C H A P T E R 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH. Inventory Issues. Inventory Issues. Inventory Issues

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1 C H A P T E R 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield 1. Identify major classifications of inventory. 2. Distinguish between perpetual and periodic inventory systems. 3. Identify the effects of inventory errors on the financial statements. 4. Understand the items to include as inventory cost. 5. Describe and compare the cost flow assumptions used to account for inventories. 6. Explain the significance and use of a reserve. 7. Understand the effect of liquidations. 8. Explain the dollar-value method. 9. Identify the major advantages and disadvantages of. 10. Understand why companies select given inventory methods. 8-3 Learning Objectives Valuation of of Inventories: Cost-Basis Approach Issues Issues Illustration 8-18 Issues Cost flow Control Basic inventory valuation Physical Goods Included in Goods in transit Consigned goods Special sales agreements errors Costs Included in Product costs Period costs Purchase discounts Cost Flow Assumptions Specific identification Average cost FIFO : Special Issues reserve liquidation Dollar-value Comparison of approaches Advantages of Disadvantages of Basis for Selection Summary of inventory valuation methods Inventories are: items held for sale, or goods to be used in the production of goods to be sold. Businesses with : Merchandiser or Manufacturer One inventory account Purchase goods ready for sale Issues Issues Issues Illustration 8-18 Cost Flow Illustration 8-28 Cost Flow Illustration 8-38 Three accounts Raw materials Work in process Finished goods Companies use one of two types of systems for maintaining inventory records perpetual system or periodic system

2 Perpetual System Cost Flow 1. Purchases of merchandise are debited to. 2. Freight-in is debited to. Purchase returns and allowances and purchase discounts are credited to. 3. Cost of goods sold is debited and is credited for each sale. 4. Subsidiary records show quantity and cost of each type of inventory on hand. The perpetual inventory system provides a continuous record of and Cost of Goods Sold. Periodic System Cost Flow 1. Purchases of merchandise are debited to Purchases. 2. Ending determined by physical count. 3. Calculation of Cost of Goods Sold: Beginning inventory $ 100,000 Purchases, net 800,000 Goods available for sale 900,000 Ending inventory 125,000 Cost of goods sold $ 775,000 Cost Flow Illustration: Fesmire Company had the following transactions during the current year. Record these transactions using the Perpetual and Periodic systems Cost Flow Cost Flow Issues Illustration: Illustration 8-48 Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows. Over and Short Control All companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports. Note: Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Over and Short in the Other revenues and gains or Other expenses and losses section of the income statement Basic Issues in in Valuation Basic Issues in in Valuation Physical Goods Included in in Valuation Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. Illustration 8-58 Valuation requires determining The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). The costs to include (product vs. period costs). The cost flow assumption (FIFO,, Average cost, Specific Identification, Retail, etc.). A company should record purchases when it obtains legal title to the goods. Illustration

3 Effect of of Errors Effect of of Errors Effect of of Errors Ending Misstated Illustration 8-78 Illustration: Jay Weiseman Corp. understates its ending inventory by $10,000 in 2009; all other items are correctly stated. Illustration 8-88 Purchases and Misstated Illustration 8-98 The effect of an error on net income in one year (2009) will be counterbalanced in the next (2010), however the income statement will be misstated for both years. The understatement does not affect cost of goods sold and net income because the errors offset one another LO 3 Identify the effects of inventory errors on the financial statements LO LO 3 Identify the effects of inventory errors on the financial statements. Costs Included in in Costs Included in in Which Cost Flow Assumption to to Adopt? Product Costs - costs directly connected with bringing the goods to the buyer s place of business and converting such goods to a salable condition. Period Costs generally selling, general, and administrative expenses. Purchase Discounts Gross vs. Net Method Treatment of Purchase Discounts * Illustration ** FIFO Average Cost Cost Flow Assumption Adopted does not need to to equal Physical Movement of of Goods Specific Identification 8-22 LO 4 Understand the items to include as inventory cost. * $4,000 x 2% = $80 ** $10,000 x 98% = $9, LO 4 Understand the items to include as inventory cost Answer: Method adopted should be one that most clearly reflects periodic income. Example makes the following purchases: 1. One item on 2/2/11 for $10 2. One item on 2/15/11 for $15 3. One item on 2/25/11 for $20 sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2011, assuming the company used the FIFO,, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. First-In-First-Out (FIFO) Balance = $ 35 First-In-First-Out (FIFO) Cost of goods sold 10 Gross profit 80 Income before tax 47 Taxes 14 Net Income $

