Financial accounting in an economic context 8e chapter 07

– Purchase returns reduce the cost of purchases contra for returned inventory.. – Purchase allowances reduce the cost of purchases contra for reduced prices due to damage or errors.. Ass

1

Chapter 7:

Merchandise Inventory

3

Merchandise Inventory

What is inventory?

 Items held for resale to customers

Who has inventory?

1 Acquiring Inventory

 What items or units to include?

– General rule: complete and unrestricted ownership

Acquiring inventory - contd.

 Which costs are included in inventory?

– General rule: all costs associated with purchase or manufacture, including shipping to facility.

– Freight-in (transportation-in) adds to the

cost of inventory

– Purchase returns reduce the cost of

purchases (contra) for returned inventory

– Purchase allowances reduce the cost of

purchases (contra) for reduced prices due to damage or errors

– Purchase discounts from early cash

payments (contra) reduce the cost of

purchases

Figure 7.3: Perpetual System

December 10 Purchase of 100 units @ $20:

Class Exercise E7-6

Sales 2008$1,262 2007$1,277Cost of Goods

E7-6

a. Assume that counting errors caused the

ending inventory (EI) in 2007 to be

understated by $50 and the ending

inventory in 2008 to be overstated by $50 Compute the impact of these errors on cost of

goods sold for the year ended December

31, 2007 and on the inventory balance as

of December 31, 2007.

b Compute the impact of these errors on cost

of goods sold for the year ended December

31, 2008 and on the inventory balance as of December 31, 2008.

c What is the impact of these errors on cost

of goods sold over the two-year period

ended December 31, 2008?

E7-6

a Error in Ending Inventory in 2007: The

$50 understated error in the Ending

inventory means that the Ending Inventory

should have been $268 + $50 = $318 This

would change the Cost of goods sold to

$1,174 - $318 = $856 which would then

increase the Gross profit to $421 ($1,277 -

$856)

b Error in Ending Inventory in 2008: =

The 2007 error in the Ending Inventory changes the Beginning Inventory in 2008

and the Goods Available for sale to $318 +

$857 = $1,175 To calculate the Cost of

Goods Sold the Ending Inventory for 2008 is deducted from the revised Goods Available

for Sale: $1,175 – ($239 - $50) = $986 The gross profit would then be $1,262 - $986 =

$276.

3 Cost Flow Assumptions

 Given: BI + P (net) = EI + COGS

 How to assign costs of inflows [BI +

P(net)] to EI and COGS?

Methods:

 Specific identification

 Average for both COGS and EI

 FIFO - (first-in, first-out) for COGS

– and LISH (last-in, still here) for EI

 LIFO - (last-in, first-out) for COGS

– and FISH (first-in, still here) for EI

International Perspective – Cost Flow

Assumptions

 Under IFRS the LIFO method is prohibited

 This poses an important potential impediment to the adoption of IFRS in the US Most LIFO

users in the US have chosen LIFO because it

results in an income tax savings

 DuPont, for example, has saved over $150

million in income taxes because it uses LIFO

 A shift to IFRS could impose a huge and

immediate tax burden on LIFO users in the US

Cost Flows

Cost Flows - Average

Cost Flows - FIFO

Cost Flows - LIFO

Cost Flows – Effects on Financial Statements

Cost Flows – Effects on Federal Income Taxes

Choosing an Inventory Cost Flow Assumption:

– Debt and Compensation Practices

– The Capital Market

Ending Inventory: Applying the

Lower-of-Cost-or-Market Rule

 Applying the lower-of-cost-or-market rule to

ending inventory is accomplished by comparing the cost allocated to ending inventory with the

market value of the inventory If the market value exceeds the cost, no adjustment is made and

the inventory remains at cost If the market value

is less than the cost, the inventories are written

down to market value with an adjusting journal

entry

The Lower-of-Cost-or-Market Rule

and Hidden Reserves

 Based on conservatism, ending inventory is

valued at cost or market value, whichever is

lower

 Problem: can create hidden reserves

– Recognizes price decreases immediately

– Defers price increase recognition until sold

 US GAAP and IFRS use different market

values when applying the

lower-of-cost-or-market rule Under US GAAP the lower-of-cost-or-market

value is usually the replacement cost Under

IFRS it is normally the realizable value

International Perspective: Japanese Business and Inventory Accounting

 Just-in-time (JIT) inventory systems, which

reduce the costs of carrying large amounts of

inventory without jeopardizing customer

service, have long been a characteristic of

this Japanese system and have given the

Japanese a definite advantage when

competing against U.S industry

 Japan has adopted international reporting

standards (IFRS), which does not allow the

use of LIFO

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