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  • 08 inventoriesmeasurement

    1. 1. Intermediate Financial Accounting IInventories: Measurement
    2. 2. Objectives of this Chapter1. Discuss the importance of inventory valuation.2. Study perpetual and periodic inventory systems and the ending period adjustments for inventory.3. Study and compare the inventory cost flow assumptions.4. Explain the effect of LIFO liquidations. Inventories: Measurement 2
    3. 3. Objectives of this Chapter (contd.)1. Identify the items that should be included in the inventory count.2. Discuss the lower of cost or market (LCM) rule.3. Study the accounting treatment of changing to LIFO cost flow assumption and the use of LIFO reserve account.4. LIFO Inventory Pools5. Dollar-value LIFO technique. Inventories: Measurement 3
    4. 4. 1. Inventories: the Importance of Inventory Valuations How would the valuation and cost flow assumptions of inventory affect the income measurement? x Valuation Methods: Historical Cost, Current Exist Value, Current Entry Value, Present Value, LCM. x Cost Flow Assumptions: LIFO, FIFO, Average, Specific Identification. x CGS = Beginning Inventory + Net Purchase - Ending Inventory Inventories: Measurement 4
    5. 5. Inventories:the Importance of Inventory Valuation (contd.)s Different valuation methods and different cost flow assumptions will result in different cost of ending inventories and therefore different cost of goods sold. Inventories: Measurement 5
    6. 6. The Impact of Valuation of EndingInventory on The CGS & IncomeYear 1Income CGS = Beg. Inv. + Net Pur. - End. Inv.under over under aover under over bYear 2over under underunder over overa. either understating the units or the valueb. either overstating the units or the value Inventories: Measurement 6
    7. 7. Impact on Omitting Goods fromPurchasesCGS = Beg. Inventory + N.P. - End. Inventory B/S I/SEnding Inv. understated Purchase understatedR/E no effect CGS no effectA/P under N/I no effectWorking Capital no effect Inventory (End.) understatedCurrent Ratio overstatingaa. When CA > CL Inventories: Measurement 7
    8. 8. Defining Inventory1. Assets held for resale purpose in a normal course of business2. Assets used to produce products for resale purpose x Merchandising Firms: Inventories x Manufacturing Firms: Raw materials Work-in-process Finished goods Inventories: Measurement 8
    9. 9. Presentation of Inventory for Merchandising andManufacturing Companies (Illustration 8-1, KWW, 14th e) Inventories: Measurement 9
    10. 10. Inventory Cost Flow (Illustration 8-3, KWW, 14 the) Inventories: Measurement 10
    11. 11. How to Determine Inventory ValuePresented on the Balance Sheet?s Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories.s Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory account. Inventories: Measurement 11
    12. 12. 2. Inventory Systems and Ending Period Adjustmentss Types of Inventory Systems x A. Perpetual Inventory System x B. Periodic Inventory System Inventories: Measurement 12
    13. 13. Comparing Perpetual and PeriodicSystems (Source: KWW, 14th e, p438)¢ Assuming that Fesmire Company had the following transactions during the current year:¢ Inventory Units Unit Cost Total Beginning Inv. 100 $6 $600 Purchases 900 $6 $5,400 Sales 600 $12 $7,200 Ending 400 $6 $2,400 Inventory Inventories: Measurement 13
    14. 14. Comparative Entries- Perpetual vs. Periodic(Illustration 8-4, KWW, 14th e) Inventories: Measurement 14
    15. 15. Perpetual Systems – Cost of Goods Sold andthe Ending Inventory s Since the inventory and the cost of goods sold (CGS) accounts are updated with all purchases and sales transactions, the balances of these two accounts are known at all time. s The CGS is determined by selecting a cost flow assumption. Inventories: Measurement 15
