Intructor manual intermediate accounting 15th kiesoch08

A Cost of Goods Sold account is used to accumulate theissuances from inventory.. The computation of cost of goods sold is made byadding beginning inventory to net purchases and then subt

CHAPTER 8 Valuation of Inventories: A Cost-Basis Approach

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Brief

Concepts for Analysis

1 Inventory accounts;

determining quantities,

costs, and items to be

included in inventory;

the inventory equation;

balance sheet disclosure.

ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives

Brief

1 Identify major classifications of inventory 1

2 Distinguish between perpetual and periodic

inventory systems.

2 4, 9, 13, 16,

17, 18, 20

4, 5, 6

3 Determine the goods included in inventory and the

effects of inventory errors on the financial

5 Describe and compare the cost flow assumptions

used to account for inventories.

5, 6, 7 13, 14, 15,

16, 17, 18,

19, 20, 22

1, 4, 5, 6, 7

6 Explain the significance and use of a LIFO reserve 21

7 Understand the effect of LIFO liquidations.

8 Explain the dollar-value LIFO method 8, 9 22, 23, 24,

ASSIGNMENT CHARACTERISTICS TABLE

Time (minut es)

E8-1 Inventoriable costs Moderate 15–20 E8-2 Inventoriable costs Moderate 10–15 E8-3 Inventoriable costs Simple 10–15 E8-4 Inventoriable costs—perpetual Simple 10–15 E8-5 Inventoriable costs—error adjustments Moderate 15–20 E8-6 Determining merchandise amounts—periodic Simple 10–20 E8-7 Purchases recorded net Simple 10–15 E8-8 Purchases recorded, gross method Simple 20–25 E8-9 Periodic versus perpetual entries Moderate 10–15 E8-10 Inventory errors, periodic Simple 10–15 E8-11 Inventory errors Simple 10–15 E8-12 Inventory errors Moderate 15–20 E8-13 FIFO and LIFO—periodic and perpetual Moderate 15–20 E8-14 FIFO, LIFO and average cost determination Moderate 20–25 E8-15 FIFO, LIFO, average cost inventory Moderate 15–20 E8-16 Compute FIFO, LIFO, average cost—periodic Moderate 15–20 E8-17 FIFO and LIFO—periodic and perpetual Simple 10–15 E8-18 FIFO and LIFO; income statement presentation Simple 15–20 E8-19 FIFO and LIFO effects Moderate 15–20 E8-20 FIFO and LIFO—periodic Simple 10–15 E8-21 LIFO effect Moderate 10–15 E8-22 Alternate inventory methods—comprehensive Moderate 25–30 E8-23 Dollar-value LIFO Simple 5–10 E8-24 Dollar-value LIFO Simple 15–20 E8-25 Dollar-value LIFO Moderate 20–25 E8-26 Dollar-value LIFO Moderate 15–20

P8-1 Various inventory issues Moderate 30–40 P8-2 Inventory adjustments Moderate 25–35 P8-3 Purchases recorded gross and net Simple 20–25 P8-4 Compute FIFO, LIFO, and average cost Complex 40–55 P8-5 Compute FIFO, LIFO, and average cost Complex 40–55 P8-6 Compute FIFO, LIFO, and average cost—periodic

and perpetual.

Moderate 25–35

P8-7 Financial statement effects of FIFO and LIFO Moderate 30–40 P8-8 Dollar-value LIFO Moderate 30–40 P8-9 Internal indexes—dollar-value LIFO Moderate 25–35 P8-10 Internal indexes—dollar-value LIFO Complex 30–35 P8-11 Dollar-value LIFO Moderate 40–50

ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Time (minut es)

CA8-1 Inventoriable costs Moderate 15–20 CA8-2 Inventoriable costs Moderate 15–25 CA8-3 Inventoriable costs Moderate 25–35 CA8-4 Accounting treatment of purchase discounts Simple 15–25 CA8-5 General inventory issues Moderate 20–25 CA8-6 LIFO inventory advantages Simple 15–20 CA8-7 Average cost, FIFO, and LIFO Simple 15–20 CA8-8 LIFO application and advantages Moderate 25–30 CA8-9 Dollar-value LIFO issues Moderate 25–30 CA8-10 FIFO and LIFO Moderate 30–35 CA8-11 LIFO Choices—Ethical Issues Moderate 20–25

