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Intermediate Financial Accounting I: Inventories: Measurement
Intermediate Financial Accounting I: Inventories: Measurement
Inventories: Measurement
1. Inventories:
How would the valuation and cost flow assumptions of inventory affect the income measurement? Valuation Methods: Historical Cost, Current Exist Value, Current Entry Value, Present Value, LCM. Cost Flow Assumptions: LIFO, FIFO, Average, Specific Identification. CGS = Beginning Inventory + Net Purchase - Ending Inventory
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Inventories:
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
Year 2
over under under over under over
a. either understating the units or the value b. either overstating the units or the value
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Ending Inv. understated R/E no effect A/P under Working Capital no effect Current Ratio overstatinga
a. When CA > CL
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Defining Inventory
1. Assets held for resale purpose in a normal course of business
Presentation of Inventory for Merchandising and Manufacturing Companies (Illustration 8-1, KWW, 14th e)
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th
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10
Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories. 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.
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12
Assuming that Fesmire Company had the following transactions during the current year:
Inventory Beginning Inv. Purchases Sales Units 100 900 600 Unit Cost $6 $6 $12 Total $600 $5,400 $7,200
Ending Inventory
400
$6
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$2,400
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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. The CGS is determined by selecting a cost flow assumption.
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Perpetual Systems Cost of Goods Sold and the Ending Inventory (contd.)
Physical inventory count is still needed at the end of a period to determine whether inventory loss occurred. A write down is required in the case of inventory loss.
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Periodic Inventory System the Ending Inventory 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
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Purchase Sell
W-A
100 $5 100 $5 100 $5 250 $5.6 150 $6 50 $5 50 $5.6 50 $5 150 $6.53 100 $7 50 $5 120 $6.53 70 $7
a. Sales price is $10 per unit. b. Sales price is $11 per unit. c.LIFO is not permiitted under IFRS
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Example (contd.)
Inventory a (FIFO) B.B.500 1100 900 180 700 E.B.820
a. The balance of inventory is known at all time under the perpetual inventory system.
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Example (contd.)
CGS (FIFO) 3/7...1100 3/28...180 1280
1.The balance of inventory is known at all time under the perpetual inventory system.
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LCM =$600
25
Adjusting entry => Given that Allowance for Declining in Market Value of inventory has a beginning balance of zero:
Allowance 0 -- 3/1 160 160 -- 3/31 3/31 Loss Due to Market Value Decline of Inventory 160 Allowance to Reduce Inventory to Market 160 760 (160) 600
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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
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If the Allowance account had a beginning balance of 200, the adjusting entry would be:
Allowance 40 200 160 Allowance 40 Gain from Recovery of M.V. of Inventory 40
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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.
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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.
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Example (contd.)
Inventory Data: Units 3/1 (B.B) 100 3/5 Pur. 150 3/14 Pur. 100
The CGS under FIFO is: Cost $500 + 1,600 - 730 = $1,370. $5 $6 If a LIFO assumption is used, the cost of end. $7 Inv. is: $5 x 100 + $6 x 5 = $530. The CGS is: $500 + 1600 - 530 = $1,570.
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Adjusting entry:
Loss Due to Market Decline of Inv. Allowance to Reduce Inv. to Market
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130
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Examples of Earnings Boosted by Selling Inventory Which Had Been Written Down previously (Source: P500 of KWW, 14th e)
Company Gain from reversal Disclosure
Vishay Intertechnology
Not Available
Did not mention the gain in its earnings release.. It only disclosed this gain from write-down in two weeks later in its SEC filing . Similar to the case of Vishay
Transwitch
$600,000
Cisco Systems
$525 million
Detailed in its earnings releases and in SEC filings the gains from selling inventory it had previously written off.
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Low
Low
Unfair
Fair
High
High
Fair
Unfair
36
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2010
666
176 26%
325 49%
147 22%
18 3%
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Switching to LIFO
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CGS):
Strategy:
Strategy:
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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.
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Disadvantage of FIFO
a. 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.
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Advantages of LIFO
a. Good match of sales revenue with CGS. b. Produce lower income during an inflation period; result in tax savings.
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Disadvantages of LIFO
a. Inventory cost presented on the B/S is not fair.
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IRS
1. 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.
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IRS (contd.)
3. LIFO is not acceptable by the IRS till 1939.
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4. LIFO Liquidations
A LIFO Liquidation profit can occur when units purchased are less than units sold in the period.
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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
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Choice of Inventory Cost-Flow Assumptions and Conversion of FIFO to LIFO for Comparison Purposes* 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.
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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 . The change in the balance of LIFO Reserve from one period to another is referred as the LIFO Effect , an impact on income.
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Assume that Acme Boot Company uses FIFO method for internal reporting purposes and a LIFO for external reporting purposes. 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. Inventory on 12/31/x5 at FIFO = $320,000 Inventory on 12/31/x6 at FIFO =$360,000
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12/31/x5 Inventory at FIFO $360,000 $320,000 LIFO Reserve (50,000) (20,000) Inventory at LIFO $310,000 $300,000 Thus, $30,000 should be added to the LIFO Reserve account. The LIFO effect (i.e., the impact on income) for 20x6 is $30,000.