    16. 16. Perpetual Systems – Cost of Goods Soldand the Ending Inventory (contd.)s Physical inventory count is still needed at the end of a period to determine whether inventory loss occurred.s A write down is required in the case of inventory loss. Inventories: Measurement 16
    17. 17. Periodic Inventory System – the EndingInventory and the Cost of Goods Sold For the periodic system, the inventory balance is only determined at the end of a period after an inventory count and applying a cost flow assumption. The cost of goods sold (CGS)is derived as: CGS = Beg. Inv. + Net purchases – cost of ending inventory Inventories: Measurement 17
    18. 18. Inventory Cost Flow Assumptions Fist-In, First-Out (FIFO) Last-In, First-Out (LIFO) Weighted-Average Cost (W-A) Specific Identification Inventories: Measurement 18
    19. 19. Perpetual Inventory System - An Example Balance Date Purchase Sell FIFO W-A LIFO3/1 (Beg. Bal.) 100 $5 100 $5 100 $5 100 $5 100 $5 3/5 150 $6 250 $5.6 150 $6 150 $6 a 3/7 200 50 $6 50 $5 50 $5.6 50 $6 50 $5 3/14 100 $7 150 $6.53 100 $7 100 $7 20 $6 50 $5 3/28 30b 120 $6.53 100 $7 70 $7 a. Sales price is $10 per unit. b. Sales price is $11 per unit. c.LIFO is not permiitted under IFRS Inventories: Measurement 19
    20. 20. Example (contd.) - Journal Entries (Perpetual vs. Periodic) Perpetual (FIFO) Periodic 3/5 Inventory 900 3/5 Purchases 900 Cash 900 Cash 900 3/7 Cash 2,000 3/7 Cash 2,000 Sales Rev. 2,000 Sales Rev. 2,000 CGS 1,100 Inventory 1,1003/14 Inventory 700 3/14 Purchases 700 Cash 700 Cash 7003/28 Cash 330 Cash 330 Sales Rev. 330 Sales Rev. 330 CGS 180 Inventory 180 Inventories: Measurement 20
    21. 21. Perpetual Inventory SystemExample (contd.) Inventory a Inventory Inventory (FIFO) (LIFO) (WA)B.B.500 1100 500 1150 500 1120 900 180 900 210 900 195.9 700 700 700E.B.820 740 784.1a. The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement 21
    22. 22. Perpetual Inventory SystemExample (contd.)The balance of cost of goods sold account1 : CGS CGS CGS (FIFO) (LIFO) (W-A)3/7...1100 1150 11203/28...180 210 195.9 1280 1360 1315.9 1.The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement 22
    23. 23. Ending Period Adjustments Perpetual Inventory System a. Adjustments for lost units. b. Adjustments for LCM valuation. Inventories: Measurement 23
    24. 24. a. Adjustments for Lost Units (Perpetual Inventory System)Assuming ending units = 110 units.On 3/31, the lost units = 10.Cost of 10 lost units => $6 x 10 = $60 (FIFO) $7 x 10 = $70 (LIFO) $6.53 x 10 = 65.3 (W-A)Adjusting Entry:3/31 Loss on Inventory Units a 60 Inventory 60a. or use the account of Inventory over and short Inventories: Measurement 24
    25. 25. b. Adjustments for LCM Valuation (Perpetual Inventory System) Inventory (FIFO)B.B 500 1,100 900 180 700 820 60 -- 3/31 (Adj. for lost units) 760Ending Inv. Cost (on 3/31, FIFO) = $760 LCMAssuming market price = $600 LCM = $600 =$600 Inventories: Measurement 25
    26. 26. Adjustments for LCM Valuation (contd.)s Adjusting entry => Given that Allowance for Declining in Market Value of inventory has a beginning balance of zero: Allowance 3/31 0 -- 3/1 Loss Due to Market Value 160 Decline of Inventory 160 160 -- 3/31 Allowance to Reduce Inventory to Market 160 B/S (3/31) Inventory 760 Allowance (160) Inv. At LCM 600 Inventories: Measurement 26
    27. 27. Adjustments for LCM Valuation (contd.)s If the allowance account had a beginning balance of $20, the adjusting entry would be: Allowance 20 -- 3/1 Loss 140 140 Allowance 140 160 -- 3/31 Inventories: Measurement 27
