Valuation of Inventories: A CostBasis Approach

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Valuation of Inventories A Cost-Basis Approach

• Chapter 8

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Learning Objectives

• Physical Goods included in Inventory
• Costs Included in Inventory
• Inventory Periodic vs. Perpetual
• Purchase Discounts
• Gross versus Net
• Cost Flow Assumptions
• Specific Identification, Average Cost, FIFO, LIFO
• Specific Issues Related to LIFO
• LIFO Reserve
• LIFO Liquidation
• Dollar-Value LIFO
• Major advantages/disadvantages

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Inventory

• Careful attention is given to the inventory
  account by many business organizations because it
  represents one of the most significant assets
  held by the enterprise.
• Inventories are of particular importance to
  merchandising and manufacturing companies because
  they represent the primary source of revenue for
  the organization.
• Inventories are also significant because of
  their impact on both the balance sheet and the
  income statement.

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Inventory Classification and Systems
Classification

• Inventories are
• items held for sale, or
• goods to be used in the production of goods to be
  sold.

Businesses with Inventory
Merchandiser
Manufacturer
or
LO 1 Identify major classifications of inventory.
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Inventory Classification and Systems
Flow of Costs
Illustration 8-2
LO 1 Identify major classifications of inventory.
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Inventory Classification and Systems
Control
Two systems for maintaining inventory records

• Perpetual system
• Periodic system

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Inventory Systems
Perpetual Method
Periodic Method

• Purchases are debited to Inventory account
• Freight-in, Purchase Returns and Allowances and
  Purchase Discounts are recorded in Inventory
  account.
• Debit COGS and credit Inventory account for each
  sale.

• Purchases are debited to Purchases account.
• Freight-in, Purchase Returns and Allowances and
  Purchase Discounts are recorded in their
  respective accounts.
• COGS is computed only periodically
• COGAS Ending Inventory COGS

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Inventory Classification and Systems
Perpetual System
Periodic System
vs.
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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.).

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

• The following goods are included in sellers
  inventory
• Goods in transit (FOB Destination)
• Goods on consignment with consignee
• Goods, sold under buy back agreements
• Goods, sold with high rates of return
• Installment sales (if bad debts can not be
  estimated)

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Guidelines for Determining Ownership
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Costs Included in Inventory

• Product Costs
• Period Costs
• Purchase Discounts Gross vs. Net Method

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Costs Included in Inventory

• Product costs are those costs that "attach" to
  the inventory and are recorded in the inventory
  account. These costs include freight charges on
  goods purchased, other direct costs of
  acquisition, and labor and other production costs
  incurred in processing the goods up to the time
  of sale.
• Period costs, such as selling expenses and
  general and administrative expenses, are not
  considered inventoriable costs. The reason these
  costs are not included as a part of the inventory
  valuation concerns the fact that, in most
  instances, these costs are unrelated to the
  immediate production process.

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Purchase Discounts Two methods

• If the gross method is used, purchase discounts
  should be reported as a deduction from purchases
  (purchase discounts) on the income statement.
• If the net method is used, purchase discounts
  lost should be considered a financial expense and
  reported in the "other expense and loss" section
  of the income statement.

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Example Treatment of Purchase Discounts
Gross Method
Net Method
vs.
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Example E8-3
Assuming each of the amounts is material, state
whether the merchandise should be included in the
clients inventory at 12/31/2007.
(1) A special machine, fabricated to order for a
customer, was finished and specifically
segregated in the back part of the shipping room
on 12/31/07. The customer was billed on that
date and the machine excluded from inventory
although it was shipped on 1/4/2008.
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Example E8-3
(2) Merchandise costing 2,800 was received on
1/3/2008, and the related purchase invoice
recorded 1.5.08. The invoice showed the shipment
was made on 12/29/2007 f.o.b. destination.
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Example E8-3
(3) A packing case containing a product costing
3,400 was standing in the shipping room when the
physical inventory was taken. It was not
included in the inventory because it was marked
Hold for shipping instructions. Your
investigation revealed that the customer's order
was dated 12/18/2007, but that the case was
shipped and customer billed on 1/10/2008. The
product was a stock item of your client.
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Example E8-3
(4) Merchandise received on 1/6/2008, costing
680 was entered in the purchase journal on
1/7/2008. The invoice showed shipment was made
f.o.b. suppliers warehouse on 12/31/2007.
Because it was not on hand at 12/31, it was not
included in inventory.
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Example E8-3
(5) Merchandise costing 720 was received on
12/28/2007, and the invoice was not recorded.
You located it in the hands of the purchasing
agent it was market on consignment.
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What Cost Flow Assumption to Adopt?
FIFO
LIFO
Cost Flow Assumption Adopted
does not need to equal
Physical Movement of Goods
Average Cost
Specific Identification High-ticket items
Automobiles, Jewelry, Real estate
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Cost Flow Assumptions
Example

