Inventory accounting a comprehensive guide phần 6 pptx

The following example of the link-chain method assumes the same inventory information just used for the double-extension example. However, we have also noted the beginning inventory cost for each year and included the extended begin- ning inventory cost for each year, which facilitates calculations under the link-chain method. Extended at Extended at Ending Unit Beginning-of-Year End-of-Year Beginning-of-Year End-of-Year Year Quantity Cost/each Cost/Each Price Price 1 3,500 $— $32.00 $— $112,000 2 7,000 32.00 34.50 224,000 241,500 3 5,500 34.50 36.00 189,750 198,000 4 7,250 36.00 37.50 261,000 271,875 As was the case for the double-extension method, there is no index for year one, which is the base year. In year two, the index will be the extended year-end price of $241,500 divided by the extended beginning-of-year price of $224,000, or 107.8%. This is the same percentage calculated for year two under the double-extension method, because the beginning-of-year price is the same as the base price used under the double-extension method. We then determine the value of the year two inventory layer by first dividing the extended year-end price of $241,500 by the cumulative index of 107.8% to ar- rive at an inventory valuation restated to the base year cost of $224,026. We then subtract the year one base layer of $112,000 from the $224,026 to arrive at a new layer at the base year cost of $112,026, which we then multiply by the cumulative index of 107.8% to bring it back to current year prices. This results in a year two inventory layer of $120,764. At this point, the inventory layers are as follows: Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index Base layer $112,000 $112,000 0.0% Year 2 layer 112,026 120,764 107.8% Total $224,026 $232,764 — ———–– ———–– ———–– ———–– In year three, the index will be the extended year-end price of $198,000 divided by the extended beginning-of-year price of $189,750, or 104.3%. Because this is the first year in which the base year was not used to compile beginning-of-year costs, we must first derive the cumulative index, which is calculated by multiply- ing the preceding year’s cumulative index of 107.8% by the new year three index of 104.3%, resulting in a new cumulative index of 112.4%. By dividing year three’s extended year-end inventory of $198,000 by this cumulative index, we arrive at in- ventory priced at base year costs of $176,157. This is less than the amount recorded in year two, so there will be no inventory layer. Instead, we must reduce the inventory layer recorded for year two. To do so, LIFO, FIFO, and Average Costing / 117 c07_4353.qxd 11/29/04 9:25 AM Page 117 we subtract the base year layer of $112,000 from the $176,157 to arrive at a re- duced year two layer of $64,157 at base year costs. We then multiply the $64,157 by the cumulative index in year two of 107.8% to arrive at a inventory valuation for the year two layer of $69,161. At this point, the inventory layers and associated cumulative indexes are as follows: Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index Base layer $112,000 $112,000 0.0% Year 2 layer 64,157 69,161 107.8% Year 3 layer — — 112.4% Total $176,157 $181,161 — ———–– ———–– ———–– ———–– In year four, the index will be the extended year-end price of $271,875 divided by the extended beginning-of-year price of $261,000, or 104.2%. We then derive the new cumulative index by multiplying the preceding year’s cumulative index of 112.4% by the year four index of 104.2%, resulting in a new cumulative index of 117.1%. By dividing year four’s extended year-end inventory of $271,875 by this cumulative index, we arrive at inventory priced at base year costs of $232,173. We then subtract the preexisting base year inventory valuation for all previous layers of $176,157 from this amount to arrive at the base year valuation of the year four inventory layer, which is $56,016. Finally, we multiply the $56,016 by the cumu- lative index in year four of 117.1% to arrive at an inventory valuation for the year four layer of $62,575. At this point, the inventory layers and associated cumulative indexes are as follows: Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index Base layer $112,000 $112,000 0.0% Year 2 layer 64,157 69,161 107.8% Year 3 layer — — 112.4% Year 4 layer 56,016 62,575 117.1% Total $232,173 $243,736 — ———–– ———–– ———–– ———–– Compare the results of this calculation to those from the double-extension method. The indexes are nearly identical, as are the final LIFO layer valuations. The primary differences between the two methods is the avoidance of a base year cost determination for any new items subsequently added to inventory, for which a cur- rent cost is used instead. 