LEARNING OBJECTIVES

1 Identify major classifications of inventory

2 Distinguish between perpetual and periodic inventory systems

3 Determine the goods included in inventory and the effects of inventory errors on thefinancial 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

CHAPTER REVIEW

1 Careful attention is given to the inventory account by many business organizations because

it represents one of the most significant assets held by an enterprise Inventories are ofparticular importance to merchandising and manufacturing companies because theyrepresent the primary source of revenue for these organizations Inventories are alsosignificant because of their impact on both the balance sheet and the income statement.Chapter 8 initiates the discussion of the basic issues involved in recording, costing, andvaluing items classified as inventory

Inventory Issues

2 (L.O 1) Inventories are asset items that a company holds for sale in the ordinary course 

of business, or goods that it will use or consume in the production of goods to be sold

Merchandise inventory refers to the goods held for resale by a merchandising concern.

The inventory of a manufacturing firm is composed of three separate accounts representing stages of completion: raw materials, work in process, and finished

goods.

3 (L.O 2) Inventory records may be maintained on a perpetual or periodic inventory system 

basis A perpetual inventory system provides a means for generating up-to-date records

related to inventory quantities Under this inventory system, data are available at any timerelative to the quantity of material or type of merchandise on hand and the related cost In aperpetual inventory system, purchases and sales of goods are recorded directly in theInventory account as they occur A Cost of Goods Sold account is used to accumulate theissuances from inventory The balance in the Inventory account at the end of the yearshould represent the ending inventory cost

4 When inventory is accounted for on a periodic inventory system, the acquisition of

inventory is debited to a Purchases account Cost of goods sold must be calculated when

a periodic inventory system is in use The computation of cost of goods sold is made byadding beginning inventory to net purchases and then subtracting ending inventory.Ending inventory is determined by a physical count at the end of the year under a periodicinventory system Even in a perpetual inventory system, a physical inventory count atyear-end is normally taken due to the potential for loss, error, or shrinkage of inventoryduring the year

5 Inventory planning and control is of vital importance to the success of a merchandising

or manufacturing concern If an excessive amount of inventory is accumulated, there isthe danger of loss owing to obsolescence If the supply of inventory is inadequate, thepotential for lost sales exists This dilemma makes inventory an asset to which manage-ment must devote a great deal of attention

6 Reconciliation between the recorded inventory amount and the actual amount of

inventory on hand is normally performed at least once a year This is called a physical

inventory and involves counting all inventory items and comparing the amount counted

with the amount shown in the detailed inventory records Any errors in the records arecorrected to agree with the physical count

7 The cost of goods sold during any accounting period is defined as all the goods

available for sale during the period less any unsold goods on hand at the end of the

period (ending inventory) The process of computing cost of goods sold is complicated

by the determination of (a) the physical goods to be included in inventory, (b) the costs to

be included in inventory, and (c) the cost flow assumption to be used

Physical Goods to be Included in Inventory

8 (L.O 3) Normally, goods are included in inventory when they are received from thesupplier However, at the end of the period, proper accounting requires that all goods towhich the company has legal title be included in ending inventory Goods in transit at the

end of the period, shipped f.o.b shipping point, should be included in the buyer’s ending inventory If goods are shipped f.o.b destination, they belong to the seller until actually received by the buyer Inventory out on consignment belongs to the consignor’s

inventory

9 In actual practice a few exceptions exist regarding the general rule that inventory is recorded

by the company that has legal title to the merchandise These exceptions are known as

special sale agreements Two of the more common special sale agreements are (a) sales

with a buy back agreement and (b) sales with high rates of return

Effect of Inventory Errors

10 Errors in recording inventory can affect the balance sheet, the income statement, or both,because inventory is used in the preparation of both financial statements For example, thefailure to include certain inventory items in a year-end physical inventory count would result

in the following items being overstated (O) or understated (U): ending inventory (U); workingcapital (U); cost of goods sold (O); and net income (U) If merchandise was not recorded as

a purchase nor counted in the ending inventory, the result would be an under-statement ofinventory and accounts payable in the balance sheet and an understatement of purchasesand inventory in the income statement Net income would be unaffected by this omission aspurchases and ending inventory would be misstated by the same amount

