1. Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Inventories: Measurement Chapter 8

2. 8-2 Recording and Measuring Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods Types of Inventory

3. 8-3 Manufacturing Inventories Raw Materials Work-in- Process Finished Goods Cost of Goods Sold Direct Labor Manufacturing Overhead $XX Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work-in-process transferred to finished goods Finished goods sold Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work-in-process transferred to finished goods Finished goods sold                

4. 8-4 Inventory Systems 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 period. Two accounting systems are used to record transactions involving inventory:

5. 8-5 Periodic Inventory System The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period.

6. 8-6 Comparison of Inventory Systems

7. 8-7 What is Included in Inventory? The Problem In some situations the identification of items that should be included in inventory can be difficult. Consider, for example the following: Goods in Transit Goods on Consignment Depends on f.o.b. shipping terms.

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

9. 8-9 Inventory Cost Flow Assumptions  Specific identification  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)  Specific identification  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)

10. 8-10 First-In, First-Out (FIFO)  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.

11. 8-11 First-In, First-Out (FIFO) 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.

12. 8-12 Last-In, First-Out (LIFO)  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.

13. 8-13 Last-In, First-Out (LIFO) Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches.

14. 8-14 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 pre-tax income. FIFO  Matches low (older) costs with current (higher) sales.  Inventory is valued at approximate replacement cost.  Results in higher pre-tax income.

15. 8-15 U. S. GAAP vs. IFRS  LIFO is permitted and used by U.S. Companies.  If used for income tax reporting, the company must use LIFO for financial reporting.  Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will impose a serious impediment to convergence.  IAS No. 2, Inventories, does not permit the use of LIFO.  Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories.

16. 8-16 Decision Makers’ Perspective Factors Influencing Method Choice How are income taxes affected by inventory method choice? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues?

17. 8-17 LIFO Liquidation LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. LIFO inventory costs in 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.”

18. 8-18 Inventory Management Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average inventory The higher the ratio, the higher the markup a company is able to achieve on its products. (Beginning inventory + Ending inventory 2 Designed to evaluate a company’s effectiveness in managing its investment in inventory

19. 8-19 Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). 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.

20. 8-20 Methods of Simplifying LIFO The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately. LIFO Inventory Pools

21. 8-21 Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO recordkeeping. 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 dollar amount to beginning inventory dollar amount.

22. 8-22 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a cost increase or an increase in inventory quantity. 1a. Compute a Cost Index for the year.

23. 8-23 Methods of Simplifying LIFO 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 at base year cost.

24. 8-24 Methods of Simplifying LIFO 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.

25. 8-25 End of Chapter 8