© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 8 Inventory: Measurement

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-2 Inventory Those assets that a company: 2. Has in production for future sale. 1. Intends to sell in the normal course of business. 1. Intends to sell in the normal course of business. 3. Uses currently in the production of goods to be sold. 3. Uses currently in the production of goods to be sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-3 Types of Inventories Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-process Finished Goods Raw Materials Work-in-process Finished Goods

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-4 Inventory Methods Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-5 Accounting Entries in a Perpetual System Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-6 Accounting Entries in a Perpetual System

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-7 Periodic Cost of Goods Sold Equation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-8 Accounting Entries in a Periodic System

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-9 Accounting Entries in a Periodic System

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-10 Accounting Entries in a Periodic System In addition to Purchases, the contra- purchase accounts are also closed to COGS at the end of the period: Purchases Discounts Purchase Returns and Allowances In addition to Purchases, the contra- purchase accounts are also closed to COGS at the end of the period: Purchases Discounts Purchase Returns and Allowances

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-11 Comparison of Inventory Systems

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-12 What is Included in Inventory? General Rule All goods owned by the company on the inventory date, regardless of their location. General Rule All goods owned by the company on the inventory date, regardless of their location. Goods in Transit Goods on Consignment Depends on FOB shipping terms.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-13 Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns Purchase Discounts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-14 Inventory Cost Flow Methods Specific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) Specific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-15 The specific cost of each inventory item must be known. By selecting specific items from inventory at the time of sale, income can be manipulated. The specific cost of each inventory item must be known. By selecting specific items from inventory at the time of sale, income can be manipulated. Specific Cost Identification Items are added to inventory at cost when they are purchased. COGS for each sale is based on the specific cost of the item sold. Items are added to inventory at cost when they are purchased. COGS for each sale is based on the specific cost of the item sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-16 Average Cost Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-17 Weighted-Average Periodic Example The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the periodic weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use the periodic weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-18 Weighted-Average Periodic Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-19 Weighted-Average Periodic Example Now, we have to assign costs to ending inventory and cost of goods sold. Beginning Inventory (800 units) Purchases (1,150 units) Beginning Inventory (800 units) Purchases (1,150 units) Available for Sale (1,950 units) Available for Sale (1,950 units) Ending Inventory (600 units) Ending Inventory (600 units) Goods Sold (1,350) Goods Sold (1,350) $47,650 ÷ 1,950 = $ weighted- average per unit cost

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-20 Weighted-Average Periodic Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-21 Moving-Average Perpetual Example The following schedule shows the Frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the Frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-22 Moving-Average Perpetual Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-23 Moving-Average Perpetual Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-24 Moving-Average Perpetual Example $11, ÷ ( ) = $23.200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-25 Moving-Average Perpetual Example $27, ÷ ( ) = $26.181

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-26 Moving-Average Perpetual Example Sum

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-27 First-In, First-Out 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. 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. The FIFO method assumes that items are sold in the chronological order of their acquisition.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-28 First-In, First-Out Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory COGS and Ending Inventory Cost are the same under both approaches. Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory COGS and Ending Inventory Cost are the same under both approaches.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-29 FIFO - Periodic Example The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the periodic FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the periodic FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-30 FIFO - Periodic Example These are the 600 most recently acquired units.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-31 FIFO - Periodic Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-32 FIFO - Periodic Example These are the first 1,350 units acquired.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-33 FIFO - Periodic Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-34 FIFO - Perpetual Example The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-35 FIFO - Perpetual Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-36 FIFO - Perpetual Example 200 The ending inventory on 9/1 consists of: 200 units from beginning $ units from beginning $22.00 The ending inventory on 9/1 consists of: 200 units from beginning $ units from beginning $22.00

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-37 FIFO - Perpetual Example 200 The ending inventory on 9/3 consists of: 200 units from beginning $ units from beginning $ units from the 9/3 $24.00 The ending inventory on 9/3 consists of: 200 units from beginning $ units from beginning $ units from the 9/3 $24.00

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-38 FIFO - Perpetual Example 200 The ending inventory on 9/10 consists of: 200 units from the 9/3 $24.00 The ending inventory on 9/10 consists of: 200 units from the 9/3 $24.00

