8-1 fileInventory Issues Physical Goods Included in Inventory Cost Included in Inventory Cost Flow...

C H A P T E R C H A P T E R 88

VALUATION OF INVENTORIES: A VALUATION OF INVENTORIES: A COSTCOST--BASIS APPROACHBASIS APPROACH

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Intermediate AccountingIFRS Edition

Kieso, Weygandt, and Warfield

1. Identify major classifications of inventory.

2. Distinguish between perpetual and periodic inventory

systems.

3. Identify the effects of inventory errors on the financial

Learning ObjectivesLearning Objectives

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statements.

4. Understand the items to include as inventory cost.

5. Describe and compare the methods used to price

inventories.

Inventory IssuesInventory IssuesPhysical Goods Physical Goods

Included in Included in InventoryInventory

Cost Included in Cost Included in InventoryInventory

Cost Flow Cost Flow AssumptionsAssumptions

Valuation of Inventories:Valuation of Inventories:CostCost--Basis ApproachBasis Approach

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Goods in transit

Consigned goods

Special sales agreements

Inventory errors

Classification

Cost flow

Control

Basic inventory valuation

Product costs

Period costs

Purchase discounts

Specific identification

Average cost

FIFO

Summary analysis

Inventories are:

items held for sale, or

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

Inventory IssuesInventory Issues

Classification

8-5 LO 1 Identify major classifications of inventory.LO 1 Identify major classifications of inventory.

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory

or

One inventory

account.

Classification


Illustration 8-1

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Purchase goods

in form ready for

sale.

LO 1 Identify major classifications of inventory.LO 1 Identify major classifications of inventory.

Three accounts

• Raw materials

Classification


Illustration 8-1

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• Raw materials

• Work in process

• Finished goods

LO 1LO 1

Inventory Cost Flow


Illustration 8-2


Inventory Cost Flow


Illustration 8-3


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

Inventory 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.

8-10 LO 2 Distinguish between perpetual and periodic inventory systems.LO 2 Distinguish between perpetual and periodic inventory systems.

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.


Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:


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


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


Record these transactions using the Perpetual and Periodic systems.


Illustration 8-4Illustration:



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.

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.


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

Basic 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).

Valuation requires determining


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

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

A company should record purchases when it obtains legal title to the goods.

Physical Goods Included in InventoryPhysical Goods Included in Inventory

Illustration 8-6



Effect of Inventory Errors

Illustration 8-7

Ending Inventory Misstated

8-19 LO 3 Identify the effects of inventory errors on the financial statements.LO 3 Identify the effects of inventory errors on the financial statements.

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.

Effect of Inventory ErrorsEffect of Inventory Errors

Illustration: Yei Chen Corp. understates its ending inventory by HK$10,000 in 2010; all other items are correctly stated.

Illustration 8-8

8-20 LO 3LO 3


Effect of Inventory Errors

Illustration 8-9

Purchases and Inventory

Misstated

8-21 LO 3 Identify the effects of inventory errors on the financial statements.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.

Costs Included in InventoryCosts Included in Inventory

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

8-22 LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

Period Costs – generally selling, general, and

administrative expenses.

Treatment of Purchase Discounts – Gross vs.

Net Method

Costs Included in InventoryCosts Included in Inventory

Treatment of Purchase DiscountsIllustration 8-11

**

8-23 LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

* $4,000 x 2% = $80

*

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

Cost Flow Assumption Adopted

does not need to equal

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

Specific Identification --- Average Cost --- LIFO

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

does not need to equal

Physical Movement of Goods

LO 5 Describe and compare the methods used to price inventories.LO 5 Describe and compare the methods used to price inventories.

Young & Crazy Company makes the following purchases:

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


Example

Cost Flow AssumptionsCost Flow Assumptions

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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%.


