CHAPTER Valuation of Inventories: A Cost-Basis Approach ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1, 2, 3, Inventory accounts; 1, 2, 4, 5, determining quantities, 6, 8, costs, and items to be included in inventory; the inventory equation; balance sheet disclosure 1, 1, 2, 3, 4, 5, 1, 2, Perpetual vs periodic 4, 9, 13, 17, 20 4, 5, Recording of discounts 10, 11 7, Inventory errors 5, 10, 11, 12 Flow assumptions 12, 13, 16, 18 5, 6, 9, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22 1, 4, 5, 6, 5, 6, 7, 8, 10, 11 Inventory accounting changes 18 6, 7, 10 LIFO liquidation and dollar-value LIFO methods 22, 23, 24, 25, 26 1, 8, 9, 10, 11 5, 8, 14, 15, 17, 18, 19, 20 8, Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems Identify major classifications of inventory Distinguish between perpetual and periodic inventory systems 4, 9, 13, 16, 17, 18, 20 4, 5, Determine the goods included in inventory and the effects of inventory errors on the financial statements 3, 5, 10, 11, 12 Understand the items to include as inventory cost 1, 2, 3, 4, 5, 6, 7, 1, 2, Describe and compare the cost flow assumptions used to account for inventories 5, 6, 13, 14, 15, 16, 17, 18, 19, 20, 22 1, 4, 5, 6, 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 8-2 21 8, 22, 23, 24, 25, 26 1, 8, 9, 10, 11 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CHARACTERISTICS TABLE It e m Description Level of Difficu lty Time (minut es) E8-1 E8-2 E8-3 E8-4 E8-5 E8-6 E8-7 E8-8 E8-9 E8-10 E8-11 E8-12 E8-13 E8-14 E8-15 E8-16 E8-17 E8-18 E8-19 E8-20 E8-21 E8-22 E8-23 E8-24 E8-25 E8-26 Inventoriable costs Inventoriable costs Inventoriable costs Inventoriable costs—perpetual Inventoriable costs—error adjustments Determining merchandise amounts—periodic Purchases recorded net Purchases recorded, gross method Periodic versus perpetual entries Inventory errors, periodic Inventory errors Inventory errors FIFO and LIFO—periodic and perpetual FIFO, LIFO and average cost determination FIFO, LIFO, average cost inventory Compute FIFO, LIFO, average cost—periodic FIFO and LIFO—periodic and perpetual FIFO and LIFO; income statement presentation FIFO and LIFO effects FIFO and LIFO—periodic LIFO effect Alternate inventory methods—comprehensive Dollar-value LIFO Dollar-value LIFO Dollar-value LIFO Dollar-value LIFO Moderate Moderate Simple Simple Moderate Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Moderate Moderate Simple Simple Moderate Moderate 15–20 10–15 10–15 10–15 15–20 10–20 10–15 20–25 10–15 10–15 10–15 15–20 15–20 20–25 15–20 15–20 10–15 15–20 15–20 10–15 10–15 25–30 5–10 15–20 20–25 15–20 P8-1 P8-2 P8-3 P8-4 P8-5 P8-6 Various inventory issues Inventory adjustments Purchases recorded gross and net Compute FIFO, LIFO, and average cost Compute FIFO, LIFO, and average cost Compute FIFO, LIFO, and average cost—periodic and perpetual Financial statement effects of FIFO and LIFO Dollar-value LIFO Internal indexes—dollar-value LIFO Internal indexes—dollar-value LIFO Dollar-value LIFO Moderate Moderate Simple Complex Complex Moderate 30–40 25–35 20–25 40–55 40–55 25–35 Moderate Moderate Moderate Complex Moderate 30–40 30–40 25–35 30–35 40–50 P8-7 P8-8 P8-9 P8-10 P8-11 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-3 ASSIGNMENT CHARACTERISTICS TABLE (Continued) It e m CA8-1 CA8-2 CA8-3 CA8-4 CA8-5 CA8-6 CA8-7 CA8-8 CA8-9 CA8-10 CA8-11 8-4 Description Inventoriable costs Inventoriable costs Inventoriable costs Accounting treatment of purchase discounts General inventory issues LIFO inventory advantages Average cost, FIFO, and LIFO LIFO application and advantages Dollar-value LIFO issues FIFO and LIFO LIFO Choices—Ethical Issues Level of Difficu lty Time (minut es) Moderate Moderate Moderate Simple Moderate Simple Simple Moderate Moderate Moderate Moderate 15–20 15–25 25–35 15–25 20–25 15–20 15–20 25–30 25–30 30–35 20–25 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LEARNING OBJECTIVES Identify major classifications of inventory Distinguish between perpetual and periodic inventory systems Determine the goods included in inventory and 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 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-5 CHAPTER REVIEW Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by an enterprise Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for these organizations Inventories are also significant because of their impact on both the balance sheet and the income statement Chapter initiates the discussion of the basic issues involved in recording, costing, and valuing items classified as inventory Inventory Issues (L.O 1) Inventories are asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold Merchandise inventory refers to the goods held for resale by a merchandising concern The inventory of a manufacturing firm is composed of three separate accounts