Chapter 10--Learning Objectives 1.Explain the importance of inventory for asset valuation and income measurement

Inventories are a significant asset for many businesses

Inventories affect income SalesXXX Beginning inventoryXXX PurchasesXXX Goods available for saleXXX Ending inventoryXXX Cost of goods soldXXX Gross profitXXX Operating expensesXXX Net incomeXXX

Chapter 10--Learning Objectives 2.Understand the nature of inventory and what is included in it

Types of inventory 1.Assets held for sale (or resale) in the ordinary course of business 2.Assets used or consumed in the production of goods to be sold in the ordinary course of business

A retail store (Sears, Wal-Mart, Safeway) Has inventory for resale to customers

A manufacturer (Ford, IBM, Exxon) Has inventories used or consumed in the production of goods for sale

A manufacturer’s inventories will usually include Raw materials inventory Items used in producing the product Work in process inventory Products started but not yet completed Finished goods inventory Products completed but not yet sold

What about this F.O.B. stuff ? “F.O.B.” means “free on board” and refers to the time and place at which the goods were turned over to the transportation carrier

If you are in Los Angeles and your supplier is in New York City You Them

If you are in Los Angeles and your supplier is in New York City Somebody has to pay for moving the goods across the country You Them

If you are in Los Angeles and your supplier is in New York City And somebody owns the goods while they are moving across the country You Them

The F.O.B. designation determines who that “somebody” is You Them

If the goods are shipped F.O.B. New York (or F.O.B. origin) You will pay the transportation cost and you will own the merchandise once it is turned over to the carrier in NYC You Them

If the goods are shipped F.O.B. Los Angeles (or F.O.B. destination) The supplier will pay the transportation cost and they will own the merchandise until in reaches you in Los Angeles You Them

The owner of the goods Is usually the entity that should include those goods in inventory This applies to goods in transit and to consignment situations But there are exceptions for some special sales agreements

An interesting situation arises in purchase commitments These are noncancellable, long-term contracts to purchase goods at a set price You might enter into such an agreement to buy a product if you thought its price was about to go up If the price does go up, everything is cool and you will make lots of money But if the price goes down, you have an economic problem and an accounting problem

The Oliver Peck Oil Company (O. Peck for short) Thinking that the price of gas is about to increase Peck signs a contract during 19X1 to purchase 100,000 gallons of gas during 19X2 at $1.00 per gallon

On December 31, 19X1, gas is selling for $.94 Since Peck has agreed to pay $1.00 per gallon, accounting conservatism mandates: December 31, 19X1 Est. Loss on Purch. Commit.6,000 Est. Liab. on Contract6,000 This reduces Peck’s income and increases his liabilities

Assume that on the April 1, 19X2, delivery date, gas is selling for $.90 Since Peck has agreed to pay $1.00 per gallon, there is an additional loss: April 1, 19X2 Purchases90,000 Est. Liab. on Contract6,000 Loss on Purchase Contract4,000 Cash100,000

Now assume that on the April 1, 19X2, delivery date, gas is selling for $.98 Peck must still pay $1.00, but the situation has improved since December 31: April 1, 19X2 Purchases98,000 Est. Liab. on Contract6,000 Recovery on Contract4,000 Cash100,000

Now assume that on the April 1, 19X2, delivery date, gas is selling for $1.05 This is what Peck was planning on, but the purchase is recorded at $1.00 and lower cost of goods sold will give Peck higher profits when the gas is sold April 1, 19X2 Purchases100,000 Est. Liab. on Contract6,000 Recovery on Contract6,000 Cash100,000

Chapter 10--Learning Objectives 3.Differentiate between perpetual and periodic inventory measurement systems

In a periodic inventory system Purchases of goods for resale are recorded in a “Purchases” account: PurchasesXXX Cash or Accts. PayableXXX

In a periodic inventory system Recording sales of merchandise is simple: Cash or Accts. ReceivableXXX SalesXXX

In a periodic inventory system An adjusting entry closes out the beginning inventory and purchases accounts and records the cost of goods sold and ending inventory Inventory (ending)XXX Cost of Goods SoldXXX Inventory (beginning)XXX PurchasesXXX

In a perpetual inventory system Purchases of merchandise for resale are recorded in the “Inventory” account InventoryXXX Cash or Accts. PayableXXX

In a perpetual inventory system Recording sales is more complicated: Cash or Accts. ReceivableXXX SalesXXX Cost of Goods SoldXXX InventoryXXX The first entry records the sale at the selling price, just like in a periodic system

