Chapter 10Learning Objectives

1
Chapter 10--Learning Objectives

• 1. Explain the importance of inventory for asset
  valuation and income measurement

2
Inventories are a significant asset for many
businesses
3
Inventories affect income

• Sales XXX
• Beginning inventory XXX
• Purchases XXX
• Goods available for sale XXX
• Ending inventory XXX
• Cost of goods sold XXX
• Gross profit XXX
• Operating expenses XXX
• Net income XXX

4
Chapter 10--Learning Objectives

• 2. Understand the nature of inventory and what is
  included in it

5
Types of inventory

• 1. Assets held for sale (or resale) in the
  ordinary course of business
• 2. Assets used or consumed in the production of
  goods to be sold in the ordinary course of
  business

6
A retail store(Sears, Wal-Mart, Safeway)

• Has inventory for resale to customers

7
A manufacturer(Ford, IBM, Exxon)

• Has inventories used or consumed in the
  production of goods for sale

8
A manufacturers inventorieswill usually include

• Raw materials inventory
• Items used in producing the product
• Work in process inventory
• Products started but not yet completed
• Finished goods inventory
• Products completed but not yet sold

9
What about this F.O.B. stuff ?

• F.O.B. means free on board and refers to the
  time and place at which the goods were turned
  over to the transportation carrier

10
If you are in Los Angelesand your supplier is in
New York City
Them
You
11
If you are in Los Angelesand your supplier is in
New York City
Them
You

• Somebody has to pay for moving the goods across
  the country

12
If you are in Los Angelesand your supplier is in
New York City
Them
You

• And somebody owns the goods while they are moving
  across the country

13
The F.O.B. designation determines who that
somebody is
Them
You
14
If the goods are shipped F.O.B. New York(or
F.O.B. origin)
Them
You

• You will pay the transportation cost
• and you will own the merchandise
• once it is turned over to the carrier in NYC

15
If the goods are shipped F.O.B. Los Angeles(or
F.O.B. destination)
Them
You

• The supplier will pay the transportation cost
• and they will own the merchandise
• until in reaches you in Los Angeles

16
The owner of the goods

• Is usually the entity that should include
• those goods in inventory
• This applies to goods in transit
• and to consignment situations
• But there are exceptions for some
• special sales agreements

17
An interesting situation arisesin purchase
commitments

• These are noncancellable, long-term contracts to
  purchase goods at a set price
• You might enter into such an agreement to buy a
  product if you thought its price was about to go
  up
• If the price does go up, everything is cool and
  you will make lots of money
• But if the price goes down, you have an economic
  problem and an accounting problem

18
The Oliver Peck Oil Company(O. Peck for short)

• Thinking that the price of gas is about to
  increase
• Peck signs a contract during 19X1 to purchase
  100,000 gallons of gas during 19X2 at 1.00 per
  gallon

19
On December 31, 19X1,gas is selling for .94

• Since Peck has agreed to pay 1.00 per gallon,
  accounting conservatism mandates
• December 31, 19X1
• Est. Loss on Purch. Commit. 6,000
• Est. Liab. on Contract 6,000
• This reduces Pecks income and increases his
  liabilities

20
Assume that on the April 1, 19X2, delivery date,
gas is selling for .90

• Since Peck has agreed to pay 1.00 per gallon,
  there is an additional loss
• April 1, 19X2
• Purchases 90,000
• Est. Liab. on Contract 6,000
• Loss on Purchase Contract 4,000
• Cash 100,000

21
Now assume that on the April 1, 19X2, delivery
date, gas is selling for .98

• Peck must still pay 1.00, but the situation has
  improved since December 31
• April 1, 19X2
• Purchases 98,000
• Est. Liab. on Contract 6,000
• Recovery on Contract 4,000
• Cash 100,000

22
Now assume that on the April 1, 19X2, delivery
date, gas is selling for 1.05

• This is what Peck was planning on, but the
  purchase is recorded at 1.00 and lower cost of
  goods sold will give Peck higher profits when the
  gas is sold
• April 1, 19X2
• Purchases 100,000
• Est. Liab. on Contract 6,000
• Recovery on Contract 6,000
• Cash 100,000

23
Chapter 10--Learning Objectives

• 3. Differentiate between perpetual and periodic
  inventory measurement systems

24
In a periodic inventory system

• Purchases of goods for resale are recorded in a
  Purchases account
• Purchases XXX
• Cash or Accts. Payable XXX

