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8-2 C H A P T E R 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Intermediate Accounting IFRS Edition Kieso, Weygandt, and Warfield

Identify major classifications of inventory Distinguish between perpetual and periodic inventory systems Identify the effects of inventory errors on the financial statements Understand the items to include as inventory cost Describe and compare the methods used to price inventories. Learning Objectives

8-4 Goods in transit Consigned goods Special sales agreements Inventory errors Inventory Issues Physical Goods Included in Inventory Cost Included in Inventory Cost Flow Assumptions Classification Cost flow Control Basic inventory valuation Product costs Period costs Purchase discounts Specific identification Average cost FIFO Summary analysis Valuation of Inventories: Cost-Basis Approach

8-5 Inventories are: items held for sale, or goods to be used in the production of goods to be sold. Inventory Issues LO 1 Identify major classifications of inventory. MerchandiserManufacturer Businesses with Inventory or Classification

8-6 One inventory account. Purchase goods in form ready for sale. Classification Inventory Issues LO 1 Identify major classifications of inventory. Illustration 8-1

8-7 Three accounts Raw materials Work in process Finished goods Classification Inventory Issues LO 1 Illustration 8-1

8-8 Inventory Cost Flow Inventory Issues Illustration 8-2 LO 1 Identify major classifications of inventory.

8-9 Inventory Cost Flow Inventory Issues Illustration 8-3 LO 1 Identify major classifications of inventory. Companies use one of two types of systems for maintaining inventory records — perpetual system or periodic system.

8-10 Inventory Cost Flow LO 2 Distinguish between perpetual and periodic inventory systems. Perpetual System 1.Purchases of merchandise are debited to Inventory. 2.Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts are credited to Inventory. 3.Cost of goods sold is debited and Inventory is credited for each sale. 4.Subsidiary records show quantity and cost of each type of inventory on hand. The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

8-11 Inventory Cost Flow LO 2 Distinguish between perpetual and periodic inventory systems. Periodic System 1.Purchases of merchandise are debited to Purchases. 2.Ending Inventory determined by physical count. 3.Calculation of Cost of Goods Sold: Beginning inventory$ 100,000 Purchases, net800,000 Goods available for sale900,000 Ending inventory125,000 Cost of goods sold$ 775,000

8-12 Inventory Cost Flow LO 2 Distinguish between perpetual and periodic inventory systems. Illustration: Fesmire Company had the following transactions during the current year. Record these transactions using the Perpetual and Periodic systems.

8-13 Inventory Cost Flow LO 2 Distinguish between perpetual and periodic inventory systems. Illustration 8-4 Illustration:

8-14 Inventory Cost Flow LO 2 Distinguish between perpetual and periodic inventory systems. Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows. Inventory Over and Short 200 Inventory 200 Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the “Other income and expense” section of the income statement.

8-15 Inventory Control Inventory Issues LO 2 Distinguish between perpetual and periodic inventory systems. All companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports.

8-16 Inventory Issues LO 2 Distinguish between perpetual and periodic inventory systems. Basic Issues in Inventory Valuation Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. Illustration 8-5

8-17 Basic Issues in Inventory Valuation LO 2 Distinguish between perpetual and periodic inventory systems. The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). The costs to include (product vs. period costs). The cost flow assumption (specific Identification, average cost, FIFO, retail, etc.). Valuation requires determining

8-18 A company should record purchases when it obtains legal title to the goods. Physical Goods Included in Inventory LO 2 Distinguish between perpetual and periodic inventory systems. Illustration 8-6

8-19 Physical Goods Included in Inventory LO 3 Identify the effects of inventory errors on the financial statements. Effect of Inventory Errors The effect of an error on net income in one year (2010) will be counterbalanced in the next (2011), however the income statement will be misstated for both years. Illustration 8-7 Ending Inventory Misstated

8-20 Effect of Inventory Errors Illustration: Yei Chen Corp. understates its ending inventory by HK$10,000 in 2010; all other items are correctly stated. Illustration 8-8 LO 3

8-21 Physical Goods Included in Inventory LO 3 Identify the effects of inventory errors on the financial statements. Effect of Inventory Errors The understatement does not affect cost of goods sold and net income because the errors offset one another. Illustration 8-9 Purchases and Inventory Misstated

8-22 Costs Included in Inventory LO 4 Understand the items to include as inventory cost. Product Costs - costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition. Period Costs – generally selling, general, and administrative expenses. Treatment of Purchase Discounts – Gross vs. Net Method

8-23 Costs Included in Inventory LO 4 Understand the items to include as inventory cost. Treatment of Purchase Discounts Illustration 8-11 * $4,000 x 2% = $80 * ** $10,000 x 98% = $9,800 **

8-24 Method adopted should be one that most clearly reflects periodic income. Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods Which Cost Flow Assumption to Adopt? Specific Identification --- Average Cost --- LIFO LO 5 Describe and compare the methods used to price inventories.

8-25 Young & Crazy Company makes the following purchases: 1.One item on 2/2/11 for $10 2.One item on 2/15/11 for $15 3.One item on 2/25/11 for $20 Young & Crazy Company sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended February 2011, assuming the company used the FIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. Example Cost Flow Assumptions LO 5 Describe and compare the methods used to price inventories.

