Inventory accounting a comprehensive guide phần 6 pptx

However, we have alsonoted the beginning inventory cost for each year and included the extended begin-ning inventory cost for each year, which facilitates calculations under the link-cha

The following example of the link-chain method assumes the same inventoryinformation just used for the double-extension example However, we have alsonoted the beginning inventory cost for each year and included the extended begin-ning inventory cost for each year, which facilitates calculations under the link-chainmethod.

Extended at Extended at Ending Unit Beginning-of-Year End-of-Year Beginning-of-Year End-of-Year

We then determine the value of the year two inventory layer by first dividingthe extended year-end price of $241,500 by the cumulative index of 107.8% to ar-rive at an inventory valuation restated to the base year cost of $224,026 We thensubtract the year one base layer of $112,000 from the $224,026 to arrive at a newlayer at the base year cost of $112,026, which we then multiply by the cumulativeindex of 107.8% to bring it back to current year prices This results in a year twoinventory layer of $120,764 At this point, the inventory layers are as follows:

Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index

In year three, the index will be the extended year-end price of $198,000 divided

by the extended beginning-of-year price of $189,750, or 104.3% Because this isthe first year in which the base year was not used to compile beginning-of-yearcosts, we must first derive the cumulative index, which is calculated by multiply-ing the preceding year’s cumulative index of 107.8% by the new year three index

of 104.3%, resulting in a new cumulative index of 112.4% By dividing year three’sextended year-end inventory of $198,000 by this cumulative index, we arrive at in-ventory priced at base year costs of $176,157

This is less than the amount recorded in year two, so there will be no inventorylayer Instead, we must reduce the inventory layer recorded for year two To do so,

LIFO, FIFO, and Average Costing / 117

we subtract the base year layer of $112,000 from the $176,157 to arrive at a duced year two layer of $64,157 at base year costs We then multiply the $64,157

re-by the cumulative index in year two of 107.8% to arrive at a inventory valuationfor the year two layer of $69,161 At this point, the inventory layers and associatedcumulative indexes are as follows:

Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index

In year four, the index will be the extended year-end price of $271,875 divided

by the extended beginning-of-year price of $261,000, or 104.2% We then derivethe new cumulative index by multiplying the preceding year’s cumulative index of112.4% by the year four index of 104.2%, resulting in a new cumulative index of117.1% By dividing year four’s extended year-end inventory of $271,875 by thiscumulative index, we arrive at inventory priced at base year costs of $232,173 Wethen subtract the preexisting base year inventory valuation for all previous layers

of $176,157 from this amount to arrive at the base year valuation of the year fourinventory layer, which is $56,016 Finally, we multiply the $56,016 by the cumu-lative index in year four of 117.1% to arrive at an inventory valuation for the yearfour layer of $62,575 At this point, the inventory layers and associated cumulativeindexes are as follows:

Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index

7-6 Weighted-Average Inventory Valuation

The weighted-average costing method is calculated exactly in accordance with itsname—it is a weighted average of the costs in inventory It has the singular advan-tage of not requiring a database that itemizes the many potential layers of inventory

118 / Inventory Accounting

at the different costs at which they were acquired Instead, the weighted average

of all units in stock is determined, at which point all of the units in stock are

ac-corded that weighted-average value When parts are used from stock, they are allissued at the same weighted-average cost If new units are added to stock, then thecost of the additions are added to the weighted average of all existing items in stock,

which will result in a new, slightly modified weighted average for all of the parts

in inventory (both the old and new ones)

This system has no particular advantage in relation to income taxes, because itdoes not skew the recognition of income based on trends in either increasing or de-clining costs This makes it a good choice for those organizations that do not want

to deal with tax planning It is also useful for small inventory valuations, where therewould not be any significant change in the reported level of income even if the LIFO

or FIFO methods were to be used

Exhibit 7-3 illustrates the weighted-average calculation for inventory valuations,using a series of 10 purchases of inventory There is a maximum of one purchaseper month, with usage (reductions from stock) also occurring in most months Each

of the columns in the exhibit show how the average cost is calculated after each chase and usage transaction

pur-We begin the illustration with the first row of calculations, which shows that

we have purchased 500 units of item BK0043 on May 3, 2003 These units cost $10per unit During the month in which the units were purchased, 450 units were sent

to production, leaving 50 units in stock Because there has been only one chase thus far, we can easily calculate, as shown in column 7, that the total inven-tory valuation is $500, by multiplying the unit cost of $10 (in column 3) by thenumber of units left in stock (in column 5) So far, we have a per-unit valuation

