Valuation of Inventories: A Cost-Basis Approach



Chapter 8-1

Inventory Classification and Systems
Inventories are:
items held for sale, or goods to be used in the production of goods to be sold.

Businesses with Inventory:




Chapter 8-2

Inventory Classification and Systems
Two systems for maintaining inventory records:
Perpetual system Periodic system

Chapter 8-3

Inventory Classification and Systems
Perpetual System

Purchases of merchandise are debited to Inventory.

2. Freight-in, purchase returns and allowances, and

purchase discounts are recorded in Inventory.
credited for each sale.

3. Cost of goods sold is debited and Inventory is 4. Physical count done to verify Inventory balance.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.
Chapter 8-4

Inventory Classification and Systems
Periodic System

Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count. 3. Calculation of Cost of Goods Sold:

Beginning inventory Purchases, net Goods available for sale Ending inventory Cost of goods sold
Chapter 8-5

$ 100,000 800,000 900,000 125,000 $ 775,000

Inventory Classification and Systems
Perpetual System
2. Purchase 900 units at $7:

| | | | | |

Periodic System

1. Beginning inventory (100 units at $7 = 700)

3. Sale of 600 units at $14:

| | | | | | |

4. Adjusting entries (ending inventory = 400 units @ $7 = $2,800)
| | |
Chapter 8-6


Basic Issues in Inventory Valuation
Valuation of Inventories
Requires the following:
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, LIFO, Average cost, Specific Identification, Retail, etc.).

Chapter 8-7

1. Physical Goods Included in Inventory
Physical Goods
A company should record purchases when it obtains legal title to the goods.

Chapter 8-8

1. Physical Goods Included in Inventory
Special Consideration:
Goods in Transit (FOB shipping point, FOB destination) Consigned goods

Sales with buyback agreement
Sales with high rates of return Sales on installment
Chapter 8-9

2. Costs Included in Inventory
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.

Chapter 8-10

Examples of Physical goods and costs included in Inventory
See Ex 8-1

Chapter 8-11

Treatment of Purchase Discounts
Similar to treatment of cash discounts for Accounts Receivable Now you are the buyer with the option of taking the cash discount rather than the seller offering the discount

Chapter 8-12

Treatment of Purchase Discounts (Ex 8-8)
Gross Method vs.

Net Method

Purchase cost $20,000, terms 2/10, net 30:
| | | |

Invoices of $15,000 are paid within discount period:
| | | | |

Invoices of $5,000 are paid after discount period:
| | |
Chapter 8-13


3. Cost Flow Assumptions

Cost Flow Assumption Adopted
does not need to equal

Physical Movement of Goods

Average Cost

Specific Identification

Method adopted should be one that most clearly reflects periodic income.
Chapter 8-14

3. Cost Flow Assumptions
Example–Perpetual and Periodic Method (Ex 8-13
June 1 10 11 15 20 27

Inventory information for Part 686 for the month of June.
Beg. Balance Sold Purchased Sold Purchased Sold 300 units @ $10 = $ 3,000 200 units @ $24 800 units @ $12 = 500 units @ $25 500 units @ $13 = 300 units @ $27 6,500 9,600

1. Assuming the Perpetual and Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. 2. See refresher material posted on WebCT
Chapter 8-15

LIFO liquidation problem
Erosion of old LIFO layers
Benefits (when prices rise)
Lower COGS lead to higher earnings reported

Future demand may not be met Can lead to higher tax expense

Disclosure requirements
Material differences in income due to liquidation must be disclosed

Chapter 8-16

LIFO liquidation problem
Solutions to reduce problem LIFO Inventory Pools
Simplifies record keeping through grouping of inventory layers and reduces need for LIFO liquidation. How? Diversification effect – reductions in levels of one good offset by increases in another

Dollar Value LIFO
Chapter 8-17

Dollar Value LIFO
Changes in a pool are measured in terms of total dollar value, not physical quantity. Each year inventory is identified as a pool (or layer), hence inflation is accounted for using cost index. Advantage:
Broader range of goods allowed in pool

replacement of goods that are similar is allowed

Chapter 8-18

Dollar value LIFO
Dollar-Value LIFO
Exercise 8-25.

Chapter 8-19

Special Issues Related to LIFO
LIFO Reserve
Many companies use
LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. LIFO troublesome for interim periods
Chapter 8-20

Special Issues Related to LIFO
LIFO Reserve is the difference between the
inventory method used for internal reporting purposes and LIFO. FIFO value per books $160,000 Example: LIFO value 145,000 LIFO Reserve $ 15,000 Journal entry to reduce inventory to LIFO:
Cost of goods sold LIFO reserve 15,000 15,000

Companies should disclose either the LIFO reserve or the replacement cost of the inventory.
Chapter 8-21

Special Issues Related to LIFO
How to compare firms that use different inventory methods Convert all LIFO firms’ inventory and CGS to FIFO See Brown Shoe Company case P.453

A better way (not usually possible) is to use LIFO numbers for income related ratios and FIFO numbers for balance sheet ratios

Chapter 8-22

Effect of Inventory Errors
How can we work out effects of inventory errors?
Compare correct and incorrect examples using inventory equation.

The effect of an error on net income in one year (2006) will normally be counterbalanced in the next (2007), however the income statement will be misstated for both years.

Chapter 8-23

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