Intermediate accounting 13th kieso warfield chapter 08

Issues Physical Goods Included in Inventory Costs Included in Inventory Cost Flow Assumptions LIFO: Special Issues Goods in transit Consigned goods Special sales agreements Inventory err

Chapter 8-1

Chapter

8-3

1. Identify major classifications of inventory

2. Distinguish between perpetual and periodic inventory systems

3. Identify the effects of inventory errors on the financial

statements

4. Understand the items to include as inventory cost

5. Describe and compare the cost flow assumptions used to account

for inventories

6. Explain the significance and use of a LIFO reserve

7. Understand the effect of LIFO liquidations

8. Explain the dollar-value LIFO method

9. Identify the major advantages and disadvantages of LIFO

10. Understand why companies select given inventory methods

Learning Objectives Learning Objectives

Issues

Physical Goods Included in Inventory

Costs Included

in Inventory

Cost Flow Assumptions

LIFO: Special Issues

Goods in transit Consigned goods Special sales agreements Inventory errors

Product costs Period costs Purchase discounts

Specific identification Average cost FIFO

LIFO

LIFO reserve LIFO liquidation Dollar-value LIFO

Comparison of LIFO approaches Advantages of LIFO

Disadvantages of LIFO

Summary of inventory valuation methods

Valuation of Inventories:

Cost-Basis Approach

Valuation of Inventories:

Cost-Basis Approach

LO 1 Identify major classifications of inventory.

Classification

Merchandiser Manufacturer

Businesses with Inventory:

or

Illustration 8-1

Chapter

8-7

Classification

Inventory Issues Inventory Issues

LO 1 Identify major classifications of inventory.

Inventory Cost Flow

Inventory Issues Inventory Issues

Illustration 8-2

Chapter

8-9

Inventory Cost Flow

Inventory Issues Inventory Issues

Illustration 8-3

LO 1 Identify major classifications of inventory.

Companies use one of two types of systems for maintaining

inventory records — perpetual system or periodic system

Inventory Cost Flow Inventory Cost Flow

Perpetual System

1 Purchases of merchandise are debited to Inventory.

2 Freight-in is debited to Inventory Purchase returns and

allowances and purchase discounts are credited to Inventory.

3 Cost of goods sold is debited and Inventory is credited for

each sale.

4 Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a continuous

record of Inventory and Cost of Goods Sold

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, net

800,000 Goods available for sale

900,000 Ending inventory

125,000 Cost of goods sold

$ 775,000

Inventory Cost Flow Inventory Cost Flow

Illustration: Fesmire Company had the following

transactions during the current year.

Record these transactions using the Perpetual and Periodic systems.

Inventory Cost Flow Inventory Cost Flow

Illustration: Assume that at the end of the reporting

period, the perpetual inventory account reported an

inventory balance of $4,000 However, a physical count

indicates inventory of $3,800 is actually on hand The entry

to record the necessary write-down is as follows.

Note: Inventory Over and Short adjusts Cost of Goods Sold In practice,

companies sometimes report Inventory Over and Short in the “Other revenues

and gains” or “Other expenses and losses” section of the income statement.

Chapter

8-15

Inventory Control

Inventory Issues Inventory Issues

LO 2 Distinguish between perpetual and periodic inventory systems.

All companies need periodic verification of the inventory records by actual count, weight, or measurement, with

the counts compared with the detailed inventory

records.

Companies should take the physical inventory near the

end of their fiscal year, to properly report inventory

quantities in their annual accounting reports.

Basic Issues in Inventory Valuation Basic Issues in Inventory Valuation

Valuation

Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand.

Illustration 8-5

Chapter

8-17

Basic Issues in Inventory Valuation Basic Issues in Inventory Valuation

LO 2 Distinguish between perpetual and periodic inventory systems.

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.).

Valuation requires determining

A company should record purchases when it obtains

legal title to the goods.

Physical Goods Included in Inventory Physical Goods Included in Inventory

Illustration 8-6

Chapter

8-19

Effect of Inventory Errors Effect of Inventory Errors

LO 3 Identify the effects of inventory errors on the financial statements.

Ending Inventory Misstated

The effect of an error on net income in one year (2009) will be

counterbalanced in the next (2010), however the income statement

will be misstated for both years.

Illustration 8-7

Effect of Inventory Errors

Effect of Inventory Errors

Illustration: Jay Weiseman Corp understates its ending inventory

by $10,000 in 2009; all other items are correctly stated.

Illustration 8-8

Chapter

8-21

Effect of Inventory Errors Effect of Inventory Errors

LO 3 Identify the effects of inventory errors on the financial statements.

Purchases and Inventory Misstated

The understatement does not affect cost of goods sold and net

income because the errors offset one another.

Illustration 8-9

Costs Included in Inventory Costs Included in Inventory

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.

Purchase Discounts – Gross vs Net Method

Chapter

8-23

Costs Included in Inventory Costs Included in Inventory

LO 4 Understand the items to include as inventory cost.

LO 4 Understand the items to include as inventory cost.

Treatment of Purchase Discounts

Answer: Method adopted should be one that most clearly reflects periodic income.

