Chapter 3

Chapter 3

inventoryinventory

1. Describe how inventory accounts are classified.

2. Explain the uses of perpetual and periodic inventory systems.

3. Identify how inventory quantities are determined.

4. Determine the cost of inventory.

5. Compute ending inventory and cost of goods sold under specific identification, FIFO, average cost, and LIFO.

6. Explain the conceptual issues regarding alternative inventory cost flow assumptions.

7. Understand dollar-value LIFO.

8. Explain additional LIFO issues.

9. Understand inventory disclosures.

10. Understand the lower of cost or market method.

11. Explain the conceptual issues regarding the lower of cost or market method.

12. Understand purchase obligations and product financing arrangements.

13. Explain the valuation of inventory above cost.

14. Use the gross profit method.

15. Understand the retail inventory method.

16. Explain the conceptual issues regarding the retail inventory method.

17. Understand the dollar-value retail method.

18. Understand the effects of inventory errors on the financial statements.

Typically represent the largestcurrent asset of manufacturing

and retail firms.

For many companies inventoriesare a significant portion

of total assets as well.

Inventory methods and managementpractices can become

profit-enhancing tools.

Importance of InventoriesImportance of InventoriesImportance of InventoriesImportance of Inventories

Merchandise inventory Goods acquired for resale

Manufacturing inventory Raw materials

Work-in-process

Finished goods

Manufacturing supplies

Miscellaneous inventory

Inventory CategoriesInventory CategoriesInventory CategoriesInventory Categories

Merchandising Company

Manufacturing Company

Merchandising CompanyMerchandising Company

Cost of Goods Sold

Accounts Payable (or Cash)

Merchandise Inventory

Goods Purchased

Goods Sold

Flow of Inventory CostsFlow of Inventory CostsFlow of Inventory CostsFlow of Inventory Costs

Manufacturing CompanyManufacturing Company

Accounts Payable (or Cash)

Raw Materials Inventory

Materials Purchased

Materials Used in

Production

To Work in Process Inventory

ContinuedContinuedContinuedContinued



Direct Labor

Actual Direct Labor

Manufacturing (Factory) Overhead

Actual Mfg. Over-head

Overhead Applied to Production


Labor Charged to Production


ContinuedContinuedContinuedContinued



Work in Process Inventory

Materials Used

Direct Labor

Overhead Applied

Finished Goods Inventory

Goods Finished (Manufactured)

Goods Sold to Cost of Goods Sold


General RuleAll goods owned by the company on the inventory date, regardless of their location.

Goods in transit depend on the FOB terms. Goods on consignment.

Items Included in InventoryItems Included in InventoryItems Included in InventoryItems Included in Inventory

Who Owns the Inventory?Who Owns the Inventory?Who Owns the Inventory?Who Owns the Inventory?

Invoice price

Freight-in

Purchase discounts

Other costs to get the inventory ready for sale

Components of Inventory CostComponents of Inventory CostComponents of Inventory CostComponents of Inventory Cost

Under the gross price method, a company records the purchase at the gross price, and

records the amount of the discount in the accounting system only if the discount is

taken.

Under the gross price method, a company records the purchase at the gross price, and

records the amount of the discount in the accounting system only if the discount is

taken.

Under the net price method, a company records the purchase at its net price, and records the amount of the discount in the

accounting system only if the discount is not taken.

Under the net price method, a company records the purchase at its net price, and records the amount of the discount in the

accounting system only if the discount is not taken.

Purchases DiscountsPurchases DiscountsPurchases DiscountsPurchases Discounts

To record the purchase

Inventory (or Purchases) 1,000Accounts Payable 1,000

A company purchases $1,000 of goods under terms of 1/10, n/30.


To record payment within the discount period:Accounts Payable 1,000

Purchases Discounts Taken 10Cash 990

To record payment after the discount period:

Accounts Payable 1,000Cash 1,000

Purchases Discounts-Purchases Discounts-Gross Price MethodGross Price Method

Purchases Discounts-Purchases Discounts-Gross Price MethodGross Price Method

To record the purchase:Inventory (or Purchases) 990

Accounts Payable990



To record payment within the discount period:Accounts Payable 990

Cash990

To record payment after the discount period:Accounts Payable 990Purchases Discounts Lost 10

Cash1,000

Purchases Discounts Lost are treated as a financing expense in the Other section of the income statement.

Purchases Discounts-Purchases Discounts-Net Price MethodNet Price Method

Purchases Discounts-Purchases Discounts-Net Price MethodNet Price Method

Net Price MethodNet Price Method

Adjusting entry at the end of period if discount has expired and invoice is unpaid:Purchases Discounts Lost 10

Accounts Payable10



Purchases DiscountsPurchases DiscountsPurchases DiscountsPurchases Discounts

PERIODIC METHOD

vs.

PERPETUAL METHOD

Inventory Recording MethodsInventory Recording MethodsInventory Recording MethodsInventory Recording Methods

A company using a periodic system does not

maintain a continuous record of the physical

quantities on hand.

A company using a periodic system does not

maintain a continuous record of the physical

quantities on hand.

Alternative Inventory SystemsAlternative Inventory SystemsAlternative Inventory SystemsAlternative Inventory Systems

Beginning Inventory+ Purchases (net)= Cost of Goods Available for Sale

- Ending Inventory = Cost of Goods Sold

Calculating Cost of Goods Sold (COGS)Calculating Cost of Goods Sold (COGS)Calculating Cost of Goods Sold (COGS)Calculating Cost of Goods Sold (COGS)

Beginning inventoryBeginning inventory

++ Purchases (net)Purchases (net)

-- Goods SoldGoods Sold

== Ending InventoryEnding Inventory



-- Goods SoldGoods Sold

== Ending InventoryEnding Inventory

Perpetual Inventory System



-- Ending InventoryEnding Inventory

== Goods SoldGoods Sold



-- Ending InventoryEnding Inventory

== Goods SoldGoods Sold

PeriodicInventory System

Comparison of SystemsComparison of SystemsComparison of SystemsComparison of Systems

Transaction or Event Periodic Inventory Perpetual InventoryRoutine purchases of various inventory items

Costs debited to purchases account

Costs debited to inventory account

Items removed from inventory for use in production

No accounting entries made

Debit WIP inventory and credit inventory account

End-of-period accounting entries and related activities

Physical count of inventory to determine cost of goods sold

No separate determination of cost of goods sold necessary

Periodic versus PerpetualPeriodic versus PerpetualPeriodic versus PerpetualPeriodic versus Perpetual

At the end of the accounting period, calculate COGS by closing: Purchases,

Purchases Discount,

Purchase Returns and Allowances,

Beginning Inventory, and

Record Ending Inventory.

COGS is closed to Income Summary.

Periodic SystemPeriodic SystemPeriodic SystemPeriodic System

The following is a partial adjusted trial balance:

Account Debit CreditInventory 1/1/X6 175,000$ Purchases 350,000 Purchases Discount 22,000$ Purchase Returns & Allowances 6,000 Sales 1,250,000 Advertising Expense 7,500 Salaries Expense 80,000 Utilities Expense 20,000

12/31/X6 ending inventory was $125,000Prepare the closing entries.