4 Last-In-First-Out () Last-In-First-Out () Average Cost Balance = $ 25 Cost of goods sold 20 Gross profit 70 Income before tax 37 Taxes 11 Net Income $ Average Cost Specific Identification Specific Identification Balance = $ 30 Depends For the Month which of one Feb is sold Cost of goods sold 15 Gross profit 75 Income before tax 42 Taxes 12 Net Income $ Specific Identification 8-34 Financial Statement Summary FIFO Average $ 90 $ 90 Cost of goods sold Gross profit Operating expenses: Income before taxes Income tax expense Net income $ 33 $ 26 $ 30 Balance Illustration: Call-Mart Inc. had the following transactions in its first month of operations. Calculate Goods Available for Sale Beginning inventory (2,000 x $4) $ 8,000 Purchases: 6,000 x $ ,400 2,000 x ,500 Goods available for sale $43, LO 5 Illustration: Assume that Call-Mart Inc. s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the amount of ending inventory and cost of goods sold Illustration 8-128

5 Weighted-Average Average Cost Illustration Moving-Average Average Cost Illustration First-In, First-Out (FIFO) Periodic Method Illustration In this method, Call-Mart computes a new average unit cost each time it makes a purchase. Determine cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory First-In, First-Out (FIFO) Last-In, First-Out () Last-In, First-Out () Perpetual Method Illustration Periodic Method Illustration Perpetual Method Illustration In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. The cost of the total quantity sold or issued during the month comes from the most recent purchases. The method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method Reserve Many companies use for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: 1. Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. troublesome for interim periods LO 6 Explain the significance and use of a reserve Reserve is the difference between the inventory method used for internal reporting purposes and. FIFO value per books $160,000 Example: value 145,000 Reserve $ 15,000 Journal entry to reduce inventory to : Cost of goods sold 15,000 Allowance to reduce inventory to 15,000 Companies should disclose either the reserve or the replacement cost of the inventory. LO 6 Explain the significance and use of a reserve Liquidation Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2010, with cost determined on a specific goods approach. LO 7 Understand the effect of liquidations.

6 Liquidation Illustration: At the end of 2011, only 6,000 pounds of steel remained in inventory. Illustration Dollar-Value Changes in a pool are measured in terms of total dollar value, not physical quantity. Advantage: Broader range of goods in pool. Permits replacement of goods that are similar. Helps protect layers from erosion. Dollar-Value Exercise 8-26 (partial): The following information relates to the Choctaw Company. Use the dollar-value method to compute the ending inventory for 2007 through LO 7 Understand the effect of liquidations Exercise 8-26 Solution at at $ Value End-of-Year Base-Year Base $ Value Year Prices Index Prices Layers Index TOTAL Reserve 2007 $ 70, $ 70,000 $ 70, $ 70,000 $ 70,000 $ - Exercise 8-26 Solution at at $ Value End-of-Year Base-Year Base $ Value Year Prices Index Prices Layers Index TOTAL Reserve 2007 $ 70, $ 70,000 $ 70, $ 70,000 $ 70,000 $ - Exercise 8-26 Solution at at $ Value End-of-Year Base-Year Base $ Value Year Prices Index Prices Layers Index TOTAL Reserve 2007 $ 70, $ 70,000 $ 70, $ 70,000 $ 70,000 $ , ,000 70, ,000 14, ,700 84,700 3, , ,000 70, ,000 14, ,700 84,700 3, , ,000 70, ,000 14, ,700 84,700 3, , ,000 70, ,000 12, ,600 82,600 12, , ,000 70, ,000 12, ,600 82,600 12, , ,000 70, ,000 12, ,600 82,600 12,520 Dec. 31 Dec. 31 Dec. 31 Balance Sheet $ 70,000 $ 88,200 $ 95,120 Reserve - (3,500) (12,520) $ 70,000 $ 84,700 $ 82,600 Journal entry Cost of goods sold 3,500 9,020 Lifo reserve (3,500) (9,020) 8-49 Dec. 31 Dec. 31 Dec. 31 Balance Sheet $ 70,000 $ 88,200 $ 95,120 Reserve - (3,500) (12,520) $ 70,000 $ 84,700 $ 82,600 Journal entry Cost of goods sold 3,500 9,020 Lifo reserve (3,500) (9,020) 8-50 Dec. 31 Dec. 31 Dec. 31 Balance Sheet $ 70,000 $ 88,200 $ 95,120 Reserve - (3,500) (12,520) $ 70,000 $ 84,700 $ 82,600 Journal entry Cost of goods sold 3,500 9,020 Lifo reserve (3,500) (9,020) 8-51 Basis for Selection of of Method Comparison of Approaches Advantages Disadvantages is generally preferred: Specific-goods - costing goods on a unit basis is expensive and time consuming. Specific-goods Pooled approach reduces record keeping and clerical costs. more difficult to erode the layers. using quantities as measurement basis can lead to untimely liquidations. Dollar-value is used by most companies. Matching Tax Benefits/Improved Cash Flow Future Earnings Hedge Reduced earnings understated Physical flow Involuntary Liquidation / Poor Buying Habits 1. if selling prices are increasing faster than costs and 2. if a company has a fairly constant base stock. is not appropriate: 1. if prices tend to lag behind costs, 2. if specific identification traditionally used, and 3. when unit costs tend to decrease as production increases LO 9 Identify the major advantages and disadvantages of LO 10 Understand why companies select given inventory methods.

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