Purchase on

Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2011

Sales $ 90Cost of goods sold 0


“First-In-First-Out (FIFO)”

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Purchase on 2/2/11 for $10



Cost of goods sold 0Gross profit 90

Expenses:Administrative 14Selling 12Interest 7

Total expenses 33Income before tax 57Taxes 17 Net Income $ 40

LO 5LO 5

Purchase on






“First-In-First-Out (FIFO)”

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Total expenses 33Income before tax 4747Taxes 14 14 Net Income $ 33$ 33

LO 5LO 5

Purchase on






“Average Cost”

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LO 5LO 5

Purchase on






“Average Cost”

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Total expenses 33Income before tax 4242Taxes 12 12 Net Income $ $ 3030

LO 5LO 5

Purchase on






“Specific Identification”

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LO 5LO 5




Depends which one is soldDepends which one is sold

Purchase on



“Specific Identification”

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LO 5LO 5

Financial Statement Summary

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

Gross profit 80 75 Operating expenses:


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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 5LO 5


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

8-33 LO 5LO 5

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

Specific 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 Cost

Illustration 8-13Weighted-Average

8-35 LO 5 Describe and compare the methods used to price inventories.LO 5 Describe and compare the methods used to price inventories.

Average CostAverage Cost

Illustration 8-14

Moving-Average

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In this method, Call-Mart computes a new average unit cost each time it makes a purchase.


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

Illustration 8-15Periodic Method

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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.


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

Illustration 8-16

Perpetual Method

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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.


Inventory Valuation Methods Inventory Valuation Methods -- SummarySummary

Illustration 8-17



Illustration 8-18Balances of Selected Items under Alternative Inventory Valuation Methods


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

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

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

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

savings.

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

LastLast--In, FirstIn, First--Out (LIFO)Out (LIFO)

8-42 LO 6LO 6

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


Illustration 8A-1

Periodic Method

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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.LO 6 Describe the LIFO cost flow assumption.


Illustration 8A-2

Perpetual Method

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


Illustration 8A-3


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


Illustration 8A-4


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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.


Many companies use

LIFO for tax and external financial reporting purposes

FIFO, average cost, or standard cost system for internal

LIFO Reserve

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

Reasons:

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

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

Illustration: Acme Boot Company uses the FIFO method for internalreporting purposes and LIFO for external reporting purposes. At January 1, 2011, the Allowance to Reduce Inventory to LIFO balance is

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Cost of goods sold 30,000

Allowance to reduce inventory to LIFO 30,000

Journal entry to reduce inventory to LIFO:

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

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

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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.LO 8 Understand the effect of LIFO liquidations.

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

LIFO Liquidation

Illustration 8B-3

Illustration 8B-2

8-50 LO 8LO 8

Changes in a pool are measured in terms of total dollar

value, not physical quantity.

Advantage:

Dollar-Value LIFO

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Advantage:

Broader range of goods in pool.

Permits replacement of goods that are similar.

Helps protect LIFO layers from erosion.

LO 9 Explain the dollarLO 9 Explain the dollar--value LIFO method.value LIFO method.

Exercise 8-29 (partial): The following information relates to the Choctaw Company.

Dollar-Value LIFO

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Use the dollar-value LIFO method to compute the ending inventory for 2007 through 2009.

Inventory at Inventory at $ ValueEnd-of-Year Base-Year Base $ Value LIFO LIFO

Year Prices Index Prices Layers Index LIFO TOTAL Reserve2007 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

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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. 31Balance 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)



2008 88,200 1.05 84,000 70,000 1.00 70,000 14,000 1.05 14,700 84,700 3,500

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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



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)



2008 88,200 1.05 84,000 70,000 1.00 70,000 14,000 1.05 14,700 84,700 3,500

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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



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)

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

expensive and time consuming.

Specific-goods Pooled LIFO approach

Comparison of LIFO Approaches

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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.

Matching

Tax Benefits/Improved Cash Flow

Advantages

Reduced Earnings

Inventory Understated

Disadvantages

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Cash Flow

Future Earnings HedgePhysical Flow

Involuntary Liquidation / Poor Buying Habits

LIFO is generally preferred:

1. if selling prices are increasing faster than costs and

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

Basis for Selection of Inventory Method

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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.

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