Chapter Eight

Chapter Eight - Intermediate Accounting Intermediate...

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Unformatted text preview: Intermediate Accounting Intermediate Chapter 8 Valuation of Inventories: A Cost­ Basis Approach Learning Objectives Learning 2 Identify major classifications of inventory Distinguish between perpetual and periodic inventory systems Identify the effects of inventory errors on the financial statements Understand the items to include as inventory cost Describe and compare the cost flow assumptions used to account for inventories Explain the significance and use of LIFO reserve Understand the effect of LIFO liquidation Explain the dollar­value LIFO method Identify the major advantages and disadvantages of LIFO Understand why companies select given inventory methods Inventory Issues Inventory Classification Inventories are: items held for sale, or goods to be used in the production of goods to be sold Businesses with Inventory: Merchandiser 3 or LO 1: Identify major classifications of inventory. Manufacturer Inventory Issues—Merchandising Company Inventory Classification Balance Sheet • One inventory account • Purchase goods ready for sale January 31, 2008 Current assets (in millions) Cash and cash equivalents $ 5,569 Receivables 3,654 Inventories 35,180 Prepaid expenses and other 3,182 Total current assets 4 LO 1: Identify major classifications of inventory. $ 47,585 Inventory Issues—Manufacturing Company Inventory Classification Balance Sheet December 31, 2008 Three accounts • Raw materials • Work in process • Finished goods Current assets (in millions) Cash $ 1,122 Accounts receivable 15,752 Inventories Raw material $2,474 Work in process 1,215 Finished goods 3,230 Supplies 285 Total inventories See Illustration 8-2 5 Other current assets Total current assets LO 1: Identify major classifications of inventory. 7,204 1,399 $ 25,477 Inventory Issues Inventory Inventory Cost Flow Beginning Inventory Cost of Goods Purchased Cost of Goods Available for Sale Cost of Goods Sold Ending Inventory Companies use one of two types of systems for maintaining inventory records – perpetual system or periodic system. 6 LO 1: Identify major classifications of inventory. Inventory Cost Flow Inventory Perpetual System 1. Purchases of merchandise are debited to Inventory. 2. Freight­in 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. 7 LO 2: Distinguish between perpetual and periodic inventory systems. Inventory Cost Flow Inventory Periodic System 1. Purchases of merchandise are debited to Purchases 2. Ending Inventory determined by physical count 3. Calculation of Cost of Goods Sold: Beginning inventory $ 100,000 Purchases, net 800,000 Goods available for sale 900,000 Ending inventory 125,000 Cost of goods sold $ 775,000 8 LO 2: Distinguish between perpetual and periodic inventory systems. Inventory Cost Flow Inventory Illustration: Fesmire Company had the following transactions during the current year. Beginning inventory Purchases Sales Ending inventory 100 units at $6 = $ 600 900 units at $6 = $5,400 600 units at $12 = $7,200 400 units at $6 = $2,400 Record these transactions using the Perpetual and Periodic systems. (See Illustration 8­4) 9 LO 2: Distinguish between perpetual and periodic inventory systems. Perpetual Inventory System Perpetual 1. Beginning inventory, 100 units at $6: The inventory account shows the inventory on hand at $600. 2. Purchase 900 units at $6: Inventory Accounts Payable 3. Sale of 600 units at $12: Accounts Receivable Sales Cost of Goods Sold (600 at $6) 3,600 Inventory 5,400 5,400 7,200 7,200 3,600 4. End-of-period entries for inventory accounts, 400 units at $6 No entry necessary ­­­ The account, Inventory, shows the ending balance of $2,400 ($600 + $5,400 ­ $3,600) 10 Periodic Inventory System Periodic 1. Beginning inventory, 100 units at $6: The inventory account shows the inventory on hand a t $600. 2. Purchase 900 units at $6: Purchases Accounts Payable 5,400 3. Sale of 600 units at $12: Accounts Receivable 5,400 7,200 Sales 7,200 4. End-of-period entries for inventory accounts, 400 units at $6 Inventory (ending, by count) 2,400 Cost of Goods Sold Purchases Inventory (beginning) 3,600 5,400 600 11 Inventory Cost Flow Inventory Illustration: Assume that at the end of the reporting period, the perpetual 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 indicated inventory of $3,800 is actually on hand. The entry to record the necessary write­down 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 revenues and gains” or “Other expenses and losses” section of the income statement. 