiplied by its unit
cost to determine the dollar value of the inventory. These amounts are then added to ob-
tain the total ending inventory for the business. This is the amount reported as Inventory
on the balance sheet. The ending balance in the inventory account may have to be adjusted
for any shortages discovered.
To illustrate the impact of a physical inventory count on the accounting records for both
a periodic and a perpetual system, we will refer back to the Grantsville Clothing Store example
used earlier. Assume that a physical count, combined with inventory costing analysis, suggests
that the correct amount for ending inventory is $5,950. This information can be combined with
previous information from the accounting system as follows:


Periodic Perpetual
System System

Beginning inventory $ 0 $ 0
Plus: Net purchases 15,876 15,876
Cost of goods available for sale $15,876 $15,876
Less: Ending inventory 5,950 6,776 (from inventory system)
Cost of goods sold $ 9,926 $ 9,100 (from inventory system)
Goods lost or stolen unknown 826 ($6,776 $5,950)
Total cost of goods sold, lost, or stolen $ 9,926 $ 9,926



Recall that, in this example, the beginning inventory is assumed to be zero. The amount of net
purchases is a combination of the items affecting the amount paid for inventory purchases dur-
ing the period: purchase price, freight in, purchase returns, and purchase discounts. The $15,876
amount for net purchases was computed earlier in connection with the closing entry for the pe-
riodic system.
This cost of goods sold computation highlights the key difference between a periodic and
a perpetual inventory system. With a periodic system, the company does not know what end-
ing inventory should be when the inventory count is performed. The best the company can
do is count the inventory and assume that the difference between the cost of goods available
for sale and the cost of goods still remaining (ending inventory) must represent the cost of
goods that were sold. Actually, a business using a periodic system has no way of knowing
whether these goods were sold, lost, stolen, or spoiled all it knows for sure is that the goods
are gone.
With a perpetual system, the accounting records themselves yield the cost of goods sold
during the period, as well as the amount of inventory that should be found when the physical
count is made. In the Grantsville Clothing example, the predicted ending inventory is $6,776
(from the T-account shown earlier); the actual ending inventory, according to the physical count,
is only $5,950. The difference of $826 ($6,776 $5,950) represents inventory lost, stolen, or
spoiled during the period. This amount is called inventory shrinkage. The adjusting entry
inventory shrinkage The
amount of inventory that is needed to record this inventory shrinkage is as follows:
lost, stolen, or spoiled dur-
ing a period; determined by
comparing perpetual inven- Inventory Shrinkage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 826
tory records to the physical
Inventory ($6,776 $5,950). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 826
count of inventory.
Adjustment of perpetual inventory balance to reflect inventory shrinkage.


For internal management purposes, the amount of inventory shrinkage would be tracked from
one period to the next to detect whether the amount of shrinkage for any given period is un-
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business environment essay


Inventory Fraud: The Great Salad Oil Founded in 1957 by Tino De Angelis, Allied Crude
Case One of the most common ways of Vegetable Oil was set up on an old petroleum tank
committing major financial statement farm in Bayonne, New Jersey. De Angelis used the
fraud and reporting income that is soybean oil that was supposedly in the tanks as col-
higher than it should be is to overstate lateral to borrow money from financial institutions. He
a company s inventory. If ending inven- then hired AMERICAN EXPRESS WAREHOUSING,
tory is overstated, cost of goods sold is LTD. (a subsidiary of AMERICAN EXPRESS) to take
understated and net income is over- charge of storing, inspecting, and documenting the
stated. The overstatement of inventory oil. The warehousing receipts issued by the ware-
and income can attract investors and house workers were used as evidence of the oil.
boost the stock price. In addition, since inventory can De Angelis handpicked 22 men to work at the tank
often be pledged as collateral to borrow money from farm, and they fooled the American Express inspec-
banks, its overstatement increases a company s bor- tors with considerable ease. For example, one of them
rowing power. Consider the famous case of ALLIED would climb to the top of a tank, drop in a weighted
CRUDE VEGETABLE OIL, one of the best-known in- tape measure, and then shout down to the inspector
ventory frauds of all time. that the tank was full. In most cases the tanks were




usually high. For external reporting purposes, the shrinkage amount would probably be
fyi
combined with normal cost of goods sold, and the title Cost of Goods Sold would be
CVS is a leader in the retail given to the total. Notice that if this practice is followed, reported cost of goods sold would
drugstore industry in the be the same under both a perpetual and a periodic inventory system. The difference is
United States with net sales of that, with a perpetual system, company management knows how much of the goods was
actually sold and how much represents inventory shrinkage.
$18.1 billion in fiscal 1999. In-
With a periodic inventory system, no journal entry for inventory shrinkage is made
ventory shrinkage for CVS for
because the amount of shrinkage is unknown. Instead, the ending inventory amount de-
1999 was $163 million, or al-
rived from the physical count is used to make the second periodic inventory closing en-
most 1% of sales.
try (refer back to the previous section). Using the $5,950 ending inventory amount, the
appropriate periodic inventory closing entry is:



Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,926
Inventory ($15,876 $5,950) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,926
Adjustment of inventory account to appropriate ending balance.




