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Inventories: Measurement 8 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Recording and Measuring Inventory Types of Inventory Merchandise Inventory Goods acquired for resale Manufacturing Invento...
Manufacturing Inventories Raw Materials Work in Process Finished Goods Cost of Goods Sold Direct Labor Manufacturing Overh...
Inventory Systems Two accounting systems are used to record transactions involving inventory: Perpetual Inventory System T...
Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the ...
Perpetual Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis ...
Periodic Inventory System The periodic inventory system is not designed to track either the quantity or cost of merchandis...
Periodic Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the p...
Periodic Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and ...
Periodic Inventory System We need the following adjusting entry to record cost of good sold. December 31, 2011 Cost of goo...
Comparison of Inventory Systems
What is Included in Inventory? <ul><li>General Rule </li></ul><ul><li>All goods owned by the company on the inventory date...
Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns and Allowances Purchase Discou...
Purchase Returns November 8, 2011 Accounts payable   2,000 Accounts payable   2,000 Purchase returns and allowances   2,00...
Purchase Discounts October 5, 2011 Purchases   20,000  Purchases   19,600 Accounts payable   20,000 Accounts payable   19,...
Inventory Cost Flow Assumptions <ul><li>Specific identification </li></ul><ul><li>Average cost </li></ul><ul><li>First-in,...
Perpetual Average Cost Picture This, LLC, uses a standard frame size for all pictures to hold down product costs. The foll...
Perpetual Average Cost
Perpetual Average Cost $61,750 ÷ (1,200 + 900 + 550) = $23.30 rounded
Perpetual Average Cost [(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded
Perpetual Average Cost Ending inventory = 1,400 units ×  $25.55 = $35,770 Rounding error
Last-In, First-Out Periodic Inventory System
Weighted-Average Periodic System Let’s use the same information to assign costs to ending inventory and cost of goods sold...
Weighted-Average Periodic System
First-In, First-Out (FIFO) <ul><li>The cost of the oldest inventory items are charged to COGS when goods are sold.  </li><...
First-In, First-Out (FIFO) Even though the  periodic  and the  perpetual  approaches differ in the timing of adjustments t...
First-In, First-Out (FIFO) Periodic Inventory System These are the 1,400 most recently acquired units.
First-In, First-Out (FIFO) Periodic Inventory System
First-In, First-Out (FIFO) Periodic Inventory System These are the first 2,650 units acquired.
First-In, First-Out (FIFO) Periodic Inventory System
Last-In, First-Out (LIFO) <ul><li>The cost of the newest inventory items are charged to COGS when goods are sold.  </li></...
Last-In, First-Out (LIFO) <ul><li>Unlike FIFO, using the  LIFO  method may result in COGS and Ending Inventory Cost that  ...
Last-In, First-Out Perpetual Inventory System  These are the oldest units in inventory and are most likely to remain in in...
Last-In, First-Out Perpetual Inventory System  The Cost of Goods Sold for the September 15 sale is  $24,550 .  After this ...
Last-In, First-Out Perpetual Inventory System  The Cost of Goods Sold for the September 15 sale is  $18,600 .  After this ...
Last-In, First-Out Perpetual Inventory System  The Cost of Goods Sold for the September 30 sale is  $26,000 .  After this ...
Last-In, First-Out Periodic Inventory System
Last-In, First-Out Periodic Inventory System
Last-In, First-Out Perpetual Inventory System
When Prices Are Rising . . .  <ul><li>LIFO </li></ul><ul><li>Matches high (newer) costs with current (higher) sales. </li>...
U. S. GAAP vs. IFRS <ul><li>LIFO is permitted and used by U.S. Companies. </li></ul><ul><li>If used for income tax reporti...
Decision Makers’ Perspective Factors Influencing Method Choice How are income taxes affected by inventory method choice? H...
Inventory Management  The higher the ratio, the higher is the markup a company is able to achieve on its products.  Design...
Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s cu...
Methods of Simplifying LIFO The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping invento...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Example The replacement inventory differs from the old inventory on ha...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginnin...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 1b. Deflate the ending inventory value using the cost index. 1c. Compa...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were ...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price informati...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price informati...