GENERAL JOURNAL

Page 1

Date Description PR Debit Credit


GENERAL JOURNAL

Page 1


Cost of Goods Sold 372,000

Inventory, 12/31/X6 125,000

Purchases Discount 22,000

Purchase Returns & Allowances 6,000

Purchases 350,000

Inventory, 1/1/X6 175,000

To close accounts to COGS


GENERAL JOURNAL

Page 1


Sales 1,250,000

Income Summary 1,250,000

To close account

Income Summary 479,500

Cost of Goods Sold 372,000

Advertising Expense 7,500

Salaries Expense 80,000

Utilities Expense 20,000

To close accounts


GENERAL JOURNAL

Page 1


Income Summary 770,500

Retained Earnings 770,500

To close account


Purchases discount and purchase returns and allowances are contra-purchases accounts, i.e., they have a credit balance.

Purchases can be recorded using the gross or net method.


The inventory account is continuously updated for:

Perpetual SystemPerpetual SystemPerpetual SystemPerpetual System

Returns of inventory are credited to the

inventory account.

Discounts on inventory purchases can be recorded using the

gross or net method.


Cable TV, Inc. used the gross method gross method to record a purchase on March 23 for $50,000 with terms of 2/10,n/30. Payment was made on April 1. Which of the following is included on the April 1 entry?

a. Credit Purchases Discount $1,000b. Debit Purchases Discount $1,000c. Credit Inventory $1,000d. Debit Inventory $1,000


Cable TV, Inc. used the gross methodgross method to

record a purchase on March 23 for $50,000

with terms of 2/10,n/30. Payment was

made on April 1. Which of the following is

included on the April 1 entry?

a. Credit Purchases Discount $1,000

b. Debit Purchases Discount $1,000

c. Credit Inventory $1,000

d. Debit Inventory $1,000


GENERAL JOURNAL

Page 1


3/23 Inventory 50,000

Accounts Payable 50,000

To record purchase at gross

4/1 Accounts Payable 50,000

Inventory 1,000

Cash 49,000

To record payment


Cable TV, Inc. used the net method to record a purchase on March 23 for $50,000 with terms of 2/10,n/30. Payment was made on April 5. Which of the following is included on the April 5 entry?

a. Credit Purchases Discount $1,000b. Debit Purchases Discount $1,000c. Credit Purchases Discounts Forfeited $1,000d. Debit Purchases Discounts Forfeited $1,000


GENERAL JOURNAL

Page 1


3/23 Purchases 49,000

Accounts Payable 49,000

To record purchase at net

4/5 Accounts Payable 49,000

Purchases Discounts Forfeited 1,000

Cash 50,000

To record paymentRepresents a finance charge and is included with misc. expenses


Cost of Goods Sold is closed to Income Summary during the usual closing entries at the end of the period.


Cost basis

Departures from cost Lower of cost or market (LCM)

Net realizable value

Replacement cost

Current cost

Selling price

Inventory Values - Unit CostInventory Values - Unit CostInventory Values - Unit CostInventory Values - Unit Cost

Specific cost identification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Inventory Cost Flow MethodsInventory Cost Flow MethodsInventory Cost Flow MethodsInventory Cost Flow Methods

Specific cost of each inventory item must be known.

Opportunity to manipulate income by selection of items at time of sale.

Specific Cost IdentificationSpecific Cost IdentificationSpecific Cost IdentificationSpecific Cost Identification

100 units @ $10 per unitApr. 1

Apr. 10

Apr. 20

80 units @ $11 per unit70 units @ $12 per unit

On April 27, sold 90 units from the beginning inventory, 50 units from the April 10

purchase.

Specific IdentificationSpecific IdentificationSpecific IdentificationSpecific Identification


Apr. 10

Apr. 20

80 units @ $11 per unit

Apr. 20 0 units @ $12 per unit





30 units @ $11 per unit70 units @ $12 per unit

Sold 90

Sold 50

Ending inventory . . . . . . . . .

= $ 100

= 330

= 840

$1,270

Cost of Goods Sold . . . . . . . . $1,450

= $900

= 550

= 0



Apr. 10

Apr. 20


Apr. 20

Apr. 1

Apr. 10




70 units @ $12 per unitEnding inventory . . . . . . . . . . . . .

Goods available for sale . . . . . . .

= $ 1,000

= 880

= 840

$2,720

= $ 100

= 330

= 840

$1,270

$ 1,480Cost of Goods Sold . . . . . . . . . . .


The periodic inventory system uses the weighted-average unit cost method.

The perpetual inventory system uses the moving-average unit cost method.

Average Cost MethodAverage Cost MethodAverage Cost MethodAverage Cost Method

Weighted-average cost (WAC) per unit Beginning inventory cost + Current purchase cost Beginning inventory units + Current purchase units

Ending InventoryEnding Inv. = Units in Ending Inv. x WAC per Unit

Cost of Goods SoldCOGS = Units Sold x WAC per Unit

Weighted-AverageWeighted-AveragePeriodic MethodPeriodic Method


The following schedule shows the mouse pad inventory for Computers, Inc. for September.

The physical inventory count shows 800800 mouse pads in ending inventory.

Use the weighted-average periodic method to Use the weighted-average periodic method to determine:determine:

(1) Ending inventory cost.(1) Ending inventory cost.

(2) Cost of goods sold.(2) Cost of goods sold.



Computer, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeg. Inventory 1,000 $5.25 $5,250.00

9/3 100 5.30 530.00 9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00

Goods Available for Sale 1,550 $8,370.00Ending Inventory 800 Cost of Goods Sold





9/3 100 5.30 530.00 9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00

Goods Available for Sale 1,550 $8,370.00Ending Inventory 800 Cost of Goods Sold 750

GAS 1,550-EI (800)COGS 750





9/3 100 5.30 530.00 9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00

Goods Available for Sale 1,550 $8,370.00Ending Inventory 800 Cost of Goods Sold 750

$8,370 ÷1,550 = $5.40 weighted-average





9/3 100 5.30 530.00 9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00

Goods Available forSale 1,550 $8,370.00Ending Inventory 800 ÷ 5.4 4,320.00 Cost of Goods Sold 750 ÷ 5.4 $4,050.00

$8,370 ÷1,550 = $5.40 weighted-average





Use the moving-average periodic method to Use the moving-average periodic method to determine:determine:



Moving-AverageMoving-AveragePerpetual ExamplePerpetual Example


A new average unit cost must be calculated after each purchase. We will update Computer, Inc.’s inventory after each purchase and sale.