pur-of $10

Next we proceed to the second row of the exhibit, where we have purchased other 1,000 units of BK0043 on June 4, 2003 This purchase was less expensive, be-cause the purchasing volume was larger, so the per-unit cost for this purchase is only

an-$9.58 Only 350 units are sent to production during the month, so we now have 700units in stock, of which 650 are added from the most recent purchase To determinethe new weighted-average cost of the total inventory, we first determine the ex-tended cost of this newest addition to the inventory As noted in column 7, we arrive

at $6,227 by multiplying the value in column 3 by the value in column 6 Wethen add this amount to the existing total inventory valuation ($6,227 plus $500) toarrive at the new extended inventory cost of $6,727, as noted in column 8 Finally,

we divide this new extended cost in column 8 by the total number of units now instock, as shown in column 5, to arrive at our new per-unit cost of $9.61

The third row reveals an additional inventory purchase of 250 units on July 11,

2003, but more units are sent to production during that month than were bought,

so the total number of units in inventory drops to 550 (column 5) This inventoryreduction requires no review of inventory layers, as was the case for the LIFO andFIFO calculations Instead, we simply charge off the 150-unit reduction at the av-erage per-unit cost of $9.61 As a result, the ending inventory valuation drops to

$5,286, with the same per-unit cost of $9.61 Thus, reductions in inventory

quanti-LIFO, FIFO, and Average Costing / 119

Average Costing Part Number BK0043 Column 1

ties under the average costing method require little calculation—just charge off therequisite number of units at the current average cost.

The remaining rows of the exhibit repeat the concepts just noted, alternatelyadding units to and deleting them from stock Although there are several columnsnoted in this exhibit that one must examine, it is really a simple concept to under-stand and work with The typical computerized accounting system will perform all

of these calculations automatically

7-7 Specific Identification Method

When each individual item of inventory can be clearly identified, it is possible tocreate inventory costing records for each one, rather than summarizing costs bygeneral inventory type This approach is rarely used, because the amount of paper-work and effort associated with developing unit costs is far greater than under allother valuation techniques It is most applicable in businesses such as home con-struction, where there are few units of inventory to track, and where each item istruly unique

LIFO, FIFO, and Average Costing / 121

The basis for this concept is contained within Statements 5 through 7 in Chapter

4 of Accounting Research Bulletin Number 43 Statement 5 notes that when the

util-ity (as indicated by damage, obsolescence, and so forth) of a good falls below itsrecorded cost, one must recognize a loss for the full amount of the difference in thecurrent period Statement 6 defines “market” as the current replacement cost of aninventory item, except that the resulting market cost cannot be less than the item’snet realizable value less a normal profit margin, nor can it exceed the net realizablevalue less any completion and disposal costs

Statement 7 notes that the lower of cost or market rule can be applied either toindividual items, groups of inventory, or the inventory as a whole; the applicationmethod chosen should be the one resulting in the most close approximation to pe-riodic income Statement 7 has been the cause of considerable interpretation, be-cause its application to a large inventory group presents the possibility (allowedwithin Discussion Note 12 to the Statement) that a company can offset losses onreduced-utility items against gains experienced by increased-utility items within thesame inventory group, resulting in no write-down of the total inventory valuation,

as long as the offsetting items are in “balanced” quantities However, in practice, theuse of inventory groups for lower of cost or market calculations is unusual and so isnot addressed further within this chapter Discussion Note 14 accompanying State-ment 7 also suggests that large write-downs caused by application of the lower ofcost or market rule can be itemized separately from the cost of goods sold within theincome statement

The remainder of this chapter explores the practical application of the lower ofcost or market rule.

8-2 Applying the Lower of Cost or Market Rule 1

The lower of cost or market (LCM) calculation means that the cost of inventorycannot be recorded higher than its replacement cost on the open market; the re-placement cost is bounded at the high end by its eventual selling price, less costs

of disposal, nor can it be recorded lower than that price, less a normal profit centage The concept is best demonstrated with the four scenarios listed in the fol-lowing example:

Selling Selling Price Normal Price Inventory Replacement Value Item Price Cost Boundary Profit Boundary Cost Cost (1) (2) LCM

A $15.00 $4.00 $11.0 $2.20 $8.80 $8.00 $12.50 $11.00 $8.00

B 40.15 6.00 34.15 5.75 28.40 35.00 34.50 34.15 34.15

C 20.00 6.50 13.50 3.00 10.50 17.00 12.00 12.00 12.00

D 10.50 2.35 8.15 2.25 5.90 8.00 5.25 5.90 5.90 (1) The cost at which an inventory item could be purchased on the open market.