• Young Crazy Company makes the following
  purchases
• One item on 2/2/07 for 10
• One item on 2/15/07 for 15
• One item on 2/25/07 for 20
• Young Crazy Company sells one item on 2/28/07
  for 90. What would be the balance of ending
  inventory and cost of goods sold for the month
  ended Feb. 2007, assuming the company used the
  FIFO, LIFO, Average Cost, and Specific
  Identification cost flow assumptions? Assume a
  tax rate of 30.

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Cost Flow Assumptions
First-In-First-Out (FIFO)
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 0 Gross
profit 90 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 57 Taxes
17 Net Income
40
Inventory Balance 45
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
First-In-First-Out (FIFO)
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 10 Gross
profit 80 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 47 Taxes
14 Net Income
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Inventory Balance 35
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Last-In-First-Out (LIFO)
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 0 Gross
profit 90 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 57 Taxes
17 Net Income
40
Inventory Balance 45
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Last-In-First-Out (LIFO)
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 20 Gross
profit 70 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 37 Taxes
11 Net Income
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Inventory Balance 25
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Average Cost
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 0 Gross
profit 90 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 57 Taxes
17 Net Income
40
Inventory Balance 45
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Average Cost
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 15 Gross
profit 75 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 42 Taxes
12 Net Income
30
Inventory Balance 30
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Specific Identification
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 0 Gross
profit 90 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 57 Taxes
17 Net Income
40
Inventory Balance 45
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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Cost Flow Assumptions
Specific Identification
Young Crazy Company Income Statement For the
Month of Feb. 2007 Sales 90
Cost of goods sold 0 Gross
profit 90 Expenses
Administrative 14 Selling
12 Interest 7
Total expenses 33 Income
before tax 57 Taxes
17 Net Income
40
Inventory Balance 45
Depends which one is sold
Purchase on 2/25/07 for 20
Purchase on 2/15/07 for 15
Purchase on 2/2/07 for 10
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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
• Record keeping easier
• Profit-sharing or bonus arrangements
• LIFO troublesome for interim periods

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Special Issues Related to LIFO
LIFO Reserve is the difference between the
inventory method used for internal reporting
purposes and LIFO. Example
FIFO value per books 160,000 LIFO value
145,000 LIFO Reserve 15,000
Journal entry to reduce inventory to LIFO
Cost of goods sold 15,000 LIFO reserve 15,000
Companies should disclose either the LIFO reserve
or the replacement cost of the inventory.
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Special Issues Related to LIFO
LIFO Liquidation
Older, low cost inventory is sold resulting in a
lower cost of goods sold, higher net income, and
higher taxes.
Illustration 8-20
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Special Issues Related to LIFO
Dollar-Value LIFO

• 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 LIFO layers from erosion.

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Special Issues Related to LIFO
Dollar-Value LIFO
Exercise 8-26 The following information relates
to the Jimmy Johnson Company.
Use the dollar-value LIFO method to compute the
ending inventory for 2003 through 2005.
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Special Issues Related to LIFO
Exercise 8-26 Solution
LO 8 Explain the dollar-value LIFO method.
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Special Issues Related to LIFO
Disadvantages
Advantages

• Matching
• Tax Benefits/Improved Cash Flow
• Future Earnings Hedge

• Reduced earnings
• Inventory understated
• Physical flow
• Involuntary Liquidation / Poor Buying Habits