1 Chapter 8: Inventory Valuation

2 The Inventory Formula Used to calculate Cost of Goods Sold (COGS) for the Income Statement and Ending Inventory (EI) for the balance sheet. BI + Purchases (net) - EI = COGS BI + Purchases (net) = EI + COGS Purchases (net) = Purchases (billed cost of inventory purchased) +Freight-in (could be accounted for separately) - Purchase Discounts (cash discounts for early payment on account) - Purchase Returns and Allowances (returns reduce inventory when given back to seller; allowances are a negotiated reduction in price of inventory purchased).

3 Inventory Systems Perpetual – Up-to-date record in inventory account. – Cost of goods sold computed for each sale. Periodic – Inventory purchases are recorded as incurred. – Separate accounts used for the inventory components. – Inventory and cost of goods sold determined at the end of each period through physical count. – Requires AJE to transfer costs to EI and COGS. Costs and benefits – Perpetual requires more bookkeeping but provides more useful information. – General application: Periodic used for external reporting; perpetual used for internal tracking of units.

4 Acquiring Inventory What items or units to include? – General rule: record in inventory when received, except: – Consignments: belong to consignor, ownership not based on physical possession. – Goods in transit - FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). Note: FOB Destination indicates seller’s inventory while in transit (until inventory reaches purchaser’s facilities) – Special sales agreements: Sales with buyback agreement. Sales with high rates of return. Sales on installment.

5 Goods in Transit SellerPurchaser FOB Shipping Point Title Transfers Belongs to Purchaser Title Transfers FOB Destination Belongs to Seller

6 Class Problem Dallas Company had the following inventory transactions at the end of Indicate whether Dallas should show the inventory in its financials as of 12/31/ On 12/28, purchased inventory, FOB Destination. Shipped 12/28, did not arrive until Jan On Dec. 29, purchased inventory, FOB Shipping Point. Shipped 12/29, did not arrive until Jan On 12/28, sold inventory to Houston Company, FOB Destination. Shipped 12/28; Houston received on Jan. 2.

7 Class Problem 4. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Jan On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Dec. 29. This inventory included a buyback agreement available for 60 days.

8 Inventory Errors Inventory Errors Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods. Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved. Other errors, particularly with purchases, may be more complicated to analyze. To analyze, use basic inventory formula.

9 Class Problem-Inventory Error Assume that the ending inventory of 2014 was undervalued by $9,000. If the error goes undetected in 2015, what effect would the error have on the balance sheet and income statement accounts for 2014 and Analyze using the following relationships: BI + P - EI = COGS NI A = L + SE Note that the asset account in inventory error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income.

10 Class Problem Analysis (O = overstated, U = understated): BI + P - EI = COGS NI A = L + SE 14: 15:

11 Journal Entries - Periodic System 1. When inventory purchased (gross method): Purchasesxx Cash or A/Pxx 2. Pay transportation on inventory: Freight-inxx Cashxx 3. If purchase discount is taken (gross method): A/Pxx Purchase discountxx 4. If inventory returned: A/Pxx Purch. Returns & Allow.xx

12 Journal Entries - Periodic System Journal Entries - Periodic System Note that Purchase and Transportation-in are created with Debits. Purchase Discounts, Returns and Allowances are created with a credit (contra to purchases). At the end of the period, the balances in all of these accounts (along with Beginning Inventory) are transferred to Ending Inventory and COGS (adjusting journal entry): Cost of Goods Soldxx ( based on FIFO,LIFO,Avg. ) Inventory - Endingxx ( based on FIFO,LIFO,Avg. ) Purchase Discountsxx Purchase Rt. & Allow.xx Purchasesxx Transportation-inxx Inventory - Beginningxx

Purchases – Gross versus Net Purchase $100 on account. Terms 2/10, n/30. Gross Method Net Method Purchase: Purchases100Purchases 98 A/Pay 100 A/Pay98 Payment within 10 days: A/Pay100A/Pay 98 Cash 98 Cash98 Purch. Discounts 2 Payment after 10 days: A/Pay100A/Pay 98 Cash 100P. Disc. Lost 2* Cash 100 *Note: Purch. Discounts Lost is a financing charge and is classified as a period expense in the I/S (like interest expense). It is NOT part of COGS. 13

14 Journal Entries - Example Journal Entries - Example Example - assume the following balance in the Unadjusted Trial Balance of Raider Co.: DRCR Merch. Inv. (1/1/14) 2,600 Purchases 12,000 Freight-in 500 Purchase Discounts900 Purchase R & A 1,400 At the end of 2014, Raider calculated its ending inventory to be $1,900, based on the FIFO technique.

