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- 1. Valuation of Inventories: A Cost-Basis Approach Chapter 8 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara
- 2. <ul><li>Identify major classifications of inventory. </li></ul><ul><li>Distinguish between perpetual and periodic inventory systems. </li></ul><ul><li>Identify the effects of inventory errors on the financial statements. </li></ul><ul><li>Understand the items to include as inventory cost. </li></ul><ul><li>Describe and compare the cost flow assumptions used to account for inventories. </li></ul><ul><li>Explain the significance and use of a LIFO reserve. </li></ul><ul><li>Understand the effect of LIFO liquidations. </li></ul><ul><li>Explain the dollar-value LIFO method. </li></ul><ul><li>Identify the major advantages and disadvantages of LIFO. </li></ul><ul><li>Understand why companies select given inventory methods. </li></ul>Learning Objectives
- 3. Inventory Classification and Control Physical Goods Included in Inventory Costs Included in Inventory Cost Flow Assumptions LIFO: Special Issues <ul><li>Classification </li></ul><ul><li>Control </li></ul><ul><li>Basic inventory valuation issues </li></ul>Basis for Selection <ul><li>Goods in transit </li></ul><ul><li>Consigned goods </li></ul><ul><li>Special sales agreements </li></ul><ul><li>Inventory errors </li></ul><ul><li>Product costs </li></ul><ul><li>Period costs </li></ul><ul><li>Purchase discounts </li></ul><ul><li>Specific identification </li></ul><ul><li>Average cost </li></ul><ul><li>FIFO </li></ul><ul><li>LIFO </li></ul><ul><li>LIFO reserve </li></ul><ul><li>LIFO liquidation </li></ul><ul><li>Dollar-value LIFO </li></ul><ul><li>Comparison of LIFO approaches </li></ul><ul><li>Advantages of LIFO </li></ul><ul><li>Disadvantages of LIFO </li></ul><ul><li>Summary of inventory valuation methods </li></ul>Valuation of Inventories: Cost-basis Approach
- 4. Inventory Classification and Systems <ul><li>Inventories are: </li></ul><ul><li>items held for sale, or </li></ul><ul><li>goods to be used in the production of goods to be sold. </li></ul>LO 1 Identify major classifications of inventory. Classification Merchandiser Manufacturer Businesses with Inventory: or
- 5. Inventory Classification and Systems Type of Business Merchandiser <ul><li>One inventory account </li></ul><ul><li>Purchase goods ready for sale </li></ul>LO 1 Identify major classifications of inventory.
- 6. Inventory Classification and Systems Type of Business Manufacturer <ul><li>Three accounts </li></ul><ul><li>Raw materials </li></ul><ul><li>Work in process </li></ul><ul><li>Finished goods </li></ul>LO 1 Identify major classifications of inventory.
- 7. Inventory Classification and Systems Flow of Costs Illustration 8-2 LO 1 Identify major classifications of inventory.
- 8. Inventory Classification and Systems Two systems for maintaining inventory records: LO 2 Distinguish between perpetual and periodic inventory systems. Control <ul><li>Perpetual system </li></ul><ul><li>Periodic system </li></ul>
- 9. Inventory Classification and Systems Features: LO 2 Distinguish between perpetual and periodic inventory systems. Perpetual System <ul><li>Purchases of merchandise are debited to Inventory. </li></ul><ul><li>Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory. </li></ul><ul><li>Cost of goods sold is debited and Inventory is credited for each sale. </li></ul><ul><li>Physical count done to verify Inventory balance. </li></ul>The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.
- 10. Inventory Classification and Systems Features: LO 2 Distinguish between perpetual and periodic inventory systems. Periodic System <ul><li>Purchases of merchandise are debited to Purchases. </li></ul><ul><li>Ending Inventory determined by physical count. </li></ul><ul><li>Calculation of Cost of Goods Sold: </li></ul>Beginning inventory $ 100,000 Purchases, net 800,000 Goods available for sale 900,000 Ending inventory 125,000 Cost of goods sold $ 775,000
- 11. Inventory Classification and Systems LO 2 Distinguish between perpetual and periodic inventory systems. Perpetual System Periodic System vs.
- 12. Basic Issues in Inventory Valuation Requires the following: LO 2 Distinguish between perpetual and periodic inventory systems. Valuation of Inventories <ul><li>The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). </li></ul><ul><li>The costs to include (product vs. period costs). </li></ul><ul><li>The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.). </li></ul>
- 13. Physical Goods Included in Inventory A company should record purchases when it obtains legal title to the goods. LO 2 Distinguish between perpetual and periodic inventory systems. Physical Goods <ul><li>Special Consideration: </li></ul><ul><li>Goods in Transit (FOB shipping point, FOB destination) </li></ul><ul><li>Consigned goods </li></ul><ul><li>Sales with buyback agreement </li></ul><ul><li>Sales with high rates of return </li></ul><ul><li>Sales on installment </li></ul><ul><li>Inventory errors </li></ul>
- 14. Effect of Inventory Errors LO 3 Identify the effects of inventory errors on the financial statements. Ending Inventory Understated The effect of an error on net income in one year (2006) will be counterbalanced in the next (2007), however the income statement will be misstated for both years. Illustration 8-6
- 15. Effect of Inventory Errors LO 3 Identify the effects of inventory errors on the financial statements. Purchases and Inventory Understated The understatement does not affect cost of goods sold and net income because the errors offset one another. Illustration 8-8
- 16. Costs Included in Inventory LO 4 Understand the items to include as inventory cost. <ul><li>Product Costs - costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition. </li></ul><ul><li>Period Costs – generally selling, general, and administrative expenses. </li></ul><ul><li>Purchase Discounts – Gross vs. Net Method </li></ul>
- 17. Treatment of Purchase Discounts Gross Method Net Method vs. LO 4 Understand the items to include as inventory cost.
