Title: Chapter 8: Valuation of Inventories: A Cost Basis Approach
1Chapter 8 Valuation of Inventories A Cost Basis
Approach
2Introduction
- Inventory info important to investors
- Inventories rising faster than sales
- Consumers spending less
- Markdowns made less profit
- Manufactures
- Increases in RM WIP building inventory to
meet increased demand
3Inventory Classification
- Inventory consists of
- Finished goods held for sale in the ordinary
course of business - Manufactured
- RM, DL OH
- Purchased
- Goods held or consumed in the production of
finished goods - Raw materials
- WIP
- RM, DL OH
4Inventory Cost Flows
Merchandising Operations
5Flow of Costs through Manufacturing and
Merchandising Companies
6Inventory Control
- Inventory control is important for
- Ensuring availability of inventory items
- Preventing excessive accumulation of inventory
items - Just in time systems
- Perpetual system
- Maintains continuous record of inventory changes
- Periodic system
- Updates inventory records only periodically
- Modified perpetual system
- Continuously updates only inventory quantities
- Any system requires periodic actual count
- At least annually
7Inventory Systems
Perpetual Method
Periodic Method
- Purchases are debited to Inventory account
- Freight-in, Purch. R A and Purch. Disc. are
recorded in Inventory account. - Debit COGS and credit Inventory account for each
sale.
- Purchases are debited to Purchases account.
- Freight-in, Purch. R A and Purch. Disc. are
recorded in their respective accounts. - COGS is computed only periodically
- COGAS
- - Ending Inventory
- COGS
8Inventory Issues
- Physical goods to include
- Who owns?
- Costs to include
- Product vs. period costs
- Cost flow assumption to use
- LIFO, FIFO, weighted average, etc.
9Items to be Included in Inventory
- Legal title to goods typically determines
inclusion - Sellers inventory
- Goods in transit (FOB Destination)
- Title passes at destination
- Goods on consignment with consignee
- Goods sold under buy back agreements
- Goods sold with high rates of return
- Installment sales (if bad debts can not be
estimated)
10Special Sales Agreements
- Legal title underlying substance do not match
- Sales with buyback parking
- Agreement to repurchase at set price covering all
costs inventory liability to seller - Sales with high rates of return
- Seller records as sold when return amount
reasonably estimable - Sales on installment
- Exclude from sellers inventory if bad debts
reasonably estimable
11Guidelines for Determining Ownership
12Effect of Inventory Errors
Error in Effect on Effect on Ending
Income Balance sheet Inventory
Items Items
Under- COGS (over) Inventory
(under) stated Net income (under)
Retained Earn (under)
Over- COGS (under) Inventory
(over) stated Net income (over) R/E
(over)
13Costs Included in Inventory
- Generally accounted for on a cost basis
- Product costs
- Inventoriable costs directly related to
inventroy acquisition or production - Freight, acquisition costs, DL, OH
- Period costs
- Not inventoriable costs - not directly related to
inventory acquisition or production - Selling, GA
- Abnormal inventory costs
- Not inventoriable costs period costs
- Idle capacity, spoilage, double freight,
re-handling, etc.
14Costs Included in Inventory
- Purchase discounts
- Gross method
- Report as deduction from purchases (IS)
- Net method
- Discounts lost financial expense (other section
of IS) - Preferred
- Correct reporting of cost of asset related
liability - Measures inefficiency (discounts not taken)
- Cost-benefit issues lessen use
15Cost Flow Assumptions
- Objective most clearly reflect periodic income
- Cost flow assumptions need not be consistent with
physical flow of goods - The cost (NOT goods) flow assumptions
- Specific identification
- Average cost
- Weighted average
- Moving average
- First-in, first-out (FIFO) and
- Last-in, first-out (LIFO)
- Specific goods LIFO
- Specific goods pooled LIFO
- Dollar-value LIFO
16Cost Flow Assumptions
- Specific identification
- Each item sold in inventory
- Conceptually ideal method
- Makes income manipulation possible
- Average cost
- Based on average cost of all similar goods
- Use moving average for perpetual records
- Practically ideal method
- Simple, objective not subject to manipulation
17Cost Flow Assumptions
- First-in, first-out (FIFO) BS focus
- Goods used in order purchased
- Approximates physical flow of goods
- EI most recent purchases
- Rapid inventory turnover
- Reasonable proxy for replacement cost
- No changes since most recent purchases
- EI COGS same for perpetual periodic
- Income manipulation not permitted
- DOES NOT match current costs revenues on IS
- Oldest costs charged distort GP NI
18Cost Flow Assumptions
- Last-in, first-out (LIFO) IS focus
- Matches last costs to revenues
- First costs EI
- DOES NOT approximate flow of goods
- Different EI COGS for perpetual periodic (pg.
383) - Periodic matches withdrawals purchases
- Perpetual matches withdrawals with immediately
preceding purchase
19Cost Flow Assumptions Example
- Susieworld reports the following transactions
for 2004 - Date Purchases Purchase Cost
- May 12 100 units 1,000
- Aug 14 200 units 2,200
- Sep 18 120 units 1,800
- 420 units 5,000
- On December 31, the company had 20 units on hand
and uses the periodic inventory system. - What are the cost of goods sold and the cost of
ending inventory?
