Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 8 Valuation of Inventories: A Cost Basis Approach

Learning Objectives 1.Identify major classifications of inventory. 2.Distinguish between perpetual and periodic inventory systems. 3.Identify the effects of inventory errors on the financial statements. 4.Identify the items that should be included as inventory cost.

Learning Objectives 5.Explain the difference between variable costing and absorption costing in assigning manufacturing costs to inventory. 6.Distinguish between the physical flow of inventory and the cost flow assigned to inventory. 7.Identify possible objectives for inventory valuation decisions.

Learning Objectives 8.Describe and compare the flow assumptions used in accounting for inventories. 9.Evaluate LIFO as a basis for understanding the differences between the cost flow methods. 10.Explain the importance of judgement in selecting an inventory cost flow method.

Valuation of Inventories: A Cost Basis Approach Inventory Classification and Control Classification Management and control Basic valuation Issues Costs Included in Inventory Purchase discounts Product costs Period costs Manufacturing costs Variable versus absorption Standard Costs Physical Goods Included in Inventory Goods in transit Consigned goods Special sales agreements Inventory errors Cost Flow Assumptions Framework for analysis Specific identification Average cost FIFO LIFO Evaluation and Choice Advantages of LIFO Disadvantages of LIFO Summary analysis Which method to select? Consistency

Inventory Classification Inventory consists of: - finished goods held for sale in the ordinary course of business - goods held or consumed in the production of finished goods A merchandising concern has one inventory account –Merchandise Inventory A manufacturing concern will normally have three inventory accounts: –Raw materials –Work in process –Finished goods

Inventory Cost Flows Merchandising Operations Cost of goods sold $$$ Merchandise Inventory PurchasesCOGS

Inventory Cost Flows Work in Process Inventory $$$ COGM Manufacturing Operations Finished Goods $$$ Raw Materials Labour Mfg. Overhead COGS $$$

Inventory Control Inventory control is important for: - ensuring availability of inventory items - preventing excessive accumulation of inventory items The perpetual system maintains a continuous record of inventory changes The periodic system updates inventory records only periodically

Perpetual System Purchases and sales of inventory recorded directly to Inventory account Inventory purchases, freight, purchase returns and discounts are debited to the Inventory account Cost of Goods Sold (COGS) is debited and Inventory is credited for each sale Subsidiary ledger is maintained for individual inventory items Periodic inventory counts are still required to ensure reliability

Periodic System Inventory purchases recorded as a debit to Purchases account COGS is a calculation on the Income Statement Physical inventory is counted and verified periodically Under both periodic and perpetual inventory systems, physical counts of inventory are conducted at least once a year Any differences in counted and recorded quantities are posted to a separate account – Inventory Over and Short

Perpetual and Periodic Systems: Example Fesmire Limited reports the following data for 2000: Beginning Inventory :100 units at $6 Purchases: (all credit) March 12: 300 units at $6 July 6:600 units at $6 Sales:(all credit) April 8:200 units at $12 August 9:400 units at $12 Ending Inventory:400 units at $6 Provide all journal entries under each method.

Perpetual System DateRecord Inventory Changes Record Sales Revenue March 12 Inventory 1,800 Accts Payable 1,800 April 8 Cost of goods sold 1,200 Accts Receiv. 2,400 Inventory 180 Sales 2,400 (200 *$6) (200 * $12) July 6 Inventory 3,600 Accts Payable 3,600 August 9 Cost of goods sold 2,400 Accts Receiv. 4,800 Inventory 2,400 Sales 4,800 (400 * $6) (400 * $12)

Perpetual System Inventory Stock Card (Subsidiary Ledger) DatePurchasesSalesBalance March units400 April 8200 units200 July 6600 units800 August 9400 units400 units January 1Opening100 units Dollar amounts are optional Periodic inventory system would not normally maintain a subsidiary ledger for inventory

DateRecord Inventory ChangesRecord Sales Revenue March 12 Purchases 1,800 Accts Payable 1,800 April 8No entry Accts Receiv 2,400 Sales 2,400 July 6 Purchases 3,600 Accts Payable 3,600 August 9No entry Accts Receiv 4,800 Sales 4,800 Dec. 31 Cost of goods sold 3,600 Inventory (ending) 2,400Adjusting Purchases 5,400Entry Inventory (beg) 600 Periodic System

Financial Statement Presentation Net Sales$,$$$ Cost of Goods Sold $$$ Gross Profit$,$$$ Net Sales $,$$$ Cost of Goods Sold: Opening Inventory$$$ Add: Net Purchases$$$ Cost of Goods Available for Sale Less: Ending Inventory$$$ Cost of Goods Sold$$$ Gross Profit $,$$$ PerpetualPeriodic

Items to Be Included in Inventory Legal title to goods determines inclusion The following goods are included in the seller’s inventory: 1 Goods in transit ( if seller has title during shipment) 2 Goods on consignment with seller 3 Goods, sold under buyback agreements 4 Goods, sold with high rates of return 5 Instalment sales ( if bad debts cannot be estimated )

Effect of Inventory Errors EndingEffect on IncomeEffect on Balance Sheet InventoryStatement ItemsItems Under-COGS (over) Retained Earnings (under) statedNet Income (under) Working Capital (under) Over-COGS (under) Retained Earnings (over) statedNet Income (over)Working Capital (over) As an example, consider Brief Exercise BE8-4.