    28. 28. Adjustments for LCM Valuation (contd.)s If the Allowance account had a beginning balance of 200, the adjusting entry would be: Allowance Allowance 40 40 200 Gain from Recovery 160 of M.V. of Inventory 40 Inventories: Measurement 28
    29. 29. Periodic Inventory Systems At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and cost of goods sold: 1. Do an inventory count. 2. Applying a cost flow assumption to determine the cost of ending inventory. 3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.a a. No adjusting entries are required. Inventories: Measurement 29
    30. 30. Periodic Inventory Systema : An Examples Using the example on Page 10 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7 × 100 + $6 × 5 = $730 a. For journal entries, see page 20. Inventories: Measurement 30
    31. 31. Periodic Inventory SystemExample (contd.)Inventory Data: The CGS under FIFO is: Units Cost $500 + 1,600 - 730 =3/1 (B.B) 100 $5 $1,370.3/5 Pur. 150 $6 If a LIFO assumption is3/14 Pur. 100 $7 used, the cost of end. Inv. is: $5 x 100 + $6 x 5 = $530. The CGS is: $500 + 1600 - 530 = $1,570. Inventories: Measurement 31
    32. 32. Ending Period Adjustments (Periodic Inventory System)1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS). Inventories: Measurement 32
    33. 33. Ending Period Adjustments (Periodic Inventory System)2.Adjustment for the LCM valuation assuming FIFO: Cost of E.I. = $730 LCM Allowance Market = $600 = $600 0 -- 3/1(assumed) 130 Adjusting entry: 130 --3/31 Loss Due to Market Decline of Inv. 130 Allowance to Reduce Inv. to Market 130 Inventories: Measurement 33
    34. 34. An Alternative of LCM Adjustment Many companies (i.e., Cisco Systems, inc. 2001, source: Spiceland, etc.)record the adjustment of LCM as follows: Cost of Goods Sold 160 Inventory 160 Note: Recording the loss as an increase in CGS will have the same impact on earnings as reporting it as a loss from value decline in the holding inventory. However, this treatment will distort the cost of goods sold and therefore, the gross profit.. Inventories: Measurement 34
    35. 35. Examples of Earnings Boosted by SellingInventory Which Had Been Written Downpreviously (Source: P500 of KWW, 14th e)Company Gain from Disclosure reversalVishay Not Available Did not mention the gain inIntertechnology its earnings release.. It only disclosed this gain from write-down in two weeks later in its SEC filing .Transwitch $600,000 Similar to the case of VishayCisco Systems $525 million Detailed in its earnings releases and in SEC filings the gains from selling inventory it had previously written off. 35
    36. 36. 3. Comparison of FIFO vs. LIFO During an Inflation Period Income Tax B/S I/S LIFO(matchingcurrent costwith revenue Low Low Unfair Fairif notdepleted toearly layers) FIFO High High Fair Unfair Inventories: Measurement 36
    37. 37. Survey: (Source: Accounting Trends & Techniquesand footnote 16 of Chapter 8 , KWW 14th e) a, b,cYearl Total LIFO FIFO W-A Others1984 1061 408 38% 366 30% 225 22% 52 5%1988 1038 379 37% 396 38% 213 21% 50 5%1991 1032 361 35% 421 41% 200 19% 50 5%2000 887 283 32% 386 44% 180 20% 38 4%2006 802 228 28% 385 48% 159 20% 30 4%2010 666 176 26% 325 49% 147 22% 18 3% Inventories: Measurement 37
    38. 38. Survey: (Source: Accounting Trends &Techniques) (contd.)a. Sample firms are 600 firms. Most companies adopt more than one inventory method. b. Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s. c. IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaies. Inventories: Measurement 38
    39. 39. Switching to LIFODuring an Inflation Periods Reason of switching to LIFO: Tax savings. Inventories: Measurement 39
