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Valuation Inventories:
A Cost-Basis Approach
IntermediateAccounting
14thEdition
Kieso,Weygandt,andWarfield
8-1
Learning Objectives
Learning Objectives
1.
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.
8-2
Identify major classifications of inventory.
Understand why companies select given inventory methods.
Inventory Issues
Inventory Issues
Classification
Inventories are:
items held for sale, or
goods to be used in the production of goods to be sold.
Businesses with Inventory
Merchandiser
8-3
or
Manufacturer
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Issues
Classification
Illustration 8-1
8-4
One inventory
account.
Purchase goods
in form ready for
sale.
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Issues
Classification
Illustration 8-1
Three accounts
Work in process
8-5
Raw materials
Finished goods
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Issues
Classification
8-6
Illustration 8-2
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Issues
Inventory Cost Flow
Illustration 8-3
Companies use one of two types of systems for maintaining
inventory records perpetual system or periodic system.
8-7
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Inventory 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.
8-8
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
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
8-9
GoodsDistinguish between perpetual and periodic inventory systems.
available for sale
LO 2
Inventory Cost Flow
Inventory Cost Flow
Illustration: Fesmire Company had the following transactions
during the current year.
Record these transactions using the Perpetual and Periodic
systems.
8-10
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Inventory Cost Flow
8-11
Illustration 8-4
LO 2
Inventory Cost Flow
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
Inventory
200
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.
8-12
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Issues
Inventory Issues
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.
8-13
LO 2 Distinguish between perpetual and periodic inventory systems.
Basic Issues in Inventory Valuation
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
8-14
LO 2 Distinguish between perpetual and periodic inventory systems.
Basic Issues in Inventory Valuation
Basic Issues in Inventory Valuation
Valuation requires determining
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.).
8-15
LO 2 Distinguish between perpetual and periodic inventory systems.
Physical Goods Included in Inventory
Physical Goods Included in Inventory
A company should record purchases when it obtains legal
title to the goods.
Illustration 8-6
8-16
LO 2 Distinguish between perpetual and periodic inventory systems.
Physical Goods Included in Inventory
Physical Goods Included in Inventory
Effect of Inventory Errors
Ending
Inventory
Misstated
Illustration 8-7
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.
8-17
LO 3 Identify the effects of inventory errors on the financial statements.
Effect of Inventory Errors
Effect 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
8-18
LO 3
Physical Goods Included in Inventory
Physical Goods Included in Inventory
Effect of Inventory Errors
O
K
Purchases and
Inventory
Misstated
Illustration 8-9
The understatement does not affect cost of goods sold and net income because the
errors offset one another.
8-19
LO 3 Identify the effects of inventory errors on the financial statements.
Costs Included in Inventory
Costs Included in Inventory
Product Costs
Costs directly connected with bringing the goods to the
buyers 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
8-20
LO 4 Understand the items to include as inventory cost.
Costs Included in Inventory
Costs Included in Inventory
Treatment of Purchase Discounts
Illustration 8-11
**
*
8-21
* $4,000 x 2% = $80
** $10,000 x 98% = $9,800
LO 4
Which Cost Flow Assumption to Adopt?
Which Cost Flow Assumption to Adopt?
Specific Identification --- Average Cost
LIFO --- FIFO
Cost Flow Assumption Adopted
Cost Flow Assumption Adopted
does not need to equal
does not need to equal
Physical Movement of Goods
Physical Movement of Goods
Method adopted should be one that most clearly reflects periodic income.
8-22
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
Cost Flow Assumptions
Illustration
Young & Crazy Company makes the following purchases:
1. One item on 2/2/11 for $10
2. One item on 2/15/11 for $15
3. One item on 2/25/11 for $20
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%.
8-23
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
Cost Flow Assumptions
First-In-First-Out (FIFO)
Inventory Balance
= $ 45
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-24
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
First-In-First-Out (FIFO)
Inventory Balance
= $ 35
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-25
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total before expenses
Income tax
Taxes
Net Income
$ 90
10
80
14
12
7
33
47
47
14
$ 33
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Average Cost
Inventory Balance
= $ 45
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-26
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Average Cost
Inventory Balance
= $ 30
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-27
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
15
75
14
12
7
33
42
12
$ 30
30
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Specific Identification
Inventory Balance
= $ 45
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-28
Young & Crazy Company
Income Statement
For the Month of Feb. 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Specific Identification
Inventory Balance
= $ 45
Purchase on
2/25/12 for $20
Purchase on
2/15/12 for $15
Purchase on
2/2/12 for $10
8-29
Young & Crazy Company
Income Statement
For the which Feb. is sold
Depends Month of one 2012
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Financial Statement Summary
Sales
Cost of goods sold
Gross profit
Operating expenses:
Administrative
Selling
Interest
Total expenses
Income before taxes
Income tax expense
Net income
Inventory Balance
8-30
FIFO
$
90
10
80
$
14
12
7
33
47
14
33
35
Average
$
90
15
75
$
14
12
7
33
42
12
30
30
LO 5
Cost Flow Assumptions
Cost Flow Assumptions
Illustration: Call-Mart Inc. had the following transactions in
its first month of operations.
