Chapter 8. Inventory Chapters. Learning Objectives. Learning Objectives. Inventory. Inventory. Valuation of Inventories: A Cost-Basis Approach

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1 Chapter 8 Valuation of Inventories: A Cost-Basis Approach Chapters Topic of chapters 8 and 9 : Asset on balance sheet Cost of goods sold: Expense on I/S See Safeway, Dr. Pepper, Campbell, Grainger, Amazon, Coca-Cola, Peet s, Tiffany Annual Reports 1 2 Learning Objectives Learning Objectives Identify classifications of inventory Explain perpetual and periodic inventory systems Identify effects of inventory errors Understand the items to include as inventory cost Describe and compare cost flow assumptions Explain the significance and use of a LIFO reserve Understand the effect of LIFO liquidations Explain the dollar-value LIFO method Identify advantages and disadvantages of LIFO Understand why inventory methods are selected 3 Identify classifications of inventory 4 Assets that a company intends to sell in the normal course of business Inventories may be Raw materials used to manufacture goods Work in process (partially completed) Finished goods held for sale Purchase cost Amount paid to make unit ready for sale Proper location, proper condition Asset on balance sheet: Expense on income statement: CGS Selling price Amount received from buyer (A/R) Income statement: Sales 5 6 1

2 Merchandising Business Finished goods purchased from manufacturer One type of inventory (items for sale) Examples Costco Target Crate and Barrel Manufacturing Business Three types of inventory Raw materials Work in process Finished goods Purchase raw materials Apply labor and overhead Produce finished goods 7 8 Raw Materials Work in Process Materials on hand but not yet placed into process of production 9 Units started but not yet complete WIP includes Cost of raw materials Cost of labor that can be directly applied to the goods in process Allocated portion of overhead Indirect labor Indirect materials Indirect services 10 Finished Goods Manufacturing process complete Costs accumulated in work in process transferred to finished goods Raw Materials (1) $XX $XX (4) Direct Labor (2) $XX $XX (5) Manufacturing Overhead (3) $XX $XX (6) Work in Process Finished Goods $XX $XX (7) $XX $XX (8) Cost of Good Sold $XX 11 (1) Raw materials purchased (2) Direct labor incurred (3) Manufacturing overhead incurred (4) Raw materials used (5) Direct labor applied (6) Manufacturing overhead applied (7) Work in process transferred to finished goods (8) Finished goods sold 12 2

3 Learning Objectives Explain perpetual and periodic inventory Cost Flow Gross and Net Methods 15 Applies to both perpetual and periodic Seller offer terms, 2/10 n/30 Gross method Record inventory at invoice amount (gross) Record discount if taken Net method Record inventory net of discount Record discounts lost expense not taken 16 Gross and Net Methods Gross method views discounts not taken as part of inventory cost Net method views discounts not taken as Interest exp or Lost discount exp Small difference in amounts, ratios Difference usually not material Perpetual and Periodic Perpetual account continuously updated as purchases and sales are made Periodic account adjusted at end of period

4 Perpetual System Continuously tracks changes in inventory quantity and inventory cost (asset) debited when Merchandise purchased Merchandise returned by customer (asset) credited when Merchandise sold Merchandise returned to supplier 19 Perpetual System Accounting records continuously show Ending inventory (goods on hand) Cost of goods sold Accounting records wrong because Errors Theft Breakage and spoilage Shrinkage (unaccounted loss of inventory) Physical count at end of period needed 20 Perpetual T-Account Beg inv Purchases Our returns Discount Gross method Cust returns Sold (CGS) End inv All amounts at cost, not selling price 21 Perpetual : Gross 600,000 Accounts payable 600,000 Purchased inventory, $600,000, terms 2/10 n/30 Accounts payable 100, ,000 Returned inventory, $100,000 Accounts payable 500,000 Cash 490,000 10,000 Paid within discount period, 2% discount on $500, Perpetual : Net Perpetual : Net 588,000 Accounts payable 588,000 Purchased inventory, $600,000, terms 2/10 n/30 Accounts payable 98,000 98,000 Returned inventory, $100, ,000 Accounts payable 588,000 Purchased inventory, $600,000, terms 2/10 n/30 Accounts payable 98,000 98,000 Returned inventory, $100,000 Accounts payable 490,000 Cash 490,000 Paid within discount period, 2% discount on $500, Accounts payable 490,000 Interest expense (Discounts lost) 10,000 Cash 500, Paid after discount period ended, $500,000 4