Costs Included in Inventory

11 (L.O 4) Inventories are recorded at cost when acquired Cost in terms of inventory 

acquisition includes all expenditures necessary in acquiring the goods and converting

them to a saleable condition Product costs are those costs that “attach” to the inventory

and are recorded in the inventory account These costs include freight charges on goodspurchased, other direct costs of acquisition, and labor and other production costs incurred

in processing the goods up to the time of sale Period costs, such as selling expenses

and general and administrative expenses, are not considered inventoriable costs Thereason these costs are not included as a part of the inventory valuation concerns the factthat, in most instances, these costs are unrelated to the immediate production process

12 The accounting profession allows for the capitalization of interest costs related to assetsconstructed for internal use or assets produced as discrete projects (such as ships or realestate projects) for sale or lease In the case of inventories that are routinely manufac-tured or produced in large quantities on a repetitive basis, interest costs should not becapitalized

Purchase Discounts

13 When purchases are recorded net of discounts, failure to pay within the discount period

results in the treatment of lost discounts as a financial expense If the gross method is

used, purchase discounts should be reported as a deduction from purchases on the

income statement If the net method is used, purchase discounts lost should be

con-sidered a financial expense and reported in the “other expense and loss” section of theincome statement

Cost Flow Assumptions

14 (L.O 5) Determining the specific cost of inventory items that have been sold as well asthose remaining in ending inventory is sometimes a difficult process This is due, in part,

to the fact that there is no requirement that the cost flow assumption adopted beconsistent with the physical flow of the goods through the inventory account Thus, it isimportant when accounting for inventory costs that a company make consistent use of acost flow assumption The major objective in selecting a method should be to choose theone which most clearly reflects periodic income

15 Inventory cost flow assumptions include (a) specific identification, (b) average cost, (c)first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO It should beremembered that these assumptions relate to the flow of costs and not the physical flow

of inventory items into and out of the company

16 Specific identification calls for identifying each item sold and each item in inventory.

The costs of the specific items sold are included in cost of goods sold, and the costs of

the specific items on hand are included in inventory The average cost method prices

items in the inventory on the basis of the average cost of all similar goods availableduring the period

FIFO

17 Use of the FIFO inventory method assumes that the first goods purchased are the first

used or sold In all cases where FIFO is used, the inventory and cost of goods sold will bethe same amount at the end of the month whether a perpetual or periodic system is used

A major advantage of the FIFO method is that the ending inventory is stated in terms of

an approximate current cost figure However, because FIFO tends to reflect current costs

on the balance sheet, a basic disadvantage of this method is that current costs are notmatched against current revenues on the income statement

LIFO

18 Use of the LIFO inventory method assumes that the most recent inventory costs are the

first costs recognized as goods manufactured or sold When inventory records are kept

on a periodic basis, the ending inventory is priced by using the total units as a basis of

computation, disregarding the exact dates of purchases The calculation of endinginventory and cost of goods sold changes somewhat when the LIFO method is used in

connection with perpetual inventory records.

LIFO Reserve

19 (L.O 6) Many companies use LIFO for tax and external reporting purposes, but maintain 

a FIFO, average cost, or standard cost system for internal reporting purposes Thedifference between the inventory method used for internal reporting purposes and LIFO is

referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve The change in the allowance balance from one period to the next is the LIFO effect.

