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

VALUATION OF INVENTORIES: VALUATION OF INVENTORIES: A COST-BASIS APPROACHA COST-BASIS APPROACH

Intermediate AccountingIFRS Edition

Kieso, Weygandt, and Warfield

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1. Identify major classifications of inventory.

2. Distinguish between perpetual and periodic inventory systems.

3. Identify the effects of inventory errors on the financial statements.

4. Understand the items to include as inventory cost.

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

Learning ObjectivesLearning Objectives

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Goods in transit

Consigned goods

Special sales agreements

Inventory errors

Inventory IssuesInventory IssuesPhysical Goods Physical Goods

Included in Included in InventoryInventory

Cost Included in Cost Included in InventoryInventory

Cost Flow Cost Flow AssumptionsAssumptions

Classification

Cost flow

Control

Basic inventory valuation

Product costs

Period costs

Purchase discounts

Specific identification

Average cost

FIFO

Summary analysis

Valuation of Inventories:Valuation of Inventories:Cost-Basis ApproachCost-Basis Approach

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Inventories are:

items held for sale, orgoods to be used in the production of goods to be sold.

Inventory IssuesInventory Issues

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

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory

or

Classification

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One inventory account.

Purchase goods in form ready for sale.

Classification



Illustration 8-1

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Three accounts

• Raw materials

• Work in process

• Finished goods

Classification


LO 1LO 1

Illustration 8-1

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Inventory Cost Flow


Illustration 8-2


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Inventory Cost Flow


Illustration 8-3


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

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Inventory Cost FlowInventory Cost Flow

LO 2 Distinguish between perpetual and periodic inventory systems.LO 2 Distinguish between perpetual and periodic inventory systems.

Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each sale.

4. Subsidiary records show quantity and cost of each type of inventory on hand.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

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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

$ 100,000Purchases, net

800,000Goods available for sale

900,000Ending inventory

125,000Cost of goods sold

$ 775,000

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

Record these transactions using the Perpetual and Periodic systems.

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Illustration 8-4Illustration:

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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.

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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.

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Basic Issues in Inventory ValuationCompanies 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

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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).

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

Valuation requires determining

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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

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

Effect of Inventory Errors

The effect of an error on net income in one year (2010) will be counterbalanced in the next (2011), however the income statement will be misstated for both years.

Illustration 8-7

Ending Inventory Misstated

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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

LO 3LO 3

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

Effect of Inventory Errors

The understatement does not affect cost of goods sold and net income because the errors offset one another.

Illustration 8-9

Purchases and Inventory

Misstated

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Costs Included in InventoryCosts Included in Inventory

LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

Product Costs - costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition.

Period Costs – generally selling, general, and administrative expenses.

Treatment of Purchase Discounts – Gross vs. Net Method

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Costs Included in InventoryCosts Included in Inventory

LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

Treatment of Purchase DiscountsIllustration 8-11

* $4,000 x 2% = $80

*

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

**

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

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

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

Specific Identification --- Average Cost --- LIFO

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

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Young & Crazy Company makes the following purchases:

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



Young & Crazy Company sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended February 2011, assuming the company used the FIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%.

Example

Cost Flow AssumptionsCost Flow Assumptions


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Purchase on 2/2/11 for $10



Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40


“First-In-First-Out (FIFO)”

LO 5LO 5

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For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income $ 33 $ 33

“First-In-First-Out (FIFO)”

LO 5LO 5

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“Average Cost”

LO 5LO 5

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For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 12 12 Net Income $ $ 3030

“Average Cost”

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“Specific Identification”

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Depends which one is soldDepends which one is sold






“Specific Identification”

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Financial Statement SummaryFIFO Average

Sales 90$ 90$ Cost of goods sold 10 15

Gross profit 80 75 Operating expenses:

Administrative 14 14 Selling 12 12 Interest 7 7

Total expenses 33 33 Income before taxes 47 42 Income tax expense 14 12 Net income 33$ 30$

Inventory Balance 3035


LO 5LO 5

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LO 5LO 5

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

Beginning inventory (2,000 x $4)

$ 8,000

Purchases:

6,000 x $4.40

26,400

2,000 x 4.75

9,500

Goods available for sale

$43,900

Calculate Goods Available for Sale

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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


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Average CostAverage Cost

Illustration 8-14

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

Moving-Average


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

Illustration 8-15Periodic Method

Determine cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory.