The Income Effect of an Error in Ending Inventory
As shown in the previous section, the results of the physical inventory count directly affect
the computation of cost of goods sold with a periodic system and inventory shrinkage with
a perpetual system. Errors in the inventory count will cause the amount of cost of goods sold
or inventory shrinkage to be misstated. To illustrate, assume that the correct inventory count
for Grantsville Clothing is $5,950 but that the ending inventory value is mistakenly com-
puted to be $6,450. The impact of this $500 ($6,450 $5,950) inventory overstatement is
as follows:
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Inventory Chapter 7
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empty, although some were filled with seawater and conservatively estimated at $200 million. Most of the
topped with a thin slick of oil. Moreover, the tanks losses were borne by 51 major banking and broker-
were connected by a jungle of pipes that allowed the age houses in the United States and Europe, 20 of
workers to pump whatever oil there was from one tank which collapsed.
to another. De Angelis pleaded guilty to four federal counts of
The maneuvers gave De Angelis an endless sup- fraud and conspiracy and was given a 20-year sen-
ply of oil and borrowing power. If anyone had checked tence. The millions of dollars loaned to De Angelis
a statistical report issued by the U.S. Census Bureau, were never found, and it is generally believed that the
he or she would have found that the oil supposedly missing oil never existed. In fact, when one oil tank
stored at the tank farm totaled twice as much as all that supposedly contained $3,575,000 worth of oil was
the oil in the country. By the close of 1963, the ware- opened, seawater ran out for 12 consecutive days.
house receipts represented 937 million pounds of oil
when actually only 100 million pounds existed.
The salad oil scandal was revealed when De An-
Source: Marshall B. Romney and W. Steve Albrecht, The Use of In-
gelis was unable to make payments on an investment. vestigative Agencies by Auditors, The Journal of Accountancy, Oc-
The ensuing investigation revealed a fraud that was tober 1979, p. 61.




Periodic Perpetual
System System

Beginning inventory $ 0 $ 0
Plus: Net purchases 15,876 15,876
Cost of goods available for sale $15,876 $15,876
Less: Ending inventory 6,450 6,776 (from inventory system)
Cost of goods sold $ 9,426 $ 9,100 (from inventory system)
Goods lost or stolen unknown 326 ($6,776 $6,450)
Total cost of goods sold, lost, or stolen $ 9,426 $ 9,426




The $500 inventory overstatement reduces the reported cost of goods sold, lost, or stolen
by $500, from $9,926 (computed earlier) to $9,426. This is because if we mistakenly think that
we have more inventory remaining, then we will also mistakenly think that we must have sold
less. Conversely, if the physical count understates ending inventory, total cost of goods sold will
be overstated.
Since an inventory overstatement decreases reported cost of goods sold, it will also increase
reported gross margin and net income. For this reason, the managers of a firm that is having
difficulty meeting profit targets are sometimes tempted to mistakenly overstate ending inven-
tory. Because of this temptation, auditors must take care to review a company s inventory count-
ing process and also to physically observe a sample of the actual inventory. Many new account-
ing graduates who are hired by public accounting firms spend a portion of their first year on
the job checking the inventory counts done by clients. The benefits of this exposure are twofold:
(1) these new auditors get an opportunity to see what a business actually does, and (2) the in-
ventory count provides assurance that the inventory amount stated on the financial statements
is accurate.
307
f308 Part 2 Inventory
Operating Activities




to summarize
A physical inventory count is necessary to ensure that inventory records match
the actual existing inventory. If a perpetual system is used, an inventory count
can be used to compute the amount of inventory shrinkage during the period.
An error in the reported ending inventory amount can have a significant effect
on reported cost of goods sold, gross margin, and net income. For example,
overstatement of ending inventory results in understatement of cost of goods
sold and overstatement of net income.




INVENTORY COST FLOW ASSUMPTIONS
4
Apply the four inventory
Consider the following transactions for the Ramona Rice Company for the year 2003.
cost flow alternatives:
specific identification, FIFO,
LIFO, and average cost.
Mar. 23 Purchased 10 kilos of rice, $4 per kilo.
Nov. 17 Purchased 10 kilos of rice, $9 per kilo.
Dec. 31 Sold 10 kilos of rice, $10 per kilo.

The surprisingly difficult question to answer with this simple example is How much money
did Ramona make in 2003? As you can see, it depends on which rice was sold on December
31. There are three possibilities:


Case #1 Case #2 Case #3
Sold Sold Sold
Old Rice New Rice Mixed Rice
Sales ($10 10 kilos) $100 $100 $100
Cost of goods sold (10 kilos) 40 90 65
Gross margin $ 60 $ 10 $ 35

