Inventories: Measurement Chapter 8 Chapter 8: Inventories: Measurement The next two chapters continue our study of assets by investigating the measurement and reporting issues involving inventories and the related expense—cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.

Recording and Measuring Inventory Types of Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods We will look at inventory for two classes of businesses. Wholesale and retail companies purchase goods that are primarily in finished form. These companies are intermediaries in the process of moving goods from the manufacturer to the end-user. The cost of merchandise inventory includes the purchase price plus any other costs necessary to get the goods in condition and location for sale. In manufacturing, companies actually produce the goods they sell to the wholesaler, retailer, or other manufacturers. These companies normally have three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items being worked on, but not yet complete. Work-in-process inventory includes the cost of raw materials used, the cost of labor that can be directly traced to the goods in process, and the allocated portion of other manufacturing costs, called manufacturing overhead. Overhead costs include electricity and other utility costs, depreciation of manufacturing equipment, and many other manufacturing costs that cannot be directly linked to the production of specific goods. Finished goods inventory consists of items that are available for sale.

Manufacturing Inventories (ACCT 322) Raw Materials Work-in- Process Finished Goods     $XX $XX Direct Labor   Cost of Goods Sold $XX Manufacturing Overhead Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work-in-process transferred to finished goods Finished goods sold    In this diagram, we see the typical inventory cost flow for a manufacturing company. The manufacturing company acquires raw materials, hires direct labor, and incurs manufacturing overhead. As raw materials, direct labor, and manufacturing overhead are used, they are transferred into work-in-process inventory. When an item in work-in-process inventory has been completed, it is transferred to finished goods inventory. Finally, finished goods are sold to the final customer, and transferred out of finished goods inventory and into cost of goods sold.       

Inventory Systems Two accounting systems are used to record transactions involving inventory: Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System (NOT COVERED) The inventory account is adjusted at the end of a reporting period. We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. An important feature of a perpetual system is that it is designed to track both inventory quantities and inventory costs from their acquisition to their sale. In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting period. In the perpetual inventory system, cost of goods sold are recorded each time a sale is made to a customer.

Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2013 Inventory 600,000 Accounts payable 600,000 To record the purchase of merchandise inventory. Lothridge Wholesale Beverage Company (LWBC) uses the perpetual inventory system. It begins the period with $120,000 of merchandise inventory on hand. During the period the company purchases $600,000 of merchandise for resale to its customers. The items were purchased on account. The journal entry required for this transaction is to debit inventory for $600,000 and credit accounts payable for $600,000. Inventory items that are returned to the supplier because they are damaged or defective will require an adjustment to the inventory account. Cash discounts applicable to the inventory items purchased will also require an adjustment to the inventory account. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

Perpetual Inventory System During 2013, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers. 2013 Inventory 600,000 Accounts payable 600,000 To record the purchase of merchandise inventory. 2013 Accounts receivable 820,000 Sales revenue 820,000 To record sales on account. Cost of goods sold 540,000 Inventory 540,000 To record cost of goods sold. During 2013, Lothridge sold, on account, inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. In the perpetual inventory system any time we have a sale we have to record the cost of goods sold. The first entry is to record the sale. We debit accounts receivable for $820,000 and credit sales for the same amount. The second entry is to record the cost of goods sold for $540,000 and credit inventory for the same amount. Under the perpetual inventory system, cost of goods sold is determined when a sale is made. The balance in the cost of goods sold account appears on the income statement at the end of the period. Inventory is updated after each sale and purchase of merchandise for resale.

Exercise 1

Periodic Inventory System (NOT COVERED) The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period. The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated after the physical inventory count at the end of the accounting period. Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts. The period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account. In the periodic inventory system, we use an equation to determine cost of goods sold. We take a beginning inventory, and add net purchases, to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold. The cost of goods sold equation assumes that all inventory quantities not on hand at the end of the period were sold. This may or may not be the case if some inventory items were either damaged or stolen.

Periodic Inventory System (Not Covered) Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2013 Purchases 600,000 Accounts payable 600,000 To record the purchase of merchandise inventory. Let’s assume that the Lothridge Wholesale Beverage Company uses the periodic inventory system, and purchases $600,000 of merchandise for resale to customers. The merchandise was purchased on account. The journal entry to record this transaction is to debit an account called purchases and credit accounts payable. Remember that in a perpetual inventory system, we debited the inventory account rather than the purchases account. Purchase discounts and purchase returns are set up as two separate contra accounts, and are recorded separately from the purchases account.

