1. Chapter 9-1

2. Chapter 9-2 CHAPTER 9 ACCOUNTING FOR INVENTORIES INTERMEDIATE ACCOUNTING Principles and Analysis 2nd Edition Warfield Weygandt Kieso

3. Chapter 9-3 Goods included in inventory Costs included in inventory Cost flow assumptions Inventory Classification and Systems Issues in Inventory Valuation LIFO Special Issues Lower-of- Cost-or- Market Presentation and Analysis Classification Inventory systems LIFO reserve LIFO liquidation Dollar-value LIFO Comparison of LIFO approaches Basis for selection Ceiling and floor How LCM works Application of LCM Evaluation of rule Presentation of inventories Analysis of inventories Accounting for Inventories

4. Chapter 9-4 1.Identify major classifications of inventory. 2.Distinguish between perpetual and periodic inventory systems. 3.Understand the items to include as inventory cost. 4.Describe and compare the cost flow assumptions used to account for inventories. 5.Explain the significance and use of a LIFO reserve. 6.Understand the effect of LIFO liquidations. 7.Explain the dollar-value LIFO method. 8.Identify the major advantages and disadvantages of LIFO. 9.Describe and apply the lower-of-cost-or-market rule. 10.Explain how to report and analyze inventory. Learning Objectives

5. Chapter 9-5 Inventories are: items held for sale, or goods to be used in the production of goods to be sold. Inventory Classification and Systems LO 1 Identify major classifications of inventory. Classification MerchandiserManufacturer Businesses with inventory: or

6. Chapter 9-6 Type of Business Merchandiser One inventory account Purchase goods ready for sale Inventory Classification and Systems LO 1 Identify major classifications of inventory.

7. Chapter 9-7 Type of Business Manufacturer Three accounts Raw materials Work in process Finished goods Inventory Classification and Systems LO 1 Identify major classifications of inventory.

8. Chapter 9-8 Two systems for maintaining inventory records: Inventory Classification and Systems LO 2 Distinguish between perpetual and periodic inventory systems. Inventory Systems Perpetual system Periodic system

9. Chapter 9-9 Features: Inventory Classification and Systems LO 2 Distinguish between perpetual and periodic inventory systems. Perpetual System 1. Purchases of merchandise are debited to Inventory. 2. Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory. 3. Cost of Goods Sold is debited and Inventory is credited for each sale. 4. Physical count done to verify inventory balance. The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

10. Chapter 9-10 Features: Inventory Classification and Systems 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

11. Chapter 9-11 Inventory Classification and Systems LO 2 Distinguish between perpetual and periodic inventory systems. Perpetual SystemPeriodic Systemvs.

12. Chapter 9-12 Requires the following: Basic Issues in Inventory Valuation LO 2 Distinguish between perpetual and periodic inventory systems. Valuation of Inventories 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 (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

13. Chapter 9-13 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. Physical Goods Special Consideration: Goods in transit (FOB shipping point, FOB destination) Consigned goods

14. Chapter 9-14 Costs Included in Inventory LO 3 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.

15. Chapter 9-15 Answer: Method adopted should be one that most clearly reflects periodic income. Cost Flow Assumption Adopted Physical Movement of Goods does not need to equal FIFO What Cost Flow Assumption to Adopt? LIFO Average CostSpecific Identification LO 4 Describe and compare the cost flow assumptions used to account for inventories.

16. Chapter 9-16 Young & Crazy Company makes the following purchases: 1. One item on 2/2/07 for $10 2. One item on 2/15/07 for $15 3. One item on 2/25/07 for $20 Young & Crazy Company sells one item on 2/28/08 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2008, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. Example Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories.

17. Chapter 9-17 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 4 Describe and compare the cost flow assumptions used to account for inventories.

18. Chapter 9-18 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Cost Flow Assumptions Inventory Balance = $ 35 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 10 Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 47 Income before tax 47 14 Taxes 14 $ 33 Net Income $ 33 “First-In-First-Out (FIFO)” LO 4 Describe and compare the cost flow assumptions used to account for inventories.