FIFO (first in, first out) An
inventory cost flow as-
In Case #1, it is assumed that the 10 kilos of rice sold on December 31 were the old ones, pur-
sumption whereby the first
chased on March 23 for $4 per kilo. Accountants call this a FIFO (first in, first out) assump-
goods purchased are as-
tion. In Case #2, it is assumed that the company sold the new rice, purchased on November 17
sumed to be the first goods
sold so that the ending in- for $9 per kilo. Accountants call this a LIFO (last in, first out) assumption. In Case #3, it is
ventory consists of the
assumed that all the rice is mixed together, so the cost per kilo is the average cost of all the rice
most recently purchased
available for sale, or $6.50 per kilo [($40 $90) 20 kilos]. Accountants call this an average
goods.
cost assumption.
LIFO (last in, first out) An The point of the Ramona Rice example is this: in most cases, there is no feasible way to
inventory cost flow as-
track exactly which units were sold. Accordingly, in order to compute cost of goods sold, the
sumption whereby the last
accountant must make an assumption. Note that this is not a case of tricky accountants trying
goods purchased are as-
to manipulate the reported numbers; instead, this is a case in which income simply cannot be
sumed to be the first goods
computed unless the accountant uses his or her judgment and makes an assumption.
sold so that the ending in-
ventory consists of the first All three of the assumptions described in the example FIFO, LIFO, and average cost are
goods purchased.
acceptable under U.S. accounting rules. An interesting question is whether a company would ran-
domly choose one of the three acceptable methods, or whether the choice would be made more
average cost An inventory
strategically. For example, if Ramona Rice were preparing financial statements to be used to sup-
cost flow assumption
whereby cost of goods sold port a bank loan application, which assumption would you suggest that the company make? On
and the cost of ending in-
the other hand, if Ramona were completing its income tax return, which assumption would be
ventory are determined by
the best? This topic of strategic accounting choice will be discussed later in this chapter.
using an average cost of all
In the following sections, we will examine in more detail the different cost flow assump-
merchandise available for
tions used by companies to determine inventories and cost of goods sold.
sale during the period.
308 f309
Inventory Chapter 7
Inventory



Specific Identification Inventory Cost Flow
An alternative to the assumptions just described is to specifically identify the cost of each par-
ticular unit that is sold. This approach, called specific identification, is often used by automo-
specific identification A
method of valuing inven- bile dealers and other businesses that sell a limited number of units at a high price. To illustrate
tory and determining cost
the specific identification inventory costing method, we will consider the September 2003 records
of goods sold whereby the
of Nephi Company, which sells one type of bicycle.
actual costs of specific in-
ventory items are assigned
Sept. 1 Beginning inventory consisted of 10 bicycles costing $200 each.
to them.
3 Purchased 8 bicycles costing $250 each.
18 Purchased 16 bicycles costing $300 each.
20 Purchased 10 bicycles costing $320 each.
25 Sold 28 bicycles, $400 each.

These inventory records show that during September the company had 44 bicycles (10 from
beginning inventory and 34 that were purchased during the month) that it could have sold.
However, only 28 bicycles were sold, leaving 16 on hand at the end of September. Using the
specific identification method of inventory costing requires that the individual costs of the ac-
tual units sold be charged against revenue as cost of goods sold. To compute cost of goods sold
and ending inventory amounts with this alternative, a company must know which units were
actually sold and what the unit cost of each was.
Suppose that of the 28 bicycles sold by Nephi on September 25, 8 came from the be-
ginning inventory, 4 came from the September 3 purchase, and 16 came from the September
18 purchase. With this information, cost of goods sold and ending inventory are computed
as follows:


Bicycles Costs

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 $ 2,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10,000
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 $12,000
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 4,600
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 $ 7,400



The cost of ending inventory is the total of the individual costs of the bicycles still on hand at
the end of the month, or:
2 bicycles from beginning inventory, $200 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400
4 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
0 bicycles purchased on September 18, $300 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0
10 bicycles purchased on September 20, $320 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Total ending inventory (16 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,600

Similarly, the cost of goods sold is the total of the costs of the specific bicycles sold, or:
8 bicycles from beginning inventory, $200 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,600
4 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
16 bicycles purchased on September 18, $300 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800
0 bicycles purchased on September 20, $320 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0
Total cost of goods sold (28 units). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,400

For many companies, it is impractical, if not impossible, to keep track of specific units. In
that case, an assumption must be made as to which units were sold during the period and which
are still in inventory, as illustrated earlier in the Ramona Rice example.
It is very important to remember that the accounting rules do not require that the assumed
flow of goods for costing purposes match the actual physical movement of goods purchased and
309
f310 Part 2 Inventory
Operating Activities


sold. In some cases, the assumed cost flow may be similar to the physical flow, but firms are not
required to match the assumed accounting cost flow to the physical flow. A grocery store, for
example, usually tries to sell the oldest units first to minimize spoilage. Thus, the physical flow
of goods would reflect a FIFO pattern, but the grocery store could use a FIFO, LIFO, or aver-
age cost assumption in determining the ending inventory and cost of goods sold numbers to be
reported in the financial statements. On the other hand, a company that stockpiles coal must
first sell the coal purchased last since it is on top of the pile. That company might use the LIFO
cost assumption, which reflects physical flow, or it might use one of the other alternatives.
In the next few sections, we will illustrate the FIFO, LIFO, and average inventory costing
methods. The bicycle inventory data for Nephi Company will again be used in illustrating the
different inventory cost flows.