Computer, Inc. Mouse Pad Inventory

Date Units Unit Cost TotalBI 1,000 5.25$ 5,250.00$ 9/3 100 5.30 530.00

9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00

Goods available for sale 1,550 8,370.00$ Ending inventory 800 Cost of goods sold 750



The 750 units were sold as follows:◦ 9/1 300◦ 9/10 200◦ 9/30 250◦ UNITS SOLD 750




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00 Purchase 9/3 100 5.30 530.00 Available for sale 800 4,205.00




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00 Purchase 9/3 100 5.30 530.00 Available for sale 800 5.25625 4,205.00

$4,205.00 ÷800 = $5.25625/unit




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00 Purchase 9/3 100 5.30 530.00 Available for sale 800 5.25625 4,205.00 Sale 9/10 (200) 5.25625 (1,051.25) Available for sale 600 5.25625 3,153.75




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00 Purchase 9/3 100 5.30 530.00 Available for sale 800 5.25625 4,205.00 Sale 9/10 (200) 5.25625 (1,051.25) Available for sale 600 5.25625 3,153.75 Purchase 9/15 150 5.60 840.00 Available for sale 750 5.325 3,993.75

$3,993.75 ÷750 = $5.325




Explanation Units Cost/Unit TotalBeg. Inventory 1,000 5.25$ 5,250.00$ Sale 9/1 (300) 5.25 (1,575.00) Available for sale 700 5.25 3,675.00 Purchase 9/3 100 5.30 530.00 Available for sale 800 5.25625 4,205.00 Sale 9/10 (200) 5.25625 (1,051.25) Available for sale 600 5.25625 3,153.75 Purchase 9/15 150 5.60 840.00 Available for sale 750 5.325 3,993.75 Purchase 9/21 200 5.80 1,160.00 Available for sale 950 5.425 5,153.75



Hey, we need a little more room!Hey, we need a little more room!




Explanation Units Cost/Unit TotalAvailable for sale 750 5.325$ 3,993.75$ Purchase 9/21 200 5.80 1,160.00 Available for sale 950 5.425 5,153.75

That’s better.




Explanation Units Cost/Unit TotalAvailable for sale 750 5.325$ 3,993.75$ Purchase 9/21 200 5.80 1,160.00 Available for sale 950 5.425 5,153.75 Purchase 9/29 100 5.90 590.00 Available for sale 1,050 5.47024 5,743.75




Explanation Units Cost/Unit TotalAvailable for sale 750 5.325$ 3,993.75$ Purchase 9/21 200 5.80 1,160.00 Available for sale 950 5.425 5,153.75 Purchase 9/29 100 5.90 590.00 Available for sale 1,050 5.47024 5,743.75 Sale 9/30 (250) 5.47024 (1,367.56) Ending inventory 800 5.47024 4,376.19

Ending inventory is $4,376.19. Let’s summarizecost of goods sold during September.



Computer, Inc.Cost of Goods Sold in September

Date of sale Units Cost/Unit Total9/1 300 5.25$ 1,575.00$

9/10 200 5.25625 1,051.25 9/30 250 5.47024 1,367.56

Total 750 3,993.81

Cost of ending inventory $4,376.19Cost of goods sold 3,993.81Goods available for sale $ 8,370.00



Objective and consistent.

Match average, rather than latest costs, with current sales revenues.

Average Cost EvaluationAverage Cost EvaluationAverage Cost EvaluationAverage Cost Evaluation

The cost of the oldest inventory items are charged to COGS when goods are sold.

The cost of the newest inventory items remain in ending inventory.

First-In, First-OutFirst-In, First-OutFirst-In, First-OutFirst-In, First-Out

Periodic ending inventory cost equals perpetual ending inventory cost.

Periodic COGS equals perpetual COGS.

First-In, First-OutFirst-In, First-OutFirst-In, First-OutFirst-In, First-Out

Advantages Easy to apply. Inventory value

approximates current cost. Flow of costs tends to be

consistent with usual physical flow of goods.

Systematic and objective. Not subject to

manipulation.

Evaluation of FIFOEvaluation of FIFOEvaluation of FIFOEvaluation of FIFO

Advantages Easy to apply. Inventory value

approximates current cost. Flow of costs tends to be

consistent with usual physical flow of goods.

Systematic and objective. Not subject to

manipulation.

Disadvantages Does not match current

cost of goods sold with current revenues.

Inventory (or phantom) profits.

In periods of rising prices, pay higher income taxes.

Evaluation of FIFOEvaluation of FIFOEvaluation of FIFOEvaluation of FIFO

Which of the following statements is true concerning the use of the FIFO inventory costing method?

a. Ending inventory includes costs from the most recent purchases.

b. COGS includes costs from the oldest purchases.

c. FIFO can be used even if the actual flow of the inventory is not on a FIFO basis.

d. All of the above statements are true.

FIFO - ExampleFIFO - ExampleFIFO - ExampleFIFO - Example



Use the FIFO method to determine:Use the FIFO method to determine:

(1) Ending inventory cost(1) Ending inventory cost

(2) Cost of goods sold(2) Cost of goods sold




9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00





9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00


Remember: Remember: FIFO ending inventory is calculated using the cost of the newest purchases. Start with 9/29 and then add other purchases until you reach the number of units in ending inventory.



Date Beg. Inv. Purchases End Inv.Cost of

Goods Sold

9/29 100@$5.90 100@$5.90Units 100




Goods Sold

9/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 300




Goods Sold

9/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 450




Goods Sold

9/3 100@$5.30 100@$5.309/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 550




Goods SoldBI 1000@$5.25

250@$5.259/3 100@$5.30 100@$5.309/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 800




Goods SoldBI 1000@$5.25 750@$5.25

250@$5.259/3 100@$5.30 100@$5.309/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 800 750Costs 4,432.50$ 3,937.50$

Cost of Goods Available for Sale $8,370.00


Any questions before we run into

LIFO?

Last-In, First-OutLast-In, First-OutLast-In, First-OutLast-In, First-Out

The cost of the newest inventory items are charged to COGS when goods are sold.

The cost of the oldest inventory items remain in ending inventory.

The actual physical flow of inventory items may differ from the LIFO cost flow assumptions.

Last-In, First-OutLast-In, First-Out Unit Cost ApproachUnit Cost Approach

Last-In, First-OutLast-In, First-Out Unit Cost ApproachUnit Cost Approach

Periodic ending inventory cost may be different from perpetual ending inventory cost.

Periodic COGS may be different from perpetual COGS.

Last-In, First-Out ResultsLast-In, First-Out ResultsLast-In, First-Out ResultsLast-In, First-Out Results

Advantages In periods of rising

prices, pay less taxes. Matches latest

inventory costs with current revenues.

Disadvantages LIFO conformity rule

for tax and book purposes.

Cost of record keeping higher.

Inventory valuation is at older costs.

Evaluation of LIFOEvaluation of LIFOEvaluation of LIFOEvaluation of LIFO



Use the LIFO periodic method to determine:Use the LIFO periodic method to determine:



LIFO Periodic - ExampleLIFO Periodic - ExampleLIFO Periodic - ExampleLIFO Periodic - Example



9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00





9/15 150 5.60 840.00 9/21 200 5.80 1,160.00 9/29 100 5.90 590.00


Remember: Remember: LIFO ending inventory is calculated using the cost of the oldest purchases. Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory.




Goods SoldBI 1000@$5.25 800@$5.25

Units 800




Goods SoldBI 1000@$5.25 800@$5.25

200@$5.25

Units 800 200




Goods SoldBI 1000@$5.25 800@$5.25

200@$5.259/3 100@$5.30 100@$5.30

Units 800 300




Goods SoldBI 1000@$5.25 800@$5.25

200@$5.259/3 100@$5.30 100@$5.309/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 800 750




Goods SoldBI 1000@$5.25 800@$5.25

200@$5.259/3 100@$5.30 100@$5.309/15 150@$5.60 150@$5.609/21 200@$5.80 200@$5.809/29 100@$5.90 100@$5.90Units 800 750Costs 4,200.00$ 4,170.00$

Cost of goods available for sale $8,370.00


In our new example, Computers, Inc. has 1,2001,200 units in inventory on November 30.