5 Perpetual: Sold Selling price, $820,000 Cost, $540,000 Accounts receivable 820,000 Sales 820,000 Selling price of inventory Cost of goods sold 540, ,000 Purchase cost of inventory, $540, Periodic System Adjusts inventory (asset) and calculates cost of goods sold only at end of period Use temporary accounts to record Merchandise purchases Purchase returns Purchase discounts Freight-in 26 Periodic Net Purchases Periodic Cost of Goods Sold Purchases + Freight-in Returns Discounts Net purchases Beginning + Net Purchases Cost of Goods Available for Sale Ending Cost of Goods Sold Periodic : Gross Purchases 600,000 Accounts payable 600,000 Purchased inventory, $600,000, terms 2/10 n30 Accounts payable 100,000 Purchase returns and allow. 100,000 Returned inventory, $100,000 Periodic : Net Purchases 588,000 Accounts payable 588,000 Purchased inventory, $600,000, terms 2/10 n30 Accounts payable 98,000 Purchase returns and allow. 98,000 Returned inventory, $100,000 Accounts payable 500,000 Cash 490,000 Purchase discounts 10,000 Paid within discount period, 2% discount on $500, Accounts payable 490,000 Cash 490,000 Paid within discount period, 2% discount on $500,

6 Periodic : Net Purchases 588,000 Accounts payable 588,000 Purchased inventory, $600,000, terms 2/10 n30 Accounts payable 98,000 Purchase returns and allow. 98,000 Returned inventory, $100,000 Accounts payable 490,000 Interest expense 10,000 Cash 500,000 Paid after discount period ended, $500, Periodic: Sold Selling price, $820,000 Cost, $540,000 Accounts receivable 820,000 Sales 820,000 Selling price of inventory No entry is made to record Cost of Good Sold. Calculate Cost of Goods Sold at end of period. 32 Periodic AJE Calculation of Cost of Goods Sold Beginning inventory $120,000 Plus: Net purchases 490,000 Goods available for sale 610,000 Less: Ending inventory 180,000 Cost of goods sold $430,000 Cost of goods sold (plug) 430,000 (ending) 180,000 (beginning) 120,000 Purchases (actual) 490, Periodic AJE Calculation of Cost of Goods Sold Beginning inventory $120,000 Plus: Net purchases 490,000 Goods available for sale 610,000 Less: Ending inventory 180,000 Cost of goods sold $430,000 Cost of goods sold (plug) 430,000 (ending) 180,000 Purchase discounts (actual) 10,000 Purchase returns (actual) 100,000 (beginning) 120,000 Purchases (actual) 600, Periodic T-Account Beg inv Beg inv End inv End inv All amounts at cost, not selling price 35 Comparison of Perpetual and Periodic Systems Impact on financial statements generally not significant Perpetual provides more timely information, more costly to implement Periodic inventory less costly to implement but requires a physical count before ending inventory and cost of goods sold can be determined 36 6

7 Perpetual and Periodic: Purchase of Perpetual and Periodic: Freight-In Perpetual Perpetual 600,000 Accounts payable 600,000 Purchased inventory, $600,000, terms 2/10 n30 2,000 Accounts payable 2,000 FOB shipping point, $2,000 to transport goods Periodic Periodic Purchases 600,000 Accounts payable 600,000 Purchased inventory, $600,000, terms 2/10 n30 37 Freight-in 2,000 Accounts payable 2,000 FOB shipping point, $2,000 to transport goods 38 Perpetual and Periodic: Return of Perpetual and Periodic: Purchase Discounts (2/10 n/30) Perpetual Accounts payable 100, ,000 Returned inventory, $100,000 Date Description Perpetual Debit Credit Accounts payable 500,000 Cash 490,000 10,000 Paid within discount period, 2% discount on $500,000 Periodic Accounts payable 100,000 Purchase returns and allow. 100,000 Returned inventory, $100, Date Description Periodic Debit Credit Accounts payable 500,000 Cash 490,000 Purchase discounts 10,000 Paid within discount period, 2% discount on $500, Perpetual and Periodic: Sale of Perpetual and Periodic: Sale of Perpetual Perpetual Accounts receivable 820,000 Sales 820,000 Selling price of inventory Cost of goods sold 540, ,000 Purchase cost of inventory, $540,000 Periodic Accounts receivable 820,000 Sales 820,000 Selling price of inventory 41 Periodic No entry is made to record Cost of Good Sold. Calculate Cost of Goods Sold at end of period. 42 7