7-6 Weighted-Average Inventory Valuation The weighted-average costing method is calculated exactly in accordance with its name—it is a weighted average of the costs in inventory. It has the singular advan- tage of not requiring a database that itemizes the many potential layers of inventory 118 / Inventory Accounting c07_4353.qxd 11/29/04 9:25 AM Page 118 at the different costs at which they were acquired. Instead, the weighted average of all units in stock is determined, at which point all of the units in stock are ac- corded that weighted-average value. When parts are used from stock, they are all issued at the same weighted-average cost. If new units are added to stock, then the cost of the additions are added to the weighted average of all existing items in stock, which will result in a new, slightly modified weighted average for all of the parts in inventory (both the old and new ones). This system has no particular advantage in relation to income taxes, because it does not skew the recognition of income based on trends in either increasing or de- clining costs. This makes it a good choice for those organizations that do not want to deal with tax planning. It is also useful for small inventory valuations, where there would not be any significant change in the reported level of income even if the LIFO or FIFO methods were to be used. Exhibit 7-3 illustrates the weighted-average calculation for inventory valuations, using a series of 10 purchases of inventory. There is a maximum of one purchase per month, with usage (reductions from stock) also occurring in most months. Each of the columns in the exhibit show how the average cost is calculated after each pur- chase and usage transaction. We begin the illustration with the first row of calculations, which shows that we have purchased 500 units of item BK0043 on May 3, 2003. These units cost $10 per unit. During the month in which the units were purchased, 450 units were sent to production, leaving 50 units in stock. Because there has been only one pur- chase thus far, we can easily calculate, as shown in column 7, that the total inven- tory valuation is $500, by multiplying the unit cost of $10 (in column 3) by the number of units left in stock (in column 5). So far, we have a per-unit valuation of $10. Next we proceed to the second row of the exhibit, where we have purchased an- other 1,000 units of BK0043 on June 4, 2003. This purchase was less expensive, be- cause the purchasing volume was larger, so the per-unit cost for this purchase is only $9.58. Only 350 units are sent to production during the month, so we now have 700 units in stock, of which 650 are added from the most recent purchase. To determine the new weighted-average cost of the total inventory, we first determine the ex- tended cost of this newest addition to the inventory. As noted in column 7, we arrive at $6,227 by multiplying the value in column 3 by the value in column 6. We then add this amount to the existing total inventory valuation ($6,227 plus $500) to arrive at the new extended inventory cost of $6,727, as noted in column 8. Finally, we divide this new extended cost in column 8 by the total number of units now in stock, as shown in column 5, to arrive at our new per-unit cost of $9.61. The third row reveals an additional inventory purchase of 250 units on July 11, 2003, but more units are sent to production during that month than were bought, so the total number of units in inventory drops to 550 (column 5). This inventory reduction requires no review of inventory layers, as was the case for the LIFO and FIFO calculations. Instead, we simply charge off the 150-unit reduction at the av- erage per-unit cost of $9.61. As a result, the ending inventory valuation drops to $5,286, with the same per-unit cost of $9.61. Thus, reductions in inventory quanti- LIFO, FIFO, and Average Costing / 119 c07_4353.qxd 11/29/04 9:25 AM Page 119 120 Exhibit 7-3 Weighted-Average Costing Valuation Example Average Costing Part Number BK0043 Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Net Net Change Extended Extended Average Date Quantity Cost per Monthly Inventory in Inventory Cost of New Inventory Inventory Purchased Purchased Unit Usage Remaining During Period Inventory Layer Cost Cost/Unit 05/03/03 500 $10.00 450 50 50 $500 $500 $10.00 06/04/03 1,000 $9.58 350 700 650 $6,227 $6,727 $9.61 07/11/03 250 $10.65 400 550 –150 $0 $5,286 $9.61 08/01/03 475 $10.25 350 675 125 $1,281 $6,567 $9.73 08/30/03 375 $10.40 400 650 –25 $0 $6,324 $9.73 09/09/03 850 $9.50 700 800 150 $1,425 $7,749 $9.69 12/12/03 700 $9.75 900 600 –200 $0 $5,811 $9.69 02/08/04 650 $9.85 800 450 –150 $0 $4,359 $9.69 05/07/04 200 $10.80 0 650 200 $2,160 $6,519 $10.03 09/23/04 600 $9.85 750 500 –150 $0 $5,014 $10.03 c07_4353.qxd 11/29/04 9:25 AM Page 120 ties under the average costing method require little calculation—just charge off the requisite number of units at the current average cost. The remaining rows of the exhibit repeat the concepts just noted, alternately adding units to and deleting them from stock. Although there are several columns noted in this exhibit that one must examine, it is really a simple concept to under- stand and work with. The typical computerized accounting system will perform all of these calculations automatically. 