1. business and industrial
2. company
3. earnings

CHAPTER 6
Merchandise Inventory
Chapter Overview
Chapter 6 examines the accounting for merchandise inventory. The perpetual inventory record is
explained. Four different costing methods—specific unit cost, average cost, FIFO cost, and LIFO cost—
are explained. Students learn how to determine the quantity and cost of inventories and cost of goods
sold for FIFO, LIFO, and average costing by using the perpetual inventory record and how to create the
related journal entries. The inventory methods are compared and the advantages and disadvantages of
each are detailed. A mid-chapter summary problem allows students to practice preparing three perpetual
inventory records, preparing journal entries using FIFO, LIFO, and average cost, and computing gross
profit for each method.
The accounting principles and concepts that affect inventory—the consistency principle, the disclosure
principle, the materiality concept, and accounting conservatism—are explained. The lower-of-cost-ormarket rule is defined, followed by an illustration of the effects of inventory errors. The process of
estimating the value of ending inventory by the gross profit method is explained. Ethical issues in
inventory accounting are emphasized. The chapter then illustrates how to estimate inventory using the
gross profit method. The Decision guidelines provide guidance for inventory management. The chapter
concludes with a summary problem that has students prepare three income statements using FIFO, LIFO,
and average cost. An appendix compares the perpetual and periodic inventory systems and illustrates
inventory costing in a periodic system for FIFO, LIFO, and average cost.
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Chapter 6: Teaching Outline
1) Explain the effect of inventory transactions on the financial statements.
a) Exhibit 6-1 Merchandising Sections of the Financial Statements
2) Apply accounting concepts and principles to inventory.
a) The Consistency Principle
b) The Disclosure Principle
c) The Materiality Concept
d) Accounting Conservatism
3) Explain the perpetual inventory record.
a) Cost per unit = Purchase price – Purchase discounts + Freight-in
b) Exhibit 6-2 Perpetual Inventory Record—Quantities Only
4) Define the inventory costing methods and the journal entries using each method assuming a perpetual
system.
a) Specific unit cost (a.k.a. specific identification method)
b) First-in, first-out (FIFO) cost
c) Last-in, first-out (LIFO) cost
d) Average cost
e) Exhibit 6-3 Cost Flows for Three Inventory Methods
f) Exhibit 6-4 Perpetual Inventory Record: FIFO
g) Exhibit 6-5 Perpetual Inventory Record: LIFO
h) Exhibit 6-6 Perpetual Inventory Record: Average Cost
5) Compare the effects of the three inventory costing methods.
a) Exhibit 6-7 Use of the Various Inventory Methods
b) Exhibit 6-8 Comparative Results for FIFO, LIFO, and Average Cost
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6) Discuss the application of the lower-of-cost-or-market rule to inventory.
7) Explain the effects of inventory errors on the financial statements.
a) Exhibit 6-9 Inventory Errors: An Example
b) Exhibit 6-10 Effects of Inventory Errors
8) Discuss the use of the gross profit method to estimate inventory.
a) Exhibit 6-11 Gross Profit Method of Estimating Inventory (amounts assumed)
9) Define the inventory costing methods and the journal entries using each method assuming a periodic
system.
a) First-in, first-out (FIFO) cost
b) Last-in, first-out (LIFO) cost
c) Average cost
d) Exhibit 6A-1 Comparing the Perpetual and Periodic Inventory Systems (all amounts assumed for
this illustration)
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Chapter 6: Summary Handout for Students
1. Effects of inventory on the financial statements:
o
Balance Sheet: current asset
o
Income Statement:
ƒ
Cost of goods sold
ƒ
Gross profit and net income
2. Accounting concepts and principles related to inventory:
o
The consistency principle
o
The disclosure principle
o
The materiality concept
o
Conservatism
3. Inventory Costing Methods:
o
Specific unit cost (a.k.a. specific identification)
ƒ
o
o
o
Uses specific cost of each unit of inventory
First-In, First-Out (FIFO)
ƒ
Cost of goods sold is based on oldest purchases
ƒ
Inventory is based on most recent purchases
Last-In, First-Out (LIFO)
ƒ
Cost of goods sold is based on most recent purchases
ƒ
Inventory is based on oldest costs of the period
Average-cost
ƒ
Cost of goods sold and inventory are based on the new weighted-average cost calculated
after each purchase
4. Comparison of inventory methods in a period of rising prices:
o
FIFO—highest inventory, lowest cost of goods sold, highest gross profit, and net income
o
LIFO—lowest inventory, highest cost of goods sold, lowest gross profit, and net income
ƒ
o
Lowest income taxes
The opposite would be true in a period of decreasing prices
ƒ
FIFO—lowest inventory, highest cost of goods sold, lowest gross profit and net income
ƒ
LIFO—highest inventory, lowest cost of goods sold, highest gross profit and net income