25
In a periodic inventory system

• Recording sales of merchandise is simple
• Cash or Accts. Receivable XXX
• Sales XXX

26
In a periodic inventory system

• An adjusting entry closes out the beginning
  inventory and purchases accounts and records the
  cost of goods sold and ending inventory
• Inventory (ending) XXX
• Cost of Goods Sold XXX
• Inventory (beginning) XXX
• Purchases XXX

27
In a perpetual inventory system

• Purchases of merchandise for resale are recorded
  in the Inventory account
• Inventory XXX
• Cash or Accts. Payable XXX

28
In a perpetual inventory system

• Recording sales is more complicated
• Cash or Accts. Receivable XXX
• Sales XXX
• Cost of Goods Sold XXX
• Inventory XXX
• The first entry records the sale at the selling
  price, just like in a periodic system

29
In a perpetual inventory system

• Recording sales is more complicated
• Cash or Accts. Receivable XXX
• Sales XXX
• Cost of Goods Sold XXX
• Inventory XXX
• The second entry removes the cost of the
  merchandise sold from the Inventory account and
  transfers it to Cost of Goods Sold

30
In a perpetual inventory system

• No end-of-period adjustment is required if the
  actual inventory cost matches the balance in the
  Inventory account

31
In a perpetual inventory system

• If items are missing, an adjustment is made to
  change the Inventory balance to reflect
  reality
• Inventory Shrinkage XXX
• Inventory XXX
• Inventory Shrinkage is treated as an expense
  account, but is often included in Cost of Goods
  Sold in practice

32
Inventory shrinkagecan be a result of

• Theft
• Spoilage
• Accidental breakage
• Mistakenly thrown away
• and other causes

33
Occasionally, a business will have more inventory
than the records indicate
P e t e s R a b b i t F a r m
34
Occasionally, a business will have more inventory
than the records indicate
P e t e s R a b b i t F a r m
35
Chapter 10--Learning Objectives

• 4. Record and report inventories for different
  valuation systems

36
Inventory cost flow assumptions

• Picture five items
• identical except for cost
• acquired in the order indicated
• 1 - 2 - 3 - 4 - 5

1 11
2 12
3 13
4 14
5 15
37
Inventory cost flow assumptions

• The total cost of the five items is 65
• (11 12 13 14 15 65)
• Assume that three items are sold for 25 each
  (total sales revenue 75)
• and that two are on hand at the end of the period

1 11
2 12
3 13
4 14
5 15
38
Specific identification

• The actual items sold are recorded
• These might be items 1, 3 and 5
• Leaving items 2 and 4 in inventory
• The cost of items 2 and 4 is 26

2 12
4 14
39
Specific identification

• Sales revenue 75
• Goods available for sale 65
• Less Ending inventory 26
• Cost of goods sold 39
• Gross profit 36

2 12
4 14
40
First-in, first-out ( FIFO )

• The first three items would be the items
  sold--items 1, 2 and 3
• Leaving items 4 and 5
• The cost of items 4 and 5 is 29

4 14
5 15
41
First-in, first-out ( FIFO )

• Sales revenue 75
• Goods available for sale 65
• Less Ending inventory 29
• Cost of goods sold 36
• Gross profit 39

4 14
5 15
42
Last-in, first-out ( LIFO )

• The last three items (3, 4 and 5) would be the
  items sold
• Leaving items 1 and 2
• The cost of items 1 and 2 is 23

1 11
2 12
43
Last-in, first-out ( LIFO )

• Sales revenue 75
• Goods available for sale 65
• Less Ending inventory 23
• Cost of goods sold 42
• Gross profit 33

1 11
2 12
44
Average cost

• The total cost of the five items is 65
• So the average cost per item is 13
• It doesnt matter which items are sold and which
  remain
• The cost of the ending inventory is 26

45
Average cost

• Sales revenue 75
• Goods available for sale 65
• Less Ending inventory 26
• Cost of goods sold 39
• Gross profit 36

46
Note that in this period of rising pricesthe
gross profits were

• FIFO 39
• Average 36
• LIFO 33
• LIFO results in a higher cost of goods sold and a
  lower gross profit because the higher cost of the
  last items purchased is being matched against
  revenues
• LIFO will also result in a lower income tax in a
  period of rising prices

47
Lower of cost or market(LCM)
INVENTORY IS PURCHASED AT COST
THERE IS NO PROBLEM IF THE VALUE INCREASES
48
Lower of cost or market(LCM)
INVENTORY IS PURCHASED AT COST
THERE ARE PROBLEMS IF THE VALUE GOES DOWN
49
A decline in inventory value...