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year . . .
Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory...
Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal...
LIFO Liquidation <ul><ul><li>LIFO inventory costs in the balance  </li></ul></ul><ul><ul><li>sheet are “out of date” becau...
End of Chapter 8
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  • Chapter 8: Inventories: Measurement In this chapter we continue our study of assets by investigating the measurement and reporting inventories and the related expense – cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.
  • We will look at inventory for two classes of businesses. Wholesale and retail companies purchase goods that are primarily in finished form. These companies are intermediaries in the process of moving goods from the manufacturer to the end-user. The cost of merchandise inventory includes the purchase price plus any other costs necessary to get the goods in condition and location for sale. In manufacturing, companies actually produce the goods they sell to the wholesaler, retailer or other manufacturers. These companies normally have three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items being worked on, but not yet complete. Work-in-process inventory includes the cost of raw materials used, the cost of labor that can be directly traced to the goods in process, and the allocated portion of other manufacturing costs, called manufacturing overhead. Overhead costs include electricity and other utility costs, depreciation of manufacturing equipment, and many other manufacturing costs that cannot be directly linked to the production of specific goods. Finished goods inventory consists of items that are available for sale.
  • In this diagram, we see the typical inventory cost flow for a manufacturing company. The manufacturing company acquires raw materials, hires direct labor and incurs manufacturing overhead. As raw materials, direct labor and manufacturing overhead are used, they are transferred into work-in-process inventory. When an item in work-in-process inventory has been completed, it is transferred to finished goods inventory. Finally, finished goods are sold to the final customer, and transferred out of finished goods inventory and into cost of goods sold.
  • We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. An important feature of a perpetual system is that it is designed to track inventory quantities from their acquisition to their sale. In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting cycle which is usually at the end of the month or the end of the year. In the perpetual inventory system, cost of goods sold are recorded each time a sale is made to a customer.
  • Lothridge Wholesale Beverage Company (LWBC) uses the perpetual inventory system. It begins the period with $120,000 of merchandise inventory on hand. During the period the company purchases $600,000 of merchandise for resale to its customers. The items were purchased on account. The journal entry required for this transaction is to debit inventory for $600,000 and credit accounts payable for $600,000. Inventory items that are returned to the supplier because they are damaged or defective will require an adjustment to the inventory account. Cash discounts applicable to the inventory items purchased will also require an adjustment to the inventory account.
  • During 2011, Lothridge sold, on account, inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. In the perpetual inventory system any time we have a sale we have to record the cost of goods sold. The first entry is to record the sale. We debit accounts receivable for $820,000 and credit sales for the same amount. The second entry is to record the cost of goods sold for $540,000 and credit inventory for the same amount. Under the perpetual inventory system, cost of goods sold is determined when a sale is made. The balance in the cost of goods sold account appears on the income statement at the end of the period. Inventory is updated after each sale and purchase of merchandise for resale.
  • The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated after the physical inventory count at the end of the accounting period. Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts. The period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account. In the periodic inventory system, we use an equation to determine cost of goods sold. We take a beginning inventory, and add net purchases, to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold. The cost of goods sold equation assumes that all inventory quantities not on hand at the end of the period were sold. This may or may not be the case if some inventory items were either damaged or stolen.
  • Let’s assume that Lothridge Wholesale Beverage Company uses the periodic inventory system, and purchases $600,000 of merchandise for resale to customers. The merchandise was purchased on account. The journal entry to record this transaction is to debit an account called purchases and credit accounts payable. Remember that in a perpetual inventory system, we debited the inventory account rather than the purchases account. Purchase discounts and purchased returns are set up as two separate contra accounts, and are recorded separately from the purchases account.
  • Once again, let’s assume that Lothridge Wholesale Beverage Company sold inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. Under the periodic inventory system, we would debit accounts receivable for $820,000 and credit sales for the same amount; there would be no entry to record cost of goods sold. We would calculate the amount of cost of goods sold at the end of the accounting period.
