ACCOUNTING FOR INVENTORIES Warfield Weygandt Kieso CHAPTER 9 ACCOUNTING FOR INVENTORIES INTERMEDIATE ACCOUNTING Principles and Analysis 2nd Edition

Accounting for Inventories Inventory Classification and Systems Issues in Inventory Valuation LIFO Special Issues Lower-of-Cost-or-Market Presentation and Analysis Classification Inventory systems Goods included in inventory Costs included in inventory Cost flow assumptions LIFO reserve LIFO liquidation Dollar-value LIFO Comparison of LIFO approaches Basis for selection Ceiling and floor How LCM works Application of LCM Evaluation of rule Presentation of inventories Analysis of inventories Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

Learning Objectives Identify major classifications of inventory. Distinguish between perpetual and periodic inventory systems. Understand the items to include as inventory cost. Describe and compare the cost flow assumptions used to account for inventories. Explain the significance and use of a LIFO reserve. Understand the effect of LIFO liquidations. Explain the dollar-value LIFO method. Identify the major advantages and disadvantages of LIFO. Describe and apply the lower-of-cost-or-market rule. Explain how to report and analyze inventory. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information)

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: Merchandiser or Manufacturer LO 1 Identify major classifications of inventory.

Inventory Classification and Systems Type of Business Merchandiser One inventory account Purchase goods ready for sale LO 1 Identify major classifications of inventory.

Inventory Classification and Systems Type of Business Manufacturer Three accounts Raw materials Work in process Finished goods LO 1 Identify major classifications of inventory.

Inventory Classification and Systems Inventory Systems Two systems for maintaining inventory records: Perpetual system Periodic system LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Classification and Systems Perpetual System Features: Purchases of merchandise are debited to Inventory. Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory. Cost of Goods Sold is debited and Inventory is credited for each sale. Physical count done to verify inventory balance. The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold. LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Classification and Systems Periodic System Features: Purchases of merchandise are debited to Purchases. Ending Inventory determined by physical count. Calculation of cost of goods sold: Beginning inventory $ 100,000 Purchases, net 800,000 Goods available for sale 900,000 Ending inventory 125,000 Cost of goods sold $ 775,000 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Classification and Systems Perpetual System vs. Periodic System LO 2 Distinguish between perpetual and periodic inventory systems.

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.). LO 2 Distinguish between perpetual and periodic inventory systems.

Physical Goods Included in Inventory A company should record purchases when it obtains legal title to the goods. Special Consideration: Goods in transit (FOB shipping point, FOB destination) Consigned goods LO 2 Distinguish between perpetual and periodic inventory systems.

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. LO 3 Understand the items to include as inventory cost.

What Cost Flow Assumption to Adopt? Specific Identification FIFO LIFO Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods Average Cost Specific Identification Answer: Method adopted should be one that most clearly reflects periodic income. LO 4 Describe and compare the cost flow assumptions used to account for inventories.

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 2/28/08 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“First-In-First-Out (FIFO)” Cost Flow Assumptions “First-In-First-Out (FIFO)” Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“First-In-First-Out (FIFO)” Cost Flow Assumptions “First-In-First-Out (FIFO)” Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 $ 33 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“Last-In-First-Out (LIFO)” Cost Flow Assumptions “Last-In-First-Out (LIFO)” Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“Last-In-First-Out (LIFO)” Cost Flow Assumptions “Last-In-First-Out (LIFO)” Inventory Balance = $ 25 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 $ 26 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

Cost Flow Assumptions “Average Cost” Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

Cost Flow Assumptions “Average Cost” Inventory Balance = $ 30 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“Specific Identification” Cost Flow Assumptions “Specific Identification” Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

“Specific Identification” Depends which one is sold Cost Flow Assumptions “Specific Identification” Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 Depends which one is sold Purchase on 2/25/08 for $20 Purchase on 2/15/08 for $15 Purchase on 2/2/08 for $10 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

Financial Statement Summary Cost Flow Assumptions Financial Statement Summary Inventory Balance 35 25 30 LO 4 Describe and compare the cost flow assumptions used to account for inventories.

Cost Flow Assumptions Example – Perpetual and Periodic Methods Inventory information for Part 686 for the month of June. June 1 Beg. Balance 300 units @ $10 = $ 3,000 10 Sold 200 units @ $24 11 Purchased 800 units @ $12 = 9,600 15 Sold 500 units @ $25 20 Purchased 500 units @ $13 = 6,500 27 Sold 300 units @ $27 Goods Available $19,100 Assuming the Perpetual Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. Assuming the Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Perpetual Inventory FIFO Method LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Perpetual Inventory LIFO Method LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Periodic Inventory FIFO Method LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Periodic Inventory LIFO Method LO 4 Describe and compare the cost flow assumptions used to account for inventories.

