8-1 CHAPTER VALUATION OF INVENTORIES: COST-BASIS APPROACH Intermediate Accounting IFRS Edition Kieso, Weygandt, and Warfield 8-2 A 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 8-3 Understand the items to include as inventory cost Describe and compare the methods used to price inventories Valuation Valuation of of Inventories: Inventories: Cost-Basis Cost-Basis Approach Approach Inventory Issues Physical Goods Included in Inventory Cost Included in Inventory Classification Goods in transit Product costs Cost flow Consigned goods Period costs Control Special sales agreements Purchase discounts Basic inventory valuation 8-4 Inventory errors Cost Flow Assumptions Specific identification Average cost FIFO Summary analysis Inventory Inventory Issues Issues Classification Inventories are: items held for sale, or goods to be used in the production of goods to be sold Businesses with Inventory Merchandiser 8-5 or Manufacturer LO Identify major classifications of inventory Inventory Inventory Issues Issues Classification Illustration 8-1 One inventory account Purchase goods in form ready for sale 8-6 LO Identify major classifications of inventory Inventory Inventory Issues Issues Classification Three accounts 8-7 • Raw materials • Work in process • Finished goods LO Illustration 8-1 Inventory Inventory Issues Issues Inventory Cost Flow 8-8 Illustration 8-2 LO Identify major classifications of inventory Inventory Inventory Issues Issues Inventory Cost Flow Illustration 8-3 Companies use one of two types of systems for maintaining inventory records — perpetual system or periodic system 8-9 LO Identify major classifications of inventory Inventory Inventory Cost Cost Flow Flow Perpetual System Purchases of merchandise are debited to Inventory Freight-in is debited to Inventory Purchase returns and allowances and purchase discounts are credited to Inventory Cost of goods sold is debited and Inventory is credited for each sale Subsidiary records show quantity and cost of each type of inventory on hand The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold 8-10 LO Distinguish between perpetual and periodic inventory systems Inventory Inventory Valuation Valuation Methods Methods Summary Summary Illustration 8A-3 Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average cost 8-45 LO Describe the LIFO cost flow assumption Inventory Inventory Valuation Valuation Methods Methods Summary Summary Illustration 8A-4 LIFO results in the highest cash balance at year-end (because taxes are lower) This example assumes that prices are rising The opposite result occurs if prices are declining 8-46 LO Describe the LIFO cost flow assumption 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: 8-47 Pricing decisions Record keeping easier Profit-sharing or bonus arrangements LIFO troublesome for interim periods LO Explain the significance and use of a LIFO reserve LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO Illustration: Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes At January 1, 2011, the Allowance to Reduce Inventory to LIFO balance is $20,000 At December 31, 2011, the balance should be $50,000 As a result, Acme Boot realizes a LIFO effect and makes the following entry at year-end Journal entry to reduce inventory to LIFO: Cost of goods sold Allowance to reduce inventory to LIFO 8-48 30,000 30,000 LO Explain the significance and use of a LIFO reserve LIFO Liquidation Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes Illustration: Basler Co has 30,000 pounds of steel in its inventory on December 31, 2011, with cost determined on a specific-goods LIFO approach 8-49 LO Understand the effect of LIFO liquidations LIFO Liquidation Illustration: At the end of 2012, only 6,000 pounds of steel remained in inventory Illustration 8B-3 Illustration 8B-2 8-50 LO 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 8-51 LO Explain the dollar-value LIFO method Dollar-Value LIFO Exercise 8-29 (partial): The following information relates to the Choctaw Company Use the dollar-value LIFO method to compute the ending inventory for 2007 through 2009 8-52 8-53 8-54 8-55 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 8-56 Advantages Matching Reduced Earnings Tax Benefits/Improved Cash Flow Inventory Understated Future Earnings Hedge 8-57 Disadvantages Physical Flow Involuntary Liquidation / Poor Buying Habits Basis for Selection of Inventory Method LIFO is generally preferred: if selling prices are increasing faster than costs and if a company has a fairly constant “base stock.” LIFO is not appropriate: if prices tend to lag behind costs, if specific identification traditionally used, and when unit costs tend to decrease as production increases 8-58 Copyright Copyright Copyright © 2011 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 8-59 ... 90 10 80 14 12 33 47 14 $ 33 LO Cost Cost Flow Flow Assumptions Assumptions “Average Cost” Inventory Balance = $ 45 Purchase on 2/25 /11 for $20 Purchase on 2 /15 /11 for $15 Purchase on 2/2 /11 for... 90 14 12 33 57 17 $ 40 LO Cost Cost Flow Flow Assumptions Assumptions “Average Cost” Inventory Balance = $ 30 Purchase on 2/25 /11 for $20 Purchase on 2 /15 /11 for $15 Purchase on 2/2 /11 for $10 ... the following purchases: One item on 2/2 /11 for $10 One item on 2 /15 /11 for $15 One item on 2/25 /11 for $20 Young & Crazy Company sells one item on 2/28 /11 for $90 What would be the balance of