  • Part I Here is a typical calculation of cost of goods sold. Let’s assume a beginning inventory of $120,000 and net purchases of $600,000. Cost of goods available for sale would be $720,000. Now we subtract ending inventory of $180,000 to arrive at cost of goods sold of $540,000. Part II Under the periodic inventory system, we need to prepare an adjusting entry to determine cost of goods sold. The entry at the end of 2011 will be to debit cost of goods sold for $540,000, debit inventory for $180,000 (our ending inventory), credit inventory for $120,000 (our beginning inventory), and finally credit purchases for $600,000. This entry has determined cost of goods sold for the income statement and has established the value of ending inventory on the balance sheet at $180,000.
  • This chart summarizes all the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.
  • As a general rule, inventory should include all costs necessary to purchase the inventory item and get it to its intended location. All goods owned by the company should be included in inventory. There is a problem with goods in transit (goods that are en route from the supplier to our company). Technically, ownership of the goods depends upon whether they are shipped FOB shipping point or FOB destination. When goods are shipped FOB shipping point, title to the goods transfers when the goods are given to the common carrier and are owned by the buyer. When goods are shipped FOB destination, the goods are owned by the seller until received by the buyer. Our company may have inventory out on consignment with another company. The consigned inventory still is owned by us and should be included in inventory.
  • An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns and allowances or purchase discounts.
  • On November 8, 2011, LWBC returns merchandise that had a cost to LWBC of $2,000, and a cost basis to the seller of 1,600. If LWBC uses the periodic inventory system, the proper journal entry is to debit, or reduce, accounts payable and credit purchase returns for $2,000. If the company uses the perpetual inventory system, the journal entry is to debit accounts payable and credit inventory for $2,000.
  • LWBC purchased $20,000 of merchandise for resale subject to the credit terms, 2/10, net 30. Let’s look at the proper accounting using the gross method of recording purchases on the left side of your screen and the net method on the right side of your screen. Under the gross method we begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000 on October 5 th . On October 14 th , within the discount period, the company makes a $14,000 payment on account. The journal entry is to debit accounts payable for $14,000, credit purchase discounts for $280 ($14,000 times two-percent) and credit cash for $13,720. LWBC pays the remaining $6,000 on November 4 th , and is not eligible for the discount. The journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount. Under the net method, LWBC will debit purchases of the net amount owed to the supplier or $19,600 ($20,000 times 1 minus the discount offered) and credits accounts payable for the same amount. On October 14 th , a the partial payment of $14,000 is made at its net amount of $13,720. On November 4 th , the final payment is made on the purchase for the amount owed to the supplies of $6,000. LWBC missed a discount of $120 ($6,000 times two percent), and records this amount with a debit to interest expense. The effect on the financial statements of the difference between the two methods usually is immaterial. Net income over time will be the same using either method.
  • How do we account for changes in the cost of inventory and cost of goods sold when we experience changes in the price of the items that we purchased during the period? We will look at four methods to handle this problem. The first is the specific identification method, next is the average cost method, then the first-in first-out or FIFO method, and finally, we will look at the last-in, first- out or LIFO method.
  • The average cost method is reasonably popular, and is used by many businesses today. If the company uses the periodic inventory method, we use a weighted average cost. The weighted average cost is determined by taking the total cost of goods available for sale and dividing it by the number of units available for sale. It is more likely that a company will use the perpetual inventory method. Under the perpetual inventory system, we use a moving average unit cost that requires computing a new average cost each time we have a new purchase. This may seem like a daunting task when we do it by hand, but with today’s microcomputers the calculation is quite easy. Let’s look at the application of the average cost method when a company is using the perpetual inventory system. We will determine the average cost of ending inventory and cost of goods sold for Yore Frame, Inc. A physical inventory was taken at September 30, and it was determined that 1,400 frames were in ending inventory.
  • In the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase. To accomplish this, we must know the date of each purchase along with the quantity purchased and the unit cost. In addition, we must know the date of each sale and the number of units sold.
  • On September 15, we sold 1,000 units, and we used our weighted average cost associated with beginning inventory of $23.30 per unit. The cost of the units sold is $23,300 and the balance in inventory is $38,450.