8 Perpetual and Periodic: Buyer Returns Perpetual and Periodic: Buyer Returns Perpetual Perpetual Sales returns 50,000 Accounts receivable 50,000 Buyer returns inventory, $50,000 50,000 Cost of goods sold 50,000 Buyer returns inventory, $50,000 Periodic Sales returns 50,000 Accounts receivable 50,000 Buyer returns inventory, $50, Periodic No entry is made to or Cost of Good Sold. Calculate Cost of Goods Sold at end of period. 44 Perpetual and Periodic: End of Period AJE Perpetual over and short (or CGS) 6,000 6,000 Adjust inventory to physical count (shrinkage) Comparison of Perpetual and Periodic Systems Transaction Perpetual Periodic Purchase inventory Debit (asset) Debit Purchases (exp) Freight-in Debit (asset) Debit Freight-in (exp) Date Description Periodic Debit Credit Cost of goods sold (plug) 432,000 (ending) 180,000 Purchase discounts (actual) 10,000 Purchase returns (actual) 100,000 Freight-in 2,000 (beginning) 120,000 Purchases (actual) 600, We return inventory Credit (asset) Credit Purch Returns (contra) Purchase disc (2/10 n/30) Credit (asset) Credit Discounts (contra) sold Credit (asset) No entry for inventory Buyer returns inventory Debit (asset) No entry for inventory End of period AJE Adjust to physical cnt Plug Cost of goods sold 46 Gross Profit Calculation: Periodic Method Net sales 4,400 Cost of goods sold calculation: Beginning inventory 500 Cost of net purchases 3,600 Cost of goods available for sale 4,100 Less ending inventory 700 Cost of goods sold 3,400 Gross profit 1, Gross Profit Calculation: Periodic Method Sales 5,000 Less sales discounts 100 Less sales returns and allowances 500 Net sales 4,400 Cost of goods sold calculation: Beginning inventory 500 Purchases 4,000 Less purchase discounts 300 Less purchase returns and allowances 200 Net purchases 3,500 Add freight-in 100 Cost of purchases 3,600 Cost of goods available for sale 4,100 Less ending inventory 700 Cost of goods sold 3, Gross profit 1,000 8

9 Learning Objectives Basic Issues in Valuation Basic Issues in Valuation Physical goods (which units to include) Costs to include (product vs. period) Cost flow assumption FIFO, LIFO, Average cost, others Substance over form 49 Included in All goods owned by company at end of period regardless of location In general, goods will be at physical location of company Exceptions Goods in transit Goods on consignment Estimated sales returns 51 Goods in Transit FOB determines where legal ownership of the goods changes hands FOB point in sales contract FOB: Free on board FOB shipping point FOB destination 52 FOB Shipping Point Legal title changes hands when seller delivers goods to common carrier Buyer owns goods in transit Buyer pays shipping costs, insurance Expense recorded as Freight-In Product cost, included inventory cost Part of CGS when inventory sold FOB Shipping Point When seller delivers goods to common carrier Seller records revenue, reduces inventory Buyer records purchase, increases inventory