The company uses the LIFO perpetual method The company uses the LIFO perpetual method to determine:to determine:



LIFO Perpetual - ExampleLIFO Perpetual - ExampleLIFO Perpetual - ExampleLIFO Perpetual - Example

To calculate the LIFO cost for ending inventory and COGS under the perpetual method, we must know when each unit was sold.

LAST-IN, FIRST-OUTLAST-IN, FIRST-OUTLAST-IN, FIRST-OUTLAST-IN, FIRST-OUT


Date Beg. Bal. Purchases BalanceCost of

Goods SoldBI 1,000@$5.25 1,000@$5.25

On November 3rd, 300units were purchased

at $5.30 per unit. We needto update the inventory.

On November 3rd, 300units were purchased





Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 300@$5.30




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 300@$5.30

On November 5th, 100units were sold. We needto update the inventory.





Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 200@$5.3011/5 100@$5.30




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 200@$5.3011/5 100@$5.30

On November 10th, 150units were purchased







Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 200@$5.3011/5 100@$5.3011/10 150@$5.60 150@$5.60




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 200@$5.3011/5 100@$5.3011/10 150@$5.60 150@$5.6011/14 200@$5.80 200@$5.80




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 150@$5.3011/5 100@$5.3011/10 150@$5.60 50@$5.3011/14 200@$5.80 150@$5.6011/17 200@$5.80




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 150@$5.3011/5 100@$5.3011/10 150@$5.60 50@$5.3011/14 200@$5.80 150@$5.6011/17 200@$5.80

On November 23rd, 100units were sold. We needto update the inventory.

On November 23rd, 100units were sold. We needto update the inventory.




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 50@$5.3011/5 100@$5.3011/10 150@$5.60 50@$5.3011/14 200@$5.80 150@$5.6011/17 200@$5.8011/23 100@$5.30




Goods SoldBI 1,000@$5.25 1,000@$5.2511/3 300@$5.30 50@$5.3011/5 100@$5.3011/10 150@$5.60 50@$5.3011/14 200@$5.80 150@$5.6011/17 200@$5.8011/23 100@$5.3011/30 150@$5.90 150@$5.90Total Units 1,200 600 Total Dollars 6,400$ 3,325$


LIFO Matches high (newer)

costs with current (higher) sales.

Values inventory on low (older) cost basis.

Results in lower taxable income.

FIFO Matches low (older)

costs with current (higher) sales.

Values inventory approximating higher current costs.

Results in higher taxable income.

In Periods of Rising Prices. . .In Periods of Rising Prices. . .In Periods of Rising Prices. . .In Periods of Rising Prices. . .

Cost of Goods Cost of Available Goods Ending for Sale Sold Inventory

Cost Flow Assumption and Method

FIFO, periodic $2,720 $1,440 $1,280FIFO, perpetual 2,720 1,440 1,280Weighted average 2,720 1,523 1,197Moving average 2,720 1,496 1,224LIFO, periodic 2,720 1,610 1,110LIFO, perpetual 2,720 1,580 1,140

Comparison of Inventory AssumptionsComparison of Inventory AssumptionsComparison of Inventory AssumptionsComparison of Inventory Assumptions

LIFO Reserve (Allowance) account is used, when:

LIFO is used for external reporting and a non-LIFO basis is used for internal reporting.

An Allowance to Reduce Inventory to LIFO is used to reduce the cost to a LIFO basis.

114

LIFO ReserveLIFO ReserveLIFO ReserveLIFO Reserve

Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004: $50,000 Inventory (LIFO basis) on Dec 31, 2004: $20,000

Adjust the cost of ending inventory to the LIFO basis

Cost of goods sold 30,000 Allowance to Reduce Inventory to LIFO 30,000

Balance Sheet (Assets):Inventory (FIFO) $50,000less: Allowance to Reduce Inventory ($30,000)Inventory (LIFO) basis $20,000

115

LIFO Reserve - ExampleLIFO Reserve - ExampleLIFO Reserve - ExampleLIFO Reserve - Example

Under the LIFO approach, a business may

build up layers of inventory from prior

periods.

A layer liquidation occurs, when: Earlier costs are matched against current sales. Such matching results in distorted income.

116

Liquidation of LayersLiquidation of LayersLiquidation of LayersLiquidation of Layers

10,000 units at $20 per unit




= $200,000

= 132,000

= 192,000

= 120,000

$644,000Inventory, January 1, 2007…………

In 2007 the company purchases 50,000 units at $35 per unit and sells 60,000 units.


2003:

2004:

2005:

2006:






2003:

2004:

2005:

2006:

2007:

= $200,00

= 132,000

= 192,000

= 120,000

=1,750,00050,000 units at $35 per unit0 units at $35 per unit Sold 50,000Sold 50,000Sold 4,000Sold 4,000

Sold 6,000Sold 6,0000 units at $30 per unit









2003:

2004:

2005:

= $ 144,000

= 120,000

= 1,750,000

$2,014,00050,000 units at $35 per unit


2005:

2006:

2007:Cost of goods sold………

Inventory Layers


Each pool represents a group of different, but related, inventory items that are considered as a single entity for inventory accounting purposes.

Uses the average cost for the entire pool to determine COGS and cost of ending inventory.

LIFO LiquidationLIFO LiquidationLIFO LiquidationLIFO Liquidation

Select all the true statements.

a. Pooled LIFO reduces the risk of a LIFO

liquidation in particular items.b. Pooled LIFO is best suited for use with a mix of unrelated inventory items.

c. Since pooled LIFO uses average cost, individual layers of inventory are meaningless.

d. Each purchase, sale, or use of the pooled inventory should be in the same general proportions.

Pooled LIFO - QuestionPooled LIFO - QuestionPooled LIFO - QuestionPooled LIFO - Question

. . . uses price indexes related to the inventory instead of units and unit costs.

. . . is applied to inventory pools rather than individual items.

. . . approximates LIFO results used for income tax and external reporting purposes.

Dollar Value (DV) LIFODollar Value (DV) LIFODollar Value (DV) LIFODollar Value (DV) LIFO

Single poolUsed when overall operations constitute a so-called

natural business unit.

Multiple poolsSeparate inventory pools are formed for each

natural business unit.

Dollar Value (DV) LIFODollar Value (DV) LIFO Inventory PoolsInventory Pools

Dollar Value (DV) LIFODollar Value (DV) LIFO Inventory PoolsInventory Pools

Step 1: Value the total ending inventory at current-year costs.

Date Ending Inventory Cost at Current Costs Index

01/1/06 $10,000 100

12/31/06 $12,100 110

12/31/07 $13,125 125

12/31/08 $16,800 140

12/31/09 $12,360 120


Step 2: Convert the ending inventory cost to base-year cost:

12/31/06 $12,100

12/31/07 $13,125

12/31/08 $16,800

12/31/09 $12,360

Ending Inventory at Current Cost

x

Base Year Cost Index

Current Cost Index

x 100/110 = $11,000

12/31/0612/31/06


Step 3: Compute the change in the inventory level for the year at base-year costs.