5. The perpetual inventory system requires the use of a perpetual record.
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o
The perpetual record keeps track of purchases, cost of goods sold, and inventory on hand.
o
Revenue is not recorded on the perpetual record.
6. The lower-of-cost-or-market (LCM) rule follows the conservatism principle. Inventory is recorded at
whichever is lower—
o
the historical cost of the inventory, or
o
the market value (i.e., current replacement cost) of the inventory.
7. An error in inventory (i.e., understatement or overstatement) affects inventory, cost of goods sold,
gross profit, and net income for two accounting periods.
o
The error carries over to the second period but has the opposite effect on each item in the second
period.
o
The third period’s financial statements would be correct.
8. The gross profit method can be used to estimate the value of ending inventory.
o
Beginning inventory + net purchases = cost of goods available for sale – cost of goods sold* =
ending inventory
o
*Cost of goods sold = Sales – gross profit
9. Ending inventory can only be determined through a physical count for the periodic system.
o
FIFO, LIFO, and average cost can be used to determine the value of ending inventory.
10. Work sheets to print for in-class practice (bookmatch), as specified by your instructor.
11. Myaccountinglab.com homework algorithmic assignments:
o E6-14; E6-15; E6-16; E6-17; E6-21; E6-22; E6-25; E6-27; P6-31A; P6-34A. For
Appendix: E6A-2; P6A-4A.
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Lecture Outline Tips: Key Topics
For FIFO, LIFO, and average cost, the method describes the cost of the inventory sold, not the cost of
what is left. For example, with FIFO, the cost of goods sold will consist of the first (or old) costs and the
ending inventory will consist of the last (or new) costs.
FIFO, LIFO, and average cost are COST methods and may not be representative of the physical
movement of inventory—for example, LIFO will result in “old” costs remaining in ending inventory.
However, this does not mean that the “old” inventory is actually still on hand.
The average cost method is a weighted average computation based on the number of units for each cost
level. Students may want to simply average the unit costs of inventory levels without taking into account
the number of units at each level—for example, 2 units @ $10 and 1 unit @ $16 is an average (i.e.,
weighted average) cost of $12 ($36/3), not $8 ($10 + $16/ 2).
The financial statement effect of choosing an inventory method depends on whether costs are increasing
or decreasing. For example, the general description of LIFO is that it results in lower income and lower
inventory balances. However, this assumes increasing costs, which may not always be true in certain
industries.
The term “market” in lower of cost or market means replacement cost, not the company’s retail sales
price. Inventory may need to be written down due to LCM, but cannot be written back up at a later date,
due to the conservatism principle.
When estimating inventory, the gross profit % must be subtracted from revenue to determine cost of
goods sold. The estimated cost of goods sold can then be used to estimate ending inventory. For
example, with a gross profit % of 40%, students may want to compute cost of goods sold as 40% of
revenue, when it really is 60% of revenue. Also, point out that the estimated inventory can vary from
actual due to an assumed gross profit % that may not be totally accurate.
