Intermediate accounting 17e stice skousen cengage chapter 09

Inventory Valuation MethodsSpecific Identification LIFO Cost Allocation Methods Cost Allocation Methods Average Cost FIFO... • Provides a highly objective method of matching costs bec

Inventory and Cost

of Goods Sold

Intermediate Accounting,17E

Stice | Stice | Skousen

PowerPoint presented by: Douglas Cloud

What Is Inventory?

• Inventory designates goods held for sale in the

normal course of business or, for a manufacturer, also includes goods in production.

• For a manufacturing firm, a broad array of production

costs is included as part of the cost of inventory

• The terms raw materials, work in process, and

finished goods refer to the inventories of a

manufacturing enterprise.

Work in Process

• Work in Process (WIP) consists of

materials partly processed and requiring

further work before they can be sold

• Work in Process includes three cost

elements

1 Direct materials

2 Direct labor

3 Manufacturing overhead

Work in Process

materials directly identified with goods in production

portion of factory overhead assignable to goods in production

directly identified with goods in production

Finished Goods

awaiting sale

Inventory Systems

Two types of inventory systems that keep track of

how much inventory has been sold and at what price are:

• Periodic system—requires a physical count of

the inventory periodically, and at the point of

sale only records the sale price.

• Perpetual system—at point of sale records

selling price and type of item sold Example: a

bar code scanning system.

Differences in Recording

The following transactions occurred during

the period for CyBorg, Inc

Periodic Inventory System

Periodic Inventory System

To record sales during the period:

Perpetual Inventory System

Perpetual Inventory System

Differences in Recording

The cost of goods sold in the CyBorg

example is computed as follows:

Whose Inventory Is It?

• Report inventory on the balance sheet of the

company that holds legal title

• Legal title is not determined by who has

physical custody of the inventory

• Issues that develop:

• Goods in transit

• Goods on consignment

Goods in Transit

Whose inventory is it?

Whose inventory is it?

When terms of sale are FOB (free on

buyer with the loading of goods at the point

of shipment

Goods in Transit

When terms of sale are FOB (free on

until the goods are received by the buyer

Whose inventory is it?

Whose inventory is it?

Goods on Consignment

• Shipper retains title and includes the goods in

inventory until their sale or use by the dealer

or customer

• Consigned goods are reported by the shipper

at the sum of:

• The cost of the goods

• The handling and shipping costs

Conditional Sales, Installment Sales, and

Repurchase Agreements

• Conditional sales and installment sales contracts

may provide for a retention of title by the seller

until the sales price is fully recovered.

• Firms sometimes sell inventory to another

company but at the same time agree to repurchase the inventory at some future date These repurchase agreements are, in essence, allowing the selling

company to use the inventory to secure a

short-term loan.

Inventory costs are comprised of all

expenditures, both direct and indirect,

relating to acquisition, preparation, and

placement for sale

• Expenditures that are relatively small and

difficult to allocate are period costs These are recognized as expenses in the current period

Items Included in Inventory Cost

Items Included in Inventory Cost

Inventory costs are comprised of all

expenditures, both direct and indirect,

relating to acquisition, preparation, and

placement for sale

• Costs that can be identified with the

product being manufactured are called

Items Included in Inventory Cost

to allocate overhead based on clearly

identified cost drivers—characteristics of

the production process that are known to

create overhead costs

Discounts as Reductions in

Cost

• Cash discounts are discounts granted for

payment of invoices within a limited time period

To record adjustment at the end of the period if

invoice has not been paid and the discount period

has lapsed:

Accounts Payable

To record adjustment at the end of the period if

invoice has not been paid and the discount period

has lapsed:

Periodic Inventory System

Periodic Inventory System

Perpetual Inventory System

Perpetual Inventory System

Accounts Payable 400 Inventory 400

Inventory Valuation Methods

Specific Identification

LIFO

Cost Allocation

Methods

Cost Allocation

Methods

Average Cost

FIFO

Inventory Valuation Methods

The four methods will be illustrated using the

following simple example for Dalton Company

Note: No beginning inventory

Specific Identification Method

• Assigns the actual cost of the asset to

inventory and cost of goods sold

• Provides a highly objective method of

matching costs because cost flow exactly

matches physical goods flow

• Is almost impossible to implement cost

effectively

Specific Identification Method

200 units @ $10 per unit 300 units @ $12 per

unit 500 units @ $11 per

unit

Sold 200 units from the January 1 and 500 from the July 15 purchase

the July 15 purchase.