FIFO Cost Flow Assumption
With FIFO, it is assumed that the oldest units are sold and the newest units remain in inven-
tory. Using the FIFO inventory cost flow assumption, the ending inventory and cost of goods
sold for Nephi Company are:


Bicycles Costs

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 $ 2,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10,000
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 $12,000
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 5,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 $ 7,000



The $7,000 cost of goods sold and $5,000 cost of ending inventory are determined as follows:
FIFO cost of goods sold (oldest 28 units):
10 bicycles from beginning inventory, $200 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
8 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
10 bicycles purchased on September 18, $300 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Total FIFO cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,000

FIFO ending inventory (newest 16 units):
6 bicycles purchased on September 18, $300 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800
10 bicycles purchased on September 20, $320 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Total FIFO ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000



LIFO Cost Flow Assumption
LIFO is the opposite of FIFO. With LIFO, the cost of the most recent units purchased is trans-
ferred to cost of goods sold. When prices are rising, as they are in the Nephi Company exam-
ple, LIFO provides higher cost of goods sold, and hence lower net income, than FIFO. This is
because the newest (high-priced) goods are assumed to have been sold. Using the LIFO inven-
tory cost flow assumption, the ending inventory and cost of goods sold for Nephi Company are:


Bicycles Costs

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 $ 2,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10,000
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 $12,000
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 3,500
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 $ 8,500
310 f311
Inventory Chapter 7
Inventory


The $8,500 cost of goods sold and $3,500 cost of ending inventory are determined as follows:
LIFO cost of goods sold (newest 28 units):
10 bicycles purchased on September 20, $320 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,200
16 bicycles purchased on September 18, $300 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800
2 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Total LIFO cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,500

LIFO ending inventory (oldest 16 units):
10 bicycles from beginning inventory, $200 each. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
6 bicycles purchased on September 3, $250 each . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Total LIFO ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,500


Average Cost Flow Assumption
With average costing, an average cost must be computed for all the inventory available for sale
during the period. The average unit cost for Nephi Company during September is computed as
follows:

Bicycles Costs

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 $ 2,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10,000
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 $12,000
$12,000 44 units $272.73 per unit


With the average cost assumption, cost of goods sold is computed by multiplying the num-
ber of units sold by the average cost per unit. Similarly, the cost of ending inventory is com-
puted by multiplying the number of units in ending inventory by the average cost per unit.
These calculations are as follows:

Average Cost of Goods Sold: 28 Units $272.73 per Unit $7,636 (rounded)

Average Ending Inventory: 16 Units $272.73 per Unit $4,364 (rounded)

This information can be shown as follows:

Bicycles Costs

Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 $ 2,000
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 10,000
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 $12,000
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 4,364
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 $ 7,636




A Comparison of All Inventory Costing Methods
The cost of goods sold and ending inventory amounts we have calculated using the three cost
flow assumptions are summarized along with the resultant gross margins as follows:

FIFO LIFO Average

Sales revenue (28 $400). . . . . . . . . . . . . . . . . . . . $11,200 $11,200 $11,200
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 8,500 7,636
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,200 $ 2,700 $ 3,564
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 3,500 $ 4,364
311
f312 Part 2 Inventory
Operating Activities


Note that the net result of each of the inventory cost flow assumptions is to allocate the to-
tal cost of goods available for sale of $12,000 between cost of goods sold and ending inven-
tory.

From a conceptual standpoint, LIFO gives a better reflec-
CONCEPTUAL COMPARISON
tion of cost of goods sold in the income statement than does FIFO because the most recent
goods ( last in ), with the most recent costs, are assumed to have been sold. Thus, LIFO cost
of goods sold matches current revenues with current costs. Average cost is somewhere between
LIFO and FIFO. On the balance sheet, however, FIFO gives a better measure of inventory value
because, with the FIFO assumption, the first in units are sold and the remaining units are the
newest ones with the most recent costs. In summary, LIFO gives a conceptually better measure
of income, but FIFO gives a conceptually better measure of inventory value on the balance sheet.

As illustrated in the Nephi Company
FINANCIAL STATEMENT IMPACT COMPARISON
example, in times of rising inventory prices (the most common situation in the majority of in-
dustries today), cost of goods sold is highest with LIFO and lowest with FIFO.
As a result, gross margin, net income, and ending inventory are lowest with
Over the entire life of a
LIFO and highest with FIFO. With the impact on the reported financial state-
company from its beginning with zero in-
ment numbers being so uniformly bad, you may be wondering why any com-
ventory until its final closeout when the last
pany would ever voluntarily choose to use LIFO (during times of inflation). It
inventory item is sold is aggregate cost of might further surprise you to learn that, since 1974, hundreds of U.S. compa-
goods sold more, less, or the same as ag- nies have voluntarily switched from FIFO to LIFO and that over half of the
gregate purchases? How is this relationship large companies in the United States currently use LIFO in accounting for at
affected by the inventory cost flow assump- least some of their inventories.
The attractiveness of LIFO can be explained with one word TAXES.
tion used?
If a company uses LIFO in a time of rising prices, reported cost of goods sold
is higher, reported taxable income is lower, and cash paid for income taxes is lower. In fact,
LIFO was invented in the 1930s in the United States for the sole purpose of allowing com-
panies to lower their income tax payments. In most instances where accounting alternatives
exist, firms are allowed to use one accounting method for tax purposes and another for fi-
nancial reporting. In 1939, however, when the Internal Revenue Service (IRS) approved the
use of LIFO, it ruled that firms may use LIFO for tax purposes only if they also use LIFO
for financial reporting purposes. Therefore, companies must choose between reporting higher
profits and paying higher taxes with FIFO or reporting lower profits and paying lower taxes
with LIFO.