Periodic Inventory System (Not Covered) During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000. 2013 Accounts receivable 820,000 Sales revenue 820,000 To record sales on account. No entry is made to record cost of goods sold. A physical count of ending inventory shows a balance of $180,000. Let’s calculate cost of goods sold at the end of 2013. Once again, let’s assume that the Lothridge Wholesale Beverage Company sold inventory with the retail price of $820,000 and a cost basis of $540,000 to a customer. Under the periodic inventory system, we would debit accounts receivable for $820,000 and credit sales for the same amount; there would be no entry to record cost of goods sold. We would calculate the amount of cost of goods sold at the end of the accounting period.

Periodic Inventory System (Not Covered) We need the following adjusting entry to record cost of good sold. December 31, 2013 Cost of goods sold 540,000 Inventory (ending) 180,000 Inventory (beginning) 120,000 Purchases 600,000 To adjust inventory, close the purchases account, and record cost of goods sold. Here is a typical calculation of cost of goods sold. Let’s assume a beginning inventory of $120,000 and net purchases of $600,000. Cost of goods available for sale would be $720,000. Now we subtract ending inventory of $180,000 to arrive at cost of goods sold of $540,000. Under the periodic inventory system, we need to prepare an adjusting entry to determine cost of goods sold. The entry at the end of 2013 will be to debit cost of goods sold for $540,000, debit inventory for $180,000 (our ending inventory), credit inventory for $120,000 (our beginning inventory), and finally credit purchases for $600,000. This entry has determined cost of goods sold for the income statement and has established the value of ending inventory on the balance sheet at $180,000.

Comparison of Inventory Systems This chart summarizes all the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.

What is Included in Inventory? Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. We must pay special attention to include inventory that we own but that is in transit or on consignment. We should also consider the condition of inventory that is damaged or obsolete when determining a cost for the inventory. Goods in Transit Goods Damaged or Obsolete Goods on Consignment 5-13

Ownership passes to the buyer here. Goods in Transit Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. Transportation costs are sometimes included in the cost of Merchandise Inventory. The FOB terms designate when title passes and who pays the transportation costs. FOB stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that buyer will pay the transportation cost. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost. So, if goods are shipped FOB Shipping Point, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account. We also need to consider goods on consignment which are goods that we own, but that are on display for sale at another place of business. Even though these goods are not in our physical possession, we still have ownership of them and should include them in our inventory count. FOB Destination Point Public Carrier Seller Buyer 5-14

Transportation Costs Buyer Seller Merchandise FOB destination (seller pays) Merchandise FOB shipping point (buyer pays) Transportation costs are sometimes included in the cost of Merchandise Inventory. For example, when buyers pay transportation costs to get merchandise inventory to them, the transportation costs are included in the Merchandise Inventory cost. FOB terms designate when title passes and who pays the transportation cost. FOB stands for Free On Board. So, if the shipping terms are Free On Board shipping point, that means that ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost. On the other hand, if the shipping terms are Free On Board destination, that means that ownership transfers from the seller to the buyer when the buyer receives the goods. It also means that seller will pay the transportation cost. So, if goods are shipped FOB Shipping Point, then the buyer owns the goods in transit and will pay the transportation costs. This transportation cost will be added to the merchandise inventory account. 4-15

Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns and Allowances Purchase Discounts Inventory includes all necessary expenditures to bring the inventory to its desired condition and location for sale or for use in the manufacturing process. An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns and allowances or purchase discounts.

Exercise 6 Exercise 7 Exercise 8

Perpetual Inventory Method Purchase Returns On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000. Perpetual Inventory Method November 8, 2013 Accounts payable 2,000 Inventory 2,000 On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000. If LWBC uses the periodic inventory system, the proper journal entry is to debit, or reduce, accounts payable and credit purchase returns for $2,000. If the company uses the perpetual inventory system, the journal entry is to debit accounts payable and credit inventory for $2,000. The returns are credited to Inventory using the perpetual inventory method.