In a perpetual inventory system Recording sales is more complicated: Cash or Accts. ReceivableXXX SalesXXX Cost of Goods SoldXXX InventoryXXX The second entry removes the cost of the merchandise sold from the “Inventory” account and transfers it to “Cost of Goods Sold”

In a perpetual inventory system No end-of-period adjustment is required if the actual inventory cost matches the balance in the “Inventory” account: XXX Inventory

In a perpetual inventory system If items are missing, an adjustment is made to change the “Inventory” balance to reflect reality: Inventory ShrinkageXXX InventoryXXX “Inventory Shrinkage” is treated as an expense account, but is often included in “Cost of Goods Sold” in practice

Inventory shrinkage can be a result of Theft Spoilage Accidental breakage Mistakenly thrown away and other causes

Occasionally, a business will have more inventory than the records indicate P e t e ’ s R a b b i t F a r m

Occasionally, a business will have more inventory than the records indicate P e t e ’ s R a b b i t F a r m

Chapter 10--Learning Objectives 4.Record and report inventories for different valuation systems

Inventory cost flow assumptions Picture five items identical except for cost acquired in the order indicated $11 2 $12 3 $13 4 $14 5 $15

Inventory cost flow assumptions The total cost of the five items is $65 ($ = $65) Assume that three items are sold for $25 each (total sales revenue = $75) and that two are on hand at the end of the period 1 $11 2 $12 3 $13 4 $14 5 $15

Specific identification The actual items sold are recorded These might be items 1, 3 and 5 Leaving items 2 and 4 in inventory The cost of items 2 and 4 is $26 2 $12 4 $14

Specific identification Sales revenue$75 Goods available for sale$65 Less: Ending inventory26 Cost of goods sold$39 Gross profit$36 2 $12 4 $14

First-in, first-out ( FIFO ) The first three items would be the items sold-- items 1, 2 and 3 Leaving items 4 and 5 The cost of items 4 and 5 is $29 4 $14 5 $15

First-in, first-out ( FIFO ) Sales revenue$75 Goods available for sale$65 Less: Ending inventory29 Cost of goods sold$36 Gross profit$39 4 $14 5 $15

Last-in, first-out ( LIFO ) The last three items (3, 4 and 5) would be the items sold Leaving items 1 and 2 The cost of items 1 and 2 is $23 1 $11 2 $12

Last-in, first-out ( LIFO ) Sales revenue$75 Goods available for sale$65 Less: Ending inventory23 Cost of goods sold$42 Gross profit$33 1 $11 2 $12

Average cost The total cost of the five items is $65 So the average cost per item is $13 It doesn’t matter which items are sold and which remain The cost of the ending inventory is $26 ??

Average cost Sales revenue$75 Goods available for sale$65 Less: Ending inventory26 Cost of goods sold$39 Gross profit$36 ??

Note that in this period of rising prices the gross profits were: FIFO$ 39 Average36 LIFO33 LIFO results in a higher cost of goods sold and a lower gross profit because the higher cost of the last items purchased is being matched against revenues LIFO will also result in a lower income tax in a period of rising prices

Lower of cost or market (LCM) INVENTORY IS PURCHASED AT COST THERE IS NO PROBLEM IF THE VALUE INCREASES

Lower of cost or market (LCM) INVENTORY IS PURCHASED AT COST THERE ARE PROBLEMS IF THE VALUE GOES DOWN

A decline in inventory value... Creates an accounting problem Means that you will lose your shirt Our job is to solve the accounting problem

Any adjustment of inventory value Must be below the ceiling And above the floor

The Ceiling is Net Realizable Value (NRV) What we expect to get less costs of completion and disposal

The Floor is NRV less normal profit margin Net realizable value less what we would expect to make on a similar item

We must remain between the ceiling and the floor

In the real world We know what cost was We can usually get a replacement cost figure We have to estimate net realizable value You never know for sure until it’s actually sold

Lower of cost or market Can be applied three ways: 1.To each inventory item separately 2.To each category of items in the inventory 3.To the inventory as a whole

Probably the best way to apply lower of cost or market Is the allowance method. The initial application entry would be: Holding LossXXX Allowance to reduce inventory to marketXXX The “Allowance” account appears on the balance sheet as a contra account to inventory

Chapter 10--Learning Objectives 5.Estimate inventories using various methods

The gross profit method Good news Simple Quick Cheap Bad news Depends on old data relationships May not be any good in a changing situation

Recall that... Amount Sales$100 Less: Cost of goods sold70 Equals: Gross profit$ 30 These numbers can be expressed as percentages of sales

