Agenda

• Return and go over Quiz 2

– Mean: 11
– Median: 12
• Quiz 3 Monday, May 14: (Chapter 7)
• Group Project 2 due Wednesday May 23
• Midterm 2 Monday, May 21 Chapters 7-9 & 18
• Wrap up chapter 7
– Notes Receivable example
– Transfers of Receivables
• Secured borrowing (pledge or assign)
• Sale with recourse
• Sale without recourse
• Chapter 8: Inventory

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 Inventory Reporting
Report inventory at the lower of cost or market (conservatism)

“Cost” – the historical cost of the inventory

• Retail – the cost to get items in location and in condition for sale
(i.e. purchase price, purchase discounts, purchase returns,
transportation in)

• Manufacturing:
– Raw materials – cost of materials on hand but not yet placed in
production.
– Work-in-process – cost of goods on which production has been started
but not yet completed (i.e. raw materials used, direct labor,
manufacturing overhead).
– Finished good – cost of goods complete but not yet sold.

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 Inventory Cost Flows

Merchandising Operations

Merchandise
Inventory
Purchases C/G/Sold
Cost of goods
sold
$$$
 Flow of Costs through
Manufacturing and
Merchandising Companies
 Inventory Control

Inventory control is important for:

1. Ensuring availability of inventory items
2. Preventing excessive accumulation of
inventory items
3. Preventing waste, spoilage, or theft
 Inventory Systems

Perpetual Method Periodic Method

• Purchases are debited • Purchases are debited
to Inventory account to Purchases account.
• Freight-in, Purch. • Freight-in, Purch. R & A
and Purch. Disc. are
Returns & Allowances
recorded in their
and Purch. Disc. are respective accounts.
recorded in Inventory • COGS is computed only
account. periodically:
• Debit COGS and credit COG Avail for Sale
Inventory account for - Ending Inventory
each sale. COGS
 Inventory System - Perpetual
J/E, Perpetual System:
Purchase of Inventory:
Dr. Inventory 1,000
Cr. A/P, Cash, etc. 1,000

Sale of Inventory:
Dr. Cost of Goods Sold 1,000
Cr. Inventory 1,000
Dr. Cash, A/R, etc. 1,500
Cr. Sales Revenue 1,500

At Year-End: no j/e required, unless errors are found in inventory count

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 Inventory System - Periodic
J/E, Periodic System:
Purchase of Inventory:
Dr. Purchases 1,000
Cr. A/P, Cash, etc. 1,000

Sale of Inventory:
Dr. Cash, A/R, etc. 1,500
Cr. Sales Revenue 1,500

At Year-End:
Dr. Ending Inventory (determined by count) 38,000
Dr. Cost of Sales (plug) 283,000
Cr. Purchases 286,000
Cr. Opening Inventory (carried forward from prior year) 35,000

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 Inventory Valuation

Basic Issues:
1. Physical goods to be included
1. Goods in transit (FOB Destination)
2. Goods on consignment with consignee
3. Goods sold under buy back agreements
4. Goods sold with high rates of return (if unable to estimate returns)
5. Installment sales (if unable to estimate bad debts)
2. Costs to be included in inventory (e.g. product (RM)
vs. period costs (office supplies)
3. Cost flow assumption used (e.g. specific
identification, average cost, FIFO, LIFO, etc.)

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 Effect of Inventory Errors

Error in Effect on Effect on

Ending Income Balance sheet
Inventory Items Items
Under- COGS (over) Inventory (under)
stated Net income (under) Retained Earn (under)

Over- COGS (under) Inventory (over)

stated Net income (over) Retained Earn (over)
Effect of Inventory Errors (O/S Ending)

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 Cost Flow Assumptions

Cost flow assumptions need not be consistent

with physical flow of goods. The objective is to
most clearly reflect periodic income.