Partial payment not made within the discount period Purchase Discounts Gross Method October 5, 2013 Inventory 20,000 Accounts payable 20,000 October 14, 2013 Accounts payable 14,000 Inventory 280 Cash 13,720 November 4, 2013 Accounts payable 6,000 Cash 6,000 LWBC purchased $20,000 of merchandise for resale subject to the credit terms, 2/10, net 30. Let’s look at the proper accounting using the gross method of recording purchases on the left side of your screen and the net method on the right side of your screen. Under the gross method we begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000 on October 5th. On October 14th, within the discount period, the company makes a $13,720 payment on account. The journal entry is to debit accounts payable for $14,000, credit purchase discounts for $280 ($14,000 times two percent), and credit cash for $13,720. LWBC pays the remaining $6,000 on November 4th, and is not eligible for the discount. The journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount. Under the net method, LWBC will debit purchases for the net amount owed to the supplier or $19,600 ($20,000 times 1 minus the discount offered) and credits accounts payable for the same amount. On October 14th, a partial payment of $14,000 is made at the net amount of $13,720. On November 4th, the final payment is made on the purchase for the amount owed to the supplies of $6,000. LWBC missed a discount of $120 ($6,000 times 2 percent), and records this amount with a debit to interest expense. The effect on the financial statements of the difference between the two methods usually is immaterial. Net income over time will be the same using either method. Discount terms are 2/10, n/30. $20,000 x 0.02 $ 400 ̵120 $ 280 Partial payment not made within the discount period $14,000 x 0.02 $ 280

Exercise 9

Inventory Cost Flow Assumptions Specific identification (Self Study) Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) How do we account for changes in the cost of inventory and cost of goods sold when we experience changes in the cost of the items that we purchased during the period? We will look at four methods to handle this problem. The first is the specific identification method, next is the average cost method, then the first-in, first-out, or FIFO method, and finally, we will look at the last-in, first-out or LIFO method.

Perpetual Average Cost Picture This, LLC, is in the process of determining the cost of goods sold for frame number 759 for the month of September. The physical inventory count on September 30 shows 2,000 frames in ending inventory. Use the perpetual AVERAGE or FIFO or LIFO cost methods to determine: (1) Ending inventory cost (2) Cost of goods sold The average cost method is reasonably popular, and is used by many businesses today. If the company uses the periodic inventory method, we use a weighted average cost. The weighted average cost is determined by taking the total cost of goods available for sale and dividing it by the number of units available for sale. It is more likely that a company will use the perpetual inventory method. Under the perpetual inventory system, we use a moving average unit cost that requires computing a new average cost each time we have a new purchase. This may seem like a daunting task when we do it by hand, but with today’s microcomputers the calculation is quite easy. Let’s look at the application of the average cost method when a company is using the perpetual inventory system. We will determine the average cost of ending inventory and cost of goods sold for Picture This, LLC. A physical inventory was taken on September 30, and it was determined that 2,000 frames were in ending inventory.

Picture This, LLC Inventory of frame number 759 In the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase. To accomplish this, we must know the date of each purchase along with the quantity purchased and the unit cost. In addition, we must know the date of each sale and the number of units sold.

Perpetual Average Cost Picture This, LLC, is in the process of determining the cost of goods sold for frame number 759 for the month of September. The physical inventory count on September 30 shows 2,000 frames in ending inventory. Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold The average cost method is reasonably popular, and is used by many businesses today. If the company uses the periodic inventory method, we use a weighted average cost. The weighted average cost is determined by taking the total cost of goods available for sale and dividing it by the number of units available for sale. It is more likely that a company will use the perpetual inventory method. Under the perpetual inventory system, we use a moving average unit cost that requires computing a new average cost each time we have a new purchase. This may seem like a daunting task when we do it by hand, but with today’s microcomputers the calculation is quite easy. Let’s look at the application of the average cost method when a company is using the perpetual inventory system. We will determine the average cost of ending inventory and cost of goods sold for Picture This, LLC. A physical inventory was taken on September 30, and it was determined that 2,000 frames were in ending inventory.

Perpetual Average Cost In the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase. To accomplish this, we must know the date of each purchase along with the quantity purchased and the unit cost. In addition, we must know the date of each sale and the number of units sold.

Perpetual Average Cost ($20,000 + 10,750) ÷ (2,000 + 1.000) = $10.25 On September 7, we sold 500 units, and we used our weighted average cost associated with goods available for sale of $10.25 per unit. The cost of the units sold is $5,125 (500 units sold times $10.25 average cost per unit) the cost of ending inventory, at this point, is $25,625 ($30, 750 minus $5,125, or 2,500 units in inventory times average cost per unit of $10.25).

Perpetual Average Cost ($25,625 + 10,950) ÷ (2,500 + 1,000) = $10.45 On September 21, we purchase 1,000 units, and we must calculate a new weighted average cost of $10.45. We calculate the new average cost of $10.45 ($25,625+10,950) ÷ (2,500+1,000). This new average cost will be assigned to all 3,500 in inventory on September 21.

Perpetual Average Cost On September 29th we sold 1,500 of the remaining 3,500 frames at our new average cost of $10.45 ($15,675). The total cost of these frames sold in September is $20,800, and the cost remaining in ending inventory to start the next period is $20,900. 3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.