  • On September 21, we purchase 600 units, and we must calculate a new weighted average cost of $24.29 rounded. We calculate this cost by dividing the cost of goods available for sale of $56,650 rounded by the units available for sale, 2,250.
  • On September 29 th we purchased an additional 800 shares and calculated the new average cost at $25.55 rounded. We record the cost of the 950 unit sale at $24,272.50 rounded, leaving us with an ending inventory of $35,774.50 rounded.
  • Here is the September 30 th ending inventory and cost of goods sold calculated under the perpetual average cost approach.
  • Part I Let’s use the same information to assign costs to ending inventory and cost of goods sold assuming the company uses the periodic inventory system and applies it with a weight-average cost method. Of the 4,050 units available for sale, 2,650 were sold and 1,400 remain in ending inventory. Part II The weighted average cost is determined by dividing $100,350 by 4,050 units. The weighted average cost is $24.7778 (rounded).
  • We multiply the 1,400 units in ending inventory by the weighted average cost to determine the cost of ending inventory of $34,688.92 (rounded). Cost of goods sold can be determined in one of two ways. First, we can subtract ending inventory from goods available for sale to get cost of goods sold, or we can multiply the 2,650 units times the weighted average cost per unit to arrive at the total of $65,661.08
  • In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.
  • Under the periodic or perpetual method, the cost of goods sold and ending inventory are the same under the first-in, first-out method. Let’s look at the calculations when using the periodic inventory system in a FIFO environment.
  • Let’s return to the Picture This example. Recall that ending inventory was determined by a physical count to be 1,400 units. Under the first-in, first-out method, we assign the most recent costs to ending inventory.
  • As you can see, the most recent costs per unit come from the purchases of September 21 and September 29, and total $38,600. Cost of goods sold is calculated to be $61,750.
  • Under the first-in, first-out method, the oldest costs are assigned to cost of goods sold.
  • The oldest costs associated with the 2,650 units total $61,750. An easier way to calculate cost of goods sold is to subtract ending inventory from cost of goods available for sale.
  • Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory. The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remained in inventory.
  • When we use last-in, first out, the periodic and perpetual inventory systems yield different ending inventories and different costs of goods sold.
  • Recall that the oldest inventory cost remained in inventory. The units associated with those old costs are likely to remain in inventory when a company uses the LIFO method. It is important that we know when sales were made during the period. Look at the upper right corner of your screen and notice that the first sale of 1,000 units took place on September 15 th . Let’s look at an example of accounting for LIFO inventory in a perpetual inventory system.
  • For the sale on September 15 th , the last goods in the inventory are the first goods sold. We begin by selling the units from the September 15 th purchase (550 units at $25.00 per unit), next we remove the 450 units from the September 3 rd purchase (450 units at $24.00), We now have 1,650 units at various unit prices. We have our 1,200 units from beginning inventory of 1,200 units and 450 units from the purchase of September 15 th , Let’s continue with the example.
  • On September 21 st , the company purchased an additional 600 units at a unit cost of $27.00. The balance in the inventory account is $16,200. On September 22 nd , 700 units were sold. Under the LIFO method, we take the last units purchased on September 21 st (600 units times $27.00 equals $16,200). We need an additional 100 units to complete the sale, so we get those units from purchase on September 3 rd . The cost of goods sold for the September 22 nd sale is $18,600. After the sale there are 1,550 units in inventory at various units costs.
  • For the 950 units sold on September 30 th , 800 units were taken first at $28 per unit for a total cost of $22,400. We still need 150 units to complete the sale and these units come from the purchase on September 3 rd , so 150 units at $24 per unit for a total cost of $3,600. Total cost of goods sold is $26,000, and there are 1,400 units remaining in inventory at the end of September.
  • When using the periodic inventory system in a LIFO system we take a different approach to the determination of cost of goods sold and ending inventory. First, let’s calculate the total cost of purchases during the month of September.