10 FOB Destination Legal title does not pass until goods arrive at customer's location When goods taken off common carrier and placed on buyer s receiving dock Seller owns goods in transit Seller pays shipping costs, insurance FOB Destination When goods taken off common carrier and placed on buyer s receiving dock Seller records revenue, reduces inventory Buyer records purchase, increases inventory Google search incoterms Shipping costs are part of Selling and marketing exp Legal ownership changes hands Who owns goods in transit Buyer Shipping Terms FOB Shipping Point At seller s location when merchandise placed into method of transit FOB Destination At buyer s location when merchandise placed on receiving dock Seller Who pays shipping costs Buyer Seller Account name Freight-In Shipping expense Where is cost Added to inventory (Asset on balance sheet) Selling expense (Expense on income stmt) Company with legal title to the goods while in transit pays the transportation costs Goods on Consignment Consignor (manufacturer or reseller) Delivers merchandise to consignee (store) Lists merchandise in inventory until sold Consignee (store or seller) Sells units Remits to consignor selling price less commissions and expenses No inventory on books Goods on Consignment Goods on Consignment Goods on consignment included in inventory of the consignor even though not in company's physical possession Consignor records a sale only when the consignee sells the goods Pepsi Corporation delivers end-cap with drinks and chips to Safeway for Super Bowl promotion on consignment for two weeks Safeway Drinks and chips 59 The goods on display at Safeway (consignee) are legally owned by Pepsi (consignor) and appear in the inventory of Pepsi; Safeway records sale and remits cash to Pepsi less a fee 60 10

11 High Rates of Sales Returns If reasonable estimates can be made Record sale (realize revenue) Adjusting journal entry required Estimate returns and include in inventory If estimates cannot be made Do not record sale until returns known Keep inventory on books even though legal title has changed hands Sales With Buyback Seller agrees to repurchase inventory from buyer at defined time and price Product financing arrangement or Parking transaction Seller reports inventory on books even though legal title has changed hands Installment Sales Buyer pays in installments, long time Legal title not transferred to buyer until all payments made If uncollectible accounts estimated Record sales and allow, reduce inventory If not possible to estimate uncollectibles Do not record sale, keep inv on books 63 Cutoff Must accurately measure inventory at balance sheet date Analyze 10 days before and after FOB point of purchases and sales Sales returns Buybacks Installment sales Consignment count 64 Learning Objectives Identify effects of inventory errors Errors Textbook method confusing If this goes up this goes down Instead arbitrarily select numbers First create gross profit calculation with numbers you select Next create a second column and change one number to introduce an error and see how the error changes the numbers

12 Error: Year 1 Overstatement of ending inventory Understates cost of goods sold and Overstates pretax income Understatement of ending inventory Overstates cost of goods sold and Understates pretax income Error: Year 1 Year 1 Correct Error Beginning inventory Add purchases Goods available for sale Less ending inventory Cost of goods sold If ending inventory too high Cost of goods sold too low 68 Error: Year 2 Overstatement of beginning inventory Overstates cost of goods sold and Understates pretax income Understatement of beginning inventory Understates cost of goods sold and Overstates pretax income Error: Year 2 Year 2 Correct Error Beginning inventory Add purchases Goods available for sale Less ending inventory Cost of goods sold If beginning inventory too high Cost of goods sold too high 70 Net Effect of Error Correct Error CGS year CGS year CGS two year period Learning Objectives Items to include as inventory cost Over two year period errors cancel out

13 Product Costs Can be directly matched to unit of inventory All costs incurred to place item in location and condition for sale Debit inventory when incurred Match to revenue at time of sale (CGS) Cost Product costs: All costs incurred to make inventory ready for sale Desired condition Desired location Invoice cost $14 Insurance $1 Freight charges $3 Import duties $2 74 Cost Net Purchases $14 Purchase cost 1 Insurance in transit 3 Freight charges 2 Import duties $20 Cost of inventory 20 Accounts payable Purchase price $600,000 +Transportation (freight in) 4,000 Purchase returns (25,000) Purchase allowances (5,000) Purchase discounts (14,000) = Net purchases of inventory $560,000 Freight out (Shipping) is a selling expense 76 NOT Cost Buying costs Costs of purchasing department Selling expenses Interest expense on Finished goods Units routinely manufactured large batches Period Costs Indirectly related to purchase of goods Cannot be matched to unit of inventory Recognized in period incurred Costs of purchasing department Costs of sales employees Interest on debt to purchase inventory Period costs not unit costs 77 Capitalize interest for discrete projects (ship, airplane) 13

