Lecture Intermediate Accounting (13th edition) - Chapter 8: Valuation of inventories: A cost-basis approach

After completing this chapter you should be able to: Identify major classifications of inventory, distinguish between perpetual and periodic inventory systems, identify the effects of inventory errors on the financial statements, understand the items to include as inventory cost, describe and compare the cost flow assumptions used to account for inventories...and other contents.

Chapter 8-1

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:

Cost­Basis Approach

Valuation of Inventories:

Cost­Basis Approach

Chapter

8-5

Inventories are:

items held for sale, or goods to be used in the production of goods to be sold.

Inventory Issues

Inventory Issues

Illustration 8­2

800,000 Goods available for sale

900,000 Ending inventory

125,000 Cost of goods sold

$ 775,000

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 write­down is as follows.

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

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 8­5

The  costs to include  (product vs. period costs).

The  cost flow assumption  (FIFO, LIFO, Average cost, Specific  Identification, Retail, etc.).

Valuation requires determining

Effect of Inventory Errors

Illustration:   Jay Weiseman Corp. understates its ending inventory by $10,000 in 2009;  all other items are correctly stated.

Illustration 8­8

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 

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

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

“First­In­First­Out (FIFO)”

Sales $ 90 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

“First­In­First­Out (FIFO)”

LO 5 Describe and compare the cost flow assumptions used to 

account for inventories.

Sales $ 90 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

“Last­In­First­Out (LIFO)”

Sales $ 90 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

“Last­In­First­Out (LIFO)”

LO 5 Describe and compare the cost flow assumptions used to 

account for inventories.

Sales $ 90 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”

Sales $ 90 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.

Sales $ 90 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”

Sales $ 90 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

FIFO LIFO Average Sales $ 90 $ 90 $ 90 Cost of goods sold 10 20 15 Gross profit 80 70 75 Operating expenses:

Administrative 14 14 14 Selling 12 12 12 Interest 7 7 7 Total expenses 33 33 33 Income before taxes 47 37 42 Income tax expense 14 11 12 Net income $ 33 $ 26 $ 30

Cost Flow Assumptions

Cost Flow Assumptions

Specific Identification

Illustration:   Assume that Call­Mart 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 8­12

Weighted­Average

Average Cost

Illustration 8­14

In this method, Call­Mart computes a new average unit cost each time it  makes a purchase.

Moving­Average

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.

Periodic Method

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

purchases.

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Many companies use 

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

Special Issues Related to LIFO

LIFO Reserve  is the difference between the inventory method used for  internal reporting purposes and LIFO. 

Chapter

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Older, low cost inventory is sold resulting in a lower cost of goods sold, higher  net income, and higher taxes. 

Chapter

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Changes in a pool are measured in terms of total dollar value, not  physical quantity.

Specific­goods LIFO  ­ costing goods on a unit basis is expensive and  time consuming.

Specific­goods 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.

Dollar­value LIFO   is used by most companies.

Special Issues Related to LIFO

Special Issues Related to LIFO

Comparison of LIFO Approaches

Involuntary Liquidation / Poor  Buying Habits

Disadvantages

Chapter

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