7-7 Specific Identification Method When each individual item of inventory can be clearly identified, it is possible to create inventory costing records for each one, rather than summarizing costs by general inventory type. This approach is rarely used, because the amount of paper- work and effort associated with developing unit costs is far greater than under all other valuation techniques. It is most applicable in businesses such as home con- struction, where there are few units of inventory to track, and where each item is truly unique. LIFO, FIFO, and Average Costing / 121 c07_4353.qxd 11/29/04 9:25 AM Page 121 c07_4353.qxd 11/29/04 9:25 AM Page 122 123 8 The Lower of Cost or Market Calculation 8-1 Introduction A key aspect of generating an inventory valuation is the concept of the lower of cost or market. Under this concept, a company is required to recognize an addi- tional expense in its cost of goods sold in the current period for any of its inven- tory whose replacement cost (subject to certain restrictions) has declined below its carrying cost. If the market value of the inventory subsequently rises back to or above its original carrying cost, its recorded value cannot be increased back to the original carrying amount. The basis for this concept is contained within Statements 5 through 7 in Chapter 4 of Accounting Research Bulletin Number 43. Statement 5 notes that when the util- ity (as indicated by damage, obsolescence, and so forth) of a good falls below its recorded cost, one must recognize a loss for the full amount of the difference in the current period. Statement 6 defines “market” as the current replacement cost of an inventory item, except that the resulting market cost cannot be less than the item’s net realizable value less a normal profit margin, nor can it exceed the net realizable value less any completion and disposal costs. Statement 7 notes that the lower of cost or market rule can be applied either to individual items, groups of inventory, or the inventory as a whole; the application method chosen should be the one resulting in the most close approximation to pe- riodic income. Statement 7 has been the cause of considerable interpretation, be- cause its application to a large inventory group presents the possibility (allowed within Discussion Note 12 to the Statement) that a company can offset losses on reduced-utility items against gains experienced by increased-utility items within the same inventory group, resulting in no write-down of the total inventory valuation, as long as the offsetting items are in “balanced” quantities. However, in practice, the use of inventory groups for lower of cost or market calculations is unusual and so is not addressed further within this chapter. Discussion Note 14 accompanying State- ment 7 also suggests that large write-downs caused by application of the lower of cost or market rule can be itemized separately from the cost of goods sold within the income statement. c08_4353.qxd 11/29/04 9:26 AM Page 123 The remainder of this chapter explores the practical application of the lower of cost or market rule. 8-2 Applying the Lower of Cost or Market Rule 1 The lower of cost or market (LCM) calculation means that the cost of inventory cannot be recorded higher than its replacement cost on the open market; the re- placement cost is bounded at the high end by its eventual selling price, less costs of disposal, nor can it be recorded lower than that price, less a normal profit per- centage. The concept is best demonstrated with the four scenarios listed in the fol- lowing example: Completion/ Upper Lower Existing Market Selling Selling Price Normal Price Inventory Replacement Value Item Price Cost Boundary Profit Boundary Cost Cost (1) (2) LCM A $15.00 $4.00 $11.0 $2.20 $8.80 $8.00 $12.50 $11.00 $8.00 B 40.15 6.00 34.15 5.75 28.40 35.00 34.50 34.15 34.15 C 20.00 6.50 13.50 3.00 10.50 17.00 12.00 12.00 12.00 D 10.50 2.35 8.15 2.25 5.90 8.00 5.25 5.90 5.90 (1) The cost at which an inventory item could be purchased on the open market. (2) Replacement cost, bracketed by the upper and lower price boundaries. In the example, the numbers in the first six columns are used to derive the upper and lower boundaries of the market values that will be used for the LCM calculation. By