$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/08

Base year, $10,000Base year, $10,000

$11,000 - $10,000$11,000 - $10,000

$1,000$1,000

1/1/0612/31/0612/31/06


Step 4a: If there has been an increase, convert this increase to current-year costs.

Base year, $10,000Base year, $10,000Base year, $10,000Base year, $10,000

$1,000$1,000$1,000$1,000

12/31/0612/31/06

x 110/100 = $ 1,100

x 100/100 = 10,000

$11,100

Ending inventory, 12/31/06



12/31/06 $12,100

12/31/07 $13,125

12/31/08 $16,800

12/31/09 $12,360

Ending Inventory at Current Cost

x


Current Cost Index

x 100/110 = $11,000

x 100/125 = $10,500

12/31/0712/31/07



$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09

Base year, $10,000Base year, $10,00012/31/0712/31/07

$1,000$1,000

$11,000 - $10,500



$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09


$500$500


Step 4b: If there is a decrease, this decrease reduces the inventory.


$500$500

12/31/0712/31/07

x 110/100 = $ 550

x 100/100 = 10,000

$10,550




12/31/06 $12,100

12/31/07 $13,125

12/31/08 $16,800

12/31/09 $12,360

x 110/100 = $11,000

x 100/125 = $10,500

x 100/140 = $12,000

12/31/0812/31/08Ending

Inventory at Current Cost

x


Current Cost Index



$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09


$500$500

$12,000 - $10,500 = $1,500


$500$500

$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09


$1,500$1,500



Step 4a: Convert increase to current-year costs.


12/31/0812/31/08

x 140/100 = $ 2,100

x 110/100 = 550

x 100/100 = 10,000$12,650


$500$500

$1,500$1,500



12/31/06 $12,100

12/31/07 $13,125

12/31/08 $16,800

12/31/09 $12,360

x 110/100 = $11,000

x 100/125 = $10,500

x 100/140 = $12,000

x 100/120 = $10,300

12/31/0912/31/09Ending

Inventory at Current Cost

x


Current Cost Index


$500$500

$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09


$1,500$1,500


$500$500

$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09



$300$300

$11,000

$10,500

$12,000

$10,300

12/31/06

12/31/07

12/31/08

12/31/09



Step 4a: Convert increase to current-year costs.


12/31/0912/31/09

x 110/100 = $ 330

x 100/100 = 10,000$10,330


$300$300


ContinueContinueContinueContinue

Current Current cost at Historical Costs base year prices Cost

12/31/06 $12,100 X 100 110

= 11,000

$10,000 X 100 100

=$10,000

1,000 X 110 100

= 1,100

$11,100

12/31/07 $13,125 X 100125

= 10,500

$10,550

$10,000 X 100 100

= $10,000

500 X 110 100

= 550

Example Example Example Example

12/31/08 $16,800 X 100140

= 12,000500 X 110

100= 550

$12,650

$10,000 X 100 100

=$10,000

1,500 X 140100

= 2,100

12/31/09 $12,360 X 100120

= $10,300

$10,330

$10,000 X 100 100

= $10,000

300 X 110

100

= 330

Current Current cost at Historical Costs base year prices Cost

Example Example Example Example

Cost Index =

Sample of Ending Inventory at Current -Year Costs

Sample of Ending Inventory at Base-Year Costs

x 100

Double-Extension MethodDouble-Extension Method

Determination of Cost IndexDetermination of Cost IndexDetermination of Cost IndexDetermination of Cost Index

Cost Index =

Sample of Ending Inventory at Current -Year Costs

Sample of Ending Inventory at Previous-Year Costs

x

Link-Chain MethodLink-Chain Method

Previous-Year Cost

Index


If an internal index cannot be determined, use an external index provided by the Bureau of Labor Statistics.


Bandy Company started using DV LIFO for income tax and external reporting purposes in 19X3. The company still uses FIFO for internal reporting.

Using the following information calculate ending inventory values for 19X3 and 19X4 under DV LIFO.

Dollar Value LIFO ExampleDollar Value LIFO ExampleDollar Value LIFO ExampleDollar Value LIFO Example

Units Cost Total2002 FIFO*Item X 2,000 $23 46,000$ Item Y 1,500 20 30,000

Ending Inventory 3,500 76,000$

* 2002 is the base year.

2003 FIFOItem X 2,500 $26 65,000$ Item Y 1,700 24 40,800


2004 FIFO Item X 2,200 $27 59,400$ Item Y 1,600 25 40,000



2003 Ending Inventory at Base Year PricesUnits Cost Total

Item X 2,500 23$ 57,500$ Item Y 1,700 20 34,000




Item X 2,500 23$ 57,500$ Item Y 1,700 20 34,000


2003 Ending Inventory at 19X3 Prices 105,800$ 2003 Ending Inventroy at Base Year Prices 91,500 Price Index ($105,800/$91,500) 1.156


2003 Ending Inventory at Base Year Prices 91,500$ Base Year Inventory Layer (76,000)

2003 Layer at Base Year Prices 15,500 2003 Price Index × 1.156

2003 Layer at 19X3 Prices 17,918$

2003 DV LIFO Inventory: IndexBase Year Layer 76,000$ 1.0002003 Layer 17,918 1.156

DV LIFO Ending Inventory 93,918$


When total inventory decreases (as in 19X4), some of the prior years’ layers of inventory

are used. The used layers are removed on a LIFO

basis.



Item X 2,200 23$ 50,600$ Item Y 1,600 20 32,000



2004 Ending Inventory at Base Year Prices 82,600$ Base Year Inventory Layer (76,000)

Adj. 2003 Layer at Base Year Prices 6,600 2003 Price Index 1.156Adj. 2003 Layer at 19X3 Prices 7,630$

2004 DV LIFO Inventory: IndexBase Year Layer 76,000$ 1.000Adj. 2003 Layer 7,630 1.156

DV LIFO Ending Inventory 83,630$


Advantages Reduces probability of

liquidating LIFO layers. Reduces accounting

costs of using LIFO. FIFO or average cost

used for internal reporting.

Disadvantages Establishing

appropriate price index.

Subjective makeup of inventory pools.

Dollar Value (DV) LIFODollar Value (DV) LIFOEvaluationEvaluation

Dollar Value (DV) LIFODollar Value (DV) LIFOEvaluationEvaluation

Cool,No?

General Rule

Inventories must be carried at cost or current market value, whichever is lower.

Cost Market

Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)

Market is the current replacement cost of an item in inventory.

Net Realizable Value (NRV)◦ Estimated selling price less the costs of completion

and disposal. Market may not be more than NRV. Called the Ceiling.

NRV Reduced by a Normal Profit Margin◦ Called the Floor,--market may not be less than this

amount.

Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)

If replacement cost is below the floor, floor = market.

If replacement cost is above the ceiling, ceiling = market.

If replacement cost falls between the ceiling and floor, replacement cost = market.

Selecting the Proper Market ValueSelecting the Proper Market ValueSelecting the Proper Market ValueSelecting the Proper Market Value

Let’s see how we apply LCM.Let’s see how we apply LCM.

Selecting the Proper Market ValueSelecting the Proper Market ValueSelecting the Proper Market ValueSelecting the Proper Market Value

Diego, Inc. has one item in inventory that is currently

carried at historical cost of $20 per unit. At the Balance

Sheet date we gather the following per unit information:◦ current replacement cost $21.50;◦ selling price $30;◦ cost to complete and dispose $4; and◦ normal profit margin of $5.

