Chapter 10--Learning Objectives 1. Explain the importance of inventory for asset valuation and income measurement
Jan 11, 2016
Chapter 10--Learning Objectives
1. Explain the importance of inventory for asset valuation and income measurement
Inventories are a significant asset for many businesses
Inventories affect income
Sales XXX
Beginning inventory XXX
Purchases XXX
Goods available for sale XXX
Ending inventory XXX
Cost of goods sold XXX
Gross profit XXX
Operating expenses XXX
Net income XXX
Chapter 10--Learning Objectives
2. Understand the nature of inventory and what is included in it
Types of inventory
1. Assets held for sale (or resale) in the ordinary course of business
2. Assets used or consumed in the production of goods to be sold in the ordinary course of business
A retail store(Sears, Wal-Mart, Safeway)
Has inventory for resale to customers
A manufacturer(Ford, IBM, Exxon)
Has inventories used or consumed in the production of goods for sale
A manufacturer’s inventorieswill usually include
Raw materials inventory
Items used in producing the productWork in process inventory
Products started but not yet completedFinished goods inventory
Products completed but not yet sold
What about this F.O.B. stuff ?
“F.O.B.” means “free on board” and refers to the time and place at which the goods were turned over to the transportation carrier
If you are in Los Angelesand your supplier is in New York City
You
Them
If you are in Los Angelesand your supplier is in New York City
Somebody has to pay for moving the goods across the country
You
Them
If you are in Los Angelesand your supplier is in New York City
And somebody owns the goods while they are moving across the country
You
Them
The F.O.B. designation determines who that “somebody” is
You
Them
If the goods are shipped F.O.B. New York(or F.O.B. origin)
You will pay the transportation cost
and you will own the merchandise
once it is turned over to the carrier in NYC
You
Them
If the goods are shipped F.O.B. Los Angeles(or F.O.B. destination)
The supplier will pay the transportation cost
and they will own the merchandise
until in reaches you in Los Angeles
You
Them
The owner of the goods
Is usually the entity that should include
those goods in inventory
This applies to goods in transit
and to consignment situations
But there are exceptions for some
special sales agreements
An interesting situation arisesin purchase commitmentsThese are noncancellable, long-term contracts to
purchase goods at a set price
You might enter into such an agreement to buy a product if you thought its price was about to go up
If the price does go up, everything is cool and you will make lots of money
But if the price goes down, you have an economic problem and an accounting problem
The Oliver Peck Oil Company(O. Peck for short)
Thinking that the price of gas is about to increase
Peck signs a contract during 19X1 to purchase 100,000 gallons of gas during 19X2 at $1.00 per gallon
On December 31, 19X1,gas is selling for $.94
Since Peck has agreed to pay $1.00 per gallon, accounting conservatism mandates:
December 31, 19X1
Est. Loss on Purch. Commit. 6,000
Est. Liab. on Contract 6,000
This reduces Peck’s income and increases his liabilities
Assume that on the April 1, 19X2, delivery date, gas is selling for $.90
Since Peck has agreed to pay $1.00 per gallon, there is an additional loss:
April 1, 19X2
Purchases 90,000
Est. Liab. on Contract 6,000
Loss on Purchase Contract 4,000
Cash 100,000
Now assume that on the April 1, 19X2, delivery date, gas is selling for $.98
Peck must still pay $1.00, but the situation has improved since December 31:
April 1, 19X2
Purchases 98,000
Est. Liab. on Contract 6,000
Recovery on Contract 4,000
Cash 100,000
Now assume that on the April 1, 19X2, delivery date, gas is selling for $1.05
This is what Peck was planning on, but the purchase is recorded at $1.00 and lower cost of goods sold will give Peck higher profits when the gas is sold