(2) Replacement cost, bracketed by the upper and lower price boundaries.

In the example, the numbers in the first six columns are used to derive theupper and lower boundaries of the market values that will be used for the LCMcalculation By subtracting the completion and selling costs from each product’sselling price, we establish the upper price boundary (in bold) of the market costcalculation By then subtracting the normal profit from the upper cost boundary ofeach product, we establish the lower price boundary Using this information, theLCM calculation for each of the listed products is as follows:

Product A, replacement cost higher than existing inventory cost The market

price cannot be higher than the upper boundary of $11, which is still higher thanthe existing inventory cost of $8 Thus, the LCM is the same as the existing in-ventory cost

Product B, replacement cost lower than existing inventory cost, but higher than upper price boundary The replacement cost of $34.50 exceeds the upper price

boundary of $34.15, so the market value is designated at $34.15 This is lowerthan the existing inventory cost, so the LCM becomes $34.15

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1 The contents of this section have been adapted with permission from p 44 of Bragg,

GAAP Implementation Guide, John Wiley & Sons, 2004.

Product C, replacement cost lower than existing inventory cost and within price boundaries The replacement cost of $12 is within the upper and lower price

boundaries, and so is used as the market value This is lower than the existinginventory cost of $17, so the LCM becomes $12

Product D, replacement cost lower than existing inventory cost, but lower than lower price boundary The replacement cost of $5.25 is below the lower price

boundary of $5.90, so the market value is designated as $5.90 This is lower thanthe existing inventory cost of $8, so the LCM becomes $5.90

Whenever there is a calculated inventory write-down, use the following nal entry to record the valuation reduction Although this loss can be recordedwithin the general cost of goods sold account, the magnitude of LCM losses tend to

jour-be lost that way, so use the “Loss on Inventory Valuation” account to more spicuously record the information

Loss on inventory valuation xxx

Although the sample journal entry shows a credit to specific inventory accounts, it

is also acceptable to credit an inventory valuation account instead

8-3 Enforcement of the LCM Rule

Given the considerable amount of manual calculation required to determine ifthere is a loss under the LCM rule, few inventory accountants are interested in fol-lowing its dictates regularly One of the better approaches to enforcement is to havethe Board of Directors formally approve a company policy requiring at least an an-nual LCM review, and to then include this policy in the job description of the in-ventory accountant An example of possible policy wording follows:

Lower of cost or market calculations shall be conducted at least nually for the entire inventory

an-This policy may be modified to require more frequent reviews, based on the ability of market rates for various inventory items

vari-Even with a policy in place, the LCM calculation is only likely to be conducted

at such infrequent intervals that the inventory accountant forgets how the tion was made in the past Thus, there is a considerable risk that the calculationswill be conducted differently each time, yielding inconsistent results To avoid thisproblem, consider including in the accounting procedures manual a clear definition

calcula-of the calculation to be followed A sample procedure is shown in Exhibit 8-1

The Lower of Cost or Market Calculation / 125

Exhibit 8-1 Lower of Cost or Market Procedure

Use this procedure to periodically adjust the inventory valuation for those items whose market value has dropped below their recorded cost.

1 Export the extended inventory valuation report to an electronic spreadsheet Sort it by declining

extended dollar cost, and delete the 80% of inventory items that do not comprise the top 20% of inventory valuation Sort the remaining 20% of inventory items by either part number or item description Print the report.

2 Send a copy of the report to the materials manager, with instructions to compare unit costs for

each item on the list to market prices, and be sure to mutually agree upon a due date for completion of the review.

3 When the materials management staff has completed its review, meet with the materials manager

to go over its results and discuss any major adjustments Have the materials management staff write down the valuation of selected items in the inventory database whose cost exceeds their market value.

4 Have the accounting staff expense the value of the write down in the accounting records.

5 Write a memo detailing the results of the lower of cost or market calculation Attach one copy to

the journal entry used to write down the valuation, and issue another copy to the materials manager.