• Creates an accounting problem
• Means that you will lose your shirt
• Our job is to solve the
• accounting problem

50
Any adjustment of inventory value
Must be below the ceiling
And above the floor
51
The Ceiling isNet Realizable Value (NRV)
What we expect to get less costs of completion
and disposal
52
The Floor isNRV less normal profit margin
Net realizable value less what we would expect
to make on a similar item
53
We must remain betweenthe ceiling and the floor
54
In the real world

• We know what cost was
• We can usually get a replacement cost figure
• We have to estimate net realizable value
• You never know for sure until its actually sold

55
Lower of cost or market

• Can be applied three ways
• 1. To each inventory item separately
• 2. To each category of items in the
• inventory
• 3. To the inventory as a whole

56
Probably the best way to apply lower of cost or
market

• Is the allowance method. The initial application
  entry would be
• Holding Loss XXX
• Allowance to reduce
• inventory to market XXX
• The Allowance account appears on the balance
  sheet as a contra account to inventory

57
Chapter 10--Learning Objectives

• 5. Estimate inventories using various methods

58
The gross profit method

• Good news
• Simple
• Quick
• Cheap
• Bad news
• Depends on old data relationships
• May not be any good in a changing situation

59
Recall that...

• Amount
• Sales 100
• Less Cost of goods sold 70
• Equals Gross profit 30
• These numbers can be expressed as percentages of
  sales

60
In this case, the percentages are

• Amount Pct.
• Sales 100 100
• Less Cost of goods sold 70 70
• Equals Gross profit 30 30
• Knowing the cost of goods sold percentage and
  some other facts allows us to estimate inventory

61
Assume that the following are known

• Beginning inventory 40,000
• Purchases 480,000
• Sales revenue 700,000
• Cost of goods sold percentage 70
• These items would be available from the
  accounting records and prior year statements

62
Using the known data

• Beginning inventory 40,000
• Plus Purchases 480,000
• Equals Goods avail. for sale 520,000
• Sales x CGS
• (700,000 x .70) 490,000
• Estimated ending inventory 30,000

63
The retail method

• Overcomes the problems of the gross profit
  method, but is more trouble
• Some more trouble in the classroom
• Considerably more trouble in the real world
• Requires keeping two sets of sales records
• One at cost (which would be done anyway)
• Another at retail
• Based on the relationship between goods available
  for sale at cost and at retail

64
Retail method example

• Cost Retail
• Beginning inventory 6,000 10,000
• Purchases 48,000 80,000
• Goods available for sale 54,000 90,000
• Cost / Retail ratio for
• Goods available for sale
• ( 54,000 / 90,000 ) .60

65
Retail method example

• Cost Retail
• Goods available for sale 54,000 90,000
• Less Sales 70,000
• Ending inventory at retail 20,000
• Cost / retail ratio .60
• Ending inventory at cost 12,000

66
Retail method terminology

• Markup--Amount by which original sales price
  exceeds cost--also called normal profit
• Additional markup--Amount added to original sales
  price
• Markup cancellation--Cancellation of all or part
  of the additional markup
• Net markup--Additional markup less the markup
  cancellation

67
More retail method terminology

• Markdown--Amount subtracted from the original
  sales price
• Markdown cancellation--Cancellation of all or
  part of the markdown. Markdown cancellation
  cannot exceed the amount of the markdown
• Net markdown--The difference between the total
  markdowns and the markdown cancellations

68
As previously demonstrated, the retail method
approximates average cost

• With modifications, it can be used to
  approximate
• Average cost on a lower of cost or market (LCM )
  basis (very widely used and known as the
  conventional method
• FIFO (with or without LCM )
• LIFO

69
Summary of modifications

• To approximate lower of cost or market ( LCM )
  exclude net markdowns from the cost / retail
  ratio calculation
• To approximate FIFO and LIFO, exclude beginning
  inventory from the cost / retail ratio calculation