subtracting the completion and selling costs from each product’s selling price, we establish the upper price boundary (in bold) of the market cost calculation. By then subtracting the normal profit from the upper cost boundary of each product, we establish the lower price boundary. Using this information, the LCM calculation for each of the listed products is as follows: Product A, replacement cost higher than existing inventory cost. The market price cannot be higher than the upper boundary of $11, which is still higher than the existing inventory cost of $8. Thus, the LCM is the same as the existing in- ventory cost. Product B, replacement cost lower than existing inventory cost, but higher than upper price boundary. The replacement cost of $34.50 exceeds the upper price boundary of $34.15, so the market value is designated at $34.15. This is lower than the existing inventory cost, so the LCM becomes $34.15. 124 / Inventory Accounting 1 The contents of this section have been adapted with permission from p. 44 of Bragg, GAAP Implementation Guide, John Wiley & Sons, 2004. c08_4353.qxd 11/29/04 9:26 AM Page 124 Product C, replacement cost lower than existing inventory cost and within price boundaries. The replacement cost of $12 is within the upper and lower price boundaries, and so is used as the market value. This is lower than the existing inventory cost of $17, so the LCM becomes $12. Product D, replacement cost lower than existing inventory cost, but lower than lower price boundary. The replacement cost of $5.25 is below the lower price boundary of $5.90, so the market value is designated as $5.90. This is lower than the existing inventory cost of $8, so the LCM becomes $5.90. Whenever there is a calculated inventory write-down, use the following jour- nal entry to record the valuation reduction. Although this loss can be recorded within the general cost of goods sold account, the magnitude of LCM losses tend to be lost that way, so use the “Loss on Inventory Valuation” account to more con- spicuously record the information. Debit Credit Loss on inventory valuation xxx Raw materials inventory xxx Work-in-process inventory xxx Finished goods inventory xxx Although the sample journal entry shows a credit to specific inventory accounts, it is also acceptable to credit an inventory valuation account instead. 8-3 Enforcement of the LCM Rule Given the considerable amount of manual calculation required to determine if there is a loss under the LCM rule, few inventory accountants are interested in fol- lowing its dictates regularly. One of the better approaches to enforcement is to have the Board of Directors formally approve a company policy requiring at least an an- nual LCM review, and to then include this policy in the job description of the in- ventory accountant. An example of possible policy wording follows: Lower of cost or market calculations shall be conducted at least an- nually for the entire inventory. This policy may be modified to require more frequent reviews, based on the vari- ability of market rates for various inventory items. Even with a policy in place, the LCM calculation is only likely to be conducted at such infrequent intervals that the inventory accountant forgets how the calcula- tion was made in the past. Thus, there is a considerable risk that the calculations will be conducted differently each time, yielding inconsistent results. To avoid this problem, consider including in the accounting procedures manual a clear definition of the calculation to be followed. A sample procedure is shown in Exhibit 8-1. The Lower of Cost or Market Calculation / 125 c08_4353.qxd 11/29/04 9:26 AM Page 125 Exhibit 8-1 Lower of Cost or Market Procedure Use this procedure to periodically adjust the inventory valuation for those items whose market value has dropped below their recorded cost. 1. Export the extended inventory valuation report to an electronic spreadsheet. Sort it by declining extended dollar cost, and delete the 80% of inventory items that do not comprise the top 20% of inventory valuation. Sort the remaining 20% of inventory items by either part number or item description. Print the report. 2. Send a copy of the report to the materials manager, with instructions to compare unit costs for each item on the list to market prices, and be sure to mutually agree upon a due date for completion of the review. 3. When the materials management staff has completed its review, meet with the materials manager to go over its results and discuss any major adjustments. Have the materials management staff write down the valuation of selected items in the inventory database whose cost exceeds their market value. 4. Have the accounting staff expense the value of the write down in the accounting records. 