  • When using the periodic inventory system in a LIFO system we take a different approach. We determine the cost of ending inventory by picking the oldest unit in inventory at the end of the period and including them in ending inventory. In our case you can see that there are 1,400 units in ending inventory made up of $1,200 from beginning inventory at $22 per unit plus 200 units from the purchase of September 3 rd at $24 per unit. To the determination of cost of goods sold we subtract ending inventory from cost of goods available for sale. In our example, we obtained the same amount whether using periodic or perpetual inventory system. This is not always the case.
  • At the end of September the inventory is composed of 1,400 units. Total cost of goods sold is equal to $69,150.
  • Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher taxable income, and LIFO results in lower taxable income.
  • LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence. From the perspective of the FASB, LIFO is permitted and used by U.S. Companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. However, IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. companies use LIFO only for domestic inventories.
  • A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how well are costs matched against related revenues; and how are income taxes affected by inventory method choice? Companies usually stay with the method they select, but sometimes companies switch for tax reporting purposes or other economic reasons.
  • Managers closely monitor inventory levels to (1) ensure that the inventories needed to sustain operations are available, and (2) hold the cost of ordering and carrying inventories to the lowest possible level. One useful profitability indicator that involves cost of goods sold is gross profit or gross margin, which highlights the important relationship between net sales revenue and cost of goods sold. The gross profit ratio is calculated by dividing gross profit by net sales. The higher the ratio, the higher is the markup a company is able to achieve on its products. Inventory turnover ratio, which is designed to evaluate a company’s effectiveness in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell or turn over its inventory, the lower its investment in inventory must be for a given level of sales. Anytime we have an income statement account in the numerator of an equation and a balance sheet account in the denominator, we need to calculated an average for the balance sheet account. In this case, average inventory is determined by adding together beginning and ending inventory and dividing the total by 2.
  • Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
  • The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.
  • DVL extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO record-keeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. When using DVL we think in terms of inventory layers rather than inventory pools.
  • The goal of DVL is to determine if an increase in ending inventory over beginning inventory is due to a price increase of a real increase in inventory. The first step in the process is to computer the cost index. This can be done in a number of ways. One method is shown on your screen, others include the use of industry specific general price indexes.
  • The second step in the process is to deflate the ending inventory value using the cost index. This is sometimes difficult for students to understand. We are attempting to state beginning and ending inventory is common dollar amounts. Next, we compare the ending inventory, at base year cost, to the beginning inventory to determine the amount of the inventory layer created in the current period.
  • Finally, we convert the year’s layer into end of period dollars and add the adjusted layer to the beginning inventory. We always keep the beginning inventory and layers created in subsequent years separately. Let’s look at an example.
  • Masterwear reports the following inventory and general price information. The company uses dollar value LIFO for determining inventory values. Let’s see how the process works for the first year. Ending inventory at December 31, 2011, is stated at base-year prices when the price index is 100 percent. At the end of 2012, the ending inventory in nominal dollars is $168,000, but there was been five-percent inflation during 2012. While it looks like the inventory increased by $18,000, this simple computation ignores inflation. Let’s begin the DVL process.
  • First, we deflate the 2012 ending inventory by the rate of inflation. We determine that the ending inventory in base-year prices is $160,000.
  • The 2011 ending inventory and the 2012 ending inventory are stated in common, or base-year dollars. We see that there has been a $10,000 LIFO layer added in 2012, stated at base year prices.
  • We now re-inflate the $10,000 layer to 2012 prices by multiplying the layer by the price index in 2012, and arrive at an adjusted layer of $10,500. The inventory at the end of 2012 will be reported on the balance sheet at $160,500.
  • Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures, allowing a company to report in a note the effect of using another method on inventory valuation rather than LIFO.
  • LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older lower prices creating increase profits. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as “LIFO liquidation profit.” A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements.
  • End of Chapter 8.
  • Transcript of "Chapter 8 Lecture"

    1. 1. Inventories: Measurement 8 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
    2. 2. Recording and Measuring Inventory Types of Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory <ul><li>Raw Materials </li></ul><ul><li>Work-in-Process </li></ul><ul><li>Finished Goods </li></ul>
    3. 3. Manufacturing Inventories Raw Materials Work in Process Finished Goods Cost of Goods Sold Direct Labor Manufacturing Overhead $XX $XX $XX Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work in process transferred to finished goods Finished goods sold                
    4. 4. Inventory Systems Two accounting systems are used to record transactions involving inventory: Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle.