- 18. Answer: 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 What Cost Flow Assumption to Adopt? LIFO Average Cost Specific Identification LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 19. <ul><li>Young & Crazy Company makes the following purchases: </li></ul><ul><ul><li>One item on 2/2/07 for $10 </li></ul></ul><ul><ul><li>One item on 2/15/07 for $15 </li></ul></ul><ul><ul><li>One item on 2/25/07 for $20 </li></ul></ul><ul><li>Young & Crazy Company sells one item on 2/28/07 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO , LIFO , Average Cost , and Specific Identification cost flow assumptions? Assume a tax rate of 30%. </li></ul>Example Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 20. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “ First-In-First-Out (FIFO)” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 21. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Cost Flow Assumptions Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 47 Taxes 14 Net Income $ 33 “ First-In-First-Out (FIFO)” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 22. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “ Last-In-First-Out (LIFO)” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 23. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Cost Flow Assumptions Inventory Balance = $ 25 Purchase on 2/25/07 for $20 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 Taxes 11 Net Income $ 26 “ Last-In-First-Out (LIFO)” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 24. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “ Average Cost” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 25. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 30 Cost Flow Assumptions Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 12 Net Income $ 30 “ Average Cost” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 26. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “ Specific Identification” LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 27. Purchase on 2/2/07 for $10 Purchase on 2/15/07 for $15 Purchase on 2/25/07 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “ Specific Identification” Depends which one is sold LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 28. <ul><li>Financial Statement Summary </li></ul>Inventory Balance 30 25 35 Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories.
- 29. 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 Methods Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. <ul><li>Assuming the Perpetual Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. </li></ul><ul><li>Assuming the Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. </li></ul>Goods Available $19,100
- 30. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory FIFO Method +
- 31. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory LIFO Method +
- 32. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. +
- 33. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. +
- 34. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory FIFO Method +
- 35. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory LIFO Method +
- 36. Cost Flow Assumptions LO 5 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory Weighted Average +
- 37. Special Issues Related to LIFO <ul><li>Many companies use </li></ul><ul><li>LIFO for tax and external financial reporting purposes </li></ul><ul><li>FIFO, average cost, or standard cost system for internal reporting purposes. </li></ul><ul><li>Reasons: </li></ul>LO 6 Explain the significance and use of a LIFO reserve. LIFO Reserve <ul><li>Pricing decisions </li></ul><ul><li>Record keeping easier </li></ul><ul><li>Profit-sharing or bonus arrangements </li></ul><ul><li>LIFO troublesome for interim periods </li></ul>
- 38. Special Issues Related to LIFO LO 6 Explain the significance and use of a LIFO reserve. LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Example: FIFO value per books $160,000 LIFO value 145,000 LIFO Reserve $ 15,000 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.
- 39. Special Issues Related to LIFO Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. LO 7 Understand the effect of LIFO liquidations. LIFO Liquidation Illustration 8-20
- 40. Special Issues Related to LIFO <ul><li>Changes in a pool are measured in terms of total dollar value, not physical quantity. </li></ul><ul><li>Advantage: </li></ul><ul><ul><li>Broader range of goods in pool. </li></ul></ul><ul><ul><li>Permits replacement of goods that are similar. </li></ul></ul><ul><ul><li>Helps protect LIFO layers from erosion. </li></ul></ul>LO 8 Explain the dollar-value LIFO method. Dollar-Value LIFO
- 41. Special Issues Related to LIFO LO 8 Explain the dollar-value LIFO method. Exercise 8-26 The following information relates to the Jimmy Johnson Company. Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005. Dollar-Value LIFO
- 42. Special Issues Related to LIFO LO 8 Explain the dollar-value LIFO method. Exercise 8-26 Solution
- 43. Special Issues Related to LIFO <ul><li>Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming. </li></ul><ul><li>Specific-goods Pooled LIFO approach </li></ul><ul><ul><li>reduces record keeping and clerical costs. </li></ul></ul><ul><ul><li>more difficult to erode the layers. </li></ul></ul><ul><ul><li>using quantities as measurement basis can lead to untimely LIFO liquidations. </li></ul></ul><ul><li>Dollar-value LIFO is used by most companies. </li></ul>LO 8 Explain the dollar-value LIFO method. Comparison of LIFO Approaches
- 44. Special Issues Related to LIFO <ul><li>Matching </li></ul><ul><li>Tax Benefits/Improved Cash Flow </li></ul><ul><li>Future Earnings Hedge </li></ul>LO 9 Identify the major advantages and disadvantages of LIFO. Advantages <ul><li>Reduced earnings </li></ul><ul><li>Inventory understated </li></ul><ul><li>Physical flow </li></ul><ul><li>Involuntary Liquidation / Poor Buying Habits </li></ul>Disadvantages
- 45. Basis for Selection of Inventory Method <ul><li>LIFO is generally preferred: </li></ul><ul><ul><li>if selling prices are increasing faster than costs and </li></ul></ul><ul><ul><li>if a company has a fairly constant “base stock.” </li></ul></ul>LO 10 Understand why companies select given inventory methods. <ul><li>LIFO not appropriate: </li></ul><ul><ul><li>if prices tend to lag behind costs, </li></ul></ul><ul><ul><li>if specific identification traditionally used, and </li></ul></ul><ul><ul><li>when unit costs tend to decrease as production increases. </li></ul></ul>
- 46. Copyright Copyright © 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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