to summarize
Some companies can use specific identification as a method of valuing in-
ventory and determining cost of goods sold. In most cases, however, an ac-
countant must make an inventory cost flow assumption in order to compute
cost of goods sold and ending inventory. With FIFO (first in, first out), it is as-
sumed that the oldest inventory units are sold first. With LIFO (last in, first
out), it is assumed that the newest units are sold first. With the average cost
assumption, the total goods available for sale are used to compute an aver-
age cost per unit for the period; this average cost is then used in calculating
cost of goods sold and ending inventory. LIFO produces a better matching of
current revenues and current expenses in the income statement; FIFO yields
a balance sheet inventory value that is closer to the current value of the in-
ventory. The primary practical attraction of LIFO is that it lowers income tax
payments.
312 f313
Inventory Chapter 7
Inventory



5 ASSESSING HOW WELL COMPANIES MANAGE
THEIR INVENTORIES
Use financial ratios to
evaluate a company s
inventory level.
Money tied up in the form of inventories cannot be used for other purposes. Therefore, com-
panies try hard to minimize the necessary investment in inventories while at the same time as-
suring that they have enough inventory on hand to meet customer demand. In recent years a
method of inventory management called just-in-time (JIT) inventory has become popular. JIT,
which will be described in Chapter 7 in the management accounting section of this text, is an
inventory management method that attempts to have exactly enough inventory arrive just in
time for sale. Its purpose is to minimize the amount of money needed to purchase and hold in-
ventory.

Evaluating the Level of Inventory
Two widely used measurements of how effectively a company is managing its inventory are the
inventory turnover ratio and number of days sales in inventory. Inventory turnover provides
inventory turnover A mea-
sure of the efficiency with a measure of how many times a company turns over, or replenishes, its inventory during a year.
which inventory is man- The calculation is similar to the accounts receivable turnover discussed in Chapter 6. It is cal-
aged; computed by dividing
culated by dividing cost of goods sold by average inventory as follows:
cost of goods sold by aver-
age inventory for a period.
Cost of Goods Sold
Inventory Turnover
Average Inventory


The average inventory amount is the average of the beginning and ending inventory bal-
ances. The inventory turnover ratios for SEARS, SAFEWAY, and CATERPILLAR for 1999
are as follows (dollar amounts are in billions):


Sears Safeway Caterpillar

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . $27.212 $20.349 $14.481
Beginning inventory. . . . . . . . . . . . . . . . . . . . . . 5.322 1.856 2.842
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . 5.648 2.445 2.594
Average inventory . . . . . . . . . . . . . . . . . . . . . . . 5.485 2.151 2.718
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . 4.96 9.46 5.33


From this analysis, you can see that Safeway, the supermarket, turns its inventory over more
frequently than Sears, the department store, and Caterpillar, the equipment dealer. This result
number of days sales in
is what we would have predicted given that the companies are in different businesses and have
inventory An alternative
different types of inventory.
measure of how well inven-
tory is being managed; Inventory turnover can also be converted into the number of days sales in inventory.
computed by dividing 365
This ratio is computed by dividing 365, or the number of days in a year, by the inventory
days by the inventory
turnover, as follows:
turnover ratio.

Number of Days 365
caution Sales in Inventory Inventory Turnover
Sometimes these two inven-
Computing this ratio for Sears, Safeway, and Caterpillar yields the following:
tory ratios are computed using
ending inventory rather than
average inventory. This is ap-
Number of Days
propriate if the inventory bal- Sales in Inventory
ance does not change much
Sears . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73.6 days
from the beginning to the end
Safeway. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.6 days
of the year.
Caterpillar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68.5 days
313
f314 Part 2 Inventory
Operating Activities



business environment essay


Phar-Mor Cooks Up Inventory Fraud Because Phar-Mor did not keep a perpetual inven-
Recall the introductory scenario from tory system, the company estimated the value of its
Chapter 5 that detailed the rise and fall inventory by using a ratio involving the cost of the
of PHAR-MOR. That case resulted from items purchased and their retail value. Inventory was
an elaborate inventory fraud perpe- counted, valued at its retail price, and then multiplied
trated by top management over several by this ratio to obtain an approximation of its cost.
years. Phar-Mor s inventory ostensibly Phar-Mor officials manipulated the ratio to ensure that
grew from $11 million in 1989 to $153 inventory was inflated and that cost of goods sold was
million in 1991, but much of this inven- understated. In addition, when Phar-Mor s accoun-
tory had been created by fabricating tants made journal entries reducing Inventory (with a
financial data and misleading the external auditors. credit), the corresponding debit (which should have




Individuals analyzing how effective a company s inventory management is would compare these
ratios with those of other firms in the same industry and with comparable ratios for the same
firm in previous years.
net work
Impact of the Inventory Cost Flow Assumption
In addition to Safeway, an-
As mentioned previously, in times of rising prices, the use of LIFO results in higher cost of
other large supermarket
chain is KROGER, based in
goods sold and lower inventory values. All three of the companies in the ratio illustration on the
Cincinnati. Access Kroger s
previous page use LIFO. Each company includes supplemental disclosures in the financial state-
Web site at
ment notes that allow users to compute what reported inventory and cost of goods sold would
http://kroger.com.
Is Kroger s inventory have been if the company had used FIFO. To illustrate the impact that the choice of inventory
turnover higher or lower
cost flow assumption can have on the reported numbers, consider the following comparison for
than Safeway s? Does
Caterpillar for 1999:
Kroger use LIFO or FIFO?