14 Learning Objectives cost flow assumptions Layers (Periodic) Date Units Unit Cost Total Cost June 5 2,000 $4.00 $ 8,000 June 15 6,000 $ ,400 June 25 2,000 $4.75 9,500 Total 10,000 $43,900 Sold 4,000 units; Calc cost of goods sold, ending inv Cost Flow Methods Specific cost identification Average cost / Moving average First-in, first-out (FIFO) Last-in, first-out (LIFO) 81 Specific Cost Identification COGS for each sale is based on specific cost of item sold Specific cost of each inventory item must be known Only used for inventories which are Low volume High cost Unique items 82 Specific Cost Identification If inventory items are identical, do not use specific identification Manipulate expenses by selecting specific items If inventory items are identical, selection of unit sold is random Cost Flow Methods Cost flow assumptions Average cost / Moving average First-in, first-out (FIFO) Last-in, first-out (LIFO) Apply both periodic and perpetual

15 Average Cost (Periodic) Moving Average (Perpetual) Avg cost = Total cost / Total units Periodic Calculate average cost of all units available for period Perpetual Calculate average cost of units available at time of sale Average Cost Method Called Weighted Average if periodic Called Moving Average if perpetual Weighted Average (Periodic) Date Units Unit Cost Total Cost June 5 2,000 $4.00 $ 8,000 June 15 6,000 $ ,400 June 25 2,000 $4.75 9,500 Total 10,000 $43,900 Sold 4,000 units; Calc cost of goods sold, ending inv Total cost / total units = Weighted average cost $43,900 / 10,000 = $4.39 Units Cost Total Cost CGS 4,000 $4.39 = $17,560 End 6,000 $4.39 = $26,340 Available 10,000 $43, Moving Average (Perpetual) Date Purchases Sales Balance June 5 $4.00 2,000 units June 15 $4.40 8,000 units June 20 3,000 units 5,000 units June 25 $4.75 7,000 units June 30 1,000 units 6,000 units Calculate costs of goods sold at time of sale on June Moving Average (Perpetual) Date Units Unit Cost Total Cost June 5 2,000 $4.00 $ 8,000 June 15 6,000 $ ,400 Total 8,000 $34,400 Sold 3,000 units; Calc cost of goods sold, ending inv Total cost / total units = Weighted average cost $34,400 / 8,000 = $4.30 Moving Average (Perpetual) Date Purchases Sales Balance Revised $4.30 5,000 units June 25 $4.75 7,000 units June 30 1,000 units 6,000 units Calculate costs of goods sold at time of sale on June 30 Units Cost Total Cost CGS 3,000 $4.30 = $12,900 End 5,000 $4.30 = $21,500 Available 8,000 $34,

16 Moving Average (Perpetual) Moving Average (Perpetual) Date Units Unit Cost Total Cost Revised 5,000 $4.30 $ 21,500 June 25 2,000 $4.75 9,500 Total 7,000 $31,000 Date Units Unit Cost Total Cost End Inv 6,000 $4.43 $ 26,580 Sold 1,000 units; Calc cost of goods sold, ending inv Total cost / total units = Weighted average cost $31,000 / 7,000 = $4.43 Units Cost Total Cost CGS 1,000 $4.43 = $ 4,420 End 6,000 $4.43 $26,580 Available 7,000 $31, Date Units Cost of Goods Sold June 20 3,000 $12,900 June 30 1,000 4,420 Total 4,000 $17, First-In, First-Out First-In, First-Out Items are sold in the chronological order of their acquisition Cost of the oldest inventory items are charged to cost of goods sold Cost of the newest inventory items remain in ending inventory Cost of goods sold and ending inventory are the same under Perpetual Periodic FIFO FIFO Sold 4,000 units; Calc cost of goods sold, ending inv Date Units Unit Cost Total Cost June 5 2,000 $4.00 CGS $ 8,000 June 15 6,000 $ ,400 June 25 2,000 $4.75 9,500 Total 10,000 End $43,900 Inv Date Units Unit Cost Total Cost June 5 2,000 $4.00 CGS $ 8,000 June 15 2,000 $4.40 8,800 June 15 4,000 $ ,600 June 25 2,000 $4.75 End 9,500 Inv Total 10,000 $43,900 Sold 4,000 units; Calc cost of goods sold, ending inv 95 Units Cost Total Cost CGS 4,000 $8, ,800 = $16,800 End 6,000 $17, ,500 = $27,100 Available 10,000 $43,

