financial accounting and accounting standards · 8-2 c h a p t e r 8 valuation of inventories: a...

8-2

C H A P T E R 8

VALUATION OF INVENTORIES: A

COST-BASIS APPROACH

Intermediate Accounting

IFRS Edition

Kieso, Weygandt, and Warfield

8-3

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 methods used to price

inventories.

Learning Objectives

8-4

Goods in transit

Consigned goods

Special sales

agreements

Inventory errors

Inventory Issues

Physical Goods

Included in

Inventory

Cost Included in

Inventory

Cost Flow

Assumptions

Classification

Cost flow

Control

Basic inventory

valuation

Product costs

Period costs

Purchase

discounts

Specific

identification

Average cost

FIFO

Summary analysis

Valuation of Inventories:

Cost-Basis Approach

8-5

Inventories are:

items held for sale, or

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

Inventory Issues

LO 1 Identify major classifications of inventory.

Merchandiser Manufacturer

Businesses with Inventory

or

Classification

8-6

One inventory

account.

Purchase goods

in form ready for

sale.

Classification

Inventory Issues


Illustration 8-1

8-7

Three accounts

• Raw materials

• Work in process

• Finished goods

Classification

Inventory Issues

LO 1

Illustration 8-1

8-8

Inventory Cost Flow

Inventory Issues

Illustration 8-2


8-9

Inventory Cost Flow

Inventory Issues

Illustration 8-3


Companies use one of two types of systems for maintaining

inventory records — perpetual system or periodic system.

8-10

Inventory Cost Flow

LO 2 Distinguish between perpetual and periodic inventory systems.

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.

8-11

Inventory Cost Flow


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

8-12

Inventory Cost Flow


Illustration: Fesmire Company had the following transactions

during the current year.

Record these transactions using the Perpetual and Periodic

systems.

8-13

Inventory Cost Flow


Illustration 8-4 Illustration:

8-14

Inventory Cost Flow


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.

8-15

Inventory Control

Inventory Issues


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.

8-16

Inventory Issues


Basic 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

8-17

Basic 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

8-18

A company should record purchases when it obtains

legal title to the goods.

Physical Goods Included in Inventory


Illustration 8-6

8-19


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 (2010) will be counterbalanced in

the next (2011), however the income statement will be misstated for both years.

Illustration 8-7

Ending

Inventory

Misstated

8-20


Illustration: Yei Chen Corp. understates its ending inventory by

HK$10,000 in 2010; all other items are correctly stated. Illustration 8-8

LO 3

8-21


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

8-22

Costs 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

8-23

Costs Included in Inventory

LO 4 Understand the items to include as inventory cost.

Treatment of Purchase Discounts

Illustration 8-11

* $4,000 x 2% = $80

*

** $10,000 x 98% = $9,800

**

8-24

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

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Which Cost Flow Assumption to Adopt?

Specific Identification --- Average Cost --- LIFO

LO 5 Describe and compare the methods used to price 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 2/28/11 for $90.

What would be the balance of ending inventory and cost of

goods sold for the month ended February 2011, assuming

the company used the FIFO, Average Cost, and Specific

Identification cost flow assumptions? Assume a tax rate of

30%.

Example

Cost Flow Assumptions


8-26

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45

Young & Crazy Company

Income Statement

For the Month of Feb. 2011

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

8-27

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20


Inventory Balance

= $ 35


Income Statement


Sales $ 90


Gross profit 80

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 14

Net Income $ 33

“First-In-First-Out (FIFO)”

LO 5

8-28

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40


“Average Cost”

LO 5

8-29

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 30



Income Statement


Sales $ 90


Gross profit 75

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 12

Net Income $ 30

“Average Cost”

LO 5

8-30

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40


“Specific Identification”

LO 5

8-31


Income Statement


Sales $ 90


Gross profit 90

Expenses:

Administrative 14

Selling 12

Interest 7

Total expenses 33


Taxes 17

Net Income $ 40

Depends which one is sold

Purchase on

2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Inventory Balance

= $ 45


“Specific Identification”

LO 5

8-32

Financial Statement Summary

FIFO Average

Sales 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 30 35


LO 5

8-33


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

8-34

Specific 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

8-35

Average Cost

Illustration 8-13 Weighted-Average


8-36

Average Cost

Illustration 8-14

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

cost each time it makes a purchase.

Moving-Average


8-37

First-In, First-Out (FIFO)

Illustration 8-15

Periodic 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.


8-38

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

Inventory Valuation Methods - Summary

Illustration 8-17


8-40


Illustration 8-18

Balances of Selected Items

under Alternative Inventory

Valuation Methods


8-41 LO 6 Describe the LIFO cost flow assumption.

Under IFRS, LIFO is not permitted for financial reporting

purposes.

Nonetheless, LIFO is permitted for financial reporting

purposes in the United States, it is permitted for tax purposes

in some countries, and its use can result in significant tax

savings.

8-42 LO 6

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

Last-In, First-Out (LIFO)

8-43


Illustration 8A-1

Periodic Method

The cost of the total quantity sold or issued during the month comes from the

most recent purchases.

LO 6 Describe the LIFO cost flow assumption.

8-44


Illustration 8A-2

Perpetual Method

The LIFO method results in different ending inventory and cost of goods sold

amounts than the amounts calculated under the periodic method.


8-45

Illustration 8A-3


Notice that gross profit and net income are lowest under LIFO, highest under

FIFO, and somewhere in the middle under average cost.


8-46

Illustration 8A-4


LIFO results in the highest cash balance at year-end (because taxes are

lower). This example assumes that prices are rising. The opposite result

occurs if prices are declining.


8-47

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 7 Explain the significance and use of a LIFO reserve.

8-48

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, 2011, the Allowance to Reduce Inventory to LIFO balance is

$20,000. At December 31, 2011, the balance should be $50,000. As a

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

at year-end.

LO 7 Explain the significance and use of a LIFO reserve.

8-49

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, 2011, with cost determined on a

specific-goods

LIFO approach.

LO 8 Understand the effect of LIFO liquidations.

8-50

Illustration: At the end of 2012, only 6,000 pounds of steel

remained in inventory.

LIFO Liquidation

Illustration 8B-3

Illustration 8B-2

LO 8

8-51

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 9 Explain the dollar-value LIFO method.

8-52

Exercise 8-29 (partial): The following information relates to

the Choctaw Company.

Use the dollar-value LIFO method to compute the ending

inventory for 2007 through 2009.

Dollar-Value LIFO

8-53

Inventory at Inventory at $ Value

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

Year Prices Index Prices Layers Index LIFO TOTAL Reserve

2007 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2008 88,200 1.05 84,000 70,000 1.00 70,000

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

2009 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 2007 2008 2009

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

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

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

Journal entry

3,500 9,020

(3,500) (9,020)

8-54




2007 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2008 88,200 1.05 84,000 70,000 1.00 70,000

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

2009 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

Cost of goods sold 3,500 9,020

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

8-55




2007 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2008 88,200 1.05 84,000 70,000 1.00 70,000

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

2009 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

Cost of goods sold 3,500 9,020

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

8-56

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

8-57

Matching

Tax Benefits/Improved Cash Flow

Future Earnings Hedge

Advantages

Reduced Earnings

Inventory Understated

Physical Flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages

8-58

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

8-59

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