5. Write a memo detailing the results of the lower of cost or market calculation. Attach one copy to the journal entry used to write down the valuation, and issue another copy to the materials manager. 126 / Inventory Accounting c08_4353.qxd 11/29/04 9:26 AM Page 126 [...]... used as the basis for allocation that not only comprises a larger share of total product cost, but that also relates to the incurrence of overhead costs Another criterion that is frequently overlooked is that the accounting or manufacturing system must have a means of accumulating information about this activity measure, so that the inventory accountant does not have to spend additional time manually... underlying data An example of an activity measure that generally fulfills these three criteria is machine hours, because standard machine hours are readily available in the bill of materials or labor routing for each product, many overhead costs are related to machine usage, and the proportion of machine time used per product is commonly greater than the proportion of direct labor An even better alternative... Related Activity Driver Facility costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Manufacturing costs Quality control costs Quality control costs Storage time (e.g., depreciation, taxes) Storage transactions (e.g., receiving) Amount... to the allocation measure, and so should not be allocated based on it Here are some of the costs stored in the overhead cost pool that have no relationship whatsoever to the most common allocation measure, direct labor: Building rent A better allocation is based on the square footage of the facility that the machinery and inventory storage areas related to a product line are using Building insurance... separate pools that can be allocated with similar allocation measures For example, computer services costs may be allocated to other cost pools based on the number of personal computers used, so any costs that can reasonably and logically be allocated based on the number of personal computers used should be stored in the same resource cost pool In a similar manner, we then store all remaining overhead... depreciation may be allocated 50% to a secondary cost pool, 40% to a batch-related primary cost pool, and 10% to a facility-related primary cost pool, because these percentages roughly reflect the number of personal computers located at various parts of the facility, which in turn is considered a reasonable means for spreading these costs among different cost pools There are varying levels of detailed analysis... the easiest and least accurate approach is to make a management decision to send a certain percentage of the total cost into each one A higher level of accuracy would require that the employees be split up into job categories, with varying percentages being allocated from each category Finally, the highest level of accuracy would require time tracking by employee, with a fresh recalculation after every... that makes products manufactured with automation look less expensive than they really are and those produced with manual labor look more expensive than they really are Another issue is that traditional cost allocation systems tend to portray lowvolume products as those with the highest profits This problem arises because the overhead costs associated with batch setups and teardowns, which can be a. .. when allocating costs The accounting literature has bemoaned the allocation of costs based on direct labor for many years The reason for this judgment is that direct labor makes up such a small component of total product cost that small swings in the direct labor component can result in a large corresponding swing in the amount of allocated overhead To avoid this issue, some other unit of activity can... alternative than the use of machine hours (or some similar single measure) as the basis for allocation is the use of multiple cost pools that are allocated with multiple activity measures This allows a company to (for example) allocate building costs based on the square footage taken up by each product, machine costs based on machine time used, labor costs based on direct labor hours used, and so on The main . year two layer of $69 , 161 . At this point, the inventory layers and associated cumulative indexes are as follows: Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index Base layer. cumulative indexes are as follows: Layer Type Base Year Valuation LIFO Layer Valuation Cumulative Index Base layer $112,000 $112,000 0.0% Year 2 layer 64 ,157 69 , 161 107.8% Year 3 layer — — 112.4% Year 4 layer. preexisting base year inventory valuation for all previous layers of $1 76, 157 from this amount to arrive at the base year valuation of the year four inventory layer, which is $ 56, 0 16. Finally, we