17 Last-In, First-Out Newest items are sold first, leaving older units in inventory Cost of newest inventory items are charged to cost of goods sold Cost of oldest inventory items remain in ending inventory Last-In, First-Out LIFO method may result in COGS and ending inventory that differ under the periodic and perpetual methods LIFO (Periodic) LIFO (Periodic) Sold 4,000 units; Calc cost of goods sold, ending inv Date Units Unit Cost End Total Cost June 5 2,000 $4.00 Inv $ 8,000 June 15 6,000 $ ,400 June 25 2,000 $4.75 9,500 Total 10,000 CGS $43,900 Date Units Unit Cost End Total Cost June 5 2,000 $4.00 Inv $ 8,000 June 15 4,000 $ ,600 June 15 2,000 $4.40 8,800 June 25 2,000 $4.75 CGS 9,500 Total 10,000 $43,900 Sold 4,000 units; Calc cost of goods sold, ending inv 99 Units Cost Total Cost CGS 4,000 $9, ,800 = $18,300 End 6,000 $8, ,600 = $25,600 Available 10,000 $43, LIFO (Perpetual) LIFO (Perpetual) Date Purchases Sales Balance June 5 $4.00 2,000 units June 15 $4.40 8,000 units June 20 3,000 units 5,000 units June 25 $4.75 7,000 units June 30 1,000 units 6,000 units Calculate costs of goods sold at time of sale on June Date Units Unit Cost End Total Cost June 5 2,000 $4.00 Inv $ 8,000 June 15 3,000 $ ,200 June 15 3,000 $ ,200 CGS Total 8,000 $34,000 Units Cost Total Cost CGS 3,000 = $13,200 End 5,000 $8, ,200 = $21,200 Available 8,000 $34,

18 LIFO (Perpetual) LIFO (Perpetual) Date Purchases Sales Balance June 5 $4.00 2,000 units June 15 $4.40 5,000 units June 25 $4.75 7,000 units June 30 1,000 units 6,000 units Calculate costs of goods sold at time of sale on June 30 Date Units Unit Cost End Total Cost June 5 2,000 $4.00 Inv $ 8,000 June 15 3,000 $ ,200 June 25 1,000 $4.75 4,750 June 25 1,000 $4.75 CGS 4,750 Total 7,000 $30, Units Cost Total Cost CGS 1,000 = $ 4,750 End 6,000 $8, , ,750 = $25,950 Available 7,000 $30, LIFO (Perpetual) Comparison of Cost Flow Methods Date Units Unit Cost Total Cost June 5 2,000 $4.00 $ 8,000 June 15 3,000 $ ,200 June 25 1,000 $4.75 4,750 Total 6,000 $25,950 Average Cost Moving Average FIFO LIFO Periodic LIFO Perpetual CGS $17,560 $ 17,320 $16,800 $18,300 $25,950 End Inv $26,340 $26,580 $27,100 $25,600 $17,950 Date Units Cost of Goods Sold June 20 3,000 $13,200 June 30 1,000 4,750 Total 4,000 $17, FIFO When Costs Are Rising Matches low (older) costs with sales Higher gross profit Higher taxable income Ending inventory approximates replacement cost LIFO When Costs Are Rising Matches high (newer) costs with sales Lower gross profit Lower taxable income Ending inventory lower (older) costs Does not approximate replacement cost Not allowed under IFRS