    40. 40. Income Manipulation When LIFO IsUsed (assuming price is rising)1. To increase income (by decreasing CGS): x Strategy:2.To decrease income (by increasing CGS): x Strategy: Inventories: Measurement 40
    41. 41. Advantages of FIFO a. Less likely to be subject to management manipulation; b. Produce higher income during an inflation period; c. Inventory cost reported on the B/S is close to the replacement cost. Inventories: Measurement 41
    42. 42. Disadvantage of FIFOa. Bad matches of sales revenue and CGS; match current sales revenue with old costs;b. Producing higher income during an inflation period results in paying more income tax. Inventories: Measurement 42
    43. 43. Advantages of LIFOa. Good match of sales revenue with CGS.b. Produce lower income during an inflation period; result in tax savings. Inventories: Measurement 43
    44. 44. Disadvantages of LIFOa. Inventory cost presented on the B/S is not fair.b. Subject to management manipulation.Note: International Accounting Standard No. 2 does not allow LIFO. Inventories: Measurement 44
    45. 45. IRS1. Does not allow firms to use LCM if firms are using LIFO.2. LIFO conformity rule. The non-LIFO income numbers are allowed on the supplementary reports since 1981. Inventories: Measurement 45
    46. 46. IRS (contd.)3. LIFO is not acceptable by the IRS till 1939. Inventories: Measurement 46
    47. 47. 4. LIFO Liquidationss A LIFO Liquidation profit can occur when units purchased are less than units sold in the period. Inventories: Measurement 47
    48. 48. An Example of LIFO LiquidationProfit 20x5 Beg. Inv. 400 $5 Pur. 300 $6 Pur. 500 $7 Pur. 600 $8 During 20x5, 1,700 units were sold. What is the LIFO liquidation profit? Total purchases of 20x5 are 1,400 units. The LIFO liquidationprofit is: (1,700-1,400) x ($8-$5) = $900 Inventories: Measurement 48
    49. 49. Choice of Inventory Cost-Flow Assumptions andConversion of FIFO to LIFO for ComparisonPurposes*a. Choice of inventory cost-flow assumptions.b. Inventory Management (JIT system, Inventory turnover rate, etc.): the example of Dell Inc.c. Adjustment of inventory cost-flow assumption on the same basis before making comparison of financial statements. Inventories: Measurement 49
    50. 50. Adjustment of Inventory Cost-FlowAssumption – An ExampleInformation: ABC is currently adopting FIFO assumption. IF LIFO were adopted, thecost of ending inventory would be $1,000 and $3,000 lower for x1 and x2, respectively.Question: How much would the CGS and income be different when LIFO is adopted rather than FIFO for x2? Inventories: Measurement 50
    51. 51. Adjustment of Inventory Cost-FlowAssumption- An Example (contd.)CGS = Beg. Inv. + Net Pur. – End. Inv.Impact => -1000 -3000of LIFO Thus, the CGS of x 2 should be increased by $2,000 when adopting LIFO rather than FIFO. The income before tax would be decreased by $2,000. Inventories: Measurement 51
    52. 52. LIFO Reserve: An Account to Adjust EndingInventory Value from FIFO to LIFOs The difference in the inventory between the inventory method used for internal (i.e., FIFO) vs. external (i.e., LIFO) reporting purposes is referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO .s The change in the balance of LIFO Reserve from one period to another is referred as the LIFO Effect , an impact on income. Inventories: Measurement 52
    53. 53. LIFO Reserve – An Examples Assume that Acme Boot Company uses FIFO method for internal reporting purposes and a LIFO for external reporting purposes.s On 12/31/x5, the LIFO Reserve balance is $20,000 and the value of ending inventory on 12/31/x6 under LIFO is $50,000 less than that of FIFO.s Inventory on 12/31/x5 at FIFO = $320,000s Inventory on 12/31/x6 at FIFO =$360,000 Inventories: Measurement 53