April 1, 19X2
Purchases 100,000
Est. Liab. on Contract 6,000
Recovery on Contract 6,000
Cash 100,000
Chapter 10--Learning Objectives
3. Differentiate between perpetual and periodic inventory measurement systems
In a periodic inventory system
Purchases of goods for resale are recorded in a “Purchases” account:
Purchases XXX
Cash or Accts. Payable XXX
In a periodic inventory system
Recording sales of merchandise is simple:
Cash or Accts. Receivable XXX
Sales XXX
In a periodic inventory system
An adjusting entry closes out the beginning inventory and purchases accounts and records the cost of goods sold and ending inventory
Inventory (ending) XXX
Cost of Goods Sold XXX
Inventory (beginning) XXX
Purchases XXX
In a perpetual inventory system
Purchases of merchandise for resale are recorded in the “Inventory” account
Inventory XXX
Cash or Accts. Payable XXX
In a perpetual inventory system
Recording sales is more complicated:
Cash or Accts. Receivable XXX
Sales XXX
Cost of Goods Sold XXX
Inventory XXX
The first entry records the sale at the selling price, just like in a periodic system
In a perpetual inventory system
Recording sales is more complicated:
Cash or Accts. Receivable XXX
Sales XXX
Cost of Goods Sold XXX
Inventory XXX
The second entry removes the cost of the merchandise sold from the “Inventory” account and transfers it to “Cost of Goods Sold”
In a perpetual inventory system
No end-of-period adjustment is required if the actual inventory cost matches the balance in the “Inventory” account:
XXX
Inventory
In a perpetual inventory system
If items are missing, an adjustment is made to change the “Inventory” balance to reflect reality:
Inventory Shrinkage XXX
Inventory XXX
“Inventory Shrinkage” is treated as an expense account, but is often included in “Cost of Goods Sold” in practice
Inventory shrinkagecan be a result of
Theft
Spoilage
Accidental breakage
Mistakenly thrown away
and other causes
Occasionally, a business will have more inventory than the records indicate
P e t e ’ sP e t e ’ sR a b b i tR a b b i t
F a r mF a r m
Occasionally, a business will have more inventory than the records indicate
P e t e ’ sP e t e ’ sR a b b i tR a b b i t
F a r mF a r m
Chapter 10--Learning Objectives
4. Record and report inventories for different valuation systems
Inventory cost flow assumptions
Picture five items
identical except for cost
acquired in the order indicated
1 - 2 - 3 - 4 - 5
1$11
2$12
3$13
4$14
5$15
Inventory cost flow assumptions
The total cost of the five items is $65($11 + 12 + 13 + 14 + 15 = $65)
Assume that three items are sold for $25 each (total sales revenue = $75)
and that two are on hand at the end of the period
1$11
2$12
3$13
4$14
5$15
Specific identification
The actual items sold are recorded
These might be items 1, 3 and 5
Leaving items 2 and 4 in inventory
The cost of items 2 and 4 is $26
2$12
4$14
Specific identification
Sales revenue $75
Goods available for sale $65
Less: Ending inventory 26
Cost of goods sold $39
Gross profit $36
2$12
4$14
First-in, first-out ( FIFO )
The first three items would be the items sold--items 1, 2 and 3
Leaving items 4 and 5
The cost of items 4 and 5 is $29
4$14
5$15
First-in, first-out ( FIFO )
Sales revenue $75
Goods available for sale $65
Less: Ending inventory 29
Cost of goods sold $36
Gross profit $39
4$14
5$15
Last-in, first-out ( LIFO )
The last three items (3, 4 and 5) would be the items sold
Leaving items 1 and 2
The cost of items 1 and 2 is $23
1$11
2$12
Last-in, first-out ( LIFO )
Sales revenue $75
Goods available for sale $65
Less: Ending inventory 23
Cost of goods sold $42
Gross profit $33
1$11
2$12
Average cost
The total cost of the five items is $65
So the average cost per item is $13
It doesn’t matter which items are sold and which remain
The cost of the ending inventory is $26
? ?
Average cost
Sales revenue $75
Goods available for sale $65
Less: Ending inventory 26
Cost of goods sold $39
Gross profit $36
? ?