+ Cost Flow Assumptions Periodic Inventory Weighted Average LO 4 Describe and compare the cost flow assumptions used to account for inventories.

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 LO 5 Explain the significance and use of a LIFO reserve.

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. LO 5 Explain the significance and use of a LIFO reserve.

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 9-13 LO 6 Understand the effect of LIFO liquidations.

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. LO 7 Explain the dollar-value LIFO method.

Special Issues Related to LIFO Dollar-Value LIFO Exercise: The following information relates to the Jimmy Johnson Company. Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005. LO 7 Explain the dollar-value LIFO method.

Special Issues Related to LIFO Exercise Solution LO 7 Explain the dollar-value LIFO method.

Special Issues Related to LIFO Comparison of LIFO Approaches Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming. Specific-goods Pooled LIFO approach Reduces record keeping and clerical costs. More difficult to erode the layers. Using quantities as measurement basis can lead to untimely LIFO liquidations. Dollar-value LIFO is used by most companies. LO 7 Explain the dollar-value LIFO method.

Basis for Selection of Inventory Method LIFO is generally preferred: if selling prices are increasing faster than costs and if a company has a fairly constant “base stock.” LIFO not appropriate: if prices tend to lag behind costs, if specific identification traditionally used, and when unit costs tend to decrease as production increases. LO 7 Explain the dollar-value LIFO method.

Basis for Selection of Inventory Method Advantages Disadvantages Matching Tax benefits/Improved cash flow Reduced earnings Inventory understated Physical flow Involuntary liquidation / Poor buying habits LO 8 Identify the major advantages and disadvantages of LIFO.

Lower-of-Cost-or-Market LCM A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Market = Replacement cost Lower of cost or replacement cost Loss should be recorded when loss occurs, not in the period of sale. LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling and Floor Why use Replacement Cost (RC) for Market? Decline in the RC usually = decline in selling price. RC allows a consistent rate of gross profit. If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used: Ceiling - Net realizable value and Floor - Net realizable value less a normal profit margin. LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling = NRV What is the rationale for the Ceiling and Floor limitations? Not > Illustration 9-21 Replacement Cost Cost Market Not < Floor = NRV less Normal Profit Margin GAAP LCM LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Rationale for Limitations Ceiling – prevents overstatement of the value of obsolete, damaged, or shopworn inventories. Floor – deters understatement of inventory and overstatement of the loss in the current period. LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market How LCM Works (Individual Items) Illustration 9-23 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Methods of Applying LCM Illustration 9-24 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Exercise: Grant Wood Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2008, the following finished desks appear in the company’s inventory. Instructions: At what amount should the desks appear in the company’s December 31, 2008, inventory, assuming that the company has adopted a lower-of-cost-or-market approach for valuation of inventories on an individual-item basis? LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling = 455 (500 – 45) Not > Replacement Cost = 460 Cost = 470 Market = 455 Not < Floor = 355 (455-(500 x 20%)) LCM = 455 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling = 480 (540 – 60) Not > Replacement Cost = 440 Cost = 450 Market = 440 Not < Floor = 372 (480-(540 x 20%)) LCM = 440 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling = 810 (900 – 90) Not > Replacement Cost = 610 Cost = 830 Market = 630 Not < Floor = 630 (810-(900 x 20%)) LCM = 630 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Ceiling = 1,070 (1,200 – 130) Not > Replacement Cost = 1,000 Cost = 960 Market = 1,000 Not < Floor = 830 (1,070-(1,200 x 20%)) LCM = 960 LO 9 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market Evaluation of LCM Rule Some Deficiencies: Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale. Inventory valued at cost in one year and at market in the next year. Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize. LCM uses a “normal profit” in determining inventory values, which is a subjective measure. LO 9 Describe and apply the lower-of-cost-or-market rule.

Presentation and Analysis Accounting standards require disclosure of: composition of the inventory, financing arrangements, and costing methods employed. Analysis: Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory. LO 10 Explain how to report and analyze inventory.

Presentation and Analysis Inventory Turnover Ratio Measures the number of times on average a company sells the inventory during the period. Illustration 9-27 LO 10 Explain how to report and analyze inventory.

Presentation and Analysis Average Days to Sell Inventory Measure represents the average number of days’ sales for which a company has inventory on hand. Illustration 9-27 Inventory Turnover Average Days to Sell 365 days / 8 times = every 45.6 days LO 10 Explain how to report and analyze inventory.

Copyright Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.