8-1 prepared by coby harmon university of california, santa barbara intermediate accounting

8-1

Prepared by Coby Harmon

University of California, Santa Barbara

Intermediate Accounting

8-2

Intermediate Accounting

14th Edition

8Valuation of Inventories:A Cost-Basis Approach

Kieso, Weygandt, and Warfield

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1. Identify major classifications of inventory.

2. Distinguish between perpetual and periodic inventory systems.

3. Identify the effects of inventory errors on the financial statements.

4. Understand the items to include as inventory cost.

5. Describe and compare the cost flow assumptions used to account for

inventories.

6. Explain the significance and use of a LIFO reserve.

7. Understand the effect of LIFO liquidations.

8. Explain the dollar-value LIFO method.

9. Identify the major advantages and disadvantages of LIFO.

10. Understand why companies select given inventory methods.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

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InventoryIssues

Physical GoodsIncluded inInventory

Costs Included

in Inventory

Cost Flow Assumptions

LIFO: Special Issues

Classification

Cost flow

Control

Basic inventory valuation

Basis for Selection

Goods in transit

Consigned goods

Special sales agreements

Inventory errors

Product costs

Period costs

Purchase discounts

Specific identification

Average cost

FIFO

LIFO

LIFO reserve

LIFO liquidation

Dollar-value LIFO

Comparison of LIFO approaches

Advantages of LIFO

Disadvantages of LIFO

Summary of inventory valuation methods

Valuation of Inventories:Valuation of Inventories:Cost-Basis ApproachCost-Basis Approach

Valuation of Inventories:Valuation of Inventories:Cost-Basis ApproachCost-Basis Approach

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Inventories are:

items held for sale, or

goods to be used in the production of goods to be sold.

Inventory IssuesInventory IssuesInventory IssuesInventory Issues

LO 1 Identify major classifications of inventory.

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory

or

Classification

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One inventory

account.

Purchase goods

in form ready for

sale.



Illustration 8-1

Classification

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Three accounts

Raw materials

Work in process

Finished goods


ClassificationIllustration 8-1


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Classification


Illustration 8-2


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Inventory Cost Flow


Illustration 8-3

Companies use one of two types of systems for maintaining inventory records — perpetual system or periodic system.

LO 2 Distinguish between perpetual and periodic inventory systems.

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Inventory Cost FlowInventory Cost FlowInventory Cost FlowInventory Cost Flow


Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and

allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each

sale.

4. Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

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Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory

$ 100,000

Purchases, net

800,000

Goods available for sale

900,000

Ending inventory

125,000

Cost of goods sold

$ 775,000

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Illustration: Fesmire Company had the following transactions during the current year.

Record these transactions using the Perpetual and Periodic systems.

8-13 LO 2


Illustration 8-4

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Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the “Other income and expense” section of the income statement.

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Inventory Control



All companies need periodic verification of the inventory

records by actual count, weight, or measurement, with the

counts compared with the detailed inventory records.

Companies should take the physical inventory near the

end of their fiscal year, to properly report inventory

quantities in their annual accounting reports.

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Basic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory Valuation


Companies must allocate the cost of all the goods available

for sale (or use) between the goods that were sold or used

and those that are still on hand.Illustration 8-5

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Basic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory Valuation


The physical goods (goods on hand, goods in transit,

consigned goods, special sales agreements).

The costs to include (product vs. period costs).

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

Valuation requires determining

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A company should record purchases when it obtains legal

title to the goods.

Physical Goods Included in InventoryPhysical Goods Included in InventoryPhysical Goods Included in InventoryPhysical Goods Included in Inventory


Illustration 8-6

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LO 3 Identify the effects of inventory errors on the financial statements.

Effect of Inventory Errors

The effect of an error on net income in one year (2011) will be counterbalanced in the next (2012), however the income statement will be misstated for both years.

Illustration 8-7

Ending Inventory Misstated

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Effect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory Errors

Illustration: Jay Weiseman Corp. understates its ending inventory by $10,000 in 2011; all other items are correctly stated.

Illustration 8-8

LO 3

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LO 3 Identify the effects of inventory errors on the financial statements.

The understatement does not affect cost of goods sold and net income because the errors offset one another.