How would Diego value the inventory item on its

Balance Sheet?

Lower of Cost or MarketLower of Cost or MarketExampleExample


Estimated current selling price 30.00$ Estimated cost to complete and dispose 4.00 Net realizable value - Ceiling 26.00$ Normal profit margin 5.00 NRV reduced by normal profit - Floor 21.00$

LCM



Current replacement cost of $21.50 falls between theceiling ($26.00) and the floor ($21.00), so current

replacement cost becomes market for comparison with cost.




Market is $21.50

Cost is $20.00

Cost is below market, so the inventory item will be valued on the Balance Sheet at its historical cost of $20.00.



Let’s modify our original example by changing only the estimated selling price from $30.00 to $25.00. Remember, all other values remain the same.

How would Diego value the inventory item on its Balance Sheet?




Replacement cost of $21.50 is above the ceiling.Replacement cost must fall between the ceiling

and the floor. We select Ceiling ($21.00$21.00) as market.



Market is $21.00

Cost is $20.00

Cost is below market, so the inventory item will

be valued at $20.00 on Diego’s Balance Sheet.



Diego, Inc. has another inventory item currently carried

at an historical cost of $95.00 per unit. At the Balance

Sheet date the following per unit information is available: ◦ Current replacement cost $90.00;

◦ NRV of $100.00 and

◦ NRV reduced by normal profit of $70.00.

How would Diego value this item on its Balance

Sheet?



Replacement Cost = $90.00

$100.00 Ceiling (NRV)

$70.00 Floor

Because replacement cost falls between the ceilingand floor, replacement cost becomes marketreplacement cost becomes market.



Market = $90.00

$100.00 Ceiling (NRV)

$70.00 Floor

Cost = $95.00

Because market is below cost, the itemwill be valued at $90.00 (market value).



Compare cost and marketseparately for each:

Item of Inventory Class of inventory items

Application of LCMApplication of LCMApplication of LCMApplication of LCM

Or you could compare

TotalTotalCostCost

TotalTotalMarketMarket

For the entire inventory

Application of LCMApplication of LCMApplication of LCMApplication of LCM

Inventory Cost MarketCategory A:

Item 1 $1,000 $ 700 $ 700Item 2 1,200 1,300 1,200

$2,200 $2,000Category B:

Item 3 $2,000 $2,400 2,000Item 4 2,500 2,200 2,200

$4,500 $4,600Total $6,700 $6,600Inventory valuation $6,100

Individual Items

Loss recognition,

$600

Loss recognition,

$600

Lower of Cost or MarketLower of Cost or MarketLower of Cost or MarketLower of Cost or Market


Item 1 $1,000 $ 700Item 2 1,200 1,300

$2,200 $2,000 $2,000Category B:

Item 3 $2,000 $2,400Item 4 2,500 2,200

$4,500 $4,600 4,500Total $6,700 $6,600Inventory valuation $6,500

Category

Loss recognition,

$200

Loss recognition,

$200



Item 1 $1,000 $ 700Item 2 1,200 1,300

$2,200 $2,000Category B:

Item 3 $2,000 $2,400Item 4 2,500 2,200

$4,500 $4,600Total $6,700 $6,600 $6,600Inventory valuation $6,600

Total

Loss recognition,

$100

Loss recognition,

$100


Direct Inventory Reduction MethodRecord and report inventory holding loss each

accounting period.

Inventory Allowance MethodRecord holding loss in a contra inventory account,

Allowance to Reduce Inventory to LCM.

Reporting LCMReporting LCMReporting LCMReporting LCM

Recording the Reduction of Inventory to CostRecording the Reduction of Inventory to Cost

Cost MarketDecember 31, 2006 $20,000 $20,000December 31, 2007 25,000 22,000December 31, 2008 30,000 28,000

Cost MarketDecember 31, 2006 $20,000 $20,000December 31, 2007 25,000 22,000December 31, 2008 30,000 28,000

Assume the company uses a perpetual system.

Assume the company uses a perpetual system.


Direct Method--December 31, 2007Direct Method--December 31, 2007Direct Method--December 31, 2007Direct Method--December 31, 2007

Cost of Good Sold 3,000Inventory

3,000

Direct Method--December 31, 2008Direct Method--December 31, 2008Direct Method--December 31, 2008Direct Method--December 31, 2008

Cost of Good Sold 2,000Inventory

2,000


Allowance Method—December 31, 2007Allowance Method—December 31, 2007

Loss due to Market Valuation 3,000Allowance to Reduce Inventory to Market

3,000

Allowance to Reduce Inventory to Market 1,000 Loss due to Market Valuation

1,000

Allowance Method—December 31, 2008Allowance Method—December 31, 2008Allowance Method—December 31, 2008Allowance Method—December 31, 2008


Because of the cost and time required to take a complete physical inventory, it is sometimes necessary to estimate the cost of ending inventory.

Two popular methods are . . .◦ Gross Margin Method

◦ Retail Method

Estimating InventoryEstimating InventoryEstimating InventoryEstimating Inventory

Assumes that the historical gross margin rate is reasonably constant in the short run.

We must know the following: Net sales for the period. Cost of beginning inventory. Net purchases for the period. The historical gross margin rate.

Gross Margin MethodGross Margin MethodGross Margin MethodGross Margin Method

1. Estimate historical gross margin rate.

2. Add beginning inventory and net purchases to get cost of goods available for sale(COGAS).

3. Multiply sales by the gross margin rate to get estimated gross margin in dollars.

4. Subtract gross margin in dollars from net sales to get cost of goods sold(COGS).

5. Subtract COGS from COGAS to get the estimated

cost of ending inventory.

Gross Margin MethodGross Margin MethodSteps to FollowSteps to Follow

Gross Margin MethodGross Margin MethodSteps to FollowSteps to Follow

NoteCo, Inc. uses the gross margin method to

estimate end of month inventory value. At the

end of May the controller develops the following

information: Gross margin 43% of sales;

Inventory at May 1 $237,400; net purchases for

May $728,300; net sales for May $1,213,000.

Let’s estimate Inventory at May 31.

Gross Margin MethodGross Margin MethodExampleExample


Beginning inventory, May 1 237,400$ Net purchases for May 728,300 Cost of goods available for sale 965,700$

Step 2




Net sales for May 1,213,000$ Estimated gross margin percentage 43%Estimated gross margin 521,590$

Step 2

Step 3





Net sales for May 1,213,000$ Estimated gross margin 521,590 Estimated cost of goods sold 691,410$

Step 2

Step 3

Step 4





Net sales for May 1,213,000$ Estimated gross margin 521,590 Estimated cost of goods sold 691,410$

Cost of goods available for sale 965,700$ Less: Estimated cost of goods sold 691,410 Estimated inventory, May 31 274,290$

Step 2

Step 3

Step 4

Step 5



Proof of Estimate

Sales for May 1,213,000$ Cost of goods sold: Beginning inventory 237,400$ Net purchases 728,300 Cost of goods available for sale 965,700 Estimated ending inventory 274,290 Cost of goods sold 691,410 Gross margin for May 521,590$



Gross Profit = Gross Profit as a Sales Percentage of Sales

Divide gross profit by sales to calculate profit as a percentage of sales.