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ASSIGNMENT GRID
Assignment
Topic(s)
Learning
Objective(s)
Short Exercises
S6-1
Inventory accounting principles
1
S6-2
Inventory methods
2
S6-3
Perpetual inventory record—FIFO
3
S6-4
Perpetual inventory record—LIFO
3
S6-5
Perpetual inventory record—average cost
3
S6-6
Journalizing inventory transactions—FIFO
3
S6-7
Journalizing inventory transactions—LIFO
3
S6-8
Journalizing inventory transactions—average cost3
S6-9
Comparing cost of goods sold under FIFO,
LIFO, and average cost
4
S6-10
Applying the lower-of-cost-or-market rule
5
S6-11
Effect of an inventory error—one year only
6
S6-12
Next year’s effect of an inventory error
6
S6-13
Estimating ending inventory by the gross profit
method
7
Exercises
E6-14
E6-15
E6-16
E6-17
E6-18
E6-19
E6-20
E6-21
E6-22
E6-23
E6-24
E6-25
E6-26
E6-27
Accounting principles related to inventory costing
methods defined
1, 2
Measuring and journalizing inventory and cost
of goods sold in a perpetual system—FIFO
3
Measuring ending inventory and cost of
goods sold in a perpetual system—LIFO
3
Measuring ending inventory and cost of
goods sold in a perpetual system—average cost 3
Journalizing perpetual inventory transactions—
cost of sales given
3
Comparing amounts for ending inventory—
perpetual inventory—FIFO and LIFO
4
Comparing cost of goods sold in a perpetual
system—FIFO and LIFO
4
Comparing cost of goods sold in a perpetual
system—FIFO, LIFO, and average cost amounts 4
Applying the lower-of-cost-or-market rule to
inventories
5
Applying the lower-of-cost-or-market
rule to inventories
5
Measuring the effect of an inventory error
6
Correcting an inventory error—two years
6
Estimating ending inventory by the gross
profit method
7
Estimating ending inventory by the gross
Estimated
Time in
Minutes
Level
of
Difficulty
5
5
10
10
10
5–10
5–10
5–10
Easy
Easy
Easy
Easy
Easy
Easy
Easy
Easy
5–10
5–10
5
5–10
Easy
Easy
Easy
Easy
10
Easy
15–20
Medium
20–25
Medium
20–25
Medium
20–25
Medium
10–15
Medium
5–10
Medium
15–20
Medium
15–20
Medium
5
Medium
5
10–15
15–20
Medium
Medium
Difficult
10–15
Medium
Instructor’s Edition Special Section Page 7 of 24 | Chapter 6
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profit method
7
Problems (Group A)
P6-28A
Accounting principles for inventory and applying
the lower-of-cost-or-market rule
1, 5
P6-29A
Accounting for inventory using the perpetual
system—LIFO; journalizing inventory
transaction
2, 3, 4
P6-30A
Accounting for results on income for inventory
using the LIFO cost method
3, 4
P6-31A
Accounting for inventory using the perpetual
system—FIFO, LIFO, and average cost;
comparing FIFO, LIFO, and average cost
3, 4
P6-32A
Applying the lower-of-cost-or-market rule to
inventories
5
P6-33A
Correcting inventory errors over a three-year
period
6
P6-34A
Estimating ending inventory by the gross
profit method; preparing the income statement 7
10–15
Medium
15–20
Medium
30–40
Medium
20–30
Medium
20–25
Medium
5
Medium
15–20
Medium
25–30
Medium
15–20
Medium
30–40
Medium
20–30
Medium
20–25
Medium
5
Medium
Problems (Group B)
P6-35B
Accounting principles for inventory and applying
the lower-of-cost-or-market rule
1, 5
P6-36B
Accounting for inventory using the perpetual
system—LIFO; journalizing inventory
transaction
2, 3, 4
P6-37B
Accounting for results on income for inventory
using the LIFO cost method
3, 4
P6-38B
Accounting for inventory using the perpetual
system—FIFO, LIFO, and average cost;
comparing FIFO, LIFO, and average cost
3, 4
P6-39B
Applying the lower-of-cost-or-market rule to
inventories
5
P6-40B
Correcting inventory errors over a three-year
period
6
P6-41B
Estimating ending inventory by the gross
profit method; preparing the income statement 7
15–20
Medium
25–30
Medium
Continuing Exercise
E6-42
Journalizing inventory transactions—FIFO;
adjusting entries
3
25–30
Medium
3
25–30
Medium
3
25–30
Medium
Continuing Problem
P6-43
Journalizing inventory transactions—LIFO;
adjusting entries
Practice Set
P6-44
Journalizing inventory transactions—FIFO;
adjusting entries
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Decision Cases
Case 1
Inventory decisions
Case 2
Increasing net income
4
4
15–20
15–20
Medium
Medium
2, 3, 4
20–30
Medium
Appendix Exercises
E6A-1
Computing periodic inventory amounts
E6A-2
Journalizing periodic inventory transactions
E6A-3
Computing periodic inventory amounts
10–15
10–15
10–15
Medium
Medium
Medium
Appendix Problems
P6A-4A
Computing periodic inventory amounts
P6A-5B
Computing periodic inventory amounts
15-20
15-20
Medium
Medium
Ethical Issue
Financial Statement Case
Case 1
Analyzing inventories
Team Project
End of Chapter Exercises and Problems Available in Alternate Accounting Software
Programs:
Excel Templates: P6-29A; P6-30A; P6-32A
QuickBooks: P6-29A; P6-30A; P6-32A
Peachtree: E6-23; P6-28A; P6-32A
General Ledger: E6-23; P6-28A; P6-32A
Pre-Test Questions on MyAccountingLab: S6-1 (1); S6-2 (2); S6-3 (3); S6-9 (4); S6-10 (5);
S6-11 (6); S6-13 (7). For Appendix: E6A-1; E6A-3
Post-Test Questions on MyAccountingLab: P6-38B (3,4); P6-41B (7). For Appendix: P6A-5B
Answer Key to Chapter 6 Quiz
1.