126 / Inventory Accounting

in overhead Because GAAP requires that some portion of overhead costs be signed to inventory, the inventory accountant has the dual tasks of determiningwhich costs to include in overhead and how to assign these costs to inventory Thelatter task is especially difficult, because the basis of allocation has historically beendirect labor, which usually constitutes only a small portion of a product’s cost, andwhich therefore can result in significant misallocations of overhead costs to spe-cific inventory items.

as-In this chapter, we review the types of costs to assign to inventory through head allocation, the assignment of overhead costs to raw materials, the contents of

over-a bill of over-activities, over-and the use of over-activity-bover-ased costing to derive the most over-accurover-atepossible overhead allocation

9-2 Overhead Identification and Allocation to Inventory 1

Some overhead costs can be charged off to inventory, rather than being recognized

in the cost of goods sold or some other expense category within the current period.Because the proper allocation of these costs can have a large impact on the level

of reported income in any given period, it is important for the inventory tant to fully understand which costs can be shifted to a cost pool for eventual allo-cation and how this allocation is to be accomplished The first question is answered

accoun-by Exhibit 9-1, which itemizes precisely which costs can be shifted into a cost pool.The only cost category about which there is some uncertainty is rework labor, scrap,

1Adapted with permission from Chapter 14 of Bragg, Accounting Reference Desktop, John

Wiley & Sons, 2002.

and spoilage The exhibit shows that this cost can be charged in either direction Therule in this case is that any rework, scrap, or spoilage that falls within a normallyexpected level can be charged to a cost pool for allocation, whereas unusual amountsmust be charged off at once This is clearly a highly subjective area, where somehistorical records should be maintained that will reveal the trend of these costs andthat can be used as the basis for proving the charging of costs to either category.With Exhibit 9-1 in hand, one can easily construct a cost pool into which thecorrect costs can be accumulated for later distribution to inventory as allocatedoverhead costs The next problem is how to go about making the allocation Thisproblem consists of four issues, which are as follows:

How to smooth out sudden changes in the cost pool It is common to see an

un-usual expenditure cause a large jump or drop in the costs accumulated in thecost pool, resulting in a significant difference between periods in the amount ofper-unit costs that are allocated out This can cause large changes in overheadcosts from period to period Although perfectly acceptable from the perspective

of GAAP, one may desire a more smoothed-out set of costs from period to

pe-128 / Inventory Accounting

Exhibit 9-1 Allocation of Costs Between Cost Pool and Expense Accounts

General and administrative expenses related to overall operations XXX

Indirect labor and production supervisory wages XXX

Officer’s salaries related to production services XXX

Pension contribution related to past service costs XXX

Salaries of officers related to overall operations XXX

Taxes other than income taxes related to production assets XXX

riod If so, it is allowable to average the costs in the cost pool over severalmonths, as long as the underlying inventory is actually in stock for a similar pe-riod For example, if the inventory turns over four times a year, then it is accept-able to allocate overhead costs each month based on a rolling average of thecosts for the preceding three months.

What basis to use when allocating costs The accounting literature has bemoaned

the allocation of costs based on direct labor for many years The reason for thisjudgment is that direct labor makes up such a small component of total productcost that small swings in the direct labor component can result in a large corre-sponding swing in the amount of allocated overhead To avoid this issue, someother unit of activity can be used as the basis for allocation that not only com-prises a larger share of total product cost, but that also relates to the incurrence

of overhead costs Another criterion that is frequently overlooked is that the counting or manufacturing system must have a means of accumulating informa-tion about this activity measure, so that the inventory accountant does not have

ac-to spend additional time manually compiling the underlying data An example of

an activity measure that generally fulfills these three criteria is machine hours,because standard machine hours are readily available in the bill of materials

or labor routing for each product, many overhead costs are related to machineusage, and the proportion of machine time used per product is commonly greaterthan the proportion of direct labor

An even better alternative than the use of machine hours (or some similar single measure) as the basis for allocation is the use of multiple cost pools that are al- located with multiple activity measures This allows a company to (for example)

allocate building costs based on the square footage taken up by each product,machine costs based on machine time used, labor costs based on direct laborhours used, and so on The main issue to be aware of when using this approach

is that the financial statements must still be produced in a timely manner, so oneshould not go overboard with the use of too many cost pools that will require

an inordinate amount of time to allocate Please review the discussion later in thischapter of activity-based costing for a more complete review of this subject area

How to calculate the overhead allocation When allocating overhead costs, they

are not simply charged off in total to the on-hand inventory at the end of themonth, because the result would be an ever-increasing overhead balance stored

in the on-hand inventory that would never be drawn down On the contrary,much of the overhead is also related to the cost of goods sold In order to make

a proper allocation of costs between the inventory and cost of goods sold, theinventory accountant must determine the total amount of each basis of activitythat occurred during the reporting period and divide this amount into the totalamount of overhead in the cost pool, yielding an overhead cost per unit of activ-ity This cost per unit should then be multiplied by the total amount of the basis

of activity related to the period-end inventory to determine the total amount ofoverhead that should be charged to inventory This is then compared to the

Applying Overhead to Inventory / 129