BE8-4 Given for the year 2002: COGS = $1.4 million Retained Earnings (R/E) = $5.2 million December 31 st inventory errors: 2001: overstated by $110, : overstated by $45,000 Calculate correct COGS and R/E for December 31, 2002.

BE 8-4 COGS (as originally stated)$1,400,000 Add: December 31, 2001 over- statement error 110,000 1,510,000 Less: December 31, 2002 over- statement error 45,000 Corrected COGS $1,465,000 Retained Earnings (original) $5,200,000 Less: correction to COGS 65,000 Retained Earnings (restated)$5,265,000

Costs Included in Inventory Costs included in inventory are known as “inventoriable costs” These costs include: 1product costs (direct materials, direct labour and manufacturing overhead) 2purchase net costs, and freight-in Period costs (selling and administrative) are not inventoriable costs

Inventory Valuation: Variable costing Under variable costing, inventory costs include only the following manufacturing costs: 1direct materials used 2direct labour 3variable manufacturing overhead Fixed manufacturing overhead is treated as a period cost All period costs are ignored Variable costing is appropriate for internal decision-making

Inventory Valuation: Absorption Costing Under absorption costing, inventory costs include all manufacturing costs as follows: 1.direct materials used in production 2.direct labour cost 3.variable manufacturing overhead 4.fixed manufacturing overhead All other costs are period costs and are ignored Absorption costing is required for external reporting

Cost Flow Assumptions The objective is to most clearly reflect periodicincome Cost flow assumptions need not be consistent with physical flow of goods Objectives of choosing an inventory valuation method are to: 1.realistically match expenses against revenue 2.report inventory at a realistic amount 3.minimize income taxes

Cost Flow Assumptions The cost flow assumptions are: 1 Specific identification 2 Average cost 3 First-in, First-out (FIFO) 4 Last-in, First-out (LIFO)

Cost Flow Assumptions: Example Call-Mart reports the following transactions for March Date Purchases (Sold) Balance 1beginning inventory 21,500 2, ,000 units 8,000 19(4,000 units sold) 4, ,000 units 6,000 Determine the cost of goods sold and the cost of ending inventory, under each cost flow assumption.

Specific Identification Items sold and purchased are individually identified as to cost Works best with items that are unique, high cost, with small numbers held as inventory Advantage: – Matches revenues and actual costs Disadvantages: –May be costly to implement and maintain –May lead to income manipulation

Average (weighted) Method Date PurchasesUnit CostPurchase Cost March 1500 units$3.80$ 1,900 March 21,500 units$4.00$ 6,000 Aug 146,000 units$4.40$26,400 Sep 182,000 units$4.75$ 9,500 10,000 units $43,800 Unit cost = $43,800  10,000 = $4.38 Cost of goods available 4,000 X $4.38 = 17,5206,000 X $4.38 = $26,280 Ending inventoryCost of goods sold $43,800

First-in, First-out Method Date PurchasesUnit CostPurchase Cost March 1500 units$3.80$ 1,900 March 21,500 units$4.00$ 6,000 Aug 146,000 units$4.40$26,400 Sep 182,000 units$4.75$ 9,500 Cost of goods available $43,800 - $27,100 = $16,700 6,000 units $4.75=$ 9,500 $4.40= 17,600 $27,100 Ending inventoryCost of goods sold $43,800

Last-in, First-out Method Date PurchasesUnit CostPurchase Cost March 1500 units$3.80$ 1,900 March 21,500 units$4.00$ 6,000 Aug 146,000 units$4.40$26,400 Sep 182,000 units$4.75$ 9,500 Cost of goods available $43,800 - $25,500 = $18,300 6,000 units $3.80=$ 1,900 $4.00= 6,000 $4.40= 17,600 $25,500 Ending inventoryCost of goods sold $43,800 $4.40 = $ 8,800 $4.75 = 9,500 $18,300

Cost Flow Assumptions: Notes The ending inventory in units is the same in all three methods: the cost is different The cost of goods sold and the cost of ending inventory are different The cost of goods available is the same in all three methods LIFO would result in the smallest reported net income (with rising prices)

Advantages of LIFO Method LIFO matches more recent costs with current revenues With increasing prices, LIFO yields the lowest taxable income (assuming inventory does not decrease) With reduced taxes, cash flow is improved Under LIFO, the need to write down inventory to market is minimized

Disadvantages of LIFO Method LIFO yields the lowest net income and therefore reduced earnings Under LIFO, the ending inventory is understated LIFO does not approximate the physical flow of goods except in special situations LIFO liquidation may result in income that is detrimental from a tax view LIFO may cause poor buying habits (because of the layer liquidation problem) Not acceptable for tax purposes Current (replacement) cost measurement lost

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