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

Illustration 8-16Perpetual Method

In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used.


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Inventory Valuation Methods - SummaryInventory Valuation Methods - Summary

Illustration 8-17


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


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

Under IFRS, LIFO is not permitted for financial reporting purposes.

Nonetheless, LIFO is permitted for financial reporting purposes in the United States, it is permitted for tax purposes in some countries, and its use can result in significant tax savings.

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

Beginning inventory (2,000 x $4)

$ 8,000

Purchases:

6,000 x $4.40

26,400

2,000 x 4.75

9,500

Goods available for sale

$43,900

Calculate Goods Available for Sale

Last-In, First-Out (LIFO)Last-In, First-Out (LIFO)

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Illustration 8A-1Periodic Method

The cost of the total quantity sold or issued during the month comes from the most recent purchases.

LO 6 Describe the LIFO cost flow assumption.LO 6 Describe the LIFO cost flow assumption.

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Illustration 8A-2

Perpetual Method

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


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Illustration 8A-3


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


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Illustration 8A-4


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.


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Many companies use

LIFO for tax and external financial reporting purposes

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

Reasons:

LIFO Reserve

1. Pricing decisions2. Record keeping easier3. Profit-sharing or bonus arrangements4. 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.

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

Cost of goods sold 30,000Allowance to reduce inventory to LIFO

30,000

Journal entry to reduce inventory to 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 $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.

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Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.

LIFO Liquidation

Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2011, with cost determined on a specific-goods LIFO approach.

LO 8 Understand the effect of LIFO liquidations.LO 8 Understand the effect of LIFO liquidations.

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

LIFO Liquidation

Illustration 8B-3

Illustration 8B-2

LO 8LO 8

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Changes in a pool are measured in terms of total dollar value, not physical quantity.

Advantage:

Broader range of goods in pool.

Permits replacement of goods that are similar.

Helps protect LIFO layers from erosion.

Dollar-Value LIFO

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

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

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

Dollar-Value LIFO

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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

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

I nventory 70,000$ 88,200$ 95,120$ LI FO Reserve - (3,500) (12,520)

70,000$ 84,700$ 82,600$ J ournal entry

3,500 9,020 (3,500) (9,020)

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

2009 95,120 1.16 82,000 70,000 1.00 70,000 12,000 1.05 12,600 82,600 12,520



70,000$ 84,700$ 82,600$ J ournal entry

Cost of goods sold 3,500 9,020 Allowance to reduce inventory to LI FO (3,500) (9,020)

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

2009 95,120 1.16 82,000 70,000 1.00 70,000 12,000 1.05 12,600 82,600 12,520



70,000$ 84,700$ 82,600$ J ournal entry

Cost of goods sold 3,500 9,020 Allowance to reduce inventory to LI FO (3,500) (9,020)

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Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming.

Specific-goods Pooled LIFO approach

reduces record keeping and clerical costs.

more difficult to erode the layers.

using quantities as measurement basis can lead to untimely LIFO liquidations.

Dollar-value LIFO is used by most companies.

Comparison of LIFO Approaches

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Matching

Tax Benefits/Improved Cash Flow

Future Earnings Hedge

Advantages

Reduced Earnings

Inventory Understated

Physical Flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages

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LIFO is generally preferred:

1. if selling prices are increasing faster than costs and2. if a company has a fairly constant “base stock.”

LIFO is not appropriate:

1. if prices tend to lag behind costs, 2. if specific identification traditionally used, and 3. when unit costs tend to decrease as production

increases.

Basis for Selection of Inventory Method

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Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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