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30,000
a. reported as a contra account to inventory or a deduction from inventory (see p53 for presentation)
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Inventory Presentation and Footnote Disclosure (also see Illustration 8-19 of KWW, 14th e)
12/31/x6: Inventories, net of adjustment to
$310,000
are valued at the lower of cost or market determined principally by the LIFO method. If the FIFO cost method had been used, inventories would have been $50,000 higher.
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th 14
e)
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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).
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Special Cases
a. Consigned Goods: Legal title remained with the consignor (manufacturers). b. Sales with High Sales Returns (conditional sale): c. Sales on Approval:
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$6 $9 $4 $12
$8 $8 $8 $8
$5 $5 $5 $5
$6 $8 $5 $8
$6 $8 $5 $8
a. Example of the ceiling can prevent future unexpected loss. b.Example of preventing the recognition of abnormal loss in the current period.
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For financial reporting, LCM can be performed at the individual item level, at the category level or at the total inventory level.
Common practice: at the individual item level. LCM performed at the individual item level is most conservative and is most commonly used because it is complied with the IRS rule.
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Market LCM (at individual level) $60 $50 $100 $100 $360 $300 $520 $450 _____ _____ _____ _____
LCM at group level ==> $490 The difference of $40 is resulting from item B: $140 - 100 = $40
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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 writedown when the conditions for write-down do not exist. US GAAP does not allow the reversal of inventory write-down. Measurement Inventories: 68
The accounting treatments for accounting method changes are: a. Current Period Approach: cumulative effect from the change reported in the I/S. (Note: eliminated by SFAS 154) b. Retrospective Approach
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When change from other method to LIFO, neither a cumulative effect nor a retrospective adjustment can be made. The base year inventory for all following years is the beginning inventory of the year In which LIFO is adopted.
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This value of the beginning inventory needs to be adjusted to the cost. The effect of the change on the current years income and on the value of the ending inventory must be disclosed.
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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):
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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.)
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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)
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8. LIFO Inventory Pools (Specific Goods Pooled 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.
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1) simplify recordkeeping by grouping inventory into pools, and 2)reduce the probability of LIFO layer liquidation/erosion.
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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.
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.
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The 2008 beg. inventory (BI)of Cole Glass Inc. LIFO inventory pool consisted of the following:
Quantity (squared foot (SF)) Cost (per SF) Total Cost
$3.00
$30,000
Grade B
Grade C
14,000
11,000
$2.50
$2.20
$35,000
$24,200
Totals
35,000
($89,200/ 35,000)
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$89,200
79
During 20x8, Cole sold 48,000 squared feet of window glass and purchased 51,000 squared feet as follows:
Quantity (squared foot (SF)) Cost (per SF) Total Cost
20,000
$3.10
$62,000
Grade B
Grade C Totals Average 2008 SF Cost of the Pool
15,000
16,000 51,000 $2.75 =
$2.60
$2.45
$39,000
$39,200 $140,200
($140,200/ 51,000)
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The average cost of 2008 beg. inventory and 2008 window glass inventory pool is $2.55 and $2.75, respectively. The ending inventory quantity for the pool is: 35,000+51,000-48,000=38,000 units
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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 . Thus, the cost of 2008 ending inventory equals: $2.55 x 35,000+ $2.75x 3,000 = $97,500
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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. Even if the product is replaced, it may not be similar to the old item and cannot be included in the same pool.
Therefore, LIFO inventory pool requires redefine pools periodically when there are changes in the product mix of the pool.
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DV LIFO technique simplifies the recordkeeping procedures (due to no need to keep unit flows). 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).
This technique is commonly used in practice for companies adopting LIFO assumption.. Inventories: Measurement
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DV LIFO defines a layer as the dollar value, not units, of ending inventory for a specific year. One layer is formed for each year. Dollar Value of Inventories: Current cost (the most recent purchase price) of the ending Inventory.
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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). 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).
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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. Cost index of a layer year =
Year
20x0 a 20x1 20x2 20x3
EI at of Ending (Price) Base year Inventory Index Price Levl. $20,000 100 $20,000 $30,000 120 $25,000 $35,100 130 $27,000 $40,600 140 $29,000
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Example (contd.)
Forming of layers: 20x0 20x1 20x2 20x3 20,000 ... 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 ..L4 Converting to the corresponding years index level: 20x0 20x1 20x2 20x3 20,000x1 =20,000 20, 000x1+ 20,000x1+ 20,000x1+ 5 ,000x1.2 5,000x1.2+ 5,000x1.2+ =26,000 2,000x1.3 2,000x1.3+ =28.600 2,000x1.489 Inventories: Measurement
Items with similar economic, not physical, characteristics (i.e., subject to similar cost change pressure) will be pooled together.
The more items are included in an inventory pool, the less likely the erosion of the LIFO layers can occur.
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Income number can be manipulated by changing the number of inventory pools. 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).
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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).
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Types of Indexes
Internal Index: Internal price index computed by the company for its own product. External Index: Computed by an outside party such as the government, commodity exchange, or trade association. General Index: Composed of several commodities, goods or services. Specific Index: For one commodity, good or service.
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The Consumer Price Index for urban consumers (CPI-U) is an example of an external general price index. CPI-U is published monthly by the Bureau of Labor Statistics of the federal government.
Specific external price indexes (i.e., for gold, silver, corn) are also available from trade associations.
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Example
Example (contd.)