    5. 5. Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method. 2011 Inventory 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account
    6. 6. Perpetual Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers. 2011 Inventory 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account. 2011 Accounts receivable 820,000 Sales revenue 820,000 Record sales on account. Cost of goods sold 540,000 Inventory 540,000 Record cost of goods sold.
    7. 7. Periodic Inventory System The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period.
    8. 8. Periodic Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2011 Purchases 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account
    9. 9. Periodic Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000. 2011 Accounts receivable 820,000 Sales revenue 820,000 Record sales on account. No entry is made to record Cost of Goods Sold. A physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of 2011.
    10. 10. Periodic Inventory System We need the following adjusting entry to record cost of good sold. December 31, 2011 Cost of goods sold 540,000 Inventory (ending) 180,000 Inventory (beginning) 120,000 Purchases 600,000 To adjust inventory, close purchases, and record cost of goods sold.
    11. 11. Comparison of Inventory Systems
    12. 12. What is Included in Inventory? <ul><li>General Rule </li></ul><ul><li>All goods owned by the company on the inventory date, regardless of their location. </li></ul>Goods in Transit Goods on Consignment Depends on FOB shipping terms.
    13. 13. Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns and Allowances Purchase Discounts
    14. 14. Purchase Returns November 8, 2011 Accounts payable 2,000 Accounts payable 2,000 Purchase returns and allowances 2,000 Inventory 2,000 On November 8, 2011, LWBC returns merchandise that had a cost to LWBC of $2,000, and a cost basis to the seller of 1,600. Periodic Inventory Method Perpetual Inventory Method Returns of inventory are credited to the Purchase Returns and Allowances account when using the periodic inventory method. The returns are credited to Inventory using the perpetual inventory method.
    15. 15. Purchase Discounts October 5, 2011 Purchases 20,000 Purchases 19,600 Accounts payable 20,000 Accounts payable 19,600 October 14, 2011 Accounts payable 14,000 Accounts payable 13,720 Purchase discounts 280 Cash 13,720 Cash 13,720 November 4, 2011 Accounts payable 6,000 Accounts payable 5,880 Cash 6,000 Interest expense 120 Cash 6,000 Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280 Partial payment not made within the discount period Gross Method Net Method $20,000 x 0.02 $ 400 -120 $ 280
    16. 16. Inventory Cost Flow Assumptions <ul><li>Specific identification </li></ul><ul><li>Average cost </li></ul><ul><li>First-in, first-out (FIFO) </li></ul><ul><li>Last-in, first-out (LIFO) </li></ul>
    17. 17. Perpetual Average Cost Picture This, LLC, uses a standard frame size for all pictures to hold down product costs. The following schedule shows the frame inventory for Picture This, LLC, for September. The physical inventory count at September 30 shows 1,400 frames in ending inventory. Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold
    18. 18. Perpetual Average Cost
    19. 19. Perpetual Average Cost $61,750 ÷ (1,200 + 900 + 550) = $23.30 rounded
    20. 20. Perpetual Average Cost [(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded
    21. 21. Perpetual Average Cost Ending inventory = 1,400 units × $25.55 = $35,770 Rounding error
    22. 22. Last-In, First-Out Periodic Inventory System
    23. 23. Weighted-Average Periodic System Let’s use the same information to assign costs to ending inventory and cost of goods sold using the periodic system. $100,350 ÷ 4,050 = $24.7778 weighted-average per unit cost Available for Sale (4,050 units) Ending Inventory (1,400 units) Goods Sold (2,650)
    24. 24. Weighted-Average Periodic System
    25. 25. First-In, First-Out (FIFO) <ul><li>The cost of the oldest inventory items are charged to COGS when goods are sold. </li></ul><ul><li>The cost of the newest inventory items remain in ending inventory. </li></ul>The FIFO method assumes that items are sold in the chronological order of their acquisition.
    26. 26. First-In, First-Out (FIFO) Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . . . . . COGS and Ending Inventory Cost are the same under both approaches.
