1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Measurement 8

2. 8-2 Inventory Those assets that a company: 2. Has in production (work in process) for future sale. 1. Intends to sell in the normal course of business. 1. Intends to sell in the normal course of business. 3. Uses currently in the production of goods to be sold (raw materials). 3. Uses currently in the production of goods to be sold (raw materials).

3. 8-3 Types of Inventories Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods Raw Materials Work-in-Process Finished Goods Types of Inventory

4. 8-4 Inventory Cost Flows Raw Materials (1) $XX $XX (4) Work in Process Finished Goods Cost of Good Sold Direct Labor Manufacturing Overhead $XX $XX (7) $XX$XX (8) $XX (2) $XX $XX (5) (3) $XX $XX (6) (1)Raw materials purchased (2)Direct labor incurred (3)Manufacturing overhead incurred (4)Raw materials used (5)Direct labor applied (6)Manufacturing overhead applied (7)Work in process transferred to finished goods (8)Finished goods sold (1)Raw materials purchased (2)Direct labor incurred (3)Manufacturing overhead incurred (4)Raw materials used (5)Direct labor applied (6)Manufacturing overhead applied (7)Work in process transferred to finished goods (8)Finished goods sold

5. 8-5 Learning Objective Explain the difference between a perpetual inventory system and a periodic inventory system.

6. 8-6 Inventory Methods Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle. Two accounting systems are used to record transactions involving inventory:

7. 8-7 Perpetual Inventory System Matrix, Inc. purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL DateDescriptionDebitCredit Inventory 600,000 Accounts Payable 600,000 2006 Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

8. 8-8 Perpetual Inventory System Matrix, Inc. sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL DateDescriptionDebitCredit Accounts Receivable820,000 Sales Cost of Goods Sold540,000 Inventory 820,000 540,000 2006

9. 8-9 Periodic Cost of Goods Sold Equation

10. 8-10 Periodic Inventory System Matrix, Inc. purchases on account $600,000 of merchandise for resale to customers. GENERAL JOURNAL DateDescriptionDebitCredit Purchases 600,000 Accounts Payable 600,000 2006 Purchase Returns and Allowances Returns of inventory are credited to the Purchase Returns and Allowances account. Discounts on inventory purchases can be recorded using the gross or net method. Purchase Returns and Allowances Returns of inventory are credited to the Purchase Returns and Allowances account. Discounts on inventory purchases can be recorded using the gross or net method.

11. 8-11 Periodic Inventory System Matrix, Inc. sold on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to a customer. GENERAL JOURNAL DateDescriptionDebitCredit Accounts Receivable820,000 Sales 820,000 2006 No entry is made to record Cost of Good Sold. Assuming Beginning Inventory of $120,000. A physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of the accounting period.

12. 8-12 Periodic Inventory System Adjusting entry to determine Cost of Goods Sold

13. 8-13 Comparison of Inventory Systems

14. 8-14 Learning Objective Explain which physical quantities of goods should be included in inventory.

15. 8-15 What is Included in Inventory? General Rule All goods owned by the company on the inventory date, regardless of their location. General Rule All goods owned by the company on the inventory date, regardless of their location. Goods in Transit Goods on Consignment Depends on FOB shipping terms.

16. 8-16 Learning Objective Determine the expenditures that should be included in the cost of inventory.

17. 8-17 Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns Purchase Discounts

18. 8-18 Purchase Discounts Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280 Partial payment not made within the discount period

19. 8-19 Net Method Using Perpetual and Periodic Matrix, Inc. purchased on account $6,000 of merchandise for resale to customers. The merchandise was purchased subject to a cash discount of 2/10, n/30. The company incurred $160 in freight-in on the merchandise. Upon inspection, the company found that $200 of merchandise was damaged and the seller agreed to accept the merchandise return and credit the account of the company. The inventory was sold for $8,300 on account. Let’s look at the journal entries under both the perpetual and periodic accounting system assuming Matrix uses the net method to record merchandise purchases.

20. 8-20 Net Method Using Perpetual and Periodic

21. 8-21 Learning Objective Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold.

22. 8-22 Inventory Cost Flow Methods  Specific cost identification  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)  Specific cost identification  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)

23. 8-23  The specific cost of each inventory item must be known.  By selecting specific items from inventory at the time of sale, income can be manipulated.  The specific cost of each inventory item must be known.  By selecting specific items from inventory at the time of sale, income can be manipulated. Specific Cost Identification  Items are added to inventory at cost when they are purchased.  COGS for each sale is based on the specific cost of the item sold.  Items are added to inventory at cost when they are purchased.  COGS for each sale is based on the specific cost of the item sold.

24. 8-24 Average Cost Method

25. 8-25 Weighted-Average Periodic System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theweighted-average method to determine: Use the periodic weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theweighted-average method to determine: Use the periodic weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold.