First-In, First-Out (FIFO) The FIFO method assumes that items are sold in the chronological order of their acquisition. The cost of the oldest inventory items are charged to COGS when goods are sold. The cost of the newest inventory items remain in ending inventory. In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.

First-In, First-Out (FIFO) Perpetual Inventory System Let’s return to the Picture This example. Recall that ending inventory was determined by a physical count to be 2,000 units. Under the first-in, first-out method, we assign the costs of the first goods in to inventory to cost of goods sold. The 2,000 units sold come from the beginning inventory and carry a cost of $10 each. These 2,000 units come from the beginning inventory (first-in, first-out).

First-In, First-Out (FIFO) Perpetual Inventory System Cost of goods sold is calculated to be $20,000 (2,000 units times $10.00 per unit).

Last-In, First-Out (LIFO) The LIFO method assumes that the newest items are sold first, leaving the older units in inventory. The cost of the newest inventory items are charged to COGS when goods are sold. The cost of the oldest inventory items remain in inventory. Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory. The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remain in inventory.

Last-In, First-Out Perpetual Inventory System These are the oldest units in inventory and are most likely to remain in inventory when using LIFO. Recall that the oldest inventory cost remained in inventory. The units associated with those old costs are likely to remain in inventory when a company uses the LIFO method. It is important that we know when sales were made during the period. A block of 500 units was sold on September 7 and a second block of 1,500 units was sold on September 29. Let’s look at an example of accounting for LIFO inventory in a perpetual inventory system.

Last-In, First-Out Perpetual Inventory System For the sale on September 7, the last goods in the inventory are the first goods sold. We begin by selling the units from the September 3 purchase (1,000 units at $10.75 per unit), for a total of $5,375. Let’s continue with the example. The inventory now contains 2,000 units at a unit cost of $10.00, 500 units at a unit cost of $10.75. At the close of business on September 7, the inventory consists of 2,000 units at a unit cost of $10.00, and 500 units at a unit cost of $10.75, for a total cost of $25,375. The Cost of Goods Sold for the September 7 sale come from the purchase of September 3, so we record the cost of goods sold at $5,375 (500 units times $10.75).

Last-In, First-Out Perpetual Inventory System The Cost of Goods Sold for the September 29 sale come from the purchase of September 3 (500 remaining units) plus 1,000 units from the purchase of September 21, for a total of 1,500 units, For the sale on September 7, the last goods in the inventory are the first goods sold. We begin by selling the units from the September 3 purchase (1,000 units at $10.75 per unit), for a total of $5,375. At the close of business on September 7, the inventory consists of 2,000 units at a unit cost of $10.00, and 500 units at a unit cost of $10.75, for a total cost of $25,375. Let’s continue the example.

Last-In, First-Out Perpetual Inventory System The 1,500 units sold on September 29, have a total cost of $16,325. Ending inventory is composed of 1,000 at $10.00 per unit or $20,000. Cost of goods sold for September for frame number 759 is $21,700.

Exercise 14

When Prices Are Rising . . . FIFO Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher pre-tax income. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower pre-tax income. Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher pre-tax income, and LIFO results in lower pre-tax income.

U. S. GAAP vs. IFRS LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will impose a serious impediment to convergence. LIFO is permitted and used by U.S. Companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories. LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will impose a serious impediment to convergence. From the perspective of the FASB, LIFO is permitted and used by U.S. companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. However, IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories.

Decision Makers’ Perspective Factors Influencing Method Choice How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues? A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how well are costs matched against related revenues; and how are income taxes affected by inventory method choice? Companies usually stay with the method they select, but sometimes companies switch for tax reporting purposes or other economic reasons. How are income taxes affected by inventory method choice?

Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this: Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures, allowing a company to report in a note the effect of using another method on inventory valuation rather than LIFO.

When prices rise . . . LIFO Liquidation LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. If inventory declines, these “out of date” costs may be charged to current earnings. LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older, lower prices creating increased profits. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as LIFO liquidation profit. A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements. This LIFO liquidation results in “paper profits.”