LIFO Liquidation

20 (L.O 7) When the LIFO inventory method is used, many companies combine inventory 

items into natural groups or pools Each pool is assumed to be one unit for the purpose

of costing the inventory Any increment above beginning inventory is normally identified

as a new inventory layer and priced at the average cost of goods purchased during theyear When inventory levels decrease, the most recently added inventory layer is the first

layer eliminated (last-in, first-out) The specific-goods pooled LIFO approach reduces

record keeping and, accordingly, LIFO liquidations, which causes the cost of utilizing theLIFO inventory method to decline

Dollar-Value LIFO

21 (L.O 8) Use of the specific-goods pooled approach can result in problems for companies 

that often change the mix of their products, materials, and production methods To

overcome these problems, the dollar-value LIFO method has been developed The

important feature of the dollar-value LIFO method is that increases and decreases in apool are determined and measured in terms of total dollar value, not the physical quantity

of the goods as is done in the traditional LIFO pool approach

22 In computing inventory under the dollar-value LIFO method, the ending inventory is firstpriced at the most current cost Current cost is then restated to prices prevailing when

LIFO was adopted This is accomplished by using a price index A new inventory layer is

formed when the ending inventory, stated in base-year costs, exceeds the base-yearcosts of beginning inventory Increases are priced at current cost If the ending inventory,stated at base-year costs, is less than beginning inventory, the decrease is subtractedfrom the most recently added layer The dollar-value method is a more practical way ofvaluing a complex, multiple-item inventory than the traditional LIFO method

23 A price index for the current year is computed by using the double-extension method by

dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory for

the Period at Base-Year Costs.

Advantages and Disadvantages of LIFO

24 (L.O 9) Proponents of the LIFO method advocate its use on the basis of its (a) proper 

matching of recent costs with current revenue, (b) tax benefits, (c) improved cash flow,and (d) future earnings hedge Those opposed to the LIFO method claim that it (a) lowersreported earnings in periods of rising prices, (b) reports outdated costs on the balance

sheet, (c) is contrary to normal physical flow, (d) creates involuntary liquidation problems,and (e) invites poor buying habits.

Selection of Inventory Method

25 (L.O 10) LIFO is generally preferable to FIFO when: (a) selling prices and revenues have 

been increasing faster than costs, and (b) LIFO has been traditional, such as its use bydepartment stores and industries where a fairly constant “base stock” is present LIFOwould not be preferable when: (a) prices tend to lag behind costs, (b) specific identi-fication is traditional, and (c) unit costs tend to decrease as production increases, therebynullifying the tax benefit that LIFO might provide

LECTURE OUTLINE

This chapter can be covered in three to four class sessions Students should have previousexposure to inventory accounting topics except for dollar-value LIFO and the modifiedperpetual system (perpetual records kept in units only)

A (L.O 1) Inventory Classification. 

1 Among the most significant assets of many enterprises, inventories are asset items heldfor sale in the ordinary course of business, or goods that will be used or consumed inthe production of goods to be sold

2 For manufacturing companies the inventory amount is separated into raw materials,work in process, and finished goods

a A Supplies Inventory account is often used for indirect materials

B (L.O 2) Inventory Cost Flow. 

1 Flow of costs—Beginning inventory plus the cost of goods purchased equals the cost

of goods available for sale The cost of goods available for sale consists of the cost ofgoods sold plus the cost of the ending inventory

T EACHING T IP

Contrast the accounting procedures under the perpetual and periodic inventory systems by

using Illustration 8-1 This example is based on Illustration 8-4 in the textbook.

in the Inventory account (perpetual record kept in units and dollars) The changes ininventory are continually tracked

or temporary) account The balance in the Inventory account remains unchangedduring the period No record is kept at the time of sale of the number or cost of theunits sold At the end of the period, the quantity of goods on hand is determined byphysical count and the cost per unit is assigned to each item in ending inventory todetermine the ending inventory cost Cost of goods sold is determined by adding thebeginning inventory to the purchases and deducting the ending inventory

the Inventory account The cost of sales is not recorded at the time of sale, but

a record is kept of the number of units sold (perpetual record kept in units only).

5 Inventory control—Because all companies need inventory verification, a physical

inventory which involves an actual inventory count, should be performed at least onceannually