    54. 54. LIFO Reserve – Example (contd.)(Inventory Disclosure, note D)12/31/x6 12/31/x5s Inventory at FIFO $360,000 $320,000s LIFO Reserve (50,000) (20,000)s Inventory at LIFO $310,000 $300,000ss Thus, $30,000 should be added to the LIFO Reserve account. The LIFO effect (i.e., the impact on income) for 20x6 is Inventories: Measurement 54
    55. 55. LIFO Reserve - Example (contd.)Journal Entry to adjust inventory from FIFO toLIFO:Cost of Goods Sold 30,000 LIFO Reserve a 30,000 (or Allowance to Reduce Inventory to LIFO) a. reported as a contra account to inventory or a deduction from inventory (see p53 for presentation) Inventories: Measurement 55
    56. 56. Inventory Presentation and FootnoteDisclosure (also see Illustration 8-19 of KWW, 14th e)12/31/x6: Inventories, net of adjustment toLIFO Reserve(Note D) $310,000Note D (contd.): Inventories. Inventoriesare valued at the lower of cost ormarket determined principally by theLIFO method. If the FIFO costmethod had been used, inventorieswould have been $50,000 higher. Inventories: Measurement 56
    57. 57. Illustration 8-19 (KWW, 14 e) th Inventories: Measurement 57
    58. 58. 5. Items to Be Included in Inventorys Any goods with the legal title transferred to the buyer should be included in the inventory of the buyer (including goods in transit with a F.O.B. shipping point term). Inventories: Measurement 58
    59. 59. Special Cases a. Consigned Goods: Legal title remained with the consignor (manufacturers). b. Sales with High Sales Returns (conditional sale): c. Sales on Approval: Inventories: Measurement 59
    60. 60. Special Cases (contd.)d. Product Financing Arrangements: Parking Transactions; sales with buyback agreements.e. Sales on Installment (revenue recognition on accrual basis if uncollectible amounts can be estimated) Inventories: Measurement 60
    61. 61. What Should Be Included in TheProduct Costs√ Purchase price √ --> Yes x --> No√ Freight-In cost v --> may bex Handling chargex Storage cost related to purchasex Buying cost of the purchasing departmentx Insurance, taxesv Interest cost: only in some cases. Inventories: Measurement 61
    62. 62. What Should Be Included in theProduct Costs (contd.)s Purchase Discount account should be treated as a contra account to purchases. Inventories: Measurement 62
    63. 63. 6. Inventory Valuation - the LCM Rule Departure from Historical Cost Assumption LCM: Lower of Cost or Market. Reasons: Conservatism. Market ==> Replacement Cost constrained by: Ceiling => Net Realizable Value = Selling price - estimated cost to complete and sell Floor => NRV - normal profits  IFRS: Market is the NRV. Inventories: Measurement 63
    64. 64. Inventory Valuation - Example• Selling price = 12• Package cost = $1• Transportation cost = $3• Normal profits = $3• NRV = Selling price - Package - Transportation = $12 - $1- $3 = $8• NRV - Normal profit = $5 Inventories: Measurement 64
    65. 65. Inventory Valuation - Example (contd.)Acquisition Replacement NRV - NRV Market LCM Cost Cost Profit $10 $6 $8 $5 $6 $6 a $10 $9 $8 $5 $8 $8 b $10 $4 $8 $5 $5 $5 $10 $12 $8 $5 $8 $8 a. Example of the ceiling can prevent future unexpected loss. b.Example of preventing the recognition of abnormal loss in the current period. Inventories: Measurement 65
    66. 66. Inventory Valuation - LCMs For financial reporting, LCM can be performed at the individual item level, at the category level or at the total inventory level.s Common practice: at the individual item level.s LCM performed at the individual item level is most conservative and is most commonly used because it is complied with the IRS rule. Inventories: Measurement 66