Reported Numbers if
LIFO Numbers Using FIFO

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14.481 $12.481
Average inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.718 4.718
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.33 2.65
Number of days sales in inventory . . . . . . . . . . . . . . . . 68.5 days 137.7 days


The difference in cost of goods sold for 1999 is not great because inflation was relatively
low in that year. However, the difference in the reported average inventory balance reflects the
cumulative effect of inflation for the many years since Caterpillar first started using LIFO. The
impact on the ratio values is dramatic. Of course, the difference between LIFO and FIFO is not
as great for most companies as shown here for Caterpillar, but the general point is that the choice
of inventory cost flow assumption can affect the conclusions drawn about the financial state-
ments if the financial statement user is not careful.

Number of Days Purchases in Accounts Payable
In Chapter 6, we introduced the average collection period ratio. In this chapter we have dis-
cussed the computation of the number of days sales in inventory. Taken together, these two ra-
tios indicate the length of a firm s operating cycle. The two ratios measure the amount of time
it takes, on average, from the point when inventory is purchased to the point when cash is col-
314 f315
Inventory Chapter 7
Inventory




been made to Cost of Goods Sold) was made to an These falsifications and more resulted in financial
asset account (with the clever name of Cookies ). statement fraud amounting to over $1 billion in losses.
This cookies account would then be broken into The external auditors in the case were found guilty of
smaller pieces and reallocated to individual stores. Be- fraud not because the audit firm was an active par-
cause the Cookies were broken into pieces, the ticipant in the scheme, but because the auditors were
smaller numbers avoided attracting the external au- reckless with regard to the conduct of the audit.
ditors attention. Another tactic used by Phar-Mor was
to artificially inflate the inventory numbers at the com- Sources: Most of these facts relating to Phar-Mor appeared in
Gabriella Stern, Chicanery at Phar-Mor Ran Deep, Close Look at Dis-
pany s fiscal year-end (June 30) and attribute the in-
counter Shows, The Wall Street Journal, January 20, 1994, p. 1; Mark
flated numbers to a buildup of inventory in prepara- F. Murray, When a Client is a Liability, Journal of Accountancy,
tion for the 4th of July. September 1992, pp. 54 58.




lected from the customer who purchased the inventory. For example, Sears 253-day operating
cycle for 1999 is depicted below:

Number of Days™
Sales in Inventory Average Collection Period


179 days
74 days




253 days


Is Sears operating cycle too long, too short, or just right? That is difficult to tell without in-
formation from prior years and from competitors. But by including one additional ratio in the
analysis, we can learn more about how Sears is managing its operating cash flow. The number
number of days purchases
in accounts payable A mea- of days purchases in accounts payable reveals the average length of time that elapses between
sure of how well operating the purchase of inventory on account and the cash payment for that inventory. The number of
cash flow is being man-
days purchases in accounts payable is computed by dividing total inventory purchases by aver-
aged; computed by dividing
age accounts payable and then dividing the result into 365 days:
total inventory purchases
by average accounts
Number of Days Purchases
payable and then dividing 365 Days
in Accounts Payable
365 days by the result. Purchases/Average Accounts Payable


The amount of inventory purchased during a year is computed by combining cost of goods sold
with the change in the inventory balance for the year. If inventory increased during the year,
then inventory purchases are equal to cost of goods sold plus the increase in the inventory bal-
ance. Similarly, if inventory decreased during the year, inventory purchases are equal to cost of
goods sold minus the decrease in the inventory balance.
The number of days purchases in accounts payable indicates how long a company takes to
pay its suppliers. For example, Sears number of days purchases in accounts payable for 1999
is computed as follows (dollar figures are in millions):
Cost of goods sold for 1999 . . . . . . . . . . . . . . $27,212
Add increase in inventory during 1999 . . . . . . 326
Inventory purchases during 1999 . . . . . . . . . . $27,538
Average accounts payable during 1999 . . . . . $ 6,862
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f316 Inventory
Part 2 EM Operating Activities