20Average (Weighted) Method
Given Data Date Purchases Cost May
12 100 units 1,000 Aug 14 200
units 2,200 Sep 18 120 units 1,800 420
units 5,000
- Steps
- Calculate per unit average cost
- 5,000/420 11.905
- Apply per unit average cost to units sold to get
COGS - 400 x 11.905 4,762
- Apply the per unit average cost to units
remaining in inventory to determine ending
inventory - 20 x 11.91 238
21First-In, First-Out (FIFO) Method
Cost of goods sold (FIFO) 1,000 (100
sold) 2,200 (200 sold) 1,500 (100 sold 20
end inv) 4,700
Given data Date Purchases
Cost May 12 100 units _at_ 10 1,000 Aug 14
200 units _at_ 11 2,200 Sep 18 120 units _at_
15 1,800 420 5,000
22Last-In, First-Out (LIFO) Method
Cost of goods sold (LIFO) 800 (80 sold 20,
end inv) 2,200 (200 sold) 1,800 (120
sold) 4,800
Given data Date Purchases
Cost May 12 100 units _at_ 10 1,000 Aug 14
200 units _at_ 11 2,200 Sep 18 120 units _at_
15 1,800 420 5,000
23Cost Flow Assumptions Notes
- The ending inventory in units is the same in all
three methods - Cost is different.
- COGS cost of ending inventory are different
- Cost of goods available is same in all three
methods - LIFO would result in the smallest reported net
income (with rising prices) - Last costs in first costs out
24LIFO Reserve
- LIFO Reserve (Allowance) account is used when
- LIFO is used for external reporting AND
- Non-LIFO basis is used for internal reporting
- An Allowance to Reduce Inventory to LIFO is used
to reduce the cost to a LIFO basis - LIFO Effect is change in LIFO allowance from
period to period - Must disclose either
- LIFO reserve OR
- Inventory replacement cost
25LIFO Reserve Example
Jeppo Inc reports the following balances
Inventory (FIFO basis) on Dec 31, 2004 50,000
Inventory (LIFO basis) on Dec 31, 2004 20,000
Adjust the cost of ending inventory to the LIFO
basis
Balance Sheet (Assets) Inventory (FIFO)
50,000 less Allowance to Reduce
Inventory (30,000) Inventory (LIFO) basis
20,000
26LIFO Layers
- Under LIFO a business may build up layers of
inventory from prior periods - A layer liquidation occurs when
- Earlier costs are matched against current sales
- Such matching results in distorted income
27Methods to Alleviate Layer Liquidation Problems
- Specific goods pooled LIFO approach
- Pool is a combination of similar items
- Reductions in one item compensated by increases
in other items (liquidations less likely) - Must continually re-define pools for changes
- Dollar-value LIFO
- Changes in pools are determined in terms of
dollars, not quantities - Broader range of goods included in pool
- Protects layers from erosion
- Replacement permitted
- Similar material
- Similar in use
- Interchangeable
28Dollar Value LIFO Example
- Given
- Base layer (12/31/X3) 20,000
- Inventory (current prices) on 12/31/X4
26,400 - Prices increased 20 during X4
- Determine dollar value LIFO at 12/31/X4
29Dollar Value LIFO Example
Price increase, 20
12/31/X3
12/31/X4
30Dollar Value LIFO Notes
- When ending inventory (at base year prices) less
than beginning inventory (at base year prices) - Decrease must be subtracted from most recently
added layer - Once a layer is eliminated (peeled off), it
cannot be rebuilt - Price index selection
- CPI-U
- Other external
- Internal only if external not readily available
or relevant
31Advantages of LIFO Method
- Matches more recent costs with current revenues
- With increasing prices, yields lowest taxable
income (assuming inventory does not decrease) - With reduced taxes, cash flow is improved
- Need to write down inventory to market is less
- Future reported earnings not affected
substantially by future price declines
32Disadvantages of LIFO Method
- Does not approximate physical flow of goods
except in special situations - Yields lowest NI (reduced earnings when prices
rise) - Ending inventory understated relative to current
costs - LIFO involuntary liquidation may result in income
that is detrimental from a tax view - May cause poor buying habits (because of the
layer liquidation issue)
33Basis for Selection of Inventory Method
- Methods can vary by type of inventories
- Pricing method most suitable for company
- Used consistently
- Tax considerations
- Current future
- LIFO
- Selling prices revenues increase faster than
costs - Traditional for industry
- Department stores, refining, chemicals, glass
- Other than LIFO
- Prices lag costs
- Specific identification is traditional
- Autos, farm equipment, art, antique jewelry
- Unit costs decrease as production increases
34Ethics Inventory Method
- Earnings pressures
- External internal financial reports
- Purchasing at period end
- Debt covenants
- Current operating ratios, etc.
- Changes
- Methods
- Pools
- Perpetual periodic
35Class Exercises
- E8-2 E8-4
- E8-5 E8-7
- E8-8 E8-11
- E8-13 E8-14
- E8-16 E8-19
- E8-23 E8-25