1.General Course Questions 2.Return Discussion Question #4 Revenue Recognition 3.Turn in Columbia Sportswear Annual Report Projects 4.Discuss Final Group Project 5.Chapter 8 Inventory (using assigned homework) A. When is it Inventory (Ex 1, 3, 5) B. Inventory Errors (BE 4 and exercise 5) C. Inventory Costing Methods (Specific Identification, FIFO, LIFO, Weighted/Moving Average) ?12,13,16. BE 5,6,7, P 6 D. Other Inventory Topics (? 3, 5, 10) E. Dollar Value LIFO, LIFO effect, LIFO reserve (Ex 21) Intermediate Accounting November 22 nd, 2010 Intermediate Accounting November 22 nd,

A company should record purchases when it obtains legal title to the goods. What is Included in Inventory? Ex 1, 3 and 5 2

3 Report inventory units at the lower of cost or market (conservatism). What is included in cost for: -Retailer: -Manufacturing Company: What is Included in Inventory?

4 Report inventory units at the lower of cost or market (conservatism). What is included in cost for: -Merchandiser: items held for sale (Finished Goods) -Manufacturing Company: items held for sale (Finished Goods) goods to be used in production (Raw Materials) goods in production (Work in Process) What is Included in Inventory?

Inventory – Cost Flow Merchandiser vs. Manufacturing Co. 5

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. Purchase Discounts – Gross vs. Net Method (? 10) Product Financing (Question 5) Costs Included in Inventory? 6

Purchase Discounts: Gross or Net Illustration 8-11 * $4,000 x 2% = $80 * ** $10,000 x 98% = $9,800 ** Solution on notes page Question 10 7

Purchase Discounts: Gross or Net Illustration 8-11 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800 ** Solution on notes page 8

Inventory – Cost Flow Perpetual vs. Periodic System 9

Purchases are debited to Inventory account Freight-in, Purchases Returns & Allowances and Purchase Discounts are recorded in the Inventory account. Debit COGS and credit Inventory account for each sale. Purchases are debited to Purchases account. Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts. COGS is computed only periodically: Cost of Goods Available – Ending Inventory = Cost of Goods Sold Perpetual Method Periodic Method The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold. Perpetual vs. Periodic System Ending Inventory is determined only by physical count at the end of the period. 10

11 Purchase of Inventory: Dr. Inventory1,000 Cr. A/P, Cash, etc.1,000 Purchase Returns, Purchases Discounts Dr. A/P100 Cr. Inventory100 Transportation In Dr. Inventory100 Cr. A/P, Cash, etc.100 Sale of Inventory: Dr. Cost of Goods Sold1,000 Cr. Inventory1,000 Dr. Cash, A/R, etc.1,500 Cr.Sales Revenue1,500 At Year-End: no j/e required, unless errors are found in inventory count (physical inventory = perpetual inventory, than adjust to physical Inventory System - Perpetual

12 Purchase of Inventory: Dr. Purchases1,000 Cr. A/P, Cash, etc.1,000 Purchase Returns, Purchases Discounts Dr. A/P100 Cr. Purchases Returns or Purchases Discounts 100 Transportation In Dr. Transportation In100 Cr. A/P, Cash, etc.100 Sale of Inventory: Dr. Cash, A/R, etc.1,500 Cr.Sales Revenue1,500 At Year-End: Dr. Ending Inventory (determined by count) 38,000 Dr. Cost of Sales (plug)283,000 Dr. Purchase Returns and Purchase Discounts (close balance) Cr. Purchases (also close Transportation In)286,000 Cr. Opening Inventory (carried forward from prior year) 35,000 Inventory System - Periodic

Inventory Control – Physical Count All companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports. Question 3 13

Error in Effect onEffect on Ending IncomeBalance sheet Inventory ItemsItems Under- COGS (over) Inventory (under) stated Net income (under) Retained Earn (under) Over- COGS (under) Inventory (over) stated Net income (over) Retained Earn (over) Effect of Inventory Errors 14