Illustration 8-9

Purchases and Inventory Misstated

Effect of Inventory Errors

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Costs Included in InventoryCosts Included in InventoryCosts Included in InventoryCosts Included in Inventory

LO 4 Understand the items to include as inventory cost.

Product Costs

Costs directly connected with bringing the goods to the

buyer’s place of business and converting such goods to a

salable condition.

Period Costs

Generally selling, general, and administrative expenses.

Treatment of Purchase Discounts

Gross vs. Net Method

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*

**

Costs Included in InventoryCosts Included in InventoryCosts Included in InventoryCosts Included in Inventory

LO 4

Treatment of Purchase DiscountsIllustration 8-11

* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

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Method adopted should be one that most clearly reflects periodic income.

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?

Specific Identification --- Average Cost

LIFO --- FIFO

LO5 Describe and compare the cost flow assumptions used to account for inventories.

8-25

Young & Crazy Company makes the following purchases:

1. One item on 2/2/11 for $10



Young & Crazy Company sells one item on 2/28/12 for $90. What

would be the balance of ending inventory and cost of goods sold

for the month ended February 2012, assuming the company used

the FIFO, Average Cost, and Specific Identification cost flow

assumptions? Assume a tax rate of 30%.

Illustration

Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions


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Purchase on 2/2/12 for $10



Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2012 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40


“First-In-First-Out (FIFO)”

LO 5

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For the Month of Feb. 2012 Sales $ 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income $ 33 $ 33

“First-In-First-Out (FIFO)”

LO 5

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“Average Cost”

LO 5

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For the Month of Feb. 2012 Sales $ 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 12 12 Net Income $ $ 3030

“Average Cost”

LO 5

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“Specific Identification”

LO 5

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Depends which one is soldDepends which one is sold






“Specific Identification”

LO 5

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Financial Statement Summary

FIFO AverageSales 90$ 90$ Cost of goods sold 10 15

Gross profit 80 75 Operating expenses:

Administrative 14 14 Selling 12 12 Interest 7 7

Total expenses 33 33 Income before taxes 47 42 Income tax expense 14 12 Net income 33$ 30$

Inventory Balance 3035


LO 5

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LO 5

Illustration: Call-Mart Inc. had the following transactions in its first month of operations.

Beginning inventory (2,000 x $4)

$ 8,000

Purchases:

6,000 x $4.40

26,400

2,000 x 4.75

9,500

Goods available for sale

$43,900

Calculate Goods Available for Sale

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Specific IdentificationSpecific IdentificationSpecific IdentificationSpecific Identification

Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the amount of ending inventory and cost of goods sold.

Illustration 8-12

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Average CostAverage CostAverage CostAverage Cost

Illustration 8-13Weighted Average

LO 5

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Average CostAverage CostAverage CostAverage Cost

Illustration 8-14

In this method, Call-Mart computes a new average unit cost

each time it makes a purchase.

Moving Average


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First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)

Illustration 8-15Periodic Method

Determine cost of ending inventory by taking the cost of the most

recent purchase and working back until it accounts for all units in the

inventory.LO5 Describe and compare the cost flow assumptions

used to account for inventories.

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First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)

Illustration 8-16

Perpetual Method

In all cases where FIFO is used, the inventory and cost of goods sold

would be the same at the end of the month whether a perpetual or

periodic system is used.


8-39

Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)

Illustration 8-17Periodic Method

The cost of the total quantity sold or issued during the month comes from the most recent purchases.


8-40

Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)

Illustration 8-18

Perpetual Method

The LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method.


8-41

Many companies use

LIFO for tax and external financial reporting purposes.

FIFO, average cost, or standard cost system for internal reporting purposes.

Reasons:

LIFO Reserve

1. Pricing decisions

2. Record keeping easier

3. Profit-sharing or bonus arrangements

4. LIFO troublesome for interim periods

LO 6 Explain the significance and use of a LIFO reserve.

Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO

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LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO.

Cost of goods sold 30,000

Allowance to reduce inventory to LIFO 30,000

Journal entry to reduce inventory to LIFO:

Illustration: Acme Boot Company uses the FIFO method for internal

reporting purposes and LIFO for external reporting purposes. At

January 1, 2012, the Allowance to Reduce Inventory to LIFO balance is

$20,000. At December 31, 2012, the balance should be $50,000. As a

result, Acme Boot realizes a LIFO effect and makes the following entry

at year-end.