In this case, the percentages are: AmountPct. Sales$ Less: Cost of goods sold7070 Equals: Gross profit$ 3030 Knowing the cost of goods sold percentage and some other facts allows us to estimate inventory

Assume that the following are known: Beginning inventory$ 40,000 Purchases480,000 Sales revenue700,000 Cost of goods sold percentage70% These items would be available from the accounting records and prior year statements

Using the known data Beginning inventory$ 40,000 Plus: Purchases480,000 Equals: Goods avail. for sale$520,000 Sales x CGS % ($700,000 x.70) =490,000 Estimated ending inventory$ 30,000

The retail method Overcomes the problems of the gross profit method, but is more trouble Some more trouble in the classroom Considerably more trouble in the real world Requires keeping two sets of sales records One at cost (which would be done anyway) Another at retail Based on the relationship between goods available for sale at cost and at retail

Retail method example CostRetail Beginning inventory$ 6,000$10,000 Purchases48,00080,000 Goods available for sale$54,000$90,000 Cost / Retail ratio for Goods available for sale ( $54,000 / $90,000 ) =.60

Retail method example CostRetail Goods available for sale$54,000$90,000 Less: Sales70,000 Ending inventory at retail$20,000 Cost / retail ratio.60 Ending inventory at cost$12,000

Retail method terminology Markup--Amount by which original sales price exceeds cost--also called normal profit Additional markup--Amount added to original sales price Markup cancellation--Cancellation of all or part of the additional markup Net markup--Additional markup less the markup cancellation

More retail method terminology Markdown--Amount subtracted from the original sales price Markdown cancellation--Cancellation of all or part of the markdown. Markdown cancellation cannot exceed the amount of the markdown Net markdown--The difference between the total markdowns and the markdown cancellations

As previously demonstrated, the retail method approximates average cost With modifications, it can be used to approximate: Average cost on a lower of cost or market (LCM ) basis (very widely used and known as the “conventional method” FIFO (with or without LCM ) LIFO

Summary of modifications To approximate lower of cost or market ( LCM ) exclude net markdowns from the cost / retail ratio calculation To approximate FIFO and LIFO, exclude beginning inventory from the cost / retail ratio calculation

Comprehensive retail method assumptions (Sales = $125,000) CostRetail Beginning inventory$ 5,000$ 8,000 Purchases85,000160,000 Purchase discounts4,000 Purchase returns1,0002,000 Freight-in5,000 Net markups14,000 Net markdowns15,000 Ending inventory at retail$ 40,000

For FIFO, cost retail ratio is: CostRetail Purchases85,000160,000 Purchase discounts- 4,000 Purchase returns- 1, ,000 Freight-in+ 5,000 Net markups+ 14,000 Net markdowns- 15,000 Ratio basis85,000157,000 Ratio =.541 EI Retail = $40,000, Est. EI = $21,656

For FIFO LCM, cost retail ratio is: CostRetail Purchases85,000160,000 Purchase discounts- 4,000 Purchase returns- 1, ,000 Freight-in+ 5,000 Net markups+ 14,000 Ratio basis85,000172,000 Ratio =.494 EI Retail = $40,000, Est. EI = $19,767

For average cost, cost retail ratio is: CostRetail Beginning inventory5,0008,000 Purchases+ 85, ,000 Purchase discounts- 4,000 Purchase returns- 1, ,000 Freight-in+ 5,000 Net markups+ 14,000 Net markdowns- 15,000 Ratio basis90,000165,000 Ratio =.545 EI Retail = $40,000, Est. EI = $21,818

For average LCM, cost retail ratio is: CostRetail Beginning inventory5,0008,000 Purchases+ 85, ,000 Purchase discounts- 4,000 Purchase returns- 1, ,000 Freight-in+ 5,000 Net markups+ 14,000 Ratio basis90,000180,000 Ratio =.500 EI Retail = $40,000, Est. EI = $20,000

LIFO advantages and disadvantages Advantages Matches current costs with revenues Results in lower income taxes in periods of rising prices Disadvantages Distorts asset values on balance sheet Becomes cumbersome to deal with Can distort income if early, low-cost layers are liquidated

Lifo pools A way of avoiding LIFO layer liquidation Similar items are put together in groups or pools Pooled items are treated as if purchased at same time Less likely to liquidate layers in practice

Dollar value LIFO A way of approximating LIFO Think in terms of layers In LIFO, if inventory quantity were constant, beginning and ending inventory would be exactly the same Additional inventory adds a layer Decreases reduce layers in LIFO order

