Chapter 10 Valuation of Inventories: A Cost-Basis Approach ACCT-30301

1. Introduction Definition ◦ Assets held for sale in the ordinary course of business or goods that will be consumed in production Importance Cost of inventory ◦ all expenditures necessary in acquiring goods and converting them to saleable condition Cutoff Who owns inventory if “sale” is a(an) product financing arrangement, installment sale, consignment, sales with high rates of return ACCT-30302

2. Inventory Systems Periodic system ◦ no running balance of inventory & CGS ◦ purchases account used ◦ beginning inv balance unchanged during year ◦ take physical inventory at year-end and record ending balance through adjusting entry ◦ CGS calculated CGS format ACCT-30303

2a. Inventory Systems Perpetual system ◦ keeps running balance of inventory & CGS ◦ no purchases account used ◦ all changes in inventory cost recorded in inventory account ◦ take physical inventory at year-end & adjust book balance to actual ACCT-30304

2b. Inventory Systems Periodic & perpetual entries Net and gross methods of recording 1.purchase merchandise, $1,200; 2/10,n/30 2.return merchandise, $200 3.sell remainder for $1,800 4.pay above a.within discount period b.after discount period ACCT-30305

2c. Inventory Systems Periodic inventory system YE adjusting entry ◦ Account balances ACCT AccountBalance Inventory, January 11,000 Inventory, December 311,500 Purchases4,000 Purchases Returns and Allowances 300 Purchases Discounts50

2c. Inventory Systems Periodic inventory system YE adjusting entry ACCT AccountDrCr Inventory, December 311,500 Purchases Returns and Allowances 300 Purchases Discounts50 CGS3,150 Purchases4,000 Inventory, January 11,000

3. Inventory Cost Flow Assumptions Problem ◦ purchases made at different prices Flow of costs v. flow of goods Four GAAP methods ◦ specific identification ◦ FIFO ◦ LIFO ◦ average ACCT-30308

3a. Inventory Cost Flow Assumptions Specific identification ◦ only used if relatively small number of high priced goods that can be easily distinguished ◦ can manipulate income ACCT-30309

3b. Inventory Cost Flow Assumptions FIFO ◦ assume goods used in order purchased ◦ ending inventory approximately at current costs ◦ CGS at old prices ◦ periodic and perpetual systems always give same result ACCT

3c. Inventory Cost Flow Assumptions LIFO ◦ assumes last goods purchased are first sold ◦ advantages  matches current costs with revenues  tax benefits  improved cash flow ◦ disadvantages  reduction in reported earnings  understatement of ending inventory on bal. sheet  does not reflect underlying physical flow of goods  causes poor buying habits  can manipulate income ◦ LIFO conformity rule  must use LIFO for financial reporting if used for tax reporting ACCT

3d. Inventory Cost Flow Assumptions Average cost ◦ weighted average or moving average used ◦ values goods based on average cost of goods on hand and acquired Other methods ◦ base stock ◦ standard cost ◦ NIFO ◦ LIFO/FIFO ACCT

3e. Inventory Cost Flow Assumptions Comparison of methods (during periods of rising prices) ACCT Method Ending Inventory CGSNet Income FIFOhighestlowesthighest LIFOlowesthighestlowest Averagein middle What would be the differences between the methods if all units had the same cost?

3f. Inventory Cost Flow Assumptions Example of methods ACCT DateActionUnitsUnit PriceTotal Price Jan 1Beg. Inv.2,000$ 9.775$ 19,550 Jan 6Purchase1,500$ $ 15,450 Jan 7Sale1,800 Jan 26Purchase3,400$ $ 36,550 Jan 31Sale3,200 Total$ 71,550 Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems.

4. Special issues related to LIFO Inventory Pools ◦ Unrealistic to assume only one product ◦ If multi product  replace one item with another – loose base layer of LIFO cost ◦ Pooled approach  group similar items together  reduces record keeping costs  more difficult to erode old LIFO layers ◦ Number of pools? ACCT

4. Special issues related to LIFO LIFO reserves ◦ maintain internal records using FIFO ◦ adjust to LIFO at year end Cost of goods soldxxx Allow to reduce inventory to LIFO xxx ACCT

5. Dollar Value LIFO Introduction ◦ emphasis is on dollar value of inventory  not units of inventory ◦ greatly reduces problem of changes in mix of inventory ◦ more practical method of valuing multi-product inventory than unit LIFO ◦ allowed for financial reporting and tax ◦ LIFO conformity rule  must use LIFO for financial reporting if used for tax ACCT

5a. Dollar Value LIFO Basics of method 1.when first adopt method (base year) value ending inventory at current costs (FIFO) 2.end of each subsequent year, value ending inventory at current costs (FIFO) 3.then restate current year-end cost to price level in base year 4.a new layer formed when EI (in base year $) exceeds base year cost of BI  increase priced at current costs 5.if EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer ACCT

5b. Dollar Value LIFO Price index ◦ company may calculate own  double extension method or link-chain method ◦ may use published price indexes  e.g., GNP implicit price deflator, CPI, or industry specific index ◦ example using market basket approach ACCT

5c. Dollar Value LIFO Example ACCT YearEnd Inv (FIFO)Price Index 2011$ 300, $ 363, $ 420, $ 430, Calculate ending inventory using dollar value LIFO for each year.