100 units @ $13 per unit

Specific Identification Method

200 units @ $10 per unit

500 units @ $11 per unit

Jan 1

July 15

= $2,000

= 5,500

Total cost of goods sold

$7,500

Specific Identification Method

300 units @ $12 per unit

100 units @ $13 per unit

Mar 23

Nov 6

= $3,600

= 1,300

Ending inventory $4,900

Average Cost Method

• The average cost method assigns the same

average cost to each unit sold and each item

in inventory

• For periodic inventory, the unit cost is the

weighted average for the entire period.

Average Cost Method

200 units @ $10 per unit 300 units @ $12 per

unit 500 units @ $11 per

unit 100 units @ $13 per unit

3,600 =

5,500

1,300

$12,400

$12,400 ÷ 1,100 units = $11.27 per unit (rounded)

Cost of goods sold = $11.27 × 700 = $7,890

Ending inventory = $11.27 × 400 = $4,510

First-In, First-Out (FIFO) Method

• FIFO assigns historical unit cost to cost of

goods sold in the order the costs are incurred

• Provides a close match between physical

product flow and product cost flow

• Results in the same inventory valuation and

cost of goods sold regardless of whether

perpetual or periodic inventory is used

FIFO Method

200 units @ $10 per unit 300 units @ $12 per

unit 500 units @ $11 per

unit 100 units @ $13 per unit

FIFO Method

300 units @ $11 per unit

100 units @ $13 per unit

Mar 23

Nov 6

= $3,300

= 1,300 Ending inventory

$4,600

Last-In, First-Out (LIFO) Method

• LIFO assigns the most recent historical costs

to cost of goods sold and the oldest costs to

inventory

• Is used primarily to minimize taxable income.

• Results in differences between cost of goods

sold and inventory for perpetual versus

periodic methods

LIFO Method

200 units @ $10 per unit 300 units @ $12 per

unit 500 units @ $11 per

unit 100 units @ $13 per unit

Jan 1

Mar 23

(continues)

(continued)

LIFO Layers

The following data are for Ryanes Company for the first three years of its existence:

LIFO Layers

• Each year in which the number of units

purchased exceeds the number of units sold,

a new LIFO layer is created in ending

inventory

• Many companies that use LIFO report the

amount of their LIFO reserve, either as a

parenthetical note in the balance or the notes

to the financial statements

LIFO Liquidation

to flow through cost of goods sold, sometimes with bizarre results

(continues)

(concluded)

Income Tax Effects

If a company has large inventory levels, is

experiencing significant inventory cost

increases, and does not anticipate reducing

inventory levels in the future, LIFO gives

substantial cash flow benefits in terms of tax deferrals

Bookkeeping Costs

• The bookkeeping associated with LIFO is a

bit more complicated than with FIFO or

average costs

• In dollars and cents, a LIFO system costs

more to operate

• Until information technology is improved,

small businesses will continue to lean

toward not using LIFO

Impact on Financial Statements

While LIFO gives tax benefits, it also gives

reduced reported income and reduced

reported inventory

International Accounting and Inventory

Valuation

• In 1992, the IASB decided to officially

endorse FIFO and average cost, to kill the

base stock method, and to let LIFO live on

as a second-class “allowed alternative

treatment.”

• In 2003, the IASB adopted a revised

version of IAS 2 and did away with LIFO.

Inventory Accounting Change

If a company changes its method of valuing inventory, the change is accounted for as a change in accounting principle.

Report the effect of changing methods

on the financial statements.

Report the effect of changing methods

on the financial statements.

or FIFO

Average Cost

or FIFO

change to

Inventory Accounting Change

No adjustment to financial statements for change to

LIFO, but special disclosure required.