    67. 67. LCM Application - at Individual Level versus at Group LevelItem Cost Market LCM (at individual level) A $50 $60 $50 B* $140 $100 $100 C $300 $360 $300 Total _____ _____ $490 _____ _____ $520 $450 _____ _____LCM at group level ==> $490 The difference of $40 is resulting from item B: $140 - 100 = $40 Inventories: Measurement 67
    68. 68. LCM and iGAAP¢ IAS No. 2 requires inventory to be valued at LCM which can be applied at different levels of inventory as in GAAP.¢ The market value of IAS is the NRV, not the replacement cost as in US GAAP.¢ IAS allows the reversal of inventory write- down when the conditions for write-down do not exist.¢ US GAAP does not allow the reversal of inventory write-down. Measurement Inventories: 68
    69. 69. 7. Initial Adoption of LIFOs The accounting treatments for accounting method changes are:s a. Current Period Approach: cumulative effect from the change reported in the I/ S. (Note: eliminated by SFAS 154)s b. Retrospective Approach Inventories: Measurement 69
    70. 70. Initial Adoption of LIFOs When change from other method to LIFO, neither a cumulative effect nor a retrospective adjustment can be made.s The base year inventory for all following years is the beginning inventory of the year In which LIFO is adopted. Inventories: Measurement 70
    71. 71. Initial Adoption of LIFOs This value of the beginning inventory needs to be adjusted to the cost.s The effect of the change on the current year’s income and on the value of the ending inventory must be disclosed. Inventories: Measurement 71
    72. 72. Journal Entry to Restatethe Beginning Inventory to Costs Assume that Rooms, Inc. decided to switch from FIFO to LIFO in 20x9. The beginning inventory of 20x9 has a cost basis of $100,000 but is reported at $90,000 on the balance sheet because market is lower than cost. The following entry is made to restate the inventory to a cost basis (ignoring tax effects): Inventories: Measurement 72
    73. 73. Journal Entry to Restate theBeginning Inventory to Cost (contd.)s Alternative 1: Allowance to Reduce Inventory to Market 10,000 Adjustment to Record Inventory at cost 10,000 (If an allowance method is used in LCM application.) Inventories: Measurement 73
    74. 74. Journal Entry to Restate theBeginning Inventory to Cost (contd.)s Alternative 2: Inventory 10,000 Adjustment to Record Inv. at Cost 10,000 (only If a direct write-off method is used in LCM application) Inventories: Measurement 74
    75. 75. Footnote Disclosure of Changingfrom FIFO to LIFONote: Inventory Pricing. In the fourth quarter, the company expanded its use of the LIFO method of inventory to additional portion of its inventories in order to more closely match current costs with current revenues. The effect of this change was to reduce net income for the current year by $2,804,000 or $0.49 per share. As of December 31, inventories valued on a LIFO basis amounted to $74,166,000. If valued on a FIFO basis, such inventories would be increased to $90,551,000. Inventories: Measurement 75
    76. 76. 8. LIFO Inventory Pools (Specific GoodsPooled LIFO) (source: Spiceland, etc.)* Problems associated with the Unit LIFO (i.e., the LIFO concept applies to units of inventory as described in previous sections; also called specific goods LIFO):  Costly to implement: It requires the records of each unit of inventory.  LIFO liquidations: When units of a specific inventory purchased are less than units sold during the period, the beginning layers are eroded. Inventories: Measurement 76
    77. 77. LIFO Inventory Pools (contd.)*s LIFO inventory pools technique can:s 1) simplify recordkeeping by grouping inventory into pools, ands 2)reduce the probability of LIFO layer liquidation/erosion. Inventories: Measurement 77
