Valuation Valuation of of Inventories: Inventories: A A Cost-Basis Cost-Basis Approach Approach Chapter Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Chapter 8-1 Prepared by Coby Harmon, University of California, Santa Barbara Learning Learning Objectives Objectives 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 Explain the significance and use of a LIFO reserve Understand the effect of LIFO liquidations Explain the dollar-value LIFO method Identify the major advantages and disadvantages of LIFO 10 Understand why companies select given inventory methods Chapter 8-2 Valuation Valuation of of Inventories: Inventories: Cost-basis Cost-basis Approach Approach Inventory Classification and Control Classification Control Basic inventory valuation issues Chapter 8-3 Physical Goods Included in Inventory Goods in transit Consigned goods Special sales agreements Inventory errors Costs Included in Inventory Product costs Period costs Purchase discounts Cost Flow Assumptions Specific identification Average cost FIFO LIFO LIFO: Special Issues LIFO reserve LIFO liquidation Dollar-value LIFO Comparison of LIFO approaches Advantages of LIFO Disadvantages of LIFO Basis for Selection Summary of inventory valuation methods Inventory Inventory Classification Classification and and Systems Systems Classification Inventories are: items held for sale, or goods to be used in the production of goods to be sold Businesses with Inventory: Merchandiser Chapter 8-4 or Manufacturer LO Identify major classifications of inventory Inventory Inventory Classification Classification and and Systems Systems Type of Business Merchandiser One inventory account Purchase goods ready for sale Chapter 8-5 Balance Sheet (in thousands) Current assets Cash Marketable securities Accounts receivable Merchandise inventory Prepaids Total current assets Investments: Invesment in ABC bonds Investment in UC Inc Notes receivable Land held for speculation Sinking fund Pension fund $ 285,000 530,000 149,000 777,000 33,000 1,774,000 321,657 253,980 150,000 550,000 225,000 653,798 LO Identify major classifications of inventory Inventory Inventory Classification Classification and and Systems Systems Type of Business Manufacturer Three accounts Raw materials Work in process Finished goods Chapter 8-6 LO Identify major classifications of inventory Inventory Inventory Classification Classification and and Systems Systems Flow of Costs Chapter 8-7 Illustration 8-2 LO Identify major classifications of inventory Inventory Inventory Classification Classification and and Systems Systems Control Two systems for maintaining inventory records: Perpetual system Periodic system Chapter 8-8 LO Distinguish between perpetual and periodic inventory systems Inventory Inventory Classification Classification and and Systems Systems Perpetual System Features: Purchases of merchandise are debited to Inventory Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory Cost of goods sold is debited and Inventory is credited for each sale Physical count done to verify Inventory balance The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold Chapter 8-9 LO Distinguish between perpetual and periodic inventory systems Inventory Inventory Classification Classification and and Systems Systems Periodic System Features: Purchases of merchandise are debited to Purchases Ending Inventory determined by physical count Calculation of Cost of Goods Sold: Beginning inventory $ 100,000 Purchases, net Chapter 8-10 800,000 Goods available for sale LO Distinguish between perpetual and periodic inventory systems Cost Cost Flow Flow Assumptions Assumptions Perpetual Inventory Transactions: Date Units Jun 300 Jun 10 (200) Jun 11 800 Jun 15 (500) Jun 20 500 Jun 27 (300) 600 Cost $ 10.00 10.00 12.00 11.78 13.00 12.46 Cost of Goods Sold: Beg inventory Purchases Goods available Ending inventory COGS Chapter 8-32 Total $ 3,000 (2,000) 9,600 (5,890) 6,500 (3,738) $ 7,472 + Moving Average Running Balances Average Units Cost Cost 300 $ 3,000 $ 10.00 100 1,000 10.00 900 10,600 11.78 400 4,710 11.78 900 11,210 12.46 600 7,472 12.46 Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase Units Dollars 300 $ 3,000 1,300 16,100 1,600 19,100 (600) (7,472) 1,000 $ 11,628 LO Describe and compare the cost flow assumptions used to account for inventories Cost Cost Flow Flow Assumptions Assumptions Perpetual Inventory Transactions: Date Units Jun 300 Jun 10 (200) Jun 11 800 Jun 15 (500) Jun 20 500 Jun 27 (300) 600 Cost $ 10.00 10.00 12.00 11.78 13.00 12.46 Cost of Goods Sold: Beg inventory Purchases Goods available Ending inventory COGS Chapter 8-33 Total $ 3,000 (2,000) 9,600 (5,890) 6,500 (3,738) $ 7,472 + Moving Average Running Balances Average Units Cost Cost 300 $ 3,000 $ 10.00 100 1,000 10.00 900 10,600 11.78 400 4,710 11.78 900 11,210 12.46 600 7,472 12.46 Cost per unit sold is determined by dividing total inventory $ by total units on hand after each purchase Units Dollars 300 $ 3,000 1,300 16,100 1,600 19,100 (600) (7,472) 1,000 $ 11,628 LO Describe and compare the cost flow assumptions used to account for inventories Cost Cost Flow Flow Assumptions Assumptions Periodic Inventory + FIFO Method FIFO: Transactions: Inventory Balance: Date Units Layer Layer Jun 