Calculate Goods Available for Sale
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
8-31
$43,900
LO 5
Specific Identification
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
8-32
Average Cost
Average Cost
Weighted Average
8-33
Illustration 8-13
LO 5
Average Cost
Average Cost
Moving Average
Illustration 8-14
In this method, Call-Mart computes a new average unit cost
each time it makes a purchase.
8-34
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
First-In, First-Out (FIFO)
First-In, First-Out (FIFO)
Periodic Method
Illustration 8-15
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.
8-35
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
First-In, First-Out (FIFO)
First-In, First-Out (FIFO)
Perpetual Method
Illustration 8-16
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.
8-36
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
Last-In, First-Out (LIFO)
Last-In, First-Out (LIFO)
Periodic Method
Illustration 8-17
The cost of the total quantity sold or issued during the month comes
from the most recent purchases.
8-37
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
Last-In, First-Out (LIFO)
Last-In, First-Out (LIFO)
Perpetual Method
Illustration 8-18
The LIFO method results in different ending inventory and cost of
goods sold amounts than the amounts calculated under the periodic
method.
8-38
LO5 Describe and compare the cost flow assumptions
used to account for inventories.
Special Issues Related to LIFO
Special Issues Related to LIFO
LIFO Reserve
Many companies use
LIFO for tax and external financial reporting purposes.
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
8-39
LO 6 Explain the significance and use of a LIFO reserve.
Special Issues Related to LIFO
Special Issues Related to LIFO
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 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.
Journal entry to reduce inventory to LIFO:
Cost of goods sold
30,000
Allowance to reduce inventory to LIFO
8-40
30,000
LO 6 Explain the significance and use of a LIFO reserve.
Special Issues Related to LIFO
Special Issues Related to LIFO
LIFO Liquidation
Older, low cost inventory is sold resulting in a lower cost of
goods sold, higher net income, and higher taxes.
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.
8-41
LO 7 Understand the effect of LIFO liquidations.
Special Issues Related to LIFO
Special Issues Related to LIFO
LIFO Liquidation
Illustration: At the end of 2012, only 6,000 pounds of steel
remained in inventory.
Illustration 8-21
Illustration 8-20
8-42
LO 7
Special Issues Related to LIFO
Special Issues Related to LIFO
Dollar-Value LIFO
Changes in a pool are measured in terms of total dollar
value, not physical quantity.
Advantage:
Permits replacement of goods that are similar.
8-43
Broader range of goods in pool.
Helps protect LIFO layers from erosion.
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Special Issues Related to LIFO
Comparison of LIFO Approaches
Specific-goods LIFO - costing goods on a unit basis is
expensive and time consuming.
Specific-goods Pooled LIFO approach
8-44
more difficult to erode the layers.
reduces record keeping and clerical costs.
using quantities as measurement basis can lead to
untimely LIFO liquidations.
Dollar-value LIFO is used by most companies.
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Special Issues Related to LIFO
Disadvantages
Advantages
Matching
Reduced Earnings
Tax Benefits/Improved
Cash Flow
Inventory Understated
Physical Flow
Involuntary Liquidation /
Poor Buying Habits
8-45
Future Earnings Hedge
LO 9 Identify the major advantages and disadvantages of LIFO.
Special Issues Related to LIFO
Special Issues Related to LIFO
Basis for Selection of Inventory Method
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.
8-46
LO 10 Understand why companies select given inventory methods.
Inventory Valuation Methods -- Summary
Inventory Valuation Methods Summary
Illustration 8-31
Notice that gross profit and net income are lowest under LIFO, highest under
FIFO, and somewhere in the middle under average cost.
8-47
LO 10 Understand why companies select given inventory methods.
Inventory Valuation Methods -- Summary
Inventory Valuation Methods Summary
Illustration 8-32
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.
8-48
LO 10 Understand why companies select given inventory methods.