Wiley - Chapter 8: Valuation of Inventories: A Cost-Basis Approach

Chapter 8-1

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

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

ChapteChapter r

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Chapter 8-2

Inventories are:

items held for sale, or

goods to be used in the production of goods to be sold.

Inventory Classification and SystemsInventory Classification and SystemsInventory Classification and SystemsInventory Classification and Systems

Classification

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory:

or

Chapter 8-3

Two systems for maintaining inventory records:


Control

Perpetual system

Periodic system

Chapter 8-4

Features:


Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory.

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

4. Physical count done to verify Inventory balance.The perpetual inventory system provides a

continuous record of Inventory and Cost of Goods Sold.

Chapter 8-5

Features:


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

Chapter 8-6

1. Beginning inventory (100 units at $7 = 700)|

2. Purchase 900 units at $7: |

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3. Sale of 600 units at $14: |

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4. Adjusting entries (ending inventory = 400 units @ $7 = $2,800)|

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Perpetual System Periodic System vs.

Chapter 8-7

Requires the following:

Basic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory Valuation

Valuation of Inventories

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 (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

Chapter 8-8

A company should record purchases when it obtains legal title to the goods.

1. Physical Goods Included in 1. Physical Goods Included in InventoryInventory


Physical Goods

Chapter 8-9



Special Consideration:

Goods in Transit (FOB shipping point, FOB destination)

Consigned goods

Sales with buyback agreement

Sales with high rates of return

Sales on installment

Chapter 8-10

2. Costs Included in Inventory2. Costs Included in Inventory2. Costs Included in Inventory2. Costs Included in Inventory

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.

Chapter 8-11

Examples of Physical goods and Examples of Physical goods and costs included in Inventorycosts included in Inventory

Examples of Physical goods and Examples of Physical goods and costs included in Inventorycosts included in Inventory

See Ex 8-1

Chapter 8-12

Treatment of Purchase DiscountsTreatment of Purchase DiscountsTreatment of Purchase DiscountsTreatment of Purchase Discounts

Similar to treatment of cash discounts for Accounts Receivable

Now you are the buyer with the option of taking the cash discount rather than the seller offering the discount

Chapter 8-13

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Purchase cost $20,000, terms 2/10, net 30:|

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Invoices of $15,000 are paid within discount period:|

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Invoices of $5,000 are paid after discount period:|

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Treatment of Purchase Discounts (Ex Treatment of Purchase Discounts (Ex 8-8)8-8)

Treatment of Purchase Discounts (Ex Treatment of Purchase Discounts (Ex 8-8)8-8)

Gross Method Net Method vs.

Chapter 8-14

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

Cost Flow Assumption Adopted

Physical Movement of Goods

does not need to equal

FIFO

3. Cost Flow Assumptions3. Cost Flow Assumptions3. Cost Flow Assumptions3. Cost Flow Assumptions

LIFO

Average Cost

Specific Identification

Chapter 8-15

Inventory information for Part 686 for the month of June.

June 1 Beg. Balance 300 units @ $10 = $ 3,000

10 Sold 200 units @ $24

11 Purchased 800 units @ $12 = 9,600

15 Sold 500 units @ $25

20 Purchased 500 units @ $13 = 6,500

27 Sold 300 units @ $27

Example–Perpetual and Periodic Method (Ex 8-13 adapted)

3. Cost Flow Assumptions3. Cost Flow Assumptions3. Cost Flow Assumptions3. Cost Flow Assumptions

1. Assuming the Perpetual and Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.

2. See refresher material posted on WebCT

Chapter 8-16

LIFO liquidation problemLIFO liquidation problemLIFO liquidation problemLIFO liquidation problem

Erosion of old LIFO layers

Benefits (when prices rise)

Lower COGS lead to higher earnings reported

Consequences

Future demand may not be met

Can lead to higher tax expense

Disclosure requirements

Material differences in income due to liquidation must be disclosed

Chapter 8-17

LIFO liquidation problemLIFO liquidation problemLIFO liquidation problemLIFO liquidation problem

Solutions to reduce problem

LIFO Inventory Pools

Simplifies record keeping through grouping of inventory layers and reduces need for LIFO liquidation. How?

Diversification effect – reductions in levels of one good offset by increases in another

Dollar Value LIFO

Chapter 8-18

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

Each year inventory is identified as a pool (or layer), hence inflation is accounted for using cost index.

Advantage:

Broader range of goods allowed in pool

replacement of goods that are similar is allowed

Dollar Value LIFODollar Value LIFODollar Value LIFODollar Value LIFO

Chapter 8-19

Dollar value LIFODollar value LIFODollar value LIFODollar value LIFO

Exercise 8-25.

Dollar-Value LIFO

Chapter 8-20

Many companies use

LIFO for tax and external financial reporting purposes

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

Reasons:

Special Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFOSpecial Issues Related to LIFO

LIFO Reserve

1. Pricing decisions2. Record keeping easier3. Profit-sharing or bonus arrangements4. LIFO troublesome for interim periods

Chapter 8-21


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

Example:FIFO value per booksFIFO value per books $160,000$160,000

LIFO value LIFO value 145,000145,000

LIFO ReserveLIFO Reserve $ $ 15,00015,000

Cost of goods sold 15,000

LIFO reserve 15,000

Journal entry to reduce inventory to LIFO:

Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

Chapter 8-22


How to compare firms that use different inventory methods

Convert all LIFO firms’ inventory and CGS to FIFO

See Brown Shoe Company case P.453

A better way (not usually possible) is to use LIFO numbers for income related ratios and FIFO numbers for balance sheet ratios

Chapter 8-23

Effect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory Errors

How can we work out effects of inventory errors?

Compare correct and incorrect examples using inventory equation.

The effect of an error on net income in one year (2006) will normally be counterbalanced in the next (2007), however the income statement will be misstated for both years.

Wiley - Chapter 8: Valuation of Inventories: A Cost-Basis Approach

Documents

internal reporting

special issues

physical goods

costs included

physical count

inventory

purchase discounts

specific identification