26. 8-26 Weighted-Average Periodic System

27. 8-27 Weighted-Average Periodic System Now, we have to assign costs to ending inventory and cost of goods sold. Beginning Inventory (800 units) Purchases (1,150 units) Beginning Inventory (800 units) Purchases (1,150 units) Available for Sale (1,950 units) Available for Sale (1,950 units) Ending Inventory (600 units) Ending Inventory (600 units) Goods Sold (1,350) Goods Sold (1,350) $47,650 ÷ 1,950 = $24.4359 weighted- average per unit cost

28. 8-28 Weighted-Average Periodic System

29. 8-29 Moving-Average Perpetual System The following schedule shows the Frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theweighted-average method to determine: Use the perpetual weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the Frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theweighted-average method to determine: Use the perpetual weighted-average method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold.

30. 8-30 Moving-Average Perpetual System

31. 8-31 Moving-Average Perpetual System

32. 8-32 Moving-Average Perpetual System $11,600.00 ÷ (800-600+300) = $23.200

33. 8-33 Moving-Average Perpetual System $27,490.00 ÷ (800-600+300-300+250+200+400) = $26.181

34. 8-34 Moving-Average Perpetual System Sum

35. 8-35 First-In, First-Out  The cost of the oldest inventory items are charged to COGS when goods are sold.  The cost of the newest inventory items remain in ending inventory.  The cost of the oldest inventory items are charged to COGS when goods are sold.  The cost of the newest inventory items remain in ending inventory. The FIFO method assumes that items are sold in the chronological order of their acquisition.

36. 8-36 First-In, First-Out Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory...... COGS and Ending Inventory Cost are the same under both approaches. Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory...... COGS and Ending Inventory Cost are the same under both approaches.

37. 8-37 FIFO - Periodic System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theFIFO method to determine: Use the periodic FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theFIFO method to determine: Use the periodic FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold.

38. 8-38 FIFO - Periodic System These are the 600 most recently acquired units.

39. 8-39 FIFO - Periodic System

40. 8-40 FIFO - Periodic System These are the first 1,350 units acquired.

41. 8-41 FIFO - Periodic System

42. 8-42 FIFO - Perpetual System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theFIFO method to determine: Use the perpetual FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theFIFO method to determine: Use the perpetual FIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold.

43. 8-43 FIFO - Perpetual System

44. 8-44 FIFO - Perpetual System 200 The ending inventory on 9/1 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00 The ending inventory on 9/1 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00

45. 8-45 FIFO - Perpetual System 200 The ending inventory on 9/3 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00 300 units from the 9/3 purchase @ $24.00 The ending inventory on 9/3 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00 300 units from the 9/3 purchase @ $24.00

46. 8-46 FIFO - Perpetual System 200 The ending inventory on 9/10 consists of: 200 units from the 9/3 purchase @ $24.00 The ending inventory on 9/10 consists of: 200 units from the 9/3 purchase @ $24.00

47. 8-47 FIFO - Perpetual System The ending inventory on 9/15 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 The ending inventory on 9/15 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 200

48. 8-48 FIFO - Perpetual System The ending inventory on 9/21 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 The ending inventory on 9/21 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 200

49. 8-49 FIFO - Perpetual System The ending inventory on 9/29 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00 The ending inventory on 9/29 consists of: 200 units from the 9/3 purchase @ $24.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00 200

50. 8-50 FIFO - Perpetual System The ending inventory on 9/30 consists of: 200 units from the 9/21 purchase @ $27.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00. The ending inventory on 9/30 consists of: 200 units from the 9/21 purchase @ $27.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00.

51. 8-51 FIFO - Perpetual System Note that this is the same COGS computed using the Periodic approach.

52. 8-52 Last-In, First-Out Any questions before we run into LIFO?

53. 8-53 Last-In, First-Out  The cost of the newest inventory items are charged to COGS when goods are sold.  The cost of the oldest inventory items remain in inventory.  The cost of the newest inventory items are charged to COGS when goods are sold.  The cost of the oldest inventory items remain in inventory. The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.

54. 8-54 Last-In, First-Out Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches.

55. 8-55 The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theLIFO method to determine: Use the periodic LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theLIFO method to determine: Use the periodic LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. LIFO - Periodic System

56. 8-56 LIFO - Periodic System These are the 600 oldest units in inventory.

57. 8-57 LIFO - Periodic System 200 600 x $22.00

58. 8-58 LIFO - Periodic System 600 x $22.00 These are the most recently acquired 1,350 units. 200

59. 8-59 LIFO - Periodic System $4,400 $4,400 + $30,050 200 x $22.00 200

60. 8-60 LIFO - Perpetual System The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theLIFO method to determine: Use the perpetual LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold. The following schedule shows the frame inventory for Yore Frame, Inc. for September. The physical inventory count at September 30 shows 600 frames in ending inventory. Use theLIFO method to determine: Use the perpetual LIFO method to determine: (1) Ending inventory cost. (2) Cost of goods sold. (2) Cost of goods sold.