Exercise 18

Inventory Management The higher the ratio, the higher the markup a company is able to achieve on its products. Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average inventory Managers closely monitor inventory levels to (1) ensure that the inventories needed to sustain operations are available, and (2) hold the cost of ordering and carrying inventories to the lowest possible level. One useful profitability indicator that involves cost of goods sold is gross profit or gross margin, which highlights the important relationship between net sales revenue and cost of goods sold. The gross profit ratio is calculated by dividing gross profit by net sales. The higher the ratio, the higher the markup a company is able to achieve on its products. Another important ratio, the inventory turnover ratio, is designed to evaluate a company’s effectiveness in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell or turn over its inventory, the lower its investment in inventory must be for a given level of sales. Anytime we have an income statement account in the numerator of an equation and a balance sheet account in the denominator, we need to calculate an average for the balance sheet account. In this case, average inventory is determined by adding together beginning and ending inventory and dividing the total by 2. (Beginning inventory + Ending inventory 2 Designed to evaluate a company’s effectiveness in managing its investment in inventory

Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

Methods of Simplifying LIFO LIFO Inventory Pools The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO Inventory Pools minimizes the probability of LIFO layer liquidation. The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value ($), rather than layers of similar units. DVL simplifies LIFO recordkeeping. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory dollar amount to beginning inventory dollar amount. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Dollar-Value LIFO (DVL) extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO recordkeeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory dollar amount to beginning inventory dollar amount. When using DVL we think in terms of inventory layers rather than inventory pools. DVL minimizes the probability of LIFO layer liquidation.

DOLLAR-VALUE LIFO (DVL) Many LIFO applications are based on this approach. DVL extends the concept of inventory pool by allowing companies to combine large variety of goods into one pool (layer). Physical units are not used to calculate inventory pool (layer). Inventory is viewed as a quantity of value($) instead of a physical quantity of goods. Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years. An inventory pool is identified in terms of economic similarity rather than physical similarity (subject to the same cost change pressures). DVL simplifies the recordkeeping procedures because no information is needed about unit flows. DVL minimizes the probability of the liquidation of LIFO inventory layers, through the aggregation of many types of inventory into larger pools.

DOLLAR-VALUE LIFO (DVL) Under unit LIFO we determine whether a new LIFO layer was added by comparing the ending quantity with the beginning quantity. Under DVL we determine whether a new LIFO layer was added by comparing the ending dollar amount with the beginning dollar amount. COST INDEXES However, if the cost level has changed, we need a way to determine whether an increase observed is a real increase or one caused by an increase in costs. So before we compare the beginning and ending inventory amounts, we need to deflate the ending inventory amount by any increase in costs so that both the beginning and ending amounts are based on the same level of costs. We accomplish this by using cost indexes.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a cost increase or an increase in inventory quantity. 1a. Compute a Cost Index for the year. The goal of dollar-value LIFO is to determine if an increase in ending inventory over beginning inventory is due to a cost increase of a real increase in inventory. The first step in the process is to compute the cost index. This can be done in a number of ways. One method is shown on your screen, others include the use of industry-specific general price indexes. The cost index for the base year (the year DVL is initially adopted) is set at 100.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and cost index information. Let’s look at the solution to this example. Masterwear reports the following inventory and cost index information. The company uses dollar-value LIFO for determining inventory values. Let’s see how the process works for the first year cost. Ending inventory at December 31, 2013, is stated at base-year costs when the cost index is 100 percent. At the end of 2014, the ending inventory at year-end costs is $168,000, but there was 5 percent inflation during 2014. While it looks like the inventory increased by $18,000, this simple computation ignores inflation. Let’s begin the DVL process.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information. First, we deflate the 2014 ending inventory by the rate of inflation. We determine that the ending inventory in base-year cost is $160,000.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year: The 2013 ending inventory and the 2014 ending inventory are stated in common, or base-year costs. We see that there has been a $10,000 LIFO layer added in 2014, stated at base-year costs.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory from last period. We now reinflate the $10,000 layer to 2014 prices by multiplying the layer by the cost index in 2014, and arrive at an adjusted layer of $10,500. The inventory at the end of 2014 is reported in the balance sheet at $160,500.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory at base year cost to beginning inventory at base year cost. The second step in the process is to deflate the ending inventory valued at year-end cost using the cost index. This is sometimes difficult for students to understand. We are attempting to state beginning and ending inventory is common dollar amounts. Next, we compare the ending inventory, at base year cost to beginning inventory at base year cost, to determine the amount of the inventory layer created in the current period.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Convert each layer’s base year cost to layer year cost by multiplying times the cost index. Sum all the layers to arrive at ending inventory at DVL cost. Finally, we convert the year’s layer into end of period dollars and add the adjusted layer to the beginning inventory. We always keep the beginning inventory and layers created in subsequent years separately. Let’s look at an example.

Exercise 22 Exercise 23

End of Chapter 8 End of Chapter 8.