Note that in this period of rising pricesthe gross profits were:
FIFO $ 39
Average 36
LIFO 33LIFO results in a higher cost of goods sold and a
lower gross profit because the higher cost of the last items purchased is being matched against revenues
LIFO will also result in a lower income tax in a period of rising prices
Lower of cost or market(LCM)
INVENTORYIS
PURCHASEDAT
COST
THERE ISNO PROBLEMIF THE VALUEINCREASES
Lower of cost or market(LCM)
INVENTORYIS
PURCHASEDAT
COST
THERE AREPROBLEMS
IF THEVALUE
GOES DOWN
A decline in inventory value...
Creates an accounting problem
Means that you will lose your shirt
Our job is to solve the
accounting problem
Any adjustment of inventory value
Must be below the ceiling
And above the floor
The Ceiling isNet Realizable Value (NRV)
What we expect to get less costs ofcompletion and disposal
The Floor isNRV less normal profit margin
Net realizable value lesswhat we would expect tomake on a similar item
We must remain betweenthe ceiling and the floor
In the real world
We know what cost was
We can usually get a replacement cost figure
We have to estimate net realizable value
You never know for sure until it’s actually sold
Lower of cost or market
Can be applied three ways:
1. To each inventory item separately
2. To each category of items in the
inventory
3. To the inventory as a whole
Probably the best way to apply lower of cost or marketIs the allowance method. The initial application entry would be:
Holding Loss XXX
Allowance to reduce
inventory to market XXX
The “Allowance” account appears on the balance sheet as a contra account to inventory
Chapter 10--Learning Objectives
5. Estimate inventories using various methods
The gross profit method
Good news
Simple
Quick
Cheap
Bad news
Depends on old data relationships
May not be any good in a changing situation
Recall that...
Amount
Sales $100
Less: Cost of goods sold 70
Equals: Gross profit $ 30
These numbers can be expressed as percentages of sales
In this case, the percentages are:
Amount Pct.
Sales $100 100
Less: Cost of goods sold 70 70
Equals: Gross profit $ 30 30
Knowing the cost of goods sold percentage and some other facts allows us to estimate inventory
Assume that the following are known:
Beginning inventory $ 40,000
Purchases 480,000
Sales revenue 700,000
Cost of goods sold percentage 70%
These items would be available from the accounting records and prior year statements
Using the known data
Beginning inventory $ 40,000
Plus: Purchases 480,000
Equals: Goods avail. for sale $520,000
Sales x CGS %
($700,000 x .70) = 490,000
Estimated ending inventory $ 30,000
The retail method
Overcomes the problems of the gross profit method, but is more trouble
Some more trouble in the classroom
Considerably more trouble in the real world
Requires keeping two sets of sales records
One at cost (which would be done anyway)
Another at retail
Based on the relationship between goods available for sale at cost and at retail
Retail method example
Cost Retail
Beginning inventory $ 6,000 $10,000
Purchases 48,000 80,000
Goods available for sale $54,000 $90,000
Cost / Retail ratio for
Goods available for sale
( $54,000 / $90,000 ) = .60
Retail method example
Cost Retail
Goods available for sale $54,000 $90,000
Less: Sales 70,000
Ending inventory at retail $20,000
Cost / retail ratio .60
Ending inventory at cost $12,000
Retail method terminology
Markup--Amount by which original sales price exceeds cost--also called normal profit
Additional markup--Amount added to original sales price
Markup cancellation--Cancellation of all or part of the additional markup
Net markup--Additional markup less the markup cancellation
More retail method terminology
Markdown--Amount subtracted from the original sales price