8-26 Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “First-In-First-Out (FIFO)” LO 5

8-27 Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Cost Flow Assumptions Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb Sales $ Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 14 $ 33 Net Income $ 33 “First-In-First-Out (FIFO)” LO 5

8-28 Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “Average Cost” LO 5

8-29 Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Inventory Balance = $ 30 Cost Flow Assumptions Young & Crazy Company Income Statement For the Month of Feb Sales $ Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 12 $ 30 Net Income $ 30 “Average Cost” LO 5

8-30 Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Cost Flow Assumptions “Specific Identification” LO 5

8-31 Young & Crazy Company Income Statement For the Month of Feb Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40 Depends which one is sold Purchase on 2/2/11 for $10 Purchase on 2/15/11 for $15 Purchase on 2/25/11 for $20 Inventory Balance = $ 45 Cost Flow Assumptions “Specific Identification” LO 5

8-32 Financial Statement Summary Inventory Balance 3035 Cost Flow Assumptions LO 5

8-33 Cost Flow Assumptions LO 5 Illustration: Call-Mart Inc. had the following transactions in its first month of operations. Beginning inventory (2,000 x $4)$ 8,000 Purchases: 6,000 x $4.4026,400 2,000 x 4.759,500 Goods available for sale$43,900 Calculate Goods Available for Sale

8-34 Specific Identification Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the amount of ending inventory and cost of goods sold. Illustration 8-12

8-35 Average Cost Illustration 8-13 Weighted-Average LO 5 Describe and compare the methods used to price inventories.

8-36 Average Cost Illustration 8-14 In this method, Call-Mart computes a new average unit cost each time it makes a purchase. Moving-Average LO 5 Describe and compare the methods used to price inventories.

8-37 First-In, First-Out (FIFO) Illustration 8-15 Periodic Method Determine cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory. LO 5 Describe and compare the methods used to price inventories.

8-38 First-In, First-Out (FIFO) Illustration 8-16 Perpetual Method In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. LO 5 Describe and compare the methods used to price inventories.

8-39 Inventory Valuation Methods - Summary Illustration 8-17 LO 5 Describe and compare the methods used to price inventories.

8-40 Inventory Valuation Methods - Summary Illustration 8-18 Balances of Selected Items under Alternative Inventory Valuation Methods LO 5 Describe and compare the methods used to price inventories.

8-41 LO 6 Describe the LIFO cost flow assumption. Under IFRS, LIFO is not permitted for financial reporting purposes. Nonetheless, LIFO is permitted for financial reporting purposes in the United States, it is permitted for tax purposes in some countries, and its use can result in significant tax savings.

8-42 LO 6 Illustration: Call-Mart Inc. had the following transactions in its first month of operations. Beginning inventory (2,000 x $4)$ 8,000 Purchases: 6,000 x $4.4026,400 2,000 x 4.759,500 Goods available for sale$43,900 Calculate Goods Available for Sale Last-In, First-Out (LIFO)

8-43 Last-In, First-Out (LIFO) Illustration 8A-1 Periodic Method The cost of the total quantity sold or issued during the month comes from the most recent purchases. LO 6 Describe the LIFO cost flow assumption.

8-44 Last-In, First-Out (LIFO) Illustration 8A-2 Perpetual Method The LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method. LO 6 Describe the LIFO cost flow assumption.

8-45 Illustration 8A-3 Inventory Valuation Methods - Summary Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average cost. LO 6 Describe the LIFO cost flow assumption.

8-46 Illustration 8A-4 Inventory Valuation Methods - Summary LIFO results in the highest cash balance at year-end (because taxes are lower). This example assumes that prices are rising. The opposite result occurs if prices are declining. LO 6 Describe the LIFO cost flow assumption.

8-47 Many companies use LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: LIFO Reserve 1.Pricing decisions 2.Record keeping easier 3.Profit-sharing or bonus arrangements 4.LIFO troublesome for interim periods LO 7 Explain the significance and use of a LIFO reserve.

8-48 LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Cost of goods sold 30,000 Allowance to reduce inventory to LIFO 30,000 Journal entry to reduce inventory to LIFO: Illustration: Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2011, the Allowance to Reduce Inventory to LIFO balance is $20,000. At December 31, 2011, the balance should be $50,000. As a result, Acme Boot realizes a LIFO effect and makes the following entry at year-end. LO 7 Explain the significance and use of a LIFO reserve.

8-49 Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. LIFO Liquidation Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2011, with cost determined on a specific-goods LIFO approach. LO 8 Understand the effect of LIFO liquidations.

8-50 Illustration: At the end of 2012, only 6,000 pounds of steel remained in inventory. LIFO Liquidation Illustration 8B-3 Illustration 8B-2 LO 8

8-51 Changes in a pool are measured in terms of total dollar value, not physical quantity. Advantage: Broader range of goods in pool. Permits replacement of goods that are similar. Helps protect LIFO layers from erosion. Dollar-Value LIFO LO 9 Explain the dollar-value LIFO method.

8-52 Exercise 8-29 (partial): The following information relates to the Choctaw Company. Use the dollar-value LIFO method to compute the ending inventory for 2007 through Dollar-Value LIFO

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8-56 Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming. Specific-goods Pooled LIFO approach reduces record keeping and clerical costs. more difficult to erode the layers. using quantities as measurement basis can lead to untimely LIFO liquidations. Dollar-value LIFO is used by most companies. Comparison of LIFO Approaches

8-57 Matching Tax Benefits/Improved Cash Flow Future Earnings Hedge Advantages Reduced Earnings Inventory Understated Physical Flow Involuntary Liquidation / Poor Buying Habits Disadvantages

8-58 LIFO is generally preferred: 1.if selling prices are increasing faster than costs and 2.if a company has a fairly constant “base stock.” LIFO is not appropriate: 1.if prices tend to lag behind costs, 2.if specific identification traditionally used, and 3.when unit costs tend to decrease as production increases. Basis for Selection of Inventory Method

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