Effect of Inventory Errors (U/S Ending) 15

Cost flow assumptions DO NOT Need to be consistent with physical flow of goods. The objective is to most clearly reflect periodic income. The cost flow assumptions are: 1 Specific identification 2 Average cost 3 First-in, first-out (FIFO) and 4 Last-in, first-out (LIFO) (prohibited under IFRS) Cost Flow Assumptions 16

Spaworld reports the following transactions for 2010 (assume no opening inventory): Date PurchasesCost/UnitPurchase Cost May $10/unit = $1,000 Aug $11/unit = 2,200 Sep $15/unit= 1, units $5,000 On December 31, the company had 20 units on hand and uses the periodic inventory system. What is the cost of goods sold? What is the cost of ending inventory? Cost Flow Assumptions: Example 17

Date PurchasesCost May units$1,000 Aug units$2,200 Sep units$1, units$5,000 Dec. 31 Ending inventory 20 units Steps: 1.Calculate per unit average cost: use four places to right of decimal 2.Apply this per unit average cost to units sold to get COGS: round to nearest dollar 3.Apply the per unit average cost to units remaining in inventory to determine Ending inventory : round to nearest dollar Average Cost Method 18

Date PurchasesCost May units$1,000 Aug units$2,200 Sep units$1, units$5,000 Dec. 31 Ending inventory 20 units 1.Calculate per unit average cost: use four places to right of decimal Cost per unit: $5000/420 = per unit 2.Apply this per unit average cost to units sold to get COGS: round to nearest dollar x 400 = $4,762 COGS 3.Apply the per unit average cost to units remaining in inventory to determine Ending inventory : round to nearest dollar x 20 = $238 ending inventory Average Cost Method 19

20 Journal Entry (Periodic Inventory): Year End Entry – Average Cost 20

21 Journal Entry: Dr. Ending Inventory 238 Dr. Cost of Sales 4,762 Cr. Purchases 5,000 Cr. Opening Inventory 0 Year End Entry – Average Cost 21

Given data: Date Purchases Cost May $10$1,000 Aug $11$2,200 Sep $15$1, $5,000 Ending Inventory 20 units COGSEI $5,000 GAFS Ending Inventory (FIFO) First-In, First-Out (FIFO) Method “Count” from one direction and “plug” the other Cost of goods sold (FIFO) 22

Given data: Date Purchases Cost May $10$1,000 Aug $11$2,200 Sep $15$1, $5,000 Ending Inventory 20 units COGS $4,700$300 EI $5,000 GAFS Ending Inventory (FIFO) 20 x $15 = $300 First-In, First-Out (FIFO) Method “Count” from one direction and “plug” the other Cost of goods sold (FIFO) 100 $10 $1, $11 $2, $15 $1,500 23

Given data: Date Purchases Cost May $10$1,000 Aug $11$2,200 Sep $15$1, $5,000 Ending Inventory 20 units COGSEI $5,000 GAFS Ending Inventory (FIFO) Last-In, First-Out (LIFO) Method “Count” from one direction and “plug” the other Cost of goods sold (FIFO) 24

Given data: Date Purchases Cost May $10$1,000 Aug $11$2,200 Sep $15$1, $5,000 Ending Inventory 20 units COGSEI $5,000 GAFS Ending Inventory (FIFO) 20 x $10 = $200 Last-In, First-Out (LIFO) Method “Count” from one direction and “plug” the other Cost of goods sold (FIFO) 80 $10 $ $11 $2, $15 $1,800 $4,800 $200 25

The ending inventory in units is the same in all three methods: the cost is different The cost of goods available is the same for all methods The cost of goods sold and the cost of ending inventory are different In periods of rising prices, LIFO would result in the smallest reported net income. Cost Flow Assumptions: Notes 26

