Chapter 8: Valuation of Inventories: A Cost Basis Approach

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Chapter 8 Valuation of Inventories A Cost Basis
Approach
Intermediate Accounting, 11th ed. Kieso,
Weygandt, and Warfield
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Flow of Costs through Manufacturing and
Merchandising Companies
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Inventory 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

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Guidelines for Determining Ownership
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Effect 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- C/G/sold (under) Inventory
(over) stated Net income (over) Retained
Earn (over)
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Costs Included in Inventory

• Generally accounted for on a cost basis.
• Product costs are inventoriable costs, whereas
• Period costs are not inventoriable costs

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Cost 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?

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Average (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 this 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

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First-In, First-Out (FIFO) Method
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
Cost of goods sold (FIFO) 1,000 (100
sold) 2,200 (200 sold) 1,500 (100 sold 20
end inv) 4,700
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Last-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
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LIFO Reserve

• LIFO Reserve (Allowance) account is used, when
• LIFO is used for external reporting and a
  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.

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LIFO 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
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LIFO Layers

• Under the LIFO approach, 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.

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Methods to Alleviate Layer Liquidation Problems

• Use the specific goods pooled LIFO approach a
  pool is a combination of similar items.
• reductions in one item, compensated by increases
  in other items.
• Use dollar-value LIFO where
• changes in pools are determined in terms of
  dollars, not quantities.

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Dollar Value LIFO Notes

• When the ending inventory (at base year prices)
  is less than the beginning inventory (at base
  year prices)
• the decrease must be subtracted from the most
  recently added layer.
• Once a layer is eliminated (peeled off), it
  cannot be rebuilt.

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Advantages of LIFO Method

• LIFO matches more recent costs with current
  revenues.
• With increasing prices, LIFO yields the lowest
  taxable income (assuming inventory does not
  decrease).
• With reduced taxes, cash flow is improved.
• Under LIFO, the need to write down inventory to
  market is lower.

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Disadvantages of LIFO Method

• LIFO does not approximate the physical flow of
  goods except in special situations.
• LIFO yields the lowest net income and therefore
  reduced earnings (when prices rise).
• Under LIFO, the ending inventory is understated
  relative to current costs.
• LIFO involuntary liquidation may result in income
  that is detrimental from a tax view.
• LIFO may cause poor buying habits (because of the
  layer liquidation problem).