Chapter. Valuation of Inventories: Valuation of Inventories: Manufacturing Companies. A Cost Basis Approach. A Cost Basis Approach. What is Inventory?

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1 Valuation of Inventories: A Cost Basis Approach Chapter Valuation of Inventories: A Cost Basis Approach Classification Errors Perpetual v. Periodic Cost Flow What is Inventory? Manufacturing Companies Asset items held for sale in the ordinary course of business or... goods that will be used or consumed in the production of goods to be sold. Classification of inventories: Raw Materials Work in Progress Finished Goods Generally a significant asset Generally a primary source of revenue Impacts both balance sheet and income statement

2 Inventory- the basics Where does inventory go? COS- Therefore Pretty important If inventory is overstated, then what else is impacted? COS is understated (rollforward) Net income AND gross profit are overstated Various ratios impacted Next year it reverses (COS is overstated etc.) It is stated at Lower of Cost or Market (LCM) Inventory issues introduced Four basic questions/ issues: 1. What is it? The costs necessary to make the product available for sale, including costs of holding it once completed. 2. Whose is it? It belongs to the party with whom the risks and rewards lie. 3. How many units are there? Perpetual, OR Periodic 4. How much did it cost? Can be tricky, because prices change over time and consequently how do you know which unit you sold and how you paid for it. Specific identification- no methodology or assumptions, but costly and perhaps not possible; Average or weighted average, can be moving average FIFO (first in first out, aka last in still here) LIFO (last in first out, aka first in still here) Can result in some strange results when inventory levels are depleted (called LIFO Liquidation). Consequently the following has been designed to mitigate: Specific goods pooled LIFO approach Dollar Value LIFO Product cost -- invoice cost, freight in, labor, and other direct production costs (up to time of sale) Period costs -- selling, general, and administrative not inventoriable

3 When title passes fob shipping point fob destination Property of the consignor ABC Freight Line not to be removed from seller s inventory acct. parking transaction, no sale should be recorded

4 UPDATE- NEW LITERATURE FASB issued new statement which aligned US GAAP with International Standards. As a result, abnormal costs are NOT to be included as a cost of inventory, and accordingly expensed as incurred. Perpetual vs. Periodic J/E s Beginning inventory 100 $6 ($600): Purchase 900 $6: Perpetual -- Debit Credit Inventory 5,400 Accounts payable 5,400 Periodic -- Purchases 5,400 Accounts payable 5, Perpetual vs. Periodic J/E s Sale of 600 $12: Perpetual -- Debit Credit Accounts receivable 7,200 Sales 7,200 Cost of goods sold 3,600 Inventory 3,600 Periodic -- Accounts receivable 7,200 Sales 7,200 Under PERIODIC-COS entry delayed until physical count, closing entries. Inventory is overstated and COS understated, until count & closing entry. Perpetual vs. Periodic J/E s Ending inventory 400 $6: Perpetual -- Debit Credit No entries (all balance are correct) Periodic (remember there was $600 to start) Inventory 5,400 Purchases 5,400 Inventory 3,600 Cost of good sold (plug) 3,

5 First-in-First-out (FIFO) First-in-First-out (FIFO) Balance = $ Cost of goods sold 10 Gross profit 80 Income before tax 47 Taxes 14 Net Income Last-in-First-out (LIFO) Last-in-First-out (LIFO) Balance = $ Cost of goods sold 20 Gross profit 70 Income before tax 37 Taxes 11 Net Income

6 Average Cost Average Cost Balance = $ Cost of goods sold 15 Gross profit 75 Income before tax 42 Taxes 12 Net Income Specific Identification Specific Identification Depends which one is sold For the Month of Jan

7 Summary FIFO LIFO Average $ 90 $ 90 Cost of goods sold Gross profit Operating expenses: Income before taxes Income tax expense Net income $ 33 $ 26 $ 30 Inventory Balance Trade Discounts Same as we did for accounts rec./ sales Gross (record full amount and treat discount appropriately when it happens) Net (record net of discount and deal with any lost discounts as an increase in COS when it happens) GROSS METHOD NET METHOD Purchase Cost $10,000 terms 2/10 net 30 Purchases 10,000 Purchases 9,800 Accounts Payable 10,000 Accounts payable 9,800 Invoices of $4,000 paid within discount period Accounts payable 4,000 Accounts payable 3,920 Purchase discount 80 Cash 3,920 Cash 3,920 Invoices of $6,000 paid after discount period Accounts payable 6,000 Accounts payable 5,880 Cash 6,000 Purchase discounts lost 120 Cash 6, Misc. Considerations Interest typically not capitalized to inventory Inventory should be turning quick enough that this should not matter Long-term discreet projects do get interest capitalized though. More mechanics What happened during 2001: Units Unit Price Value Opening inventory 11 Purchases ,500 Inventory available for sale 161 1,610 SOLD 140 UNITS (140) 10 (1,400) COGS SHOULD BE Ending inventory should be Company erroneously records inventory at Error (10) The error overstates inventory. The only reasonable way that could occur is if the Company understatrd COS. What happens in 2002: During 2002, the Company "catches up". In order to do so, they Must overstate COS because their opening inventory is overstated. Units Unit Price Value Inventory count is made, there are 20 units 20 Bal Sheet should reflect They made purchases of $1,600 and sold $1,610 (161 units), therefore they should record COS of $1,610- right? 8-27 Opening inventory 220 Purchases 1,600 Ending inventory (200) COS recorded to "get to" proper invent. 1,620 BUT the proper amount is 1,610 (10) THIS IS WHAT WE CALL THE "TURNAROUND IMPACT" 8-28

8 27 10/13/96 DOLLAR VALUE LIFO MECHANIX Dollar Value Lifo seeks to account for inflation by looking at the change from year to year in base year dollars and then converting THE CHANGE back to current dollars. STEPS: 1) Convert ending inventory to base year (divide ending by price index) 2) Compute change in base year dollars 3) If increased, convert the increase back to current year by multiplying the increase by the price index and adding to the prior year balance 1) If decreased, then subtract from the prior year base, recompute the prior year change using the prior year price index. 4) Add Layers all back together to compute ending inventory. DOLLAR VALUE LIFO EXAMPLE (Text p. 388) Inventory at Price Inventory at Base Yr Convert Base Yr INVENTORY AT 31-Dec Year-end Prices Index Base-year Price Change Back Layer YEAR END , ,000 n/a n/a 200, , , ,000 60, , , , ,000 (10,000) 115 (11,500) 257, , ,000 20, , ,500 In 2003, we "convert back" using the prior year index- BECAUSE there was a decline in the base year inventory, meaning the inventory came out of the prior year. If it was purchased in the prior year, then the proper index is from the prior year. Divide Subtract Multiply Add Last-in-First-out (LIFO) Balance = $ 25 For the Month of Jan Cost of goods sold 20 Gross profit 70 Income before tax 37 Taxes 11 Net Income