Dollar value LIFO example with no price-level change 2000 ending inventory$20, ending inventory23, inventory consists of: 2000 base layer$20,000 plus additional layer of3,100 Total$23,100

Dollar value LIFO example with no price-level change 2000 ending inventory$20, ending inventory23, ending inventory27, inventory consists of: 2000 base layer$20,000 plus 2001 layer of3,100 plus 2002 layer of4,150 Total$27,250

Dollar value LIFO When price levels change 1.Convert current inventory value to base dollars 2.Analyze change in inventory in terms of base dollars 3.If inventory increases, add a layer, use current index 4.If inventory decreases, reduce layers in LIFO order

Dollar value LIFO example with price-level changes Price Amountindex 2000 ending inventory$20, ending inventory23, converted to base $ ( 23,100 / 1.05 ) =$22,000 Change from 2000 (increase)2,000

Dollar value LIFO example with price-level changes BaseCurrent LayerIndexdollarsdollars Base1.00$20,000$20, addl. layer1.052,0002,100 Totals$22,000$22,100 The 2001 ending inventory will be reported as $22,100

Dollar value LIFO example with price-level changes Price Amountindex 2000 ending inventory$20, ending inventory23, ending inventory27, conv. to base$22, conv. to base$25, increase in base $$ 3,000

Dollar value LIFO example with price-level changes BaseCurrent LayerIndexdollarsdollars Base1.00$20,000$20, addl. layer1.052,0002, addl. layer1.093,0003,270 Totals$25,000$25,370 The 2002 ending inventory will be reported as $25,370

Retail dollar value LIFO Combines the retail method and dollar value LIFO Calculate cost / retail ratio as was done for FIFO Convert retail ending inventory to base dollars Follow dollar value LIFO layer procedures

1999 retail dollar value LIFO ratio (data from Exhibit 10-15) CostRetail Purchases80,000150,000 Purchase returns- 2, ,000 Freight-in+ 2,000 Net markups+ 23,000 Net markdowns- 4,760 Ratio basis79,800164,240 Ratio =.486

1999 ending inventory at retail Retail Beginning inventory25,000 Purchases150,000 Purchase returns - 4,000 Net markups+ 23,000 Net markdowns- 4,760 Sales-160,000 Net sales returns+ 1,000 Ending inventory at retail30,240

1999 retail dollar value LIFO layers Price Amountindex 1998 ending inventory$25, ending inventory30, converted to base $ ( 30,240 / 1.08 ) =$28,000 Change from 1998 (increase)3,000

Retail dollar value LIFO-1999 LayerBase $IndexC/RDVL Base25, , , ,575 Totals28,00013,575

2000 retail dollar value LIFO ratio CostRetail Purchases95,000180,000 Purchase returns Freight-in+ 4,000 Net markups+ 25,000 Net markdowns- 5,000 Ratio basis99,000200,000 Ratio =.495

2000 ending inventory at retail Retail Beginning inventory30,240 Purchases180,000 Purchase returns -0- Net markups+ 25,000 Net markdowns- 5,000 Sales-191,000 Net sales+ 1,010 Ending inventory at retail40,250

2000 retail dollar value LIFO layers Price Amountindex 1995 ending inventory$25, ending inventory30, ending inventory40, conv. to base28, conv. to base35, increase in base $7,000

Retail dollar value LIFO-2000 LayerBase $IndexC/RDVL Base25, , , , , ,985 Totals35,00017,560

2001 retail dollar value LIFO ratio CostRetail Purchases110,000198,000 Purchase returns- 1,600- 3,000 Freight-in+ 5,000 Net markups+ 35,000 Net markdowns- 6,000 Ratio basis113,400224,000 Ratio =.506

2001 ending inventory at retail Retail Beginning inventory40,250 Purchases198,000 Purchase returns - 3,000 Net markups+ 35,000 Net markdowns- 6,000 Sales-235,000 Sales returns+ 7,350 Ending inventory at retail36,600

2001 retail dollar value LIFO layers Amountindex 1995 ending inventory$25, ending inventory30, ending inventory40, ending inventory36, conv. to base35, conv. to base30, decrease in base $5,000

Retail dollar value LIFO-2001 LayerBase $IndexC/RDVL Base25, , , , , ,138 Totals30,00014,713 Note reduction of 2000 layer from $7,000 to $2,000

Chapter 10--Learning Objectives 6.Analyze the impact of inventory valuation on liquidity and profitability analysis

Inventory turnover Cost of goods sold Average inventory Average inventory usually calculated ( Beginning inv. + Ending inv. ) / 2

Days sales in inventory 365 days Inventory turnover