    78. 78. LIFO Inventory Pools (contd.)s Within pools, all purchases of goods in the pool are considered to be made at the same time during the period and at the average cost.s When the quantity of ending inventory in the pool increases (i.e., the quantity of ending inv. is greater than that of the beg. Inv.), the ending inventory of the pool will consist of the beg. Inv. and the layer of the period. Inventories: Measurement 78
    79. 79. LIFO Inventory Pools: An Example(contd.) (skip 78-81)s The 2008 beg. inventory (BI)of Cole Glass Inc. LIFO inventory pool consisted of the following: Quantity (squared Cost (per Total Cost foot (SF)) SF) Grade A 10,000 $3.00 $30,000 Window Glass Grade B 14,000 $2.50 $35,000 Grade C 11,000 $2.20 $24,200 Totals 35,000 $89,200 Average SF Cost $2.55 = ($89,200/ of the Pool -BI 35,000) Inventories: Measurement 79
    80. 80. LIFO Inventory Pools: An Examples During 20x8, Cole sold 48,000 squared feet of window glass and purchased 51,000 squared feet as follows: Quantity (squared Cost (per SF) Total Cost foot (SF)) Grade A Window 20,000 $3.10 $62,000 Glass Grade B 15,000 $2.60 $39,000 Grade C 16,000 $2.45 $39,200 Totals 51,000 $140,200 Average 2008 SF $2.75 = ($140,200/ Cost of the Pool 51,000) Inventories: Measurement 80
    81. 81. LIFO Inventory Pools: An Example(contd.)s The average cost of 2008 beg. inventory and 2008 window glass inventory pool is $2.55 and $2.75, respectively.s The ending inventory quantity for the pool is: 35,000+51,000-48,000=38,000 units Inventories: Measurement 81
    82. 82. LIFO Inventory Pools: An Example(contd.)s Since the ending inventory of 2008 exceeds its beg. Inventory, the ending inventory will include the beginning inventory (i.e., 35,000 units ) and a LIFO layer of 3,000 units from 2008 .s Thus, the cost of 2008 ending inventory equals: $2.55 x 35,000+ $2.75x 3,000 = $97,500 Inventories: Measurement 82
    83. 83. Problems Associated with LIFOInventory Poolss When a product in an inventory pool is discontinued, the old costs of the discontinued item will become the cost of goods sold and therefore, result in LIFO liquidation.s Even if the product is replaced, it may not be similar to the old item and cannot be included in the same pool.s Therefore, LIFO inventory pool requires redefine pools periodically when there are changes in the product Measurement the pool. 83 Inventories: mix of
    84. 84. 9. Dollar-Value LIFO (DV LIFO)Technique*s DV LIFO technique simplifies the recordkeeping procedures (due to no need to keep unit flows).s DV LIFO technique helps to protect LIFO layers from erosion (i.e., reduce the probability of LIFO liquidations; more than the LIFO inventory pool technique).s This technique is commonly used in practice for companies adopting LIFO assumption.. Inventories: Measurement 84
    85. 85. DV LIFO Technique (contd.)*s DV LIFO defines a layer as the dollar value, not units, of ending inventory for a specific year.s One layer is formed for each year.s Dollar Value of Inventories: Current cost (the most recent purchase price) of the ending Inventory. Inventories: Measurement 85
    86. 86. DV LIFO Technique (contd.)*s To determine whether a new LIFO layer is added under DV LIFO, the DV of ending inventory (EI) is compared with that of the beg. Inventory (BI).s If the DV of EI exceeds that of the BI, the EI layers will consist of the DV of the BI layer plus a new DV layer created for the current year (i.e., the DV of EI – the DV of BI). Inventories: Measurement 86
    87. 87. The Cost Indexs When the price level of the EI differs from that of BI, a cost index should be used to adjust the DV of EI at the price level of the BI before forming the layers for the EI.s Cost index of a layer year = Cost in layer year/Cost in base year Base year is the year in which DV LIFO is adopted and a layer year is any subsequent year in which an inv. Layer is Inventories: Measurement 87