19. Chapter 9-19 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 “Last-In-First-Out (LIFO)” LO 4 Describe and compare the cost flow assumptions used to account for inventories.

20. Chapter 9-20 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Cost Flow Assumptions Inventory Balance = $ 25 Purchase on 2/25/08 for $20 Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 20 Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 37 Income before tax 37 11 Taxes 11 $ 26 Net Income $ 26 “Last-In-First-Out (LIFO)” LO 4 Describe and compare the cost flow assumptions used to account for inventories.

21. Chapter 9-21 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 4 Describe and compare the cost flow assumptions used to account for inventories.

22. Chapter 9-22 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 30 Cost Flow Assumptions Young & Crazy Company Income Statement For the Month of Feb. 2008 Sales $ 90 15 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 42 Income before tax 42 12 Taxes 12 $ 30 Net Income $ 30 “Average Cost” LO 4 Describe and compare the cost flow assumptions used to account for inventories.

23. Chapter 9-23 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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 4 Describe and compare the cost flow assumptions used to account for inventories.

24. Chapter 9-24 Purchase on 2/2/08 for $10 Purchase on 2/15/08 for $15 Purchase on 2/25/08 for $20 Inventory Balance = $ 45 Young & Crazy Company Income Statement For the Month of Feb. 2008 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” Depends which one is sold LO 4 Describe and compare the cost flow assumptions used to account for inventories.

25. Chapter 9-25 Financial Statement Summary Inventory Balance 302535 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories.

26. Chapter 9-26 Inventory information for Part 686 for the month of June. June 1 Beg. Balance 300 units @ $10 = $ 3,000 10Sold 200 units @ $24 11Purchased 800 units @ $12 =9,600 15 Sold 500 units @ $25 20 Purchased 500 units @ $13 =6,500 27 Sold 300 units @ $27 Example – Perpetual and Periodic Methods Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. 1.Assuming the Perpetual Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. 2.Assuming the Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. Goods Available $19,100

27. Chapter 9-27 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory FIFO Method +

28. Chapter 9-28 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory LIFO Method +

29. Chapter 9-29 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. +

30. Chapter 9-30 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Perpetual Inventory Moving Average Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase. +

31. Chapter 9-31 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory FIFO Method +

32. Chapter 9-32 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory LIFO Method +

33. Chapter 9-33 Cost Flow Assumptions LO 4 Describe and compare the cost flow assumptions used to account for inventories. Periodic Inventory Weighted Average +

34. Chapter 9-34 Many companies use LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: Special Issues Related to LIFO LO 5 Explain the significance and use of a LIFO reserve. LIFO Reserve 1. Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. LIFO troublesome for interim periods

35. Chapter 9-35 Special Issues Related to LIFO LO 5 Explain the significance and use of a LIFO reserve. LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Example: FIFO value per books$160,000 LIFO value 145,000 LIFO Reserve$ 15,000 Cost of Goods Sold 15,000 LIFO Reserve 15,000 Journal entry to reduce inventory to LIFO: Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

36. Chapter 9-36 Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. Special Issues Related to LIFO LO 6 Understand the effect of LIFO liquidations. LIFO Liquidation Illustration 9-13

37. Chapter 9-37 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. Special Issues Related to LIFO LO 7 Explain the dollar-value LIFO method. Dollar-Value LIFO

38. Chapter 9-38 Special Issues Related to LIFO LO 7 Explain the dollar-value LIFO method. Exercise: The following information relates to the Jimmy Johnson Company. Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005. Dollar-Value LIFO

39. Chapter 9-39 Special Issues Related to LIFO LO 7 Explain the dollar-value LIFO method. Exercise Solution

40. Chapter 9-40 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. Special Issues Related to LIFO LO 7 Explain the dollar-value LIFO method. Comparison of LIFO Approaches

41. Chapter 9-41 LIFO is generally preferred: 1. if selling prices are increasing faster than costs and 2. if a company has a fairly constant “base stock.” Basis for Selection of Inventory Method LIFO 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. LO 7 Explain the dollar-value LIFO method.