The cost flow assumptions are:

1 Specific identification
2 Average cost
3 First-in, first-out (FIFO) and
4 Last-in, first-out (LIFO)
Cost Flow Assumptions: Example

Spaworld reports the following transactions for 2004

(assume no opening inventory):
Date Purchases Purchase Cost
May 12 100 units $1,000
Aug 14 200 units 2,200
Sep 18 120 units 1,800
420 units $5,000
On December 31, the company had 20 units on hand
and uses the periodic inventory system.
What are the cost of goods sold and the cost of
ending inventory?
 Average Cost Method

Given Data:
Date Purchases Cost
May 12 100 units $1,000
Aug 14 200 units $2,200
Sep 18 120 units $1,800
420 units $5,000

Steps:
1. Calculate per unit average cost: $5,000/420 = $11.905
2. Apply this per unit average cost to units sold to get COGS:
400 x $11.905 = $4,762
3. Apply the per unit average cost to units remaining in
inventory to determine Ending inventory: 20 x $11.91 = $238
 Average Cost Method
Journal Entries:
Dr. Cost of Sales 4,762
Dr. Ending Inventory 238
Cr. Opening Inventory 0
Cr. Purchases 5,000

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 First-In, First-Out (FIFO) Method

Given data: Cost of goods sold (FIFO)

Date Purchases Cost $1,000 (100 sold)
May 12 100 units @ $10 $1,000 $2,200 (200 sold)
Aug 14 200 units @ $11 $2,200 $1,500 (100 sold; 20 end inv)
Sep 18 120 units @ $15 $1,800 $4,700
420 $5,000
“Count” from one direction and “plug” the
Cost of goods
other
available Cost of goods sold $4,700

$5,000 Ending inventory 20 X $15 = $300

Note: FIFO = LISH (Last In Still Here)
 Last-In, First-Out (LIFO) Method

Given data: Cost of goods sold (LIFO)

Date Purchases Cost $ 800 (80 sold; 20, end inv)
May 12 100 units @ $10 $1,000 $2,200 (200 sold)
Aug 14 200 units @ $11 $2,200 $1,800 (120 sold)
Sep 18 120 units @ $15 $1,800 $4,800
420 $5,000

Cost of goods
available Cost of goods sold $4,800

$5,000 Ending inventory 20 X $10 = $200

LIFO = FISH (First In Still Here)
 Cost Flow Assumptions: Notes

• The ending inventory in units is the same in

all three methods: the cost is different.
• The cost of goods sold and the cost of
ending inventory are different, but
• In periods of rising prices, LIFO would result
in the smallest reported net income.
• The cost of goods available is the same for
all methods
 Advantages of LIFO Method

• LIFO matches more recent costs with

current revenues.
• With increasing prices, LIFO yields the
lowest taxable income (assuming inventory
does not decrease).
• With reduced taxes, cash flow is improved.
• Under LIFO, the need to write down
inventory down to market is lower.
 Disadvantages of LIFO Method
• LIFO does not approximate the physical flow of
goods except in special situations.
• LIFO yields the lowest net income and therefore
reduced earnings (when prices rise).
• Under LIFO, the ending inventory is understated
relative to current costs.
• LIFO involuntary liquidation may result in income
that is detrimental from a tax view.
• LIFO may cause poor buying habits (because of the
layer liquidation problem).
• LIFO Conformity Rule: if you use LIFO for tax
purposes, you must use it for financial reporting
too
 Periodic vs. Perpetual
• FIFO: CGS and EI numbers are exactly the same
under either periodic or perpetual systems
• BUT – LIFO, Weighted Average will give you
different numbers
– Under perpetual LIFO, with each sale, you cut into only
existing layers (so you must stop and calculate the cost
of goods sold at each sale)
– Under perpetual Weighted Average (more accurately,
Moving Average), you stop and calculate a new average
cost for every sale

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Same Example - Perpetual Basis
Purchased
Unit Total Units
Units Cost Cost Sold
12-May 100 10 1000
1-Jun 85
14-Aug 200 11 2200
1-Sep 100
18-Sep 120 15 1800
20-Sep 215
420 5000 400