70
Comprehensive retail methodassumptions (Sales
125,000)

• Cost Retail
• Beginning inventory 5,000 8,000
• Purchases 85,000 160,000
• Purchase discounts 4,000
• Purchase returns 1,000 2,000
• Freight-in 5,000
• Net markups 14,000
• Net markdowns 15,000
• Ending inventory at retail 40,000

71
For FIFO, cost retail ratio is

• Cost Retail
• Purchases 85,000 160,000
• Purchase discounts - 4,000
• Purchase returns - 1,000 - 2,000
• Freight-in 5,000
• Net markups 14,000
• Net markdowns - 15,000
• Ratio basis 85,000 157,000
• Ratio .541
• EI Retail 40,000, Est. EI 21,656

72
For FIFO LCM, cost retail ratio is

• Cost Retail
• Purchases 85,000 160,000
• Purchase discounts - 4,000
• Purchase returns - 1,000 - 2,000
• Freight-in 5,000
• Net markups 14,000
• Ratio basis 85,000 172,000
• Ratio .494
• EI Retail 40,000, Est. EI 19,767

73
For average cost, cost retail ratio is

• Cost Retail
• Beginning inventory 5,000 8,000
• Purchases 85,000 160,000
• Purchase discounts - 4,000
• Purchase returns - 1,000 - 2,000
• Freight-in 5,000
• Net markups 14,000
• Net markdowns - 15,000
• Ratio basis 90,000 165,000
• Ratio .545
• EI Retail 40,000, Est. EI 21,818

74
For average LCM, cost retail ratio is

• Cost Retail
• Beginning inventory 5,000 8,000
• Purchases 85,000 160,000
• Purchase discounts - 4,000
• Purchase returns - 1,000 - 2,000
• Freight-in 5,000
• Net markups 14,000
• Ratio basis 90,000 180,000
• Ratio .500
• EI Retail 40,000, Est. EI 20,000

75
LIFO advantages and disadvantages

• Advantages
• Matches current costs with revenues
• Results in lower income taxes in periods of
  rising prices
• Disadvantages
• Distorts asset values on balance sheet
• Becomes cumbersome to deal with
• Can distort income if early, low-cost layers are
  liquidated

76
Lifo pools

• A way of avoiding LIFO layer liquidation
• Similar items are put together in groups or pools
• Pooled items are treated as if purchased at same
  time
• Less likely to liquidate layers in practice

77
Dollar value LIFO

• A way of approximating LIFO
• Think in terms of layers
• In LIFO, if inventory quantity were constant,
  beginning and ending inventory would be exactly
  the same
• Additional inventory adds a layer
• Decreases reduce layers in LIFO order

78
Dollar value LIFO examplewith no price-level
change

• 2000 ending inventory 20,000
• 2001 ending inventory 23,100
• 2001 inventory consists of
• 2000 base layer 20,000
• plus additional layer of 3,100
• Total 23,100

79
Dollar value LIFO examplewith no price-level
change

• 2000 ending inventory 20,000
• 2001 ending inventory 23,100
• 2002 ending inventory 27,250
• 2002 inventory consists of
• 2000 base layer 20,000
• plus 2001 layer of 3,100
• plus 2002 layer of 4,150
• Total 27,250

80
Dollar value LIFOWhen price levels change

• 1. Convert current inventory value to base
  dollars
• 2. Analyze change in inventory in terms of base
  dollars
• 3. If inventory increases, add a layer, use
  current index
• 4. If inventory decreases, reduce layers in LIFO
  order

81
Dollar value LIFO examplewith price-level changes

• Price
• Amount index
• 2000 ending inventory 20,000 1.00
• 2001 ending inventory 23,100 1.05
• 2001 converted to base
• ( 23,100 / 1.05 ) 22,000
• Change from 2000 (increase) 2,000

82
Dollar value LIFO examplewith price-level changes

• Base Current
• Layer Index dollars dollars
• Base 1.00 20,000 20,000
• 2001 addl. layer 1.05 2,000 2,100
• Totals 22,000 22,100
• The 2001 ending inventory will be reported as
  22,100

83
Dollar value LIFO examplewith price-level changes

• Price
• Amount index
• 2000 ending inventory 20,000 1.00
• 2001 ending inventory 23,100 1.05
• 2002 ending inventory 27,250 1.09
• 2001 conv. to base 22,000
• 2002 conv. to base 25,000
• 2002 increase in base 3,000