300 Jun 10 (200) Jun 11 800 100 Jun 15 (500) Jun 20 500 Jun 27 (300) 100 Cost $ 10 $ 12 600 $ $ 1,200 Calculation of Cost of Goods Sold: Beg inventory Purchases Goods available Ending inventory COGS Chapter 8-34 Layer Total 500 $ $ 500 13 6,500 600 $ 7,700 Units Dollars 300 $ 3,000 1,300 16,100 1,600 19,100 (600) (7,700) 1,000 $ 11,400 LO Describe and compare the cost flow assumptions used to account for inventories Cost Cost Flow Flow Assumptions Assumptions Periodic Inventory + LIFO Method LIFO: Transactions: Inventory Balance: Date Units Layer Layer Jun 300 300 Jun 10 (200) Jun 11 800 300 Jun 15 (500) Jun 20 500 Jun 27 (300) 300 300 Cost $ 10 $ 12 600 $ 3,000 $ 3,600 Calculation of Cost of Goods Sold: Beg inventory Purchases Goods available Ending inventory COGS Chapter 8-35 Layer Total $ $ 600 13 - $ 6,600 Units Dollars 300 $ 3,000 1,300 16,100 1,600 19,100 (600) (6,600) 1,000 $ 12,500 LO Describe and compare the cost flow assumptions used to account for inventories Cost Cost Flow Flow Assumptions Assumptions Periodic Inventory Chapter 8-36 + Weighted Average LO Describe and compare the cost flow assumptions used to account for inventories Special Special Issues Issues Related Related to to LIFO LIFO LIFO Reserve Many companies use LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes Reasons: Pricing decisions Record keeping easier Profit-sharing or bonus arrangements LIFO troublesome for interim periods Chapter 8-37 LO Explain the significance and use of a LIFO reserve Special Special Issues Issues Related Related to to LIFO LIFO LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO FIFO value per books $160,000 Example: LIFO value 145,000 LIFO Reserve $ 15,000 Journal entry to reduce inventory to LIFO: Cost of goods sold LIFO reserve 15,000 15,000 Companies should disclose either the LIFO reserve or the replacement cost of the inventory Chapter 8-38 LO Explain the significance and use of a LIFO reserve Special Special Issues Issues Related Related to to LIFO LIFO LIFO Liquidation Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes Illustration 8-20 Chapter 8-39 LO Understand the effect of LIFO liquidations Special Special Issues Issues Related Related to to LIFO LIFO Dollar-Value LIFO Changes in a pool are measured in terms of total dollar value, not physical quantity Advantage: Broader range of goods in pool Permits replacement of goods that are similar Helps protect LIFO layers from erosion Chapter 8-40 LO Explain the dollar-value LIFO method Special Special Issues Issues Related Related to to LIFO LIFO Dollar-Value LIFO Exercise 8-26 The following information relates to the Jimmy Johnson Company Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005 Chapter 8-41 LO Explain the dollar-value LIFO method Special Special Issues Issues Related Related to to LIFO LIFO Exercise 8-26 Solution Inventory at Inventory at End-of-Year Base-Year Base Prices Layers Year 2003 2004 2005 Prices $ Index $ Value Index LIFO LIFO LIFO TOTAL Reserve 70,000 1.00 $ 70,000 $ 70,000 1.00 90,300 1.05 86,000 70,000 1.00 70,000 16,000 1.05 16,800 70,000 1.00 70,000 12,000 1.05 12,600 95,120 1.16 82,000 70,000 $ 70,000 $ - 86,800 3,500 82,600 12,520 Dec 31 2004 $ 90,300 (3,500) $ 86,800 Dec 31 2005 $ 95,120 (12,520) $ 82,600 Journal entry Cost of goods sold Lifo reserve 3,500 (3,500) 9,020 (9,020) Chapter 8-42 LO Explain the dollar-value LIFO method Balance Sheet Inventory LIFO Reserve Dec 31 2003 $ 70,000 $ 70,000 $ $ Value Special Special Issues Issues Related Related to to LIFO LIFO Comparison of LIFO Approaches Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming Specific-goods 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 Dollar-value LIFO is used by most companies Chapter 8-43 LO Explain the dollar-value LIFO method Special Special Issues Issues Related Related to to LIFO LIFO Advantages Matching Reduced earnings Tax Benefits/Improved Cash Flow Inventory understated Future Earnings Hedge Chapter 8-44 Disadvantages Physical flow Involuntary Liquidation / Poor Buying Habits LO Identify the major advantages and disadvantages of LIFO Basis Basis for for Selection Selection of of Inventory Inventory Method Method LIFO is generally preferred: if selling prices are increasing faster than costs and if a company has a fairly constant “base stock.” LIFO not appropriate: if prices tend to lag behind costs, if specific identification traditionally used, and when unit costs tend to decrease as production increases Chapter 8-45 LO 10 Understand why companies select given inventory methods Copyright Copyright Copyright © 2006 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Chapter 8-46 ... process Finished goods Chapter 8-6 LO Identify major classifications of inventory Inventory Inventory Classification Classification and and Systems Systems Flow of Costs Chapter 8-7 Illustration... Approach Inventory Classification and Control Classification Control Basic inventory valuation issues Chapter 8-3 Physical Goods Included in Inventory Goods in transit Consigned goods Special sales... goods to be used in the production of goods to be sold Businesses with Inventory: Merchandiser Chapter 8-4 or Manufacturer LO Identify major classifications of inventory Inventory Inventory