Number of Days Purchases 365 Days
in Accounts Payable $27,538/$6,862

91 Days


Number of Days™
Sales in Inventory Average Collection Period

179 days
74 days



253 days

162 days
91 days



Number of Days™ External Financing
Purchases in Needed
Accounts Payable


Sears must pay its suppliers in 91 days but must wait for 253 days before receiving
caution
the cash from its customers. Sears must finance the remaining 162 days (253 days 91
This computation of the num-
days) of its operating cycle with bank loans or additional stockholder investment or by
ber of days purchases in ac-
charging interest to those using its credit card debt. Sears is famous for using the last op-
counts payable assumes that tion charging customers for the use of credit. In 1999 alone, Sears reported revenue from
only inventory purchases on its credit card activities of over $4.3 billion.
These calculations illustrate that proper management of the sales/collection cycle, cou-
account are included in ac-
pled with prudent financing of inventory purchases on account, can reduce a company s
counts payable. It is likely that
reliance on external financing.
the accounts payable balance
also includes such items as
supplies purchased on account.
Nevertheless, the purchase of
to summarize
inventory is typically the most
Proper inventory management seeks a balance between keeping a lower
significant element of accounts
inventory level to avoid tying up excess resources and maintaining a suf-
payable.
ficient inventory balance to ensure smooth business operation. Compa-
nies assess how well their inventory is being managed by using two ra-
tios: (1) inventory turnover and (2) number of days sales in inventory. A
company s choice of inventory cost flow assumption can significantly affect
the values of these inventory ratios; intelligent ratio analysis requires consid-
ering possible accounting differences among companies. Comparison of the
average collection period, number of days sales in inventory, and number of
days purchases in accounts payable reveals how much of a company s oper-
ating cycle it must finance through external financing.




Thus far we have defined inventory and cost of goods sold; we have described
the perpetual and periodic inventory systems, three inventory cost flow as-
sumptions, and the use of financial ratios to evaluate a company s manage-
316 f317
Inventory EM Chapter 7
Inventory



ment of its inventory. These topics are all sufficient for a basic understanding
of the nature of inventory and cost of goods sold, as well as the most com-
mon ways of accounting for inventory. The four topics that will be discussed
in the expanded material are (1) the impact of more complicated inventory er-
rors, (2) complications that arise in using LIFO and average cost with a per-
petual inventory system, (3) reporting inventory at amounts below cost, and
(4) a method for estimating inventory without taking a physical count.



6 FURTHER COVERAGE OF INVENTORY ERRORS
Analyze the impact of
Incorrect amounts for inventory on the balance sheet and cost of goods sold on the income state-
inventory errors on
reported cost of goods ment can result from errors in counting inventories, recording inventory transactions, or both.
sold.
The effect of an error in the end-of-period inventory count was discussed earlier in the chapter.
To examine the effects of other types of inventory errors, we will assume that Richfield Com-
pany had the following inventory records for 2003:
Inventory balance, January 1, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000
Purchases through December 30, 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Inventory balance, December 30, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

We will further assume that on December 31 the company purchased and received another
$1,000 of inventory. The following comparison shows the kinds of inventory situations that
might result:


Incorrect* Incorrect Incorrect Correct
The $1,000 of
merchandise not recorded as a recorded as a not recorded as a recorded as a
purchased on purchase and not purchase but not purchase but counted purchase and
December 31 was counted as inventory counted as inventory as inventory counted as inventory

Beginning inventory $ 8,000 (OK)** $ 8,000 (OK) $ 8,000 (OK) $ 8,000 (OK)
Net purchases 20,000 ()) 21,000 (OK) 20,000 ()) 21,000 (OK)
Cost of goods avail-
able for sale $28,000 ()) $29,000 (OK) $28,000 ()) $29,000 (OK)
Ending inventory 12,000 ()) 12,000 ()) 13,000 (OK) 13,000 (OK)
Cost of goods sold $16,000 (OK) $17,000 (+) $15,000 ()) $16,000 (OK)

*This calculation produces the correct cost of goods sold but by an incorrect route the errors in purchases and ending inventory offset each other.
**For the amount, ) indicates it is too low, + means it is too high, and OK means it is correct.


In these calculations, the beginning inventory plus purchases equals the cost of goods that
were available for sale. In other words, everything that could be sold must have either been
on hand at the beginning of the period (beginning inventory) or purchased during the period
(net purchases). Then, ending inventory (what wasn t sold) was subtracted from the cost of goods
available for sale. The result is the cost of goods that were sold. Everything on hand (available)
had to be either sold or left in ending inventory. From this example, you can see how inven-
tory and cost of goods sold can be misstated by the improper recording of inventory purchases
or counting of inventory.
Similar errors can occur when inventory is sold. If a sale is recorded but the merchandise
remains in the warehouse and is counted in the ending inventory, cost of goods sold will be un-
derstated, whereas gross margin and net income will be overstated. If a sale is not recorded but
inventory is shipped and not counted in the ending inventory, gross margin and net income will
be understated, and cost of goods sold will be overstated.
317
f318 Inventory
Part 2 EM Operating Activities


To illustrate these potential inventory errors, we will again consider the data of Richfield
Company. Note that sales figures have been added and the ending inventory and the 2003 pur-
chases now correctly include the $1,000 purchase of merchandise made on December 31, 2003.
Sales revenue through December 30, 2003 (200% of cost) . . . . . . . . . . . . . . . . . . . . . . . $32,000
Inventory balance, January 1, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Net purchases during 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Inventory balance, December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000
In addition, assume that on December 31, inventory that cost $1,000 was sold for $2,000.
The merchandise was delivered to the buyer on December 31. The following analysis shows the
kinds of situations that might result:

