Benjamin Ip

Financial Accounting
12/15/2015
Chapter 6 Summary
In this chapter, it shows the steps in determining inventory quantities. This
chapter explain the accounting for inventories and apply the inventory cost flow
methods. It also explains the financial effects of the inventory cost flow and the
assumptions and the lower-of-cost-or-market basis of accounting for inventories. At the
end of the chapter, the inventory turnover ratio will be shown.
It is complicated to determine the ownership of the goods when the goods are in
transit at the end of the period. When the terms are FOB shipping point, ownership of
the goods passes to the buyer when the public carrier accepts the goods from the seller.
When the terms are FOB destination, ownership of the goods remains with the seller
until the goods reach the buyer.
There are three ways to determine the cost flow of inventories: First-in, first-out
(FIFO), Last-in, first-out (LIFO), and Average-cost. The Cost of Goods Sold formula in a
periodic system is: Cost of Goods Sold = (Beginning Inventory + Purchases) Ending Inventory. The first-in, first-out (FIFO) method assumes that the first goods
purchased are the first to be sold. FIFO often parallels the actual physical flow of
merchandise. Under the FIFO method, the costs of the earliest goods purchased are
the first to be recognized in determining cost of goods sold. The companies obtain the
cost of the ending inventory by taking the unit cost of the most recent purchase and
working backward until all units of inventory have been costed. The last-in, first-out
(LIFO) method assumes that the latest goods purchased are the first to be sold. It is
assumed that the first goods sold were those that were most recently purchased. under
LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the
earliest goods available for sale and working forward until all units of inventory have
been costed. The average-cost method allocates the cost of goods available for sale on
the basis of the weighted-average unit cost (Cost of Goods /Total Units) incurred. The
company then applies the weighted-average unit cost to the units on hand to determine
the cost of the ending inventory.
When the value of inventory is lower than its cost, companies can write down the
inventory to its market value. This is done by valuing the inventory at the lower-of-cost-

Benjamin Ip
Financial Accounting
12/15/2015
or-market (LCM) in the period in which the price decline occurs. LCM is an example of
the accounting concept of conservatism, which means that the best accounting method
is the one having smallest impact on overstating assets and net income. Under the LCM
basis, market is defined as current replacement cost. For a merchandising company,
market is the cost of purchasing the same goods at the present time from the usual
suppliers in the usual quantities. Current replacement cost is used because a decline in
the replacement cost of an item usually leads to a decline in the selling price of the item.
The reasons why companies adopt different inventory cost flow methods are
involving with effects on income statement, balance sheet, or tax. FIFO produces a
higher net income if the price of inventories is rising, vice versa, because the lower unit
costs of the first units purchased are matched against revenues. Higher net income
causes external users to view the company more favorably. However, higher income
means that the companies have to pay more income taxes. Therefore, some companies
choose to use LIFO method even though it has its shortcomings on income statement
and balance sheet.
The errors on inventories can cause the Cost of Goods Sold understated or
overstated. If the error understates beginning inventory, cost of goods sold will be
understated and net income will be overstated. If the error understates ending inventory,
cost of goods sold will be overstated and net income will be understated. Moreover, an
error in the ending inventory of the current period will have a reverse effect on net
income of the next accounting period. On the balance sheet, overstated ending
inventory will overstate assets and equity, vice versa.
Inventory turnover measures the number of times on average the inventory is
sold during the period. Its purpose is to measure the liquidity of the inventory. The
inventory turnover is computed: Cost of Goods Sold / Average Inventory. Unless
seasonal factors are significant, average inventory can be computed by the sum of
beginning and ending inventory balances and then divided by two. A variant of the
inventory turnover ratio is days in inventory. This measures the average number of days
that inventory is held. The formula is: Inventory turnover / 365.