19 Decision Makers Perspective Match Replacement Cost to Revenue How closely do reported costs reflect actual flow of inventory? (not factor) Are costs matched to revenues? Does ending inventory = replacement How does the choice effect Net income Income taxes Cash flow 109 Selling price: $100, sell one unit Two inventory layers Older layer: 10 units at $95 Newer layer: 5 units at $104 FIFO LIFO Revenues Cost of goods sold Gross profit 5 (4) 110 Tax Advantage Of LIFO LIFO Conformity Rule FIFO LIFO Revenues Cost of goods sold Gross profit Wages expense Rent expense Net income before taxes If LIFO used for tax purposes IRS requires LIFO for book purposes In notes can disclose value of ending inventory using alternate method (FIFO or weighted average) Income tax (40%) Net income FIFO net income advantage 42 LIFO tax savings / cash flow advantage How Popular is Each Cost Flow Method Learning Objectives LIFO reserve Method Percentage FIFO % 1973 LIFO 30% Average cost 20% Other 4% Total 100%

20 LIFO Reserve or Allowance Many companies use LIFO for external reporting and income tax purposes Maintain internal records using FIFO or average cost Disclosure describes difference between LIFO and book inventory LIFO Reserve or Allowance Conversion from FIFO or average cost to LIFO takes place at end of period LIFO reserve may be contra account Use disclosure note at FIFO cost $12,541 $11,544 Less: LIFO reserve (or allowance) 1,581 1,807 at LIFO cost $10,960 $9, Annual report: Dr. Pepper note LIFO Reconciliation Note For comparison with other companies, a disclosure note is required to convert LIFO inventory to replacement cost Learning Objectives LIFO liquidations Codification: S99 (bottom of page) at LIFO cost $10,960 $9,737 Add: Conversion to FIFO 1,581 1,807 at FIFO cost, which approximates replacement cost $12,541 $11, LIFO Liquidation LIFO Liquidation In time of rising costs (usual case) Older LIFO layers have lower cost If older layers sold (LIFO liquidation) Lower cost of goods sold Higher net income before taxes Date Units Cost Total January 1,000 $12 $12,000 May 1,200 $15 $18,000 September 1,500 $20 $30,000 If 2,000 units sold CGS = (1,500 $20) + (500 $15) CGS = $37,500 Higher taxes Paper profits If material, disclose in notes If 2,000 had been purchased in September at $20 CGS = 2,000 $20 CGS = $40,000 Problem: Old CGS expense matched to current revenue 119 CGS $2,500 lower because LIFO liquidation

21 Learning Objectives Dollar-value LIFO LIFO Pools Large retailers have More than 10,000 different items in stock More than 100,000 total units in inventory Unit LIFO costly to implement LIFO liquidations always possible, but should be avoided LIFO Pools Dollar-Value LIFO (DVL) pools consist of inventory units grouped according to similarities Physical similarities (lumber, tools, paint) pool simplifies record keeping Pools reduce risk of LIFO liquidation Similar units purchased in same period are pooled, assigned average cost 123 DVL extends concept of pools Most LIFO applications use DVL Pools based on similar cost changes Costs increase 0% to 2% Costs increase 2% to 5% Costs increase 5% to 10% Not based upon physical similarities Large variety of goods in one pool 124 Dollar-Value LIFO (DVL) Dollar-Value LIFO (DVL) DVL pools layers of dollars, not units Layers have similar cost changes Each pool has one layer per year Reduces risk of LIFO liquidations Simplifies pool record-keeping records during period Do not record purchase costs as layers Do not record unit inflows and outflows At end of period Count ending inventory Value at end of period costs

22 Dollar-Value LIFO (DVL) Unit LIFO compares Ending units to beginning units Dollar-Value LIFO compares Ending inv cost to beginning inv cost Dollar-Value LIFO (DVL) Comparing costs creates a problem Costs change over time If end inv cost > beg inv cost Do we have more inventory? Do we have less inventory at higher cost? Cost Similar to Consumer (CPI) Companies create cost index internally Double-extension method Link-chain method In our class cost index given Dollar-Value LIFO (DVL) At end of period, determine if a new inventory layer was added by Converting ending inventory to beginning inventory price level Comparing converted ending dollar amount to beginning dollar amount If ending > beginning, create new layer Dollar-Value LIFO (DVL) Restate layers to actual cost Identify layers in ending inventory and the years they were created Convert each layer s base year cost to actual cost by multiplying by cost index Sum all the layers to arrive at ending inventory at DVL cost Dollar-Value LIFO (DVL) Example 1 Purchase, sell 10,000+ chairs per year Ending inventory always one chair Year Units Year-End $ Base-Year $ Yearly Change = = = = Ending inventory valued at $100 at the end of each year