27 Periodic vs. Perpetual FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems BUT – LIFO, Weighted Average will give you different numbers –Under perpetual LIFO, with each sale, you cut into only existing layers (so you must stop and calculate the cost of goods sold at each sale) –Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale

28 Same Example - Perpetual Basis

29 Same Example - Perpetual Basis

LIFO matches more recent costs with current revenues. With increasing prices: – LIFO yields the lowest taxable income (assuming inventory does not decrease). –Under LIFO, there is less need to write down inventory down to market Advantages of LIFO Method 30

LIFO Reserve (Allowance) account is used, when: LIFO is used for tax & external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: Special Issues Related to LIFO: Setting up a LIFO Reserve 1. Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. LIFO troublesome for interim periods SEC reporting requirements – disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet which is the LIFO RESERVE 31

Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004:$50,000 Inventory (LIFO basis) on Dec 31, 2004:$20,000 Adjust the cost of ending inventory to the LIFO basis Dr. Cost of goods sold $30,000 Cr. Allowance to Reduce Inventory to LIFO$30,000 Balance Sheet (Assets): Inventory (FIFO) $50,000 less: Allowance to Reduce Inventory($30,000) Inventory (LIFO) basis $20,000 LIFO Reserve: Example 32

Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when: –Earlier costs are matched against current sales due to a reduction of quantities of inventory during a period (results in “costing” items at older prices) –Such matching results in distorted income. LIFO Layers 33

LIFO yields the lowest net income and therefore reduced earnings (with increasing prices) Under LIFO, the ending inventory is understated relative to current costs LIFO liquidation (reduction of quantities of inventory during a period – results in “costing” items at older prices): –May result in income that is detrimental from a tax view –May cause poor buying habits (because of the layer liquidation problem) LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also. Disadvantages of LIFO Method 34

35 Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units Used for external purposes (i.e., financial statements and taxes) Advantages over regular LIFO: –Reduces record keeping (maximum of one layer per year). –Mitigates likelihood of eroding old layers (some decreases in goods in the pool are offset by increases in other goods in the pool). Price index – a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year –Internal = Ending inventory quantities X current year costs Ending inventory quantities X base year costs –External – calculated by the Bureau of Labor Statistics Dollar Value LIFO

36 Compare ending inventory at base year prices to beginning of year inventory, also at base year prices – if there is an increase – we add a new LIFO layer at Current Year prices: 1.Calculate Ending Inventory at current year costs (FIFO) 2.Calculate or locate the current year price index. 3.Convert the ending inventory at current cost to inventory at base-year cost by dividing the current year cost by the current price index (1 / 2 ) 4.Split the ending inventory at current cost into layers depending on the year the items were acquired by comparing current inventory at base prices to prior inventory at base prices. If there is an increase add an additional layer. If there is a decrease deduct from the most recently purchased layer. Once a layer is eliminated (peeled off), it can not be rebuilt. 5.Multiply each layer by the appropriate price index (price index of the year of acquisition) to obtain the quantity in ending inventory at dollar- value LIFO cost. Dollar Value LIFO Calculation Steps

37 Given: Base layer (Dec 31, 2009):$20,000 Inventory (current prices) Dec 31, 2010: $26,400 Prices increased 20% during Determine dollar value LIFO at Dec 31, 2010 Dollar Value LIFO: Example

38 Dec 31, 2009Dec 31, 2010 Price increase, 20% At EOY prices: $26,400 $26,400 / 1.20 At base $: $22,000 Net increase at base $: $22,000 less $20,000 Restate at current $: $2,400 (layer added) $2,000 * 1.20 $20,000 plus $2,400 = $22,400 Dollar value LIFO Inventory Dollar Value LIFO: Example

39 When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000): –the decrease must be subtracted from the most recently added layer. –Once a layer is eliminated (peeled off), it cannot be rebuilt. Dollar Value LIFO: Notes