Cost Flow Assumption Adopted

does not need to equal Physical Movement of Goods

Cost Flow Assumption Adopted

does not need to equal Physical Movement of Goods

FIFO

Which Cost Flow Assumption to Adopt?

Which Cost Flow Assumption to Adopt?

LIFO

Chapter

8-25

Young & Crazy Company makes the following purchases:

2 One item on 2/15/11 for $15

Young & Crazy Company sells one item on 2/28/11 for

$90 What would be the balance of ending inventory and

cost of goods sold for the month ended Feb 2011,

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 Cost Flow Assumptions

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

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 Cost Flow Assumptions

“First-In-First-Out (FIFO)”

Chapter

8-27

Purchase on 2/2/07 for $10

Cost of goods sold 10 Gross profit 80 Expenses:

Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 47 47

Taxes 14 Net Income $ 33

“First-In-First-Out (FIFO)”

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

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 Cost Flow Assumptions

“Last-In-First-Out (LIFO)”

Young & Crazy Company Income Statement For the Month of Feb 2007

Cost of goods sold 20 Gross profit 70 Expenses:

Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 37

Taxes 11 Net Income $ 26

“Last-In-First-Out (LIFO)”

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

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 Cost Flow Assumptions

“Average Cost”

Cost of goods sold 15 Gross profit 75 Expenses:

Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42

Taxes 12 Net Income $ 30

“Average Cost”

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

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 Cost Flow Assumptions

“Specific Identification”

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

Cost Flow Assumptions

“Specific Identification”

Depends which one is sold

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

Financial Statement Summary

Cost of goods sold 10 20 15 Gross profit 80 70 75 Operating expenses:

Administrative 14 14 14

Interest 7 7 7 Total expenses 33 33 33 Income before taxes 47 37 42 Income tax expense 14 11 12

Cost Flow Assumptions Cost Flow Assumptions

Illustration: Call-Mart Inc had the following transactions

in its first month of operations.

Beginning inventory (2,000 x $4) $ 8,000

Purchases:

Goods available for sale $43,900

Calculate Goods Available for Sale

Specific Identification

Specific Identification

Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase

Compute the amount of ending inventory and cost of goods sold.

Illustration 8-12

Chapter

8-37

Average Cost Average Cost

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

Solution on notes page

Illustration 8-13

Weighted-Average

Average Cost Average Cost

Illustration 8-14

In this method, Call-Mart computes a new average unit

cost each time it makes a purchase.

Moving-Average

Chapter

8-39

First-In, First-Out (FIFO) First-In, First-Out (FIFO)

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

Solution on notes page

Illustration 8-15

Periodic Method

Determine cost of ending inventory by taking the cost of the most recent

purchase and working back until it accounts for all units in the inventory

First-In, First-Out (FIFO) First-In, First-Out (FIFO)

Illustration 8-16

Perpetual Method

In all cases where FIFO is used, the inventory and cost of goods sold

would be the same at the end of the month whether a perpetual or

periodic system is used

Chapter

8-41

Last-In, First-Out (LIFO) Last-In, First-Out (LIFO)

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.

Solution on notes page

Illustration 8-17

Periodic Method

The cost of the total quantity sold or issued during the month comes

from the most recent purchases

Last-In, First-Out (LIFO) Last-In, First-Out (LIFO)

Illustration 8-18

Perpetual Method

The LIFO method results in different ending inventory and cost of goods

sold amounts than the amounts calculated under the periodic method

Chapter

8-43

Many companies use

LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for

internal reporting purposes.

2 Record keeping easier

3 Profit-sharing or bonus arrangements

4 LIFO troublesome for interim periods

Special Issues Related to LIFO

Special Issues Related to LIFO

LIFO Reserve is the difference between the

inventory method used for internal reporting purposes and LIFO

Companies should disclose either the LIFO reserve or the replacement

Chapter

8-45

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 Special Issues Related to LIFO

LO 7 Understand the effect of LIFO liquidations.

Illustration: At the end of 2011, only 6,000 pounds of

steel remained in inventory.

Special Issues Related to LIFO

Special Issues Related to LIFO

LIFO Liquidation

Illustration 8-21

Broader range of goods in pool.

Permits replacement of goods that are similar.

Helps protect LIFO layers from erosion.

Special Issues Related to LIFO Special Issues Related to LIFO

LO 8 Explain the dollar-value LIFO method.

Dollar-Value LIFO

Special Issues Related to LIFO Special Issues Related to LIFO

Exercise 8-26 (partial): The following information relates

to the Choctaw Company.

Use the dollar-value LIFO method to compute the ending

inventory for 2007 through 2009

Dollar-Value LIFO

Special Issues Related to LIFO Special Issues Related to LIFO

Exercise 8-26 Solution

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.

Special Issues Related to LIFO Special Issues Related to LIFO

Comparison of LIFO Approaches

Future Earnings Hedge

Special Issues Related to LIFO Special Issues Related to LIFO

LO 9 Identify the major advantages and disadvantages of LIFO.

Advantages

Reduced earnings Inventory understated Physical flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages

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

Basis for Selection of Inventory Method

LIFO is 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

Chapter

8-55

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