84
Dollar value LIFO examplewith price-level changes

• Base Current
• Layer Index dollars dollars
• Base 1.00 20,000 20,000
• 2001 addl. layer 1.05 2,000 2,100
• 2002 addl. layer 1.09 3,000 3,270
• Totals 25,000 25,370
• The 2002 ending inventory will be reported as
  25,370

85
Retail dollar value LIFO

• Combines the retail method and dollar value LIFO
• Calculate cost / retail ratio as was done for
  FIFO
• Convert retail ending inventory to base dollars
• Follow dollar value LIFO layer procedures

86
1999 retail dollar value LIFO ratio(data from
Exhibit 10-15)

• Cost Retail
• Purchases 80,000 150,000
• Purchase returns - 2,200 - 4,000
• Freight-in 2,000
• Net markups 23,000
• Net markdowns - 4,760
• Ratio basis 79,800 164,240
• Ratio .486

87
1999 ending inventory at retail

• Retail
• Beginning inventory 25,000
• Purchases 150,000
• Purchase returns - 4,000
• Net markups 23,000
• Net markdowns - 4,760
• Sales -160,000
• Net sales returns 1,000
• Ending inventory at retail 30,240

88
1999 retail dollar value LIFO layers

• Price
• Amount index
• 1998 ending inventory 25,000 1.00
• 1999 ending inventory 30,240 1.08
• 1999 converted to base
• ( 30,240 / 1.08 ) 28,000
• Change from 1998 (increase) 3,000

89
Retail dollar value LIFO-1999

• Layer Base Index C/R DVL
• Base 25,000 1.00 .480 12,000
• 1999 3,000 1.08 .486 1,575
• Totals 28,000 13,575

90
2000 retail dollar value LIFO ratio

• Cost Retail
• Purchases 95,000 180,000
• Purchase returns -0- -0-
• Freight-in 4,000
• Net markups 25,000
• Net markdowns - 5,000
• Ratio basis 99,000 200,000
• Ratio .495

91
2000 ending inventory at retail

• Retail
• Beginning inventory 30,240
• Purchases 180,000
• Purchase returns -0-
• Net markups 25,000
• Net markdowns - 5,000
• Sales -191,000
• Net sales 1,010
• Ending inventory at retail 40,250

92
2000 retail dollar value LIFO layers

• Price
• Amount index
• 1995 ending inventory 25,000 1.00
• 1996 ending inventory 30,240 1.08
• 2000 ending inventory 40,250 1.15
• 1996 conv. to base 28,000
• 2000 conv. to base 35,000
• 2000 increase in base 7,000

93
Retail dollar value LIFO-2000

• Layer Base Index C/R DVL
• Base 25,000 1.00 .480 12,000
• 1996 3,000 1.08 .486 1,575
• 2000 7,000 1.15 .495 3,985
• Totals 35,000 17,560

94
2001 retail dollar value LIFO ratio

• Cost Retail
• Purchases 110,000 198,000
• Purchase returns - 1,600 - 3,000
• Freight-in 5,000
• Net markups 35,000
• Net markdowns - 6,000
• Ratio basis 113,400 224,000
• Ratio .506

95
2001 ending inventory at retail

• Retail
• Beginning inventory 40,250
• Purchases 198,000
• Purchase returns - 3,000
• Net markups 35,000
• Net markdowns - 6,000
• Sales -235,000
• Sales returns 7,350
• Ending inventory at retail 36,600

96
2001 retail dollar value LIFO layers

• Amount index
• 1995 ending inventory 25,000 1.00
• 1996 ending inventory 30,240 1.08
• 2000 ending inventory 40,250 1.15
• 2001 ending inventory 36,600 1.22
• 2000 conv. to base 35,000
• 2001 conv. to base 30,000
• 2001 decrease in base 5,000

97
Retail dollar value LIFO-2001

• Layer Base Index C/R DVL
• Base 25,000 1.00 .480 12,000
• 1996 3,000 1.08 .486 1,575
• 2000 2,000 1.15 .495 1,138
• Totals 30,000 14,713
• Note reduction of 2000 layer from 7,000 to 2,000

98
Chapter 10--Learning Objectives

• 6. Analyze the impact of inventory valuation on
  liquidity and profitability analysis

99
Inventory turnover

• Cost of goods sold
• Average inventory
• Average inventory usually calculated
• ( Beginning inv. Ending inv. ) / 2

100
Days sales in inventory

• 365 days
• Inventory turnover