Incorrect Incorrect Incorrect Correct

not recorded and the recorded and the
not recorded and the recorded and the merchandise was merchandise was
The $2,000 sale on merchandise was merchandise was excluded from excluded from
December 31 was counted as inventory counted as inventory inventory inventory

Sales revenue $32,000 ())* $34,000 (OK) $32,000 ()) $34,000 (OK)
Cost of goods sold:
Beginning inventory $ 8,000 (OK) $ 8,000 (OK) $ 8,000 (OK) $ 8,000 (OK)
Net purchases 21,000 (OK) 21,000 (OK) 21,000 (OK) 21,000 (OK)
Cost of goods avail-
able for sale $29,000 (OK) $29,000 (OK) $29,000 (OK) $29,000 (OK)
Ending inventory 13,000 (+) 13,000 (+) 12,000 (OK) 12,000 (OK)
Cost of goods sold $16,000 ()) $16,000 ()) $17,000 (OK) $17,000 (OK)
Gross margin $16,000 ()) $18,000 (+) $15,000 ()) $17,000 (OK)

*For the amount, ) indicates it is too low, + means it is too high, and OK means it is correct.


To reduce the possibility of these types of inventory cutoff errors, most businesses close
their warehouses at year-end while they count inventory. If they are retailers, they will probably
count inventory after hours. During the inventory counting period, businesses do not accept or
ship merchandise, nor do they enter purchase or sales transactions in their accounting records.
As explained, an error in inventory results in cost of goods sold being overstated or under-
stated. This error has the opposite effect on gross margin and, hence, on net income. For ex-
ample, if at the end of the accounting period $2,000 of inventory is not counted, cost of goods
sold will be $2,000 higher than it should be, and gross margin and net income will be under-
stated by $2,000. Such inventory errors affect gross margin and net income not only in the cur-
rent year but in the following year as well. A recording delay resulting in an understatement of
purchases in one year, for example, results in an overstatement in the next year.
To illustrate how inventory errors affect gross margin and net income, let us first assume
the following correct data for Salina Corporation:

2002 2003

Sales revenue $50,000 $40,000
Cost of goods sold:
Beginning inventory $10,000 $ 5,000
Net purchases 20,000 25,000
Cost of goods available for sale $30,000 $30,000
Ending inventory 5,000 10,000
Cost of goods sold 25,000 20,000
Gross margin $25,000 $20,000
Operating expenses 10,000 10,000
Net income $15,000 $10,000
318 f319
Inventory EM Chapter 7
Inventory


Now suppose that ending inventory in 2002 was overstated; that is, instead of the correct
amount of $5,000, the count erroneously showed $7,000 of inventory on hand. The following
analysis shows the effect of the error on net income in both 2002 and 2003:

2002 2003

Sales revenue $50,000 $40,000
Cost of goods sold:
Beginning inventory $10,000 $ 7,000 (+)
Net purchases 20,000 25,000
Cost of goods available for sale $30,000 $32,000 (+)
Ending inventory 7,000 (+)* 10,000
Cost of goods sold 23,000 ()) 22,000 (+)
Gross margin $27,000 (+) $18,000 ())
Operating expenses 10,000 10,000
Net income $17,000 (+) $ 8,000 ())


*For the amount, + means it is too high, ) means it is too low.




When the amount of ending inventory is overstated (as it was in 2002), both gross margin
and net income are overstated by the same amount ($2,000 in 2002). If the ending inventory
amount had been understated, net income and gross margin would also have been understated,
again by the same amount.
Since the ending inventory in 2002 becomes the beginning inventory in 2003, the net in-
come and gross margin for 2003 are also misstated. In 2003, however, beginning inventory is
overstated, so gross margin and net income are understated, again by $2,000. Thus, the errors
in the two years offset or counterbalance each other, and if the count taken at the end of 2003
is correct, income in subsequent years will not be affected by this error.




to summarize
Inventory errors can have a significant effect on cost of goods sold, gross mar-
gin, and net income. In addition, a misstatement of an ending inventory bal-
ance affects net income, both in the current year and in the next year. Errors
in beginning and ending inventory have the opposite effect on cost of goods
sold, gross margin, and net income. Errors in inventory correct themselves af-
ter two years if the physical count at the end of the second year shows the cor-
rect amount of ending inventory for that period.




7 COMPLICATIONS OF THE PERPETUAL METHOD
WITH LIFO AND AVERAGE COST
Describe the complications
that arise when LIFO or
average cost is used with a
In the Nephi Company bicycle example used earlier in the chapter, the simplifying assumption
perpetual inventory system.
was made that all 28 bicycles were sold at the end of the month. In essence, this is the assumption
made when a periodic inventory system is used goods are assumed to be sold at the end of the
period because the exact time when particular goods are sold is not recorded. Computation of
average cost and LIFO under a perpetual system is complicated because the average cost of units
available for sale changes every time a purchase is made, and the identification of the last in
units also changes with every purchase.
319
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Part 2 EM Operating Activities


These perpetual system complications are illustrated below using the same Nephi Company
example used earlier, but now assuming that sales occurred at different times during the month.

Sept. 1 Beginning inventory consisted of 10 bicycles costing $200 each.

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