CHAPTER 7

Merchandise Inventory

Key Points

The following key points are emphasized in this chapter:

  • Inventory and how it affects the financial statements.
  • Four issues that must be addressed when accounting for inventory.
  • General rules for including items in inventory and attaching costs to these items.
  • The three cost flow assumptions—average, FIFO, and LIFO.
  • The lower-of-cost-or-market rule.

When the shareholders of Ann Taylor Stores, a national retailer of upscale women's clothing, brought suit against company management, the company was accused of misleading investors by hiding the fact that it had accumulated huge amounts of excessive and overvalued inventory. Although the company reported disappointing results, surprising Wall Street, management denied any wrongdoing. The financial press often reports incidents where management uses inventory accounting to manipulate earnings. This chapter covers inventory accounting, providing analysts with the knowledge necessary to recognize how decisions involving inventory accounting influence the financial statements.

Inventory refers to items held for sale in the ordinary course of business. It is very important to retail and manufacturing enterprises, whose performance depends significantly on their sales. The demand for a company's products and the effectiveness of its inventory management are often the most important determinants of a company's success. To illustrate, BusinessWeek once reported that the international grocery store, ...

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