Markdown cancellation--Cancellation of all or part of the markdown. Markdown cancellation cannot exceed the amount of the markdown
Net markdown--The difference between the total markdowns and the markdown cancellations
As previously demonstrated, the retail method approximates average cost
With modifications, it can be used to approximate:
Average cost on a lower of cost or market (LCM ) basis (very widely used and known as the “conventional method”
FIFO (with or without LCM )
LIFO
Summary of modifications
To approximate lower of cost or market ( LCM ) exclude net markdowns from the cost / retail ratio calculation
To approximate FIFO and LIFO, exclude beginning inventory from the cost / retail ratio calculation
Comprehensive retail methodassumptions (Sales = $125,000)
Cost Retail
Beginning inventory $ 5,000 $ 8,000
Purchases 85,000 160,000
Purchase discounts 4,000
Purchase returns 1,000 2,000
Freight-in 5,000
Net markups 14,000
Net markdowns 15,000
Ending inventory at retail $ 40,000
For FIFO, cost retail ratio is:
Cost RetailPurchases 85,000 160,000Purchase discounts - 4,000Purchase returns - 1,000 - 2,000Freight-in + 5,000Net markups + 14,000Net markdowns - 15,000Ratio basis 85,000 157,000
Ratio = .541EI Retail = $40,000, Est. EI = $21,656
For FIFO LCM, cost retail ratio is:
Cost Retail
Purchases 85,000 160,000
Purchase discounts - 4,000
Purchase returns - 1,000 - 2,000
Freight-in + 5,000
Net markups + 14,000
Ratio basis 85,000 172,000
Ratio = .494
EI Retail = $40,000, Est. EI = $19,767
For average cost, cost retail ratio is:
Cost RetailBeginning inventory 5,000 8,000Purchases + 85,000+160,000Purchase discounts - 4,000Purchase returns - 1,000 - 2,000Freight-in + 5,000Net markups + 14,000Net markdowns - 15,000Ratio basis 90,000 165,000
Ratio = .545EI Retail = $40,000, Est. EI = $21,818
For average LCM, cost retail ratio is:
Cost Retail
Beginning inventory 5,000 8,000
Purchases + 85,000+160,000
Purchase discounts - 4,000
Purchase returns - 1,000 - 2,000
Freight-in + 5,000
Net markups + 14,000
Ratio basis 90,000 180,000
Ratio = .500
EI Retail = $40,000, Est. EI = $20,000
LIFO advantages and disadvantages
Advantages
Matches current costs with revenues
Results in lower income taxes in periods of rising prices
Disadvantages
Distorts asset values on balance sheet
Becomes cumbersome to deal with
Can distort income if early, low-cost layers are liquidated
Lifo pools
A way of avoiding LIFO layer liquidation
Similar items are put together in groups or pools
Pooled items are treated as if purchased at same time
Less likely to liquidate layers in practice
Dollar value LIFO
A way of approximating LIFO
Think in terms of layers
In LIFO, if inventory quantity were constant, beginning and ending inventory would be exactly the same
Additional inventory adds a layer
Decreases reduce layers in LIFO order
Dollar value LIFO examplewith no price-level change
2000 ending inventory $20,000
2001 ending inventory 23,100
2001 inventory consists of:
2000 base layer $20,000
plus additional layer of 3,100
Total $23,100
Dollar value LIFO examplewith no price-level change
2000 ending inventory $20,0002001 ending inventory 23,1002002 ending inventory 27,250
2002 inventory consists of:2000 base layer $20,000plus 2001 layer of 3,100plus 2002 layer of 4,150
Total $27,250
Dollar value LIFOWhen price levels change
1. Convert current inventory value to base dollars
2. Analyze change in inventory in terms of base dollars
3. If inventory increases, add a layer, use current index
4. If inventory decreases, reduce layers in LIFO order
Dollar value LIFO examplewith price-level changes
Price
Amount index
2000 ending inventory $20,000 1.00
2001 ending inventory 23,100 1.05
2001 converted to base $
( 23,100 / 1.05 ) = $22,000
Change from 2000 (increase) 2,000