    27. 27. First-In, First-Out (FIFO) Periodic Inventory System These are the 1,400 most recently acquired units.
    28. 28. First-In, First-Out (FIFO) Periodic Inventory System
    29. 29. First-In, First-Out (FIFO) Periodic Inventory System These are the first 2,650 units acquired.
    30. 30. First-In, First-Out (FIFO) Periodic Inventory System
    31. 31. Last-In, First-Out (LIFO) <ul><li>The cost of the newest inventory items are charged to COGS when goods are sold. </li></ul><ul><li>The cost of the oldest inventory items remain in inventory. </li></ul>The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.
    32. 32. Last-In, First-Out (LIFO) <ul><li>Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. </li></ul>
    33. 33. Last-In, First-Out Perpetual Inventory System These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.
    34. 34. Last-In, First-Out Perpetual Inventory System The Cost of Goods Sold for the September 15 sale is $24,550 . After this sale, there are 1,650 units in inventory at various costs per unit.
    35. 35. Last-In, First-Out Perpetual Inventory System The Cost of Goods Sold for the September 15 sale is $18,600 . After this sale, there are 1,550 units in inventory at various per unit cost.
    36. 36. Last-In, First-Out Perpetual Inventory System The Cost of Goods Sold for the September 30 sale is $26,000 . After this sale, there are 1,400 units in inventory (1,200 × $22.00) per unit and (200 × $24.00) for a total cost of ending inventory of $31,200 .
    37. 37. Last-In, First-Out Periodic Inventory System
    38. 38. Last-In, First-Out Periodic Inventory System
    39. 39. Last-In, First-Out Perpetual Inventory System
    40. 40. When Prices Are Rising . . . <ul><li>LIFO </li></ul><ul><li>Matches high (newer) costs with current (higher) sales. </li></ul><ul><li>Inventory is valued based on low (older) cost basis. </li></ul><ul><li>Results in lower taxable income . </li></ul><ul><li>FIFO </li></ul><ul><li>Matches low (older) costs with current (higher) sales. </li></ul><ul><li>Inventory is valued at approximate replacement cost. </li></ul><ul><li>Results in higher taxable income. </li></ul>
    41. 41. U. S. GAAP vs. IFRS <ul><li>LIFO is permitted and used by U.S. Companies. </li></ul><ul><li>If used for income tax reporting, the company must use LIFO for financial reporting. </li></ul><ul><li>Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. </li></ul>LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence. <ul><li>IAS No. 2, Inventories, does not permit the use of LIFO. </li></ul><ul><li>Because of this restriction, many U.S. companies use LIFO only for domestic inventories. </li></ul>
    42. 42. Decision Makers’ Perspective Factors Influencing Method Choice How are income taxes affected by inventory method choice? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues?
    43. 43. Inventory Management The higher the ratio, the higher is the markup a company is able to achieve on its products. Designed to evaluate a company’s effectiveness in managing its investment in inventory Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average inventory (Beginning inventory + Ending inventory 2
    44. 44. Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
    45. 45. Methods of Simplifying LIFO The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately. LIFO Inventory Pools
    46. 46. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Example The replacement inventory differs from the old inventory on hand. We just create a new layer. DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. DVL minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory.
    47. 47. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory. 1a. Compute a Cost Index for the year.
    48. 48. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory (at base year cost) to beginning inventory.
    49. 49. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Sum all the layers to arrive at Ending Inventory at DVL cost. Convert each layer’s base year cost to layer year cost by multiplying times the cost index.
    50. 50. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information. Let’s look at the solution to this example.
    51. 51. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information.
    52. 52. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year . . .
    53. 53. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory from last period.
    54. 54. Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this:
    55. 55. LIFO Liquidation <ul><ul><li>LIFO inventory costs in the balance </li></ul></ul><ul><ul><li>sheet are “out of date” because they reflect old purchase transactions. </li></ul></ul>When prices rise . . . If inventory declines, these “out of date” costs may be charged to current earnings. This LIFO liquidation results in “paper profits.”
    56. 56. End of Chapter 8
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