Divide gross profit by sales to calculate profit as a percentage of sales.

Expressing Gross Profit PercentagesExpressing Gross Profit PercentagesExpressing Gross Profit PercentagesExpressing Gross Profit Percentages

If the gross margin percentage is expressed as a percentage of cost it must be converted to a gross margin

as a percentage of sales

Gross Profit as a % of Cost = Gross Profit as a Cost + Gross Profit as a % of Cost % of Sales

Expressing Gross Profit PercentagesExpressing Gross Profit PercentagesExpressing Gross Profit PercentagesExpressing Gross Profit Percentages

1. A company should adjust the gross profit rate for known changes in the relationship between its gross profit and net sales.

2. A company may use a separate gross profit rate for each department or type of inventory that has a different markup percentage.

3. A company may use an average gross profit rate based on several past periods to average out period-to-period fluctuations.

1. A company should adjust the gross profit rate for known changes in the relationship between its gross profit and net sales.

2. A company may use a separate gross profit rate for each department or type of inventory that has a different markup percentage.

3. A company may use an average gross profit rate based on several past periods to average out period-to-period fluctuations.

Enhancing the Accuracy of the Gross Profit Enhancing the Accuracy of the Gross Profit MethodMethod

Enhancing the Accuracy of the Gross Profit Enhancing the Accuracy of the Gross Profit MethodMethod

This method was developed for retail operations like department stores.

Uses both the retail value and cost of items for sales to calculate a cost-to- retail-ratio.

Convert ending inventory at retail to ending inventory at cost.

Retail MethodRetail MethodRetail MethodRetail Method

To use this method we must know:Sales for the period.Beginning inventory at retail and cost.Net purchases at retail and cost.Adjustments to the original retail price:

Additional markups and markdowns, Markup and markdown cancellations, Employee discounts.

Retail MethodRetail MethodRetail MethodRetail Method

1. Determine cost of goods sold and retail value of goods sold.

2. Calculate the cost-to-retail percentage.

3. Subtract retail value of goods available for sale from sales to get ending inventory at retail.

4. Multiply the cost-to-retail percentage times ending inventory at retail to get ending inventory at cost.

Retail MethodRetail MethodSteps to FollowSteps to FollowRetail MethodRetail Method

Steps to FollowSteps to Follow

Webb Clothiers, Inc. uses the retail method to estimate inventory at the end of each month. For the month of May the controller gathers the following information: Beginning inventory at cost $60,000, at retail $92,000, net purchases at cost $200,000, at retail $308,000; net sales for May $300,000.

Let’s estimate inventory at May 31.

Retail Method ExampleRetail Method ExampleRetail Method ExampleRetail Method Example

Cost RetailInventory, May 1 60,000$ 92,000$ Net purchases for May 200,000 308,000 Goods available for sale 260,000 400,000 Cost ratio (260,000 ÷ 400,000)

65%Sales for May 300,000 Ending inventory at retail 100,000$ Cost ratio 65%Ending inventory at cost 65,000$


Markup - original amount by which item is marked up above cost.

Additional Markup - Increase in sales price above the original sales price.

Additional Markup Cancellation - cancellation of some or all of an additional markup.

Markdown - reduction in original sales price. Markdown Cancellation - increase in sales

price after a markdown.

Retail MethodRetail MethodMarkups and MarkdownsMarkups and Markdowns

Retail MethodRetail MethodMarkups and MarkdownsMarkups and Markdowns

Cost ($6)

Markup

Increased selling price to $11 Additional

MarkupOriginal selling price

($10)

Retail Inventory Method TerminologyRetail Inventory Method TerminologyRetail Inventory Method TerminologyRetail Inventory Method Terminology

Cost ($6)

Reduced selling price to $10.25

Net markup =Total additional markups - total markup cancellations

Markup Cancella

-tion


Cost ($6)

Reduced selling price to $9

Markup Cancella

-tion

Mark-down


Cost ($6)

Increased selling price to $9.60

Markdown Cancellation

Net markdown =Total additional markdowns - total markdown cancellations


For methods using cost, such as average cost,

FIFO and LIFO, the net markdowns are

included in calculating the ratio.

For methods using cost, such as average cost,

FIFO and LIFO, the net markdowns are

included in calculating the ratio.

Retail Inventory Method Retail Inventory Method Retail Inventory Method Retail Inventory Method

Estimating Inventory on a FIFO BasisExclude beginning inventory from the cost ratio.

Cost of net purchases FIFO cost ratio = Retail value of (net purchases + net markups - net markdowns)

Retail Method - FIFO Retail Method - FIFO Markups and MarkdownsMarkups and Markdowns

Retail Method - FIFO Retail Method - FIFO Markups and MarkdownsMarkups and Markdowns

Webb Clothiers, Inc. uses retail FIFO to estimate inventory at the end of each month. For the month of May the controller gathers the following information: Beginning inventory at cost $60,000, at retail $92,000, net purchases at cost $200,000, at retail $308,000; net markups $8,000; net markdowns $4,000; and net sales for May $300,000.

Let’s estimate inventory at May 31.

Retail Method - FIFO ExampleRetail Method - FIFO ExampleRetail Method - FIFO ExampleRetail Method - FIFO Example

Cost RetailInventory, May 1 60,000$ 92,000$ Net purchases for May 200,000 308,000 Net markups 8,000 Net markdowns (4,000) Purchases, markups & markdowns 312,000 Cost ratio (200,000 ÷ 312,000)

64.103%Goods available for sale 260,000 404,000 Sales for May 300,000 Ending inventory at retail 104,000$ Cost ratio 64.103%Ending inventory at FIFO cost 66,667$


Average Cost

The average cost method includes the beginning inventory in determining the cost-to-retail

ratio.

The average cost method includes the beginning inventory in determining the cost-to-retail

ratio.

Retail Inventory Method--Average CostRetail Inventory Method--Average CostRetail Inventory Method--Average CostRetail Inventory Method--Average Cost

Average Cost Basis

Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases + net markups - net markdowns)

Averagecost =ratio

Retail Method -Average Cost Retail Method -Average Cost Markups and MarkdownsMarkups and Markdowns

Retail Method -Average Cost Retail Method -Average Cost Markups and MarkdownsMarkups and Markdowns

Cost RetailBeginning inventory $20 $ 35 Purchases 40 80 Net markups 5 Net markdowns (10)Goods available for sale $60 $110

$60

$110= 0.545

Ending inventory, average cost (0.545 x $44) = $23.98

Less sales (66)Ending inventory at retail $ 44

Retail Inventory Method--Average CostRetail Inventory Method--Average CostRetail Inventory Method--Average CostRetail Inventory Method--Average Cost

Lower-of-Cost-or-Market Basis

Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases + net markups)

LCMcost =ratio

Exclude net markdowns from the ratio.Exclude net markdowns from the ratio.