61. 8-61 LIFO - Perpetual System

62. 8-62 LIFO - Perpetual System In LIFO, we assume that we sell the newest units in inventory first. In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer. In LIFO, we assume that we sell the newest units in inventory first. In this case, the 600 “newest” units come from beginning inventory, leaving 200 units in the beginning inventory layer. 200

63. 8-63 LIFO - Perpetual System The ending inventory on 9/3 consists of: 200 units from beginning inventory @ $22.00 300 units from the 9/3 purchase @ $24.00 The ending inventory on 9/3 consists of: 200 units from beginning inventory @ $22.00 300 units from the 9/3 purchase @ $24.00 200

64. 8-64 LIFO - Perpetual System For the 9/10 sale, we must identify the 300 newest units. They all come from the September 3 purchase. Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain. For the 9/10 sale, we must identify the 300 newest units. They all come from the September 3 purchase. Note that all of the 9/3 units have been “sold” and only 200 of the beginning inventory units remain. 200

65. 8-65 LIFO - Perpetual System The ending inventory on 9/15 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 The ending inventory on 9/15 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 200

66. 8-66 LIFO - Perpetual System The ending inventory on 9/21 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 The ending inventory on 9/21 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 200

67. 8-67 LIFO - Perpetual System The ending inventory on 9/29 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00. The ending inventory on 9/29 consists of: 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 200 units from the 9/21 purchase @ $27.00 400 units from the 9/29 purchase @ $28.00. 200

68. 8-68 LIFO - Perpetual System 150 For the 9/30 sale, we must identify the 450 newest units. 400 of them come from the 9/29 purchase. The other 50 come from the 9/21 purchase. 200

69. 8-69 LIFO - Perpetual System 150 200 The ending inventory on 9/30 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 150 units from the 9/21 purchase @ $27.00. The ending inventory on 9/30 consists of: 200 units from beginning inventory @ $22.00 200 units from beginning inventory @ $22.00 250 units from the 9/15 purchase @ $25.00 150 units from the 9/21 purchase @ $27.00.

70. 8-70 When Prices Are Rising... LIFO  Matches high (newer) costs with current (higher) sales.  Inventory is valued based on low (older) cost basis.  Results in lower taxable income.  Is not officially endorsed by the IASC. LIFO  Matches high (newer) costs with current (higher) sales.  Inventory is valued based on low (older) cost basis.  Results in lower taxable income.  Is not officially endorsed by the IASC. FIFO  Matches low (older) costs with current (higher) sales.  Inventory is valued at approximate replacement cost.  Results in higher taxable income. FIFO  Matches low (older) costs with current (higher) sales.  Inventory is valued at approximate replacement cost.  Results in higher taxable income.

71. 8-71 Comparison of Cost Flow Methods

72. 8-72 Comparison of Cost Flow Methods Inventory Method Used by Major Companies 20031973

73. 8-73 Learning Objective Discuss the factors affecting a company’s choice of inventory method.

74. 8-74 Decision Makers’ Perspective What factors motivate companies to select one inventory method over another? How accurate is the timing of reported income and income taxes? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues?

75. 8-75 Learning Objective Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income.

76. 8-76 LIFO Liquidation LIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. LIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. When prices rise... If inventory declines, these “out of date” costs may be charged to current earnings. This LIFO liquidation results in “paper profits.” This LIFO liquidation results in “paper profits.”

77. 8-77 LIFO Reserves Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this:

78. 8-78 Learning Objective Calculate the key ratios used by analysts to monitor a company’s investment in inventories.

79. 8-79 Gross Profit Ratio Gross profit ratio Gross profit Net sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

80. 8-80 Inventory Turnover Ratio Cost of goods sold Average inventory Inventory turnover ratio = This ratio measures how many times a company’s inventory has been sold and replaced during the year. If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

81. 8-81 Earnings Quality Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory- related techniques a company could use to manipulate earnings.

82. 8-82 Learning Objective Determine ending inventory using the dollar-value LIFO inventory method.

83. 8-83 LIFO Inventory Pools Inventory Pools consist of inventory units grouped according to similarities. For example, all similar units purchased at the same time can be “pooled” and assigned an average unit cost. Using Inventory Pools with LIFO simplifies record keeping.

84. 8-84 Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. DVL minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory.

85. 8-85 Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory. 1a. Compute a Cost Index for the year.

86. 8-86 Dollar-Value LIFO (DVL) 1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory (at base year cost) to beginning inventory.

87. 8-87 Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Sum all the layers to arrive at Ending Inventory at DVL cost. Convert each layer’s base year cost to layer year cost by multiplying times the cost index.

88. 8-88 End of Chapter 8