No adjustment to financial statements for change to

LIFO, but special disclosure required.

Lower of Cost or Market

• The term market in lower of cost or market means

Floor: Net realizable value less a

normal profit margin

Market Historical Cost

compare to

Range

9-56

Gross Profit Method

Last year’s 40% is considered a good estimate.

Effects of Errors in Recording

Inventory

Failure to correctly report inventory results in

misstatements on both the balance sheet and the

income statement There are three typical inventory errors:

1 Overstatement of ending inventory through an

improper physical count

2 Understatement of ending inventory through an

improper physical count

3 Understatement of ending inventory through

delay in recording a purchase until the following year

9-62

Using Inventory Information

for Financial Analysis

Consider the financial information relating to

inventories for Deere & Co provided below.

Inventory Turnover

Appropriateness of inventory size and

position can be measured by calculating the

Cost of Goods Sold $16,252.8

Average Inventory = $2,147

= 7.57 times

($2,337 + $1,957)/2 = $2,147

Number of Days’ Sales

Deere’s number of days’ sales in inventory

results mean that, on average, Deere & Co

has enough inventory to continue operations for 48.2 days using just its existing

inventory

Number of Days’ Sales

in Inventory

Retail Inventory Method

• The retail inventory method is widely

employed by retail firms to arrive at reliable

estimates of inventory position whenever

desired

inventory amount without the time and

expense of taking a physical inventory or

maintaining detailed perpetual records.

Retail Inventory Method

Inventory, Jan 1 $30,000

$50,000 Purchases in January 30,000 40,000

Goods available for sale $60,000

Retail Inventory Method: Lower of

Cost or Market

LIFO Pools

To illustrate the formation of LIFO pools, the following data

are provided for Elohar Co., a seller of fine neckties:

LIFO Pools

If two types of neckties are accounted for

separately, computations of LIFO ending

inventory are as follows:

LIFO Pools

LIFO cost of goods sold:

Dollar-Value LIFO

Under dollar-value LIFO, LIFO layers

are determined based on total dollar

changes rather than quantity changes

With dollar-value LIFO, the unit of

measurement is the dollar

Dollar-Value LIFO

First, the replacement cost of ending

inventory is computed using prices prevailing

at the end of the period

The beginning inventory was $22,000, so

there was an increase in inventory during the period

To determine if a new LIFO layer was added,

we need to find out what the value of the

beginning inventory would be at ending

prices

Dollar-Value LIFO

After adjusting for price increases during the year, we can see that the dollar value of

inventory increased

Dollar-Value LIFO

Finally, dollar-value LIFO ending inventory is computed as follows:

Dollar-Value LIFO

Dollar-Value LIFO Retail

Method

The following is the LIFO retail layer data for Miracle Max Department Store as of

December 31

Dollar-Value LIFO Retail

Method

Purchase Commitments

• Extreme fluctuations in the price of

inventory purchases can expose a company

to excessive risk

• Of the different ways to manage this risk, the

simplest is a purchase commitment that

locks in the inventory purchase price in

advance

Purchase Commitments

Rollins Oat Company entered into a purchase

commitment on November 1, 2010, for 100,000 bushes of wheat at $3.40 per bushel to be

delivered on March 2011 At the end of 2010, the market price for wheat had dropped to $3.20 per bushel

Purchase Commitments

2010

Estimated Loss on Purchase Commitments

Foreign Currency Inventory

Transactions

On November 1, 2010, Washington Company purchased inventory from Swiss Company and the invoice was denominated in Swiss francs with a purchase price of 50,000 francs At the time, the spot rate was 5 francs per U.S dollar

Foreign Currency Inventory

Transactions

Washington Company would make the

following journal entry to record the purchase

2010

Accounts Payable (fc) 10,000

(50,000 francs/5 = $10,000)

Foreign Currency Inventory

$50,000/4.7

Foreign Currency Inventory

Transactions

If the spot rate on December 31, 2010 is 4.8

francs per dollar, the following adjusting entry

is needed:

2010

Accounts Payable (fc) 417

($50,000/4.8) − $10,000

$50,000/4.7