representing stages of completion: raw materials, work in process, and finished goods (L.O 2) Inventory records may be maintained on a perpetual or periodic inventory system basis A perpetual inventory system provides a means for generating up-to-date records related to inventory quantities Under this inventory system, data are available at any time relative to the quantity of material or type of merchandise on hand and the related cost In a perpetual inventory system, purchases and sales of goods are recorded directly in the Inventory account as they occur A Cost of Goods Sold account is used to accumulate the issuances from inventory The balance in the Inventory account at the end of the year should represent the ending inventory cost When inventory is accounted for on a periodic inventory system, the acquisition of inventory is debited to a Purchases account Cost of goods sold must be calculated when a periodic inventory system is in use The computation of cost of goods sold is made by adding beginning inventory to net purchases and then subtracting ending inventory Ending inventory is determined by a physical count at the end of the year under a periodic inventory system Even in a perpetual inventory system, a physical inventory count at year-end is normally taken due to the potential for loss, error, or shrinkage of inventory during the year Inventory planning and control is of vital importance to the success of a merchandising or manufacturing concern If an excessive amount of inventory is accumulated, there is the danger of loss owing to obsolescence If the supply of inventory is inadequate, the potential for lost sales exists This dilemma makes inventory an asset to which management must devote a great deal of attention Reconciliation between the recorded inventory amount and the actual amount of inventory on hand is normally performed at least once a year This is called a physical inventory and involves counting all inventory items and comparing the amount counted with the amount shown in the detailed inventory records Any errors in the records are corrected to agree with the physical count 8-6 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) The cost of goods sold during any accounting period is defined as all the goods available for sale during the period less any unsold goods on hand at the end of the period (ending inventory) The process of computing cost of goods sold is complicated by the determination of (a) the physical goods to be included in inventory, (b) the costs to be included in inventory, and (c) the cost flow assumption to be used Physical Goods to be Included in Inventory (L.O 3) Normally, goods are included in inventory when they are received from the supplier However, at the end of the period, proper accounting requires that all goods to which the company has legal title be included in ending inventory Goods in transit at the end of the period, shipped f.o.b shipping point, should be included in the buyer’s ending inventory If goods are shipped f.o.b destination, they belong to the seller until actually received by the buyer Inventory out on consignment belongs to the consignor’s inventory In actual practice a few exceptions exist regarding the general rule that inventory is recorded by the company that has legal title to the merchandise These exceptions are known as special sale agreements Two of the more common special sale agreements are (a) sales with a buy back agreement and (b) sales with high rates of return Effect of Inventory Errors 10 Errors in recording inventory can affect the balance sheet, the income statement, or both, because inventory is used in the preparation of both financial statements For example, the failure to include certain inventory items in a year-end physical inventory count would result in the following items being overstated (O) or understated (U): ending inventory (U); working capital (U); cost of goods sold (O); and net income (U) If merchandise was not recorded as a purchase nor counted in the ending inventory, the result would be an under-statement of inventory and accounts payable in the balance sheet and an understatement of purchases and inventory in the income statement Net income would be unaffected by this omission as purchases and ending inventory would be misstated by the same amount Costs Included in Inventory 11 (L.O 4) Inventories are recorded at cost when acquired Cost in terms of inventory acquisition includes all expenditures necessary in acquiring the goods and converting them to a saleable condition Product costs are those costs that “attach” to the inventory and are recorded in the inventory account These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process 12 The accounting profession allows for the capitalization of interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease In the case