Dollar value LIFO examplewith price-level changes
Base Current
Layer Index dollars dollars
Base 1.00 $20,000 $20,000
2001 addl. layer 1.05 2,000 2,100
Totals $22,000 $22,100
The 2001 ending inventory will be reported as $22,100
Dollar value LIFO examplewith price-level changes
PriceAmount index
2000 ending inventory $20,000 1.002001 ending inventory 23,100 1.052002 ending inventory 27,250 1.09
2001 conv. to base $22,0002002 conv. to base $25,0002002 increase in base $ $ 3,000
Dollar value LIFO examplewith price-level changes
Base CurrentLayer Index dollars dollarsBase 1.00 $20,000 $20,0002001 addl. layer 1.05 2,000 2,1002002 addl. layer 1.09 3,000 3,270
Totals $25,000 $25,370
The 2002 ending inventory will be reported as $25,370
Retail dollar value LIFO
Combines the retail method and dollar value LIFO
Calculate cost / retail ratio as was done for FIFO
Convert retail ending inventory to base dollars
Follow dollar value LIFO layer procedures
1999 retail dollar value LIFO ratio(data from Exhibit 10-15)
Cost Retail
Purchases 80,000 150,000
Purchase returns - 2,200 - 4,000
Freight-in + 2,000
Net markups + 23,000
Net markdowns - 4,760
Ratio basis 79,800 164,240
Ratio = .486
1999 ending inventory at retail
Retail
Beginning inventory 25,000
Purchases 150,000
Purchase returns - 4,000
Net markups + 23,000
Net markdowns - 4,760
Sales -160,000
Net sales returns + 1,000
Ending inventory at retail 30,240
1999 retail dollar value LIFO layers
Price
Amount index
1998 ending inventory $25,000 1.00
1999 ending inventory 30,240 1.08
1999 converted to base $
( 30,240 / 1.08 ) = $28,000
Change from 1998 (increase) 3,000
Retail dollar value LIFO-1999
Layer Base $ Index C/R DVL
Base 25,000 1.00 .480 12,000
1999 3,000 1.08 .486 1,575
Totals 28,000 13,575
2000 retail dollar value LIFO ratio
Cost Retail
Purchases 95,000 180,000
Purchase returns -0- -0-
Freight-in + 4,000
Net markups + 25,000
Net markdowns - 5,000
Ratio basis 99,000 200,000
Ratio = .495
2000 ending inventory at retail
Retail
Beginning inventory 30,240
Purchases 180,000
Purchase returns -0-
Net markups + 25,000
Net markdowns - 5,000
Sales -191,000
Net sales + 1,010
Ending inventory at retail 40,250
2000 retail dollar value LIFO layers
PriceAmount index
1995 ending inventory $25,000 1.001996 ending inventory 30,240 1.082000 ending inventory 40,250 1.15
1996 conv. to base 28,0002000 conv. to base 35,0002000 increase in base $ 7,000
Retail dollar value LIFO-2000
Layer Base $ Index C/R DVL
Base 25,000 1.00 .480 12,000
1996 3,000 1.08 .486 1,575
2000 7,000 1.15 .495 3,985
Totals 35,000 17,560
2001 retail dollar value LIFO ratio
Cost Retail
Purchases 110,000 198,000
Purchase returns - 1,600 - 3,000
Freight-in + 5,000
Net markups + 35,000
Net markdowns - 6,000
Ratio basis 113,400 224,000
Ratio = .506
2001 ending inventory at retail
Retail
Beginning inventory 40,250
Purchases 198,000
Purchase returns - 3,000
Net markups + 35,000
Net markdowns - 6,000
Sales -235,000
Sales returns + 7,350
Ending inventory at retail 36,600
2001 retail dollar value LIFO layers
Amount index1995 ending inventory $25,000 1.001996 ending inventory 30,240 1.082000 ending inventory 40,250 1.152001 ending inventory 36,600 1.22
2000 conv. to base 35,0002001 conv. to base 30,0002001 decrease in base $ 5,000
Retail dollar value LIFO-2001
Layer Base $ Index C/R DVL
Base 25,000 1.00 .480 12,000
1996 3,000 1.08 .486 1,575
2000 2,000 1.15 .495 1,138
Totals 30,000 14,713
Note reduction of 2000 layer from $7,000 to $2,000
Chapter 10--Learning Objectives
6. Analyze the impact of inventory valuation on liquidity and profitability analysis
Inventory turnover
Cost of goods sold
Average inventory
Average inventory usually calculated
( Beginning inv. + Ending inv. ) / 2
Days sales in inventory
365 days
Inventory turnover