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-39 FIFO - Perpetual Example The ending inventory on 9/15 consists of: 200 units from the 9/3 $ units from the 9/15 $25.00 The ending inventory on 9/15 consists of: 200 units from the 9/3 $ units from the 9/15 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-40 FIFO - Perpetual Example The ending inventory on 9/21 consists of: 200 units from the 9/3 $ units from the 9/15 $ units from the 9/21 $27.00 The ending inventory on 9/21 consists of: 200 units from the 9/3 $ units from the 9/15 $ units from the 9/21 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-41 FIFO - Perpetual Example The ending inventory on 9/21 consists of: 200 units from the 9/3 $ units from the 9/15 $ units from the 9/21 $ units from the 9/29 $28.00 The ending inventory on 9/21 consists of: 200 units from the 9/3 $ units from the 9/15 $ units from the 9/21 $ units from the 9/29 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-42 FIFO - Perpetual Example The ending inventory on 9/30 consists of: 200 units from the 9/21 $ units from the 9/21 $ units from the 9/29 $ The ending inventory on 9/30 consists of: 200 units from the 9/21 $ units from the 9/21 $ units from the 9/29 $28.00.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-43 FIFO - Perpetual Example Note that this is the same COGS computed using the Periodic approach.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-44 Last-In, First-Out Any questions before we run into LIFO?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-45 Last-In, First-Out 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. 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. The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-46 Last-In, First-Out Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-47 The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the periodic LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the periodic LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. LIFO - Periodic Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-48 LIFO - Periodic Example These are the 600 oldest units in inventory.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-49 LIFO - Periodic Example x $22.00

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-50 LIFO - Periodic Example 600 x $22.00 These are the most recently acquired 1,350 units. 200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-51 LIFO - Periodic Example $4,400 + $30, x $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-52 LIFO - Perpetual Example The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 mouse pads in ending inventory. Use the perpetual LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-53 LIFO - Perpetual Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-54 LIFO - Perpetual Example In LIFO, we assume that we sell the newest units in inventory first. In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer. In LIFO, we assume that we sell the newest units in inventory first. In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer. 200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-55 LIFO - Perpetual Example The ending inventory on 9/3 consists of: 200 units from beginning $ units from the 9/3 $24.00 The ending inventory on 9/3 consists of: 200 units from beginning $ units from the 9/3 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-56 LIFO - Perpetual Example For the 9/30 sale, we must identify the 300 newest units. They all come from the September 3 purchase. Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain. For the 9/30 sale, we must identify the 300 newest units. They all come from the September 3 purchase. Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain. 200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-57 LIFO - Perpetual Example The ending inventory on 9/15 consists of: 200 units from beginning $ units from the 9/15 $25.00 The ending inventory on 9/15 consists of: 200 units from beginning $ units from the 9/15 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-58 LIFO - Perpetual Example The ending inventory on 9/21 consists of: 200 units from beginning $ units from the 9/15 $ units from the 9/21 $27.00 The ending inventory on 9/21 consists of: 200 units from beginning $ units from the 9/15 $ units from the 9/21 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-59 LIFO - Perpetual Example The ending inventory on 9/29 consists of: 200 units from beginning $ units from the 9/15 $ units from the 9/21 $ units from the 9/29 $ The ending inventory on 9/29 consists of: 200 units from beginning $ units from the 9/15 $ units from the 9/21 $ units from the 9/29 $

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-60 LIFO - Perpetual Example 150 For the 9/30 sale, we must identify the 450 newest units. 400 of them come from the 9/29 purchase. The other 50 come from the 9/21 purchase. 200

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-61 LIFO - Perpetual Example The ending inventory on 9/30 consists of: 200 units from beginning $ units from beginning $ units from the 9/15 $ units from the 9/21 $ The ending inventory on 9/30 consists of: 200 units from beginning $ units from beginning $ units from the 9/15 $ units from the 9/21 $27.00.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-62 When Prices Are Rising... LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income. Is not officially endorsed by the IASC. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income. Is not officially endorsed by the IASC. FIFO Matches low (older) costs with current (higher) sales. Inventory is valued approximates replacement cost. Results in higher taxable income. FIFO Matches low (older) costs with current (higher) sales. Inventory is valued approximates replacement cost. Results in higher taxable income.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-63 Decision Makers’ Perspective What factors motivate companies to select one inventory method over another? How accurate are the timing of reported income and income taxes? How accurate are the timing of reported income and income taxes? How closely do reported costs reflect actual flow of inventory? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues? How well are costs matched against related revenues?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-64 LIFO Liquidation LIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. LIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. When prices rise... If inventory declines, these “out of date” costs may be charged to current earnings. This LIFO liquidation results in “paper profits.” This LIFO liquidation results in “paper profits.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-65 LIFO Inventory Pools Inventory Pools consist of inventory units grouped according to similarities. For example, all similar units purchased at the same time can be “pooled” and assigned an average unit cost. Using Inventory Pools with LIFO simplifies record keeping.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-66 Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. DVL 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 to beginning inventory.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-67 Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory. 1a. Compute a Cost Index for the year.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-68 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-69 Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Sum all the layers to arrive at Ending Inventory at DVL cost. Convert each layer’s base year cost to layer year cost by multiplying times the cost index.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 8-70 End of Chapter 8 It’s Over