Retail Method Retail Method Markups and MarkdownsMarkups and Markdowns

Retail Method Retail Method Markups and MarkdownsMarkups and Markdowns

Cost RetailBeginning inventory $20 $ 35 Purchases 40 80 Net markups 5

$60 $120 Net markdowns (10)Goods available for sale $60 $110 Less sales (66)Ending inventory at retail $ 44

Ending inventory at LCM (0.50 x $44) = $22

$60

$120= 0.50

Retail Inventory Method--LCMRetail Inventory Method--LCMRetail Inventory Method--LCMRetail Inventory Method--LCM

At Cost At RetailGoods available for sale: Beginning inventory $ 550 $ 900 Net purchases during period 6,290 8,900 Additional markups during period $ 225 Less: Additional markup cancellations (25) Net additional markups 200 Markdowns (600) Less: Markdown cancellations 100 Net markdowns (500) Total goods available for sale 6,840 9,500Deduct: Sales (8,500)Ending inventory: At retail $ 1,000 At approximate FIFO cost with LCM ? At approximate average cost with LCM ?

Retail Method - ExampleRetail Method - ExampleRetail Method - ExampleRetail Method - Example

Steps to follow: Estimate ending inventory at FIFO cost.

Convert to LIFO Cost◦ Compute an internal conversion price index for the

current period.◦ Adjust current layer and each prior layer for change

in price.

Cost of net purchases FIFO cost ratio = Retail value of (net purchases + net markups - net markdowns)

Retail Method - LIFO ExampleRetail Method - LIFO ExampleRetail Method - LIFO ExampleRetail Method - LIFO Example

Let’s build on our last example. Remember that Webb Clothier used Retail FIFO to estimate its inventory at the end of each month. Keep the given information the same but now assume that Webb uses DV LIFO to estimate its ending inventory. The only new information is that the price index was 100 at the beginning of May (LIFO base) and 102 at the end of the month.

We begin by estimating ending inventory using DV LIFO.


Cost RetailInventory, May 1 60,000$ 92,000$ Net purchases for May 200,000 308,000 Net markups 8,000 Net markdowns (4,000) Purchases, markups & markdowns 312,000 Cost ratio (200,000 ÷ 312,000)

64.103%Goods available for sale 260,000 404,000 Sales for May 300,000 Ending inventory at retail 104,000$ Cost ratio 64.103%Ending inventory at FIFO cost 66,667$

This is our solution to the Webb Retail This is our solution to the Webb Retail FIFOFIFO example example


May 31 inventory at FIFO retail 104,000$ May 31 conversion price index × 102%May 31 inventory at base-period retail 101,961

Ending inventory is still shown at retail, but now it is stated at beginning of month prices.


Price Cost DV LIFORetail Index Ratio* Cost

(a) (b) (c) (a ×b ×c)May 1, base layer 92,000$ 100% 65.217% 60,000$ May additional layer 9,961 102% 64.103% 6,513

101,961$ 66,513$

*BI cost ratio = ($60,000 ÷$92,000) = 65.217%

May 31 inventory at FIFO retail 104,000$ May 31 conversion price index × 102%May 31 inventory at base-period retail 101,961


Valuing inventory at Current replacement cost

Net realizable value

Selling price

Losses on purchase commitments Effect of inventory errors

Other Inventory IssuesOther Inventory IssuesOther Inventory IssuesOther Inventory Issues

To lock in prices and assure sufficient quantities of materials, companies often contract with suppliers to purchase a specified quantity of materials in the

future at an agreed upon unit cost.

To lock in prices and assure sufficient quantities of materials, companies often contract with suppliers to purchase a specified quantity of materials in the

future at an agreed upon unit cost.

Purchase ObligationsPurchase ObligationsPurchase ObligationsPurchase Obligations

Formal, non-cancelable purchase contracts are not recognized in the accounts but should be disclosed.

If it is expected that execution of the contract will result in a loss, then recognition of the loss is appropriate.

Purchase ObligationsPurchase ObligationsPurchase ObligationsPurchase Obligations

A company entered into a noncancelable

commitment to purchase inventory at

a fixed price of $500,000 and the

market price at the end of the year is

$450,000.

A company entered into a noncancelable

commitment to purchase inventory at

a fixed price of $500,000 and the

market price at the end of the year is

$450,000.

Purchasing Obligations and Product Purchasing Obligations and Product ArrangementsArrangements


Year-end adjusting entry:

Loss on Purchase Commitments 50,000 Accrued Loss on Purchase Commitments 50,000

When the goods are purchased:

Inventory (or Purchases) 450,000Accrued Loss on PurchaseCommitments 50,000 Accounts Payable 500,000



If we make an error in inventory, how willit impact the financial statements?

Inventory ErrorsInventory ErrorsInventory ErrorsInventory Errors

Overstatement of ending inventory Understates cost of goods sold and

Overstates pretax income.

Understatement of ending inventory Overstates cost of goods sold and

Understates pretax income.


Overstatement of beginning inventory Overstates cost of goods sold and


Understatement of beginning inventory Understates cost of goods sold and



Overstatement of purchases Overstates cost of goods sold and


Understatement of purchases Understates cost of goods sold and



Opti, Inc. reported sales of $18,000 during 19X7. Beginning inventory was $5,000, ending inventory was $5,500 and purchases were recorded at $12,000. We learn the Purchases were incorrectly recorded. The correct amount is $11,000 (Purchases were overstated by $1,000). This was the only error in Opti’s books.

Let’s look at the effect of the error.


Partial Income Statement as reportedSales revenue 18,000$ Cost of goods sold: Beginning inventory 5,000$ Purchases (the error) 12,000 Cost of goods available for sale 17,000 Ending inventory 5,500 Cost of goods sold 11,500 Gross margin 6,500$


Partial Income Statement as correctedSales revenue 18,000$ Cost of goods sold: Beginning inventory 5,000$ Purchases (corrected) 11,000 Cost of goods available for sale 16,000 Ending inventory 5,500 Cost of goods sold 10,500 Gross margin 7,500$


Wick, Co. reported sales of $22,000 during 19X7. Beginning inventory was incorrectly reported as $5,000. The correct amount is $5,200 (BI understated by $200), ending inventory was $5,300 and purchases were recorded at $12,500. This was the only error in Wick’s books.



Partial Income Statement as reportedSales revenue 22,000$ Cost of goods sold: Beginning inventory (the error) 5,000$ Purchases 12,500 Cost of goods available for sale 17,500 Ending inventory 5,300 Cost of goods sold 12,200 Gross margin 9,800$


Partial Income Statement as correctedSales revenue 22,000$ Cost of goods sold: Beginning inventory (corrected) 5,200$ Purchases 12,500 Cost of goods available for sale 17,700 Ending inventory 5,300 Cost of goods sold 12,400 Gross margin 9,600$


Vickers, Inc. reported sales of $17,000 during 19X7. Beginning inventory was reported as $5,000, ending inventory was incorrectly reported as $5,300, the correct amount is $5,500 (ending inventory is understated by $200) and purchases were recorded at $12,500. This was the only error in Vickers?books.



Partial Income Statement as reportedSales revenue 17,000$ Cost of goods sold: Beginning inventory 5,000$ Purchases 12,500 Cost of goods available for sale 17,500 Ending inventory (the error) 5,300 Cost of goods sold 12,200 Gross margin 4,800$


Partial Income Statement as correctedSales revenue 17,000$ Cost of goods sold: Beginning inventory 5,000$ Purchases 12,500 Cost of goods available for sale 17,500 Ending inventory (corrected) 5,500 Cost of goods sold 12,000 Gross margin 5,000$


Chapter3

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Chapter 3

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