Unit Extended Unit Extended

FIFO: Units Cost Value LIFO: Units Cost Value
1-Jun 85 10 850 1-Jun 85 10 850
1-Sep 15 10 150 1-Sep 100 11 1100
85 11 935 20-Sep 120 15 1800
20-Sep 115 11 1265 95 11 1045
100 15 1500
COGS 400 4700 COGS 400 4795

EI 20 15 300 EI 15 10 150
Same as Periodic 5 11 55
205
Different from Periodic 22
Same Example - Perpetual Basis
Purchased Sold
Unit Extended
Units Cost Cost Units
12-May 100 10 1000
1-Jun 85
14-Aug 200 11 2200
1-Sep 100
18-Sep 120 15 1800
20-Sep 215
420 5000 400

Calculate the average cost at time of each sale

Unit Extended
Wt. Av. Units Cost Value 1-Sep
1-Jun 85 10 850 costs to date 3200
1-Sep 100 10.9 1093.02 costs expensed 850
20-Sep 215 13 2796.81 0 2350
0 215
0 Av Cost 10.9
COGS 400 4739.83
Sept. 20
EI 20 13 260.168 Costs to date 5000
Costs expensed 1943
Remaining costs 3057
Remaining units 235
Different from Periodic Av cost 13

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 LIFO Reserve

LIFO Reserve (Allowance) account is used,

when:
LIFO is used for external reporting and a non-
LIFO basis is used for internal reporting.
An Allowance to Reduce Inventory to LIFO
is used to reduce the cost to a LIFO basis.
SEC reporting requirements – disclose the
difference between LIFO and current cost of
inventory reported on the Balance Sheet
 LIFO Reserve: Example
Jeppo Inc reports the following balances:
Inventory (FIFO basis) on Dec 31, 2004: $50,000
Inventory (LIFO basis) on Dec 31, 2004: $20,000
Adjust the cost of ending inventory to the LIFO basis
Dr. Cost of goods sold $30,000
Cr. Allowance to Reduce Inventory
to LIFO $30,000

Balance Sheet (Assets):

Inventory (FIFO) $50,000
less: Allowance to Reduce Inventory ($30,000)
Inventory (LIFO) basis $20,000
 LIFO Layers

Under the LIFO approach, a business

may build up layers of inventory from
prior periods.
A layer liquidation occurs, when:
• Earlier costs are matched against current
sales.

Such matching results in distorted income.

 Dollar Value LIFO
• Dollar value LIFO applies LIFO procedures to pools of similar goods
based on dollars rather than units
• Used for external purposes (i.e., financial statements and taxes
• Advantages over regular LIFO:
– Reduces record keeping (maximum of one layer per year).
– Reduces likelihood of eroding old layers (some decreases in goods in the
pool are offset by increases in other goods in the pool).

• Price index – a measure of the change in prices from a base year (the
year dollar value LIFO is adopted in this case) to the current year

• Internal = Ending inventory quantities X current year costs

• Ending inventory quantities X base year costs

• External – calculated by the Bureau of Labor Statistics

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 Dollar Value LIFO: Example

Given:
Base layer (Dec 31, 2003): $20,000
Inventory (current prices)
Dec 31, 2004: $26,400
Prices increased 20% during 2004.

Determine dollar value LIFO at Dec 31,

2004
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 Dollar Value LIFO: Example

Price increase, 20%

Dec 31, 2003 Dec 31, 200

At base $: $26,400 / 1.20 At EOY prices:

$22,000 $26,400

Dollar value
Net increase LIFO Inventory

at base $: Restate at $20,000

$22,000 less current $: plus
$20,000 $2,000 * 1.20 $2,400 $2,400 =
(layer added) $22,400
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 Dollar Value LIFO: Notes

When the ending inventory (at base year

prices) is less than the beginning inventory
(at base year prices):
• the decrease must be subtracted from the
most recently added layer.
• Once a layer is eliminated (peeled off), it
cannot be rebuilt.

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