15 Journal Entries - Periodic System Journal Entries - Periodic System Part 1: What is the value of Cost of Goods Sold? BI + P (net) - EI = COGS Part 2, AJE:

16 Journal Entries – Perpetual System For perpetual system, all entries are directly to and against the inventory account, rather than the detail components. Instead of debiting Purchases, the company debits inventory. Instead of crediting Purchase Discounts, the company credits Inventory. Additionally, when inventory is sold, the transaction is recorded immediately with a debit to COGS and a credit to Inventory. Thus, no AJE is needed at the end of the period; all accounts are already updated.

17 Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification Average for both COGS and EI FIFO - (first-in, first-out) for COGS – and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS – and FISH (first-in, still here) for EI Note that these techniques may be used for either periodic or perpetual systems; calculations for perpetual are more cumbersome.

18 Class Problem - Cost Flows Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00 $180 Purchase 1/ Purchase 1/ Total available 90 units $910 Sales on Jan units Sales on Jan units Total units sold: 55 Total units in EI 35

19 Periodic FIFO(LISH) FIFO for COGS (top down) LISH for EI (bottom up)

20 Periodic LIFO(FISH) LIFO for COGS (bottom up) FISH for EI (top down)

21 Average Periodic First calculate average: Goods available cost = $910 Goods available units = 90 units Avg. = $10.11 per unit Now COGS: 55 units x $10.11 per unit = $ 556 Now EI: 35 units x $10.11 per unit = $354

22 Perpetual FIFO (not tested) Units Per Unit EI COGS Begin Inv. 20 $ 9.00 Purch. 1/ Sale 1/12 (30) = 180 Balance Purch. 1/ Sale 1/24 (25) Balance = = 330____________ Totals EI=380 COGS=530

23 Perpetual LIFO (not tested) Units Per Unit EI COGS Begin Inv. 20 $ 9.00 Purch. 1/ Sale 1/12 (30) = 300 Balance Purch. 1/ Sale 1/24 (25) Balance = = = 55____________ Totals EI = 335 COGS =575

24 Average Perpetual (not tested) (calculate average before each sale) Units Per Unit Total EI COGS Begin Inv. 20 $ 9.00 = $180 Purch. 1/ = 400 Average Sale 1/ = (290) $290 Balance = 290 Purch. 1/ = 330 Average Sale 1/24 (25) = (258)258 Balance = 362 $362 $

25 Comparison of FIFO, LIFO, and Average In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income

LIFO Advantages/Disadvantages Advantages: Tax benefits - cash flow savings in times of rising prices. Matching on the income statement – current revenues and current costs. Minimize write downs of inventory (already at a low cost). Disadvantages: Inventory may be significantly undervalued. LIFO liquidation may cause significant increases in income (and in taxes). Difficulty in comparing LIFO firms to FIFO firms.

LIFO Layer Liquidation If an old, low LIFO layer is liquidated (usually when an product line or large segment is eliminated), then current income may increase significantly, as COGS absorbs much lower costs. This effect, in the past, had been another technique that managers might use to manipulate income (with a corresponding net decrease in cash). The SEC now requires that any income increases from LIFO layer liquidation now be disclosed separately in the financials.

28 LIFO Reserve For companies that use LIFO for tax and external financial reporting, a financial statement disclosure is required that indicates the calculated inventory(ies) at FIFO. The difference between the FIFO and LIFO inventories is called the LIFO Reserve. This number may be used to convert LIFO Inventory and COGS and Net Income to a FIFO basis, to allow for comparison to other companies. It also facilitates the calculation of the cash flow savings from reduced taxes.

Dollar Value LIFO Unit LIFO (from previous section) is cumbersome and very difficult to implement for any company with even a modest amount of inventory. Most companies that use LIFO choose to use Dollar Value LIFO. In this technique, the different groups of inventories are turned into annual dollar layers. First the units of EI are turned into dollars by extending all the units at end of the year prices. Then the dollars are added to create a single layer of inventory costs, in dollars. Each year the new layers are compared to old layers (in common dollars), and inventory change is calculated. See Handout for example.