Intermediate accounting volum 1 IFRS edition chapter 08

Goods in transit Consigned goods Special sales agreements Inventory errorsInventory Issues Physical Goods Included in Inventory Cost Included in Inventory Cost Flow Assumptions Specific

8-1

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 methods used to price

inventories

Learning Objectives

Learning Objectives

Goods in transit Consigned goods Special sales agreements Inventory errors

Inventory Issues

Physical Goods Included in Inventory

Cost Included in Inventory

Cost Flow Assumptions

Specific identification Average cost FIFO

Inventory Cost Flow

Inventory Issues

Inventory Issues

Illustration 8-2

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.

Inventory Cost Flow

Inventory Cost Flow

LO 2 Distinguish between perpetual and periodic inventory systems.

Periodic System

1 Purchases of merchandise are debited to Purchases

2 Ending Inventory determined by physical count

3 Calculation of Cost of Goods Sold:

Beginning inventory

$ 100,000Purchases, net

800,000Goods available for sale

900,000Ending inventory

125,000Cost 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

LO 2 Distinguish between perpetual and periodic inventory systems.

Illustration 8-4

Illustration:

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

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

Inventory Issues

Inventory Issues

Basic Issues in Inventory 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

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 (specific Identification, average cost, FIFO, 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

Physical Goods Included in Inventory

Physical Goods Included in Inventory

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

Effect of Inventory Errors

The effect of an error on net income in one year (2010) will be counterbalanced in the next (2011), however the income statement will be misstated for both years.

Illustration 8-7

Ending Inventory Misstated

Effect of Inventory Errors

Effect of Inventory Errors

Illustration: Yei Chen Corp understates its ending inventory by

HK$10,000 in 2010; all other items are correctly stated.

Illustration 8-8

Physical Goods Included in Inventory

Physical Goods Included in Inventory

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

Effect of Inventory Errors

The understatement does not affect cost of goods sold and net income because the

errors offset one another.

Illustration 8-9

Purchases and Inventory Misstated

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.

Treatment of Purchase Discounts – Gross vs

Net Method

Costs Included in Inventory

Costs Included in Inventory

LO 4 Understand the items to include as inventory cost.

Treatment of Purchase Discounts

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

Which Cost Flow Assumption to Adopt?

Which Cost Flow Assumption to Adopt?

Specific Identification - Average Cost - LIFO

Young & Crazy Company makes the following purchases:

1 One item on 2/2/11 for $10

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

3 One item on 2/25/11 for $20Young & 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 February 2011, assuming

the company used the FIFO, 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 methods used to price 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

“First-In-First-Out (FIFO)”

Purchase on 2/2/11 for $10

Purchase on

2/15/11 for $15

Purchase on

2/25/11 for $20

Cost Flow Assumptions

Cost Flow Assumptions

Inventory Balance

= $ 35

Young & Crazy Company Income Statement For the Month of Feb 2011

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

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 Flow Assumptions

Cost Flow Assumptions

Young & Crazy Company Income Statement For the Month of Feb 2011

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

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”

Young & Crazy Company Income Statement For the Month of Feb 2011

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

Depends which one is sold

Cost Flow Assumptions

Cost Flow Assumptions

“Specific Identification”

LO 5

Financial Statement Summary

Cost Flow Assumptions

Cost Flow Assumptions

Cost Flow Assumptions

Cost Flow Assumptions

LO 5

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

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

First-In, First-Out (FIFO)

First-In, First-Out (FIFO)

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.

LO 5 Describe and compare the methods used to price inventories.

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.

Inventory Valuation Methods - Summary

Inventory Valuation Methods - Summary

Illustration 8-17

LO 5 Describe and compare the methods used to price inventories.

Inventory Valuation Methods - Summary

Inventory Valuation Methods - Summary

Illustration 8-18

Balances of Selected Items under Alternative Inventory Valuation Methods

8-41 LO 6 Describe the LIFO cost flow assumption.

Under IFRS, LIFO is not permitted for financial reporting

purposes

Nonetheless, LIFO is permitted for financial reporting

purposes in the United States, it is permitted for tax purposes

in some countries, and its use can result in significant tax

savings

Illustration: Call-Mart Inc had the following transactions in

its first month of operations

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

Purchases:

Calculate Goods Available for Sale

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO)

Illustration 8A-2

Perpetual Method

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

amounts than the amounts calculated under the periodic method.

Illustration 8A-3

Inventory Valuation Methods - Summary

Inventory Valuation Methods - Summary

Notice that gross profit and net income are lowest under LIFO, highest under

FIFO, and somewhere in the middle under average cost.

LO 6 Describe the LIFO cost flow assumption.

Illustration 8A-4

Inventory Valuation Methods - Summary

Inventory Valuation Methods - Summary

LIFO results in the highest cash balance at year-end (because taxes are

lower) This example assumes that prices are rising The opposite result

Many companies use

LIFO for tax and external financial reporting purposes

FIFO, average cost, or standard cost system for internal reporting purposes

Reasons:

LIFO Reserve

1 Pricing decisions

2 Record keeping easier

3 Profit-sharing or bonus arrangements

4 LIFO troublesome for interim periods

LO 7 Explain the significance and use of a LIFO reserve.

LIFO Reserve is the difference between the inventory method

used for internal reporting purposes and LIFO

Allowance to reduce inventory to LIFO 30,000

Journal entry to reduce inventory to LIFO:

Illustration: Acme Boot Company uses the FIFO method for internal

reporting purposes and LIFO for external reporting purposes At

January 1, 2011, the Allowance to Reduce Inventory to LIFO balance is

$20,000 At December 31, 2011, the balance should be $50,000 As a result, Acme Boot realizes a LIFO effect and makes the following entry

at year-end.

Older, low cost inventory is sold resulting in a lower cost of

goods sold, higher net income, and higher taxes

LIFO Liquidation

Illustration: Basler Co has 30,000 pounds of steel in its

inventory on December 31, 2011, with cost determined on a

specific-goods

LIFO approach

LO 8 Understand the effect of LIFO liquidations.

Illustration: At the end of 2012, only 6,000 pounds of steel

remained in inventory.

LIFO Liquidation

Illustration 8B-3 Illustration 8B-2

Changes in a pool are measured in terms of total dollar

value, not physical quantity.

Advantage:

Broader range of goods in pool

Permits replacement of goods that are similar

Helps protect LIFO layers from erosion

Dollar-Value LIFO

LO 9 Explain the dollar-value LIFO method.

Exercise 8-29 (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

8-53

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

Comparison of LIFO Approaches

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.”

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

increases

Basis for Selection of Inventory Method

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