6. Effect of errors Self-correcting errors ◦ most errors correct themselves over time  e.g., inventory – this year’s ending inventory is next year’s beginning inventory  depreciable assets – over the life of the assets ◦ but each year is incorrect over that period Permanent errors ◦ never will correct themselves ◦ e.g., expensing land, recording wrong amount ACCT

6a. Inventory Errors Overstatement of ending inventory ◦ Understates cost of goods sold ◦ Overstates income Understatement of ending inventory ◦ Overstates cost of goods sold ◦ Understates income Overstatement of beginning inventory ◦ Overstates cost of goods sold ◦ Understates income Understatement of beginning inventory ◦ Understates cost of goods sold ◦ Overstates income ACCT

6b. Effect of errors Determining effect of errors ◦ determine effect for all accounts involved ◦ examples  ending inventory overstated  interest expense not accrued on N/P this year, next year principle and interest paid in full ACCT

Chapter 9 Inventories: Additional Valuations Issues ACCT

1. Lower of Cost or Market Required by GAAP* ◦ Inventory must be reported at LCM Theory ◦ should not report inventory at a value higher than benefits to be received from selling it Stated reason: “conservative approach” ACCT

1a. Lower of Cost or Market Definition of market ◦ cost to replace the item (replacement cost) ◦ really “lower of cost or constrained market” Ceiling ◦ market can’t exceed NRV ◦ NRV = selling price – selling costs Floor ◦ market can’t be lower than NRV less normal profit ◦ floor = NRV – normal profit margin Can apply to individual items, groups of items, or whole inventory Does not apply to damaged or deteriorated goods ACCT

1b. Lower of Cost or Market Example Selling price$60 Additional selling costs$10 Normal profit margin40% (of selling price) Cost$36 Current replacement cost Case A$58 Case B$37 Case C$21 ACCT

1c. Other Valuation Bases Valuation at Net Realizable Value ◦ e.g., recognizing revenue at completion of production Valuation using Relative Sales Value ◦ basket purchase ◦ meat-packing plant ACCT

2. Purchase Commitments Generally seller retains title to merchandise Buyer recognizes no asset or liability If material, the buyer should disclose contract details in footnote If contract price > the market price, and buyer expects that losses will occur when purchase made ◦ buyer should recognize liability and corresponding loss in period when market declined Omit Hedging ACCT

3. Inventory Estimation Methods Gross profit method ◦ based on relationship between sales and gross profit ◦ not acceptable for financial reporting or taxes Retail method ◦ used by large volume retailers ◦ dollar based method – not unit based method ◦ acceptable for financial reporting and taxes ACCT

4. Gross Profit Method Based on assumptions that ◦ gross profit is constant from period-to-period ◦ sales mix of products is constant Used to estimate inventory value ACCT

4a. Gross Profit Method Example Sales$200 Cost of goods sold$120 Gross profit$ 80 GP % = 80/200 = 40% CGS% = 120/200 = 60% GP% on sales = 80/200 = 40% GP% on cost = 80/120 = 66⅔% ACCT GP on Sales = GP on Costs 1 + GP on Costs

4a. Gross Profit Method Example A hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory$220,000 Purchases$400,000 Sales$600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory. ACCT

4a. Gross Profit Method Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales$600,000 Less: Estimated gross profit of 30%(180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000 ACCT

5. Retail Method Method is based on the pattern between the cost and retail value of the goods Method requires: 1.total costs of goods purchased 2.total retail value of goods available for sale 3.total sales Companies always keep 1 & 3 ◦ with this method also must keep 2 ACCT

5a. Retail Method Basic method ACCT CostRetail Beginning Inventory6001,000 Net Purchases5,0008,000 Goods Available for Sale5,6009,000 Cost Ratio: 5,600/9,000 = Sales7,500 Ending Inventory at Retail1,500 End Inv at Cost (1,500 x.62222) 933

5c. Retail Method Retail terminology ACCT TermMeaning Initial markupOriginal markup reflected in sales price Additional markupAdditional increase in selling price after original markup Markup cancellationElimination of additional markup MarkdownReduction in selling price below original selling price Markdown cancellationElimination of markdown Net markups and net markdowns

5b. Retail Method Ratios – computed as: cost of goods available for sale retail value of goods available for sale Based on how ratio computed, can be used to approximate following methods: ◦ average – include everything ◦ LCM – exclude markdowns (conventional retail method) ◦ FIFO – exclude beginning inventory ◦ LIFO – compute separate ratio for each layer ACCT

5d. Retail Method ACCT CostRetail Beginning Inventory++ Purchases++ Purchases Returns-- Purchases Discounts- Freight-In+ Net Markups+ Net Markdowns- Available for SaleXX Sales- Sales Returns and Allow.+ Sales Discounts+ Ending Inventory at RetailX Ending Inventory at CostX

5e. Retail Method ACCT CostRetail Beginning Inventory++ Purchases++ Purchases Returns and Allow.-- Purchases Discounts- Freight-In+ Net Markups+ Net Markdowns- Available for SaleXX Sales- Sales Returns and Allow.+ Sales Discounts+ Ending Inventory at RetailX Ending Inventory at CostX Avg. method

5f. Retail Method ACCT CostRetail Beginning Inventory++ Purchases++ Purchases Returns and Allow.-- Purchases Discounts- Freight-In+ Net Markups+ Net Markdowns- Available for SaleXX Sales- Sales Returns and Allow.+ Sales Discounts+ Ending Inventory at RetailX Ending Inventory at CostX LCM method

5g. Retail Method ACCT CostRetail Beginning Inventory++ Purchases++ Purchases Returns and Allow.-- Purchases Discounts- Freight-In+ Net Markups+ Net Markdowns- Available for SaleXX Sales- Sales Returns and Allow.+ Sales Discounts+ Ending Inventory at RetailX Ending Inventory at CostX FIFO method

5h. Retail Method ACCT CostRetail Beginning Inventory195,000400,000 Net Purchases300,000450,000 Net Markups50,000 Net Markdowns Available for Sale495,000880,000 Net Sales407,000 Ending Inventory at Retail473,000 Ending Inventory at Cost Example