42. Chapter 9-42 Matching Tax benefits/Improved cash flow LO 8Identify the major advantages and disadvantages of LIFO. LO 8 Identify the major advantages and disadvantages of LIFO. Advantages Reduced earnings Inventory understated Physical flow Involuntary liquidation / Poor buying habits Disadvantages Basis for Selection of Inventory Method

43. Chapter 9-43 Market = Replacement cost Lower of cost or replacement cost Loss should be recorded when loss occurs, not in the period of sale. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. LCM

44. Chapter 9-44 Decline in the RC usually = decline in selling price. RC allows a consistent rate of gross profit. If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:  Ceiling - Net realizable value and  Floor - Net realizable value less a normal profit margin. Why use Replacement Cost (RC) for Market? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Ceiling and Floor

45. Chapter 9-45 Not< Cost Market Ceiling = NRV Replacement Cost Replacement Cost Floor = NRV less Normal Profit Margin Floor = NRV less Normal Profit Margin GAAP LCM GAAP LCM What is the rationale for the Ceiling and Floor limitations? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Not> Illustration 9-21

46. Chapter 9-46 Ceiling – prevents overstatement of the value of obsolete, damaged, or shopworn inventories. Floor – deters understatement of inventory and overstatement of the loss in the current period. Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Rationale for Limitations

47. Chapter 9-47 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. How LCM Works (Individual Items) Illustration 9-23

48. Chapter 9-48 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Methods of Applying LCM Illustration 9-24

49. Chapter 9-49 Exercise: Grant Wood Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2008, the following finished desks appear in the company’s inventory. Instructions: At what amount should the desks appear in the company’s December 31, 2008, inventory, assuming that the company has adopted a lower-of-cost-or- market approach for valuation of inventories on an individual-item basis? Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule.

50. Chapter 9-50 Not< Cost = 470 Market = 455 Ceiling = 455 (500 – 45) Ceiling = 455 (500 – 45) Replacement Cost = 460 Replacement Cost = 460 Floor = 355 (455-(500 x 20%)) Floor = 355 (455-(500 x 20%)) LCM = 455 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Not>

51. Chapter 9-51 Not< Cost = 450 Market = 440 Ceiling = 480 (540 – 60) Ceiling = 480 (540 – 60) Replacement Cost = 440 Replacement Cost = 440 Floor = 372 (480-(540 x 20%)) Floor = 372 (480-(540 x 20%)) LCM = 440 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Not>

52. Chapter 9-52 Not< Cost = 830 Market = 630 Ceiling = 810 (900 – 90) Ceiling = 810 (900 – 90) Replacement Cost = 610 Replacement Cost = 610 Floor = 630 (810-(900 x 20%)) Floor = 630 (810-(900 x 20%)) LCM = 630 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Not>

53. Chapter 9-53 Not< Cost = 960 Market = 1,000 Ceiling = 1,070 (1,200 – 130) Ceiling = 1,070 (1,200 – 130) Replacement Cost = 1,000 Replacement Cost = 1,000 Floor = 830 (1,070-(1,200 x 20%)) Floor = 830 (1,070-(1,200 x 20%)) LCM = 960 Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Not>

54. Chapter 9-54 Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale. Inventory valued at cost in one year and at market in the next year. Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize. LCM uses a “normal profit” in determining inventory values, which is a subjective measure. Some Deficiencies: Lower-of-Cost-or-MarketLower-of-Cost-or-Market LO 9 Describe and apply the lower-of-cost-or-market rule. Evaluation of LCM Rule

55. Chapter 9-55 Accounting standards require disclosure of: Presentation and Analysis LO 10 Explain how to report and analyze inventory. Presentation: (1)composition of the inventory, (2)financing arrangements, and (3)costing methods employed. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell the inventory. Analysis:

56. Chapter 9-56 Measures the number of times on average a company sells the inventory during the period. Presentation and Analysis LO 10 Explain how to report and analyze inventory. Inventory Turnover Ratio Illustration 9-27

57. Chapter 9-57 Measure represents the average number of days’ sales for which a company has inventory on hand. Presentation and Analysis LO 10 Explain how to report and analyze inventory. Average Days to Sell Inventory 365 days / 8 times = every 45.6 days Inventory Turnover Average Days to Sell Illustration 9-27

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