12 LO 2: Distinguish between perpetual and periodic inventory systems. Inventory Issues Inventory 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. 13 LO 2: Distinguish between perpetual and periodic inventory systems. Basic Issues in Inventory Valuation Basic Valuation requires determining 1. The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). 2. The costs to include (product vs. period costs). 3. The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.). 14 LO 2: Distinguish between perpetual and periodic inventory systems. Physical Goods Included in Inventory Physical A company should record purchases when it obtains legal title to the goods. General Rule Inventory is buyer’s when received except: FOB shipping point ­­­ Buyer’s at time of delivery to common carrier Consignment goods ­­­ Seller’s, not buyer’s Sales with buybacks ­­­ Seller’s, not buyer’s Sales with high rates of returns ­­­ Buyer’s if you can estimate returns Sales on installments ­­­ Buyer’s, if you can estimate collectability 15 LO 2: Distinguish between perpetual and periodic inventory systems. Effect of Inventory Errors Effect Ending Inventory Misstated See Illustrations 8-7, 8-8, and 8-9 16 LO 3: Identify the effects of inventory errors on the financial statements. Costs Included in Inventory Costs Products Costs – costs directly connected with bringing the Products costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition. Period Costs – generally selling, general, and administrative Period generally selling, general, and administrative expenses. Purchase Discount – Gross vs. Net Method See Illustration 8-11 17 LO 4: Understand the items to include as inventory cost. Which Cost Flow Assumption to Adopt? Which Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods equal FIFO FIFO LIFO LIFO Average Cost Average Specific Identification Specific Answer: Method adopted should be one that most clearly reflects Answer: Method adopted should be one that most clearly reflects periodic income. 18 LO 5: Describe and compare the cost flow assumptions used to account for inventories Which Cost Flow Assumption to Adopt? Which See Illustrations: 8-13 8-15 8-16 8-17 8-18 19 Special Issues Related to LIFO Special 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. Profit­sharing or bonus arrangements 4. LIFO troublesome for interim periods 20 LO 6: Explain the significance and use of a LIFO reserve. Special Issues Related to LIFO Special LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Example: LIFO value LIFO Reserve FIFO value per books $160,000 FIFO value per books $160,000 145,000 $ 15,000 Journal entry to reduce inventory to LIFO: Cost of goods sold 15,000 Allowance to reduce inventory to LIFO 15,000 15,000 Companies should disclose either the LIFO reserve or the replacement cost of the inventory. 21 LO 6: Explain the significance and use of a LIFO reserve. Special Issues Related to LIFO Special 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, 2010, with cost determined on a specific goods LIFO approach. Ending Inventory (2010) Pounds Unit Cost See Illustration See 20 and 8-21 22 LIFO Cost 2007 8,000 $4 2008 10,000 6 2009 7,000 9 2010 5,000 10 $ 32,000 60,000 8 63,000 50,000 30,000 $ 205,000 LO 7: Understand the effect of LIFO liquidations. Special Issues Related to LIFO Special Dollar­Value LIFO • Changes in a pool are measured in terms of total dollar value, not physical quantity. Advantage: • Broader range of goods in pool • Permits replacement of goods that are similar • Helps protect LIFO layers from erosion 23 LO 8: Explain the dollar­value LIFO method. Special Issues Related to LIFO Special Comparison of LIFO Approaches Specific­goods LIFO – costing goods on a unit basis is expensive and time consuming. Specific­goods 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. Dollar­value LIFO is used by most companies. 24 LO 8: Explain the dollar­value LIFO method. Special Issues Related to LIFO Special Advantages Disadvantages • Matching • Reduced earnings • Tax Benefits/Improved Cash Flow • Inventory understated • Physical flow • Involuntary Liquidation/ Poor Buying Habits 25 LO 8: Identify the major advantages and disadvantages of LIFO. Basis for Selection of Inventory Method Basis 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. 26 LO 10: Understand why companies select given inventory methods. ...
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This note was uploaded on 11/09/2011 for the course ACC 3313 taught by Professor Humphrey during the Spring '08 term at Texas State.

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