McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVENTORIES: MEASUREMENT Chapter 8

Slide Recording and Measuring Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods Raw Materials Work-in-Process Finished Goods Types of Inventory

Slide Manufacturing Inventories Raw Materials (1) $XX $XX (4) Work in Process Finished Goods Cost of Goods Sold Direct Labor Manufacturing Overhead $XX $XX (7) $XX$XX (8) $XX (2) $XX $XX (5) (3) $XX $XX (6) (1)Raw materials purchased (2)Direct labor incurred (3)Manufacturing overhead incurred (4)Raw materials used (5)Direct labor applied (6)Manufacturing overhead applied (7)Work in process transferred to finished goods (8)Finished goods sold (1)Raw materials purchased (2)Direct labor incurred (3)Manufacturing overhead incurred (4)Raw materials used (5)Direct labor applied (6)Manufacturing overhead applied (7)Work in process transferred to finished goods (8)Finished goods sold

Slide Inventory Systems 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. Two accounting systems are used to record transactions involving inventory:

Slide Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL DateDescriptionDebitCredit Inventory 600,000 Accounts Payable 600, 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.

Slide Perpetual Inventory System LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL DateDescriptionDebitCredit Accounts Receivable820,000 Sales Cost of Goods Sold540,000 Inventory 820, ,

Slide Periodic Inventory System

Slide Periodic Inventory System LWBC purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL DateDescriptionDebitCredit Purchases 600,000 Accounts Payable 600, Purchase Returns and Allowances Returns of inventory are credited to the Purchase Returns and Allowances account. Discounts on inventory purchases can be recorded using the gross or net method. Purchase Returns and Allowances Returns of inventory are credited to the Purchase Returns and Allowances account. Discounts on inventory purchases can be recorded using the gross or net method.

Slide Periodic Inventory System LWBC sold on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL DateDescriptionDebitCredit Accounts Receivable820,000 Sales 820, No entry is made to record Cost of Goods Sold. Assuming Beginning Inventory of $120,000, a physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of the accounting period.

Slide Periodic Inventory System Adjusting entry to determine Cost of Goods Sold

Slide Comparison of Inventory Systems

Slide What is Included in Inventory? 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.

Slide Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns Purchase Discounts

Slide Purchase Discounts Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280 Partial payment not made within the discount period

Slide Inventory Cost Flow Assumptions Specific identification Specific identification Average cost Average cost First-in, first-out (FIFO) First-in, first-out (FIFO) Last-in, first-out (LIFO) Last-in, first-out (LIFO) Specific identification Specific identification Average cost Average cost First-in, first-out (FIFO) First-in, first-out (FIFO) Last-in, first-out (LIFO) Last-in, first-out (LIFO)

Slide Perpetual Average Cost 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 theaverage cost method to determine: Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold (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 theaverage cost method to determine: Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold (2) Cost of goods sold

Slide Perpetual Average Cost

Slide Perpetual Average Cost

Slide Perpetual Average Cost $11, ÷ ( ) = $23.200

Slide Perpetual Average Cost $27, ÷ ( ) = $26.181

Slide Perpetual Average Cost Sum

Slide Weighted-Average Periodic System Let’s use the same information to assign costs to ending inventory and cost of goods sold using the periodic system. Available for Sale (1,950 units) Available for Sale (1,950 units) Ending Inventory (600 units) Goods Sold (1,350) $47,650 ÷ 1,950 = $ weighted- average per unit cost

Slide Weighted-Average Periodic System

Slide First-In, First-Out (FIFO) 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.

Slide First-In, First-Out (FIFO) 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.

Slide First-In, First-Out (FIFO) These are the 600 most recently acquired units.

Slide First-In, First-Out (FIFO)

Slide First-In, First-Out (FIFO) These are the first 1,350 units acquired.

Slide First-In, First-Out (FIFO)

Slide 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.

Slide 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.

Slide 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. Not permitted by international accounting standards. FIFO Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher taxable income.

Slide 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:

Slide Decision Makers’ Perspective Factors Influencing Method Choice How are income taxes affected by inventory method choice? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues?

Slide LIFO Liquidation LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. LIFO inventory costs in 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.”

Slide Inventory Management Gross profit ratio Gross profit Net sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

8-37 Inventory Management Cost of goods sold Average inventory Inventory turnover ratio = This ratio measures how many times a company’s inventory has been sold and replaced during the year. If a company’s inventory turnover is less than its industry average, it may experience difficulties in generating sales because of obsolete or slow- moving inventory items.

Slide Earnings Quality 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.

Slide Methods of Simplifying LIFO LIFO 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.

Slide 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. Methods of Simplifying LIFO 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. Dollar-Value LIFO (DVL)

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 8