    88. 88. Dollar Value LIFO – An ExampleLayer Current Cost Cost EI at Value ofYear of Ending (Price) Base year Inv. At Inventory Index Price Levl. D-V LIFO20x0 a $20,000 100 $20,000 $20,00020x1 $30,000 120 $25,000 $26,00020x2 $35,100 130 $27,000 $28,60020x3 $40,600 140 $29,000 $31,400a. the base year Inventories: Measurement 88
    89. 89. Example (contd.)Forming of layers: 20x0 20x1 20x2 20x320,000 ... L1 20,000...L1 20,000...L1 20,000...L1 5,000...L2 5,000...L2 5,000...L2 2,000...L3 2,000...L3 2,000 ..L4Converting to the corresponding year’s index level: 20x0 20x1 20x2 20x3 20,000x1 20, 000x1+ 20,000x1+ 20,000x1+ =20,000 5 ,000x1.2 5,000x1.2+ 5,000x1.2+ =26,000 2,000x1.3 2,000x1.3+ Inventories:=28.600 Measurement 2,000x1.489
    90. 90. Comments on Dollar-Value LIFOs Items with similar economic, not physical, characteristics (i.e., subject to similar cost change pressure) will be pooled together.s The more items are included in an inventory pool, the less likely the erosion of the LIFO layers can occur. Inventories: Measurement 90
    91. 91. Comments on Dollar-Value LIFO(contd.)*s Income number can be manipulated by changing the number of inventory pools.s On average, retailers form 6 pools for their inventories and non-retailers form 3 pools for their inventories with about a third of non-retailers use a single pool. (source: footnote 6 of chapter 8, KWW, 14th e). Inventories: Measurement 91
    92. 92. An Example of Manipulating Income byChanging the Number of Inventory Poolss Stauffer Chemical Company had increased LIFO pools from 8 to 280 , boosting its net income by $16,515,000 (13%) (source: KWW, 14th edition, p461). Inventories: Measurement 92
    93. 93. Types of Indexess Internal Index: Internal price index computed by the company for its own product.s External Index: Computed by an outside party such as the government, commodity exchange, or trade association.s General Index: Composed of several commodities, goods or services.s Specific Index: For one commodity, good or service. Inventories: Measurement 93
    94. 94. External Price Index*s The Consumer Price Index for urban consumers (CPI-U) is an example of an external general price index.s CPI-U is published monthly by the Bureau of Labor Statistics of the federal government.s Specific external price indexes (i.e., for gold, silver, corn…) are also available from trade associations. Inventories: Measurement 94
    95. 95. The Internal IndexesA Double-Extension Method (i.e., the valueof inv. units extended at both current and base-yearprices):Internal Index for the Current Year =End. Inv*. at Current Year’s CostEnd. Inv. at Base-Year Cost End. Inv. is the ending inventory of the current year. The cost index for the base year equals one. Inventories: Measurement 95
    96. 96. Examples To compute specific internal price indexes: Year Current Units of Cost Cost End. Inv. Index(%) 20x0 (base year) $19 300 100a 20x1 $22.8 400 120b 20x2 $24.7 450 130c 20x3 $26.6 370 140d a. 19*300/19.0*300=100% c.24.7*450/19*450=130% b. 22.8*400/19*400=120% d.26.6*370/19*370=140% Inventories: Measurement 96
    97. 97. Example (contd.)s General internal price index: (for more than one inventory in the pool): Inv. A Inv. B Current Units of Current Units of Cost End. Inv. Cost End. Inv. 20x0(base year) $19 100 $20 150 20x1 $22.8 110 $22 120 General internal price index of 20x0: (19x100+20x150) / (19x100+20x150)=100% General internal price index of 20x1: (22.8x110+22x120) / (19x110+20x120)=114.6% Inventories: Measurement 97
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