2.
3.
4.
5.
B
C
C
A
B
6.
7.
8.
9.
10.
C
D
D
A
B
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Name
Date
Section
CHAPTER 6
TEN-MINUTE QUIZ
Circle the letter of the best response.
1.
Which of the following statements is false?
A.
When prices are constant, the ending inventory value will be the same regardless of the
inventory method chosen.
B.
Under the last-in, first-out method, the cost of goods sold is based on the oldest
purchases.
C.
FIFO costing is consistent with the physical movement of inventory for most companies.
D.
The specific-unit-cost method is appropriate for items that differ from unit to unit.
Hermione, Co., reported the following information:
Table 6-1
Unit Cost
Units
Beginning inventory (Jan 1)
4
$400
Sale (Mar 1)
Purchase (Apr 15)
4
405
Sale (June 22)
Purchase (Oct 11)
2
425
Total
10
Units in ending inventory
4
Total Cost
$1,600
Units Sold
3
1,620
3
850
$4,070
6
2.
Refer to Table 6-1. Assume that Hermione uses perpetual LIFO. The cost of the ending
inventory is
A.
$1,700.
B.
$1,670.
C.
$1,655.
D.
$1,600.
3.
Refer to Table 6-1. Assume that Hermione uses perpetual average costing. The average cost of a
unit sold on June 22 is
A.
$400.00.
B.
$402.50.
C.
$404.00.
D.
$405.00.
4.
Refer to Table 6-1. Assume that Hermione uses perpetual FIFO. The entry to record the March 1
credit sale at a sale price of $800 per unit would include all of the following except
A.
credit Inventory, $2,400.
B.
debit Cost of goods sold, $1,200.
C.
debit Accounts receivable, $2,400.
D.
credit Sales revenue, $2,400.
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5.
Refer to Table 6-1. Assume that Hermione uses periodic FIFO. The cost of goods sold for the
period is
A.
$2,470.
B.
$2.410.
C.
$1,660.
D.
$1,600.
6.
In a period of rising prices, which method will yield the highest net income, lowest inventory
cost, and lowest amount of income taxes?
Highest
Lowest
Lowest
Inventory
Income Taxes
Net income
A.
LIFO
LIFO
LIFO
B.
FIFO
LIFO
FIFO
C.
FIFO
LIFO
LIFO
D.
LIFO
FIFO
LIFO
7.
The appropriate value for inventory on the balance sheet is
A.
the sale price.
B.
the cost determined by using LIFO, FIFO, average cost, or specific unit cost.
C.
replacement cost.
D.
B or C, whichever is lower.
8.
A company uses FIFO in 20X1 and switches to LIFO in 20X2. Which accounting principle or
concept has been violated?
A.
The disclosure principle
B.
The objectivity principle
C.
The time-period concept
D.
The consistency principle
9.
An understatement of the ending inventory in 20X1 will have the following effects on cost of
goods sold and net income in 20X1:
Cost of
Net Income
Goods Sold
A.
overstate
understate
B.
overstate
overstate
C.
understate
overstate
D.
understate
understate
10.
H. Potter, Co., estimates its inventory by the gross profit method. Potter’s gross profit averages
40%. Potter reports the following information:
Beginning inventory
$450,000
Net purchases
200,000
Net sales revenue
350,000
The estimated cost of the ending inventory is
A.
$210,000.
B.
$440,000.
C.
$240,000.
D.
$250,000.
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