23 Dollar-Value LIFO (DVL) Example 2 Purchase, sell 10,000+ chairs per year Ending inventory varies Year Units Year-End $ Base-Year $ Yearly Change = = = 200 (200) = Year Units Year-End $ Base-Year $ Yearly Change = = = 200 (200) = Deflate inventory at year-end cost to base year cost (4.20 / 1.05) 420 (216 / 1.08) (672 / 1.12) : Dollar-Value LIFO (DVL) Example 2 Year Units Year-End $ Base-Year $ Yearly Change = = = 200 (200) = at Base-Year s Layers at Base-Year s at DV LIFO Cost 420 (2011) = 100 (2012) = 315 Total = 400 = 415 Reflate inventory to actual cost during year purchased at Base-Year s Layers at Base-Year s at DV LIFO Cost 420 (2011) = 100 (2012) = 315 Total = 400 = ( ) : Dollar-Value LIFO (DVL) Example 2 Year Units Year-End $ Base-Year $ Yearly Change = = = 200 (200) = at Base-Year s Layers at Base-Year s at DV LIFO Cost 200 (2011) = 100 (2012) = 105 Total = 200 = 205 Reflate inventory to actual cost during year purchased at Base-Year s Layers at Base-Year s at DV LIFO Cost 200 (2011) = 100 (2012) = ( ) 105 Total = 200 =

24 2014: Dollar-Value LIFO (DVL) Example 2 Year Units Year-End $ Base-Year $ Yearly Change = = = 200 (200) = at Base-Year s Layers at Base-Year s at DV LIFO Cost 600 (2011) = 100 (2012) = 105 (2014) = 448 Total = 600 = 653 Reflate inventory to actual cost during year purchased at Base-Year s Layers at Base-Year s at DV LIFO Cost 600 (2011) = 100 (2012) = 105 (2014) = 448 Total = 600 = ( ) 105 ( ) Year Dollar-Value LIFO (DVL) Example 3 Year-End $ Base-Year $ Yearly Change , = 200, , = 260,000 60, , = 250,000 (10,000) , = 270,000 20, : Dollar-Value LIFO (DVL) Example 3 Year Year-End $ Base-Year $ Yearly Change , = 200,000 at Base-Year s Layers at Base-Year s at DV LIFO Cost 200, , = 200,000 First year using dollar-value LIFO : Dollar-Value LIFO (DVL) Example : Dollar-Value LIFO (DVL) Example 3 Year Year-End $ at Base-Year s Layers at Base-Year s Base-Year $ Yearly Change , = 200, , = 260,000 60,000 at DV LIFO Cost 260,000 (2011) 200, = 200,000 (2012) 60, = 69,000 Total = 260,000 = 269,000 Year Year-End $ at Base-Year s Layers at Base-Year s Base-Year $ Yearly Change , = 200, , = 260,000 60, , = 250,000 (10,000) at DV LIFO Cost 250,000 (2011) 200, = 200,000 (2012) 50, = 57,500 Total = 250,000 = 257,

25 2014: Dollar-Value LIFO (DVL) Example 3 Turnover Year Year-End $ at Base-Year s Layers at Base-Year s Base-Year $ Yearly Change , = 200, , = 260,000 60, , = 250,000 (10,000) , = 270,000 20,000 at DV LIFO Cost 270,000 (2011) 200, = 200,000 (2012) 50, = 57,500 (2014) 20, = 26,000 Total = 270,000 = 283, How many times do we buy and sell average inventory during year turnover = Cost of goods sold Average inventory 146 Turnover Days To Sell How many times do we buy and sell average inventory during year How many days to sell $1 of inventory turnover = Cost of goods sold Beg inv + End inv ( 2 ) Days to sell inventory = 365 turnover Gross Profit Ratio End of Chapter How much of every $1 of sales becomes gross profit? Gross profit ratio = Gross profit Net sales

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