LO 6 Explain the significance and use of a LIFO reserve.


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Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.

LIFO Liquidation

Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2012, with cost determined on a specific-goods LIFO approach.

LO 7 Understand the effect of LIFO liquidations.


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Illustration: At the end of 2012, only 6,000 pounds of steel remained in inventory.

LIFO Liquidation

Illustration 8-21

Illustration 8-20

LO 7


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Changes in a pool are measured in terms of total dollar

value, not physical quantity.

Advantage:

Broader range of goods in pool.

Permits replacement of goods that are similar.

Helps protect LIFO layers from erosion.

Dollar-Value LIFO

LO 8 Explain the dollar-value LIFO method.


8-46

Exercise 8-25 (partial): The following information relates to the Martin Company.

Use the dollar-value LIFO method to compute the ending inventory for 2009 through 2011.

Dollar-Value LIFO



8-47

Inventory at Inventory at $ Value

End-of-Year Base-Year Base $ Value LIFO LIFO

Year Prices Index Prices Layers Index LIFO TOTAL Reserve

2009 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2010 88,200 1.05 84,000 70,000 1.00 70,000

14,000 1.05 14,700 84,700 3,500

2011 95,120 1.16 82,000 70,000 1.00 70,000

12,000 1.05 12,600 82,600 12,520

Dec. 31 Dec. 31 Dec. 31

Balance Sheet 2009 2010 2011

Inventory 70,000$ 88,200$ 95,120$

LIFO Reserve - (3,500) (12,520)

70,000$ 84,700$ 82,600$

Journal entry

Cost of goods sold 3,500 9,020

Allowance to reduce inventory to LIFO (3,500) (9,020)


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2009 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2010 88,200 1.05 84,000 70,000 1.00 70,000

14,000 1.05 14,700 84,700 3,500

2011 95,120 1.16 82,000 70,000 1.00 70,000

12,000 1.05 12,600 82,600 12,520

Dec. 31 Dec. 31 Dec. 31


Inventory 70,000$ 88,200$ 95,120$

LIFO Reserve - (3,500) (12,520)

70,000$ 84,700$ 82,600$

Journal entry




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2009 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2010 88,200 1.05 84,000 70,000 1.00 70,000

14,000 1.05 14,700 84,700 3,500

2011 95,120 1.16 82,000 70,000 1.00 70,000

12,000 1.05 12,600 82,600 12,520

Dec. 31 Dec. 31 Dec. 31


Inventory 70,000$ 88,200$ 95,120$

LIFO Reserve - (3,500) (12,520)

70,000$ 84,700$ 82,600$

Journal entry




8-50

Specific-goods LIFO - costing goods on a unit basis is

expensive and time consuming.

Specific-goods Pooled LIFO approach

► reduces record keeping and clerical costs.

► more difficult to erode the layers.

► using quantities as measurement basis can lead to

untimely LIFO liquidations.

Dollar-value LIFO is used by most companies.

Comparison of LIFO Approaches



8-51

Matching

Tax Benefits/Improved Cash Flow

Future Earnings Hedge

Advantages

Reduced Earnings

Inventory Understated

Physical Flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages


LO 9 Identify the major advantages and disadvantages of LIFO.

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LIFO is generally preferred:

1. if selling prices are increasing faster than costs and

2. if a company has a fairly constant “base stock.”

LIFO is not appropriate:

1. if prices tend to lag behind costs,

2. if specific identification traditionally used, and

3. when unit costs tend to decrease as production increases.

Basis for Selection of Inventory Method


LO 10 Understand why companies select given inventory methods.

8-53

Illustration 8-31

Inventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - Summary

Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average cost.


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Illustration 8-32

Inventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - Summary

LIFO results in the highest cash balance at year-end (because taxes arelower). This example assumes that prices are rising. The opposite result occurs if prices are declining.


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CopyrightCopyrightCopyrightCopyright

8-1 prepared by coby harmon university of california, santa barbara intermediate accounting

Documents

inventory costs

inventory account

type of inventory

perpetual inventory

periodic inventory systems

effects of inventory

given inventory methods

continuous record of