of inventories that are routinely manufactured or produced in large quantities on a repetitive basis, interest costs should not be capitalized Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-7 Purchase Discounts 13 When purchases are recorded net of discounts, failure to pay within the discount period results in the treatment of lost discounts as a financial expense If the gross method is used, purchase discounts should be reported as a deduction from purchases on the income statement If the net method is used, purchase discounts lost should be considered a financial expense and reported in the “other expense and loss” section of the income statement Cost Flow Assumptions 14 (L.O 5) Determining the specific cost of inventory items that have been sold as well as those remaining in ending inventory is sometimes a difficult process This is due, in part, to the fact that there is no requirement that the cost flow assumption adopted be consistent with the physical flow of the goods through the inventory account Thus, it is important when accounting for inventory costs that a company make consistent use of a cost flow assumption The major objective in selecting a method should be to choose the one which most clearly reflects periodic income 15 Inventory cost flow assumptions include (a) specific identification, (b) average cost, (c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO It should be remembered that these assumptions relate to the flow of costs and not the physical flow of inventory items into and out of the company 16 Specific identification calls for identifying each item sold and each item in inventory The costs of the specific items sold are included in cost of goods sold, and the costs of the specific items on hand are included in inventory The average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period FIFO 17 Use of the FIFO inventory method assumes that the first goods purchased are the first used or sold In all cases where FIFO is used, the inventory and cost of goods sold will be the same amount at the end of the month whether a perpetual or periodic system is used A major advantage of the FIFO method is that the ending inventory is stated in terms of an approximate current cost figure However, because FIFO tends to reflect current costs on the balance sheet, a basic disadvantage of this method is that current costs are not matched against current revenues on the income statement LIFO 18 Use of the LIFO inventory method assumes that the most recent inventory costs are the first costs recognized as goods manufactured or sold When inventory records are kept on a periodic basis, the ending inventory is priced by using the total units as a basis of computation, disregarding the exact dates of purchases The calculation of ending inventory and cost of goods sold changes somewhat when the LIFO method is used in connection with perpetual inventory records 8-8 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LIFO Reserve 19 (L.O 6) Many companies use LIFO for tax and external reporting purposes, but maintain a FIFO, average cost, or standard cost system for internal reporting purposes The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve The change in the allowance balance from one period to the next is the LIFO effect LIFO Liquidation 20 (L.O 7) When the LIFO inventory method is used, many companies combine inventory items into natural groups or pools Each pool is assumed to be one unit for the purpose of costing the inventory Any increment above beginning inventory is normally identified as a new inventory layer and priced at the average cost of goods purchased during the year When inventory levels decrease, the most recently added inventory layer is the first layer eliminated (last-in, first-out) The specific-goods pooled LIFO approach reduces record keeping and, accordingly, LIFO liquidations, which causes the cost of utilizing the LIFO inventory method to decline Dollar-Value LIFO 21 (L.O 8) Use of the specific-goods pooled approach can result in problems for companies that often change the mix of their products, materials, and production methods To overcome these problems, the dollar-value LIFO method has been developed The important feature of the dollar-value LIFO method is that increases and decreases in a pool are determined and measured in terms of total dollar value, not the physical quantity of the goods as is done in the traditional LIFO pool approach 22 In computing inventory under the dollar-value LIFO method, the ending inventory is first priced at the most current cost Current cost is then restated to prices prevailing when LIFO was adopted This is accomplished by using a price index A new inventory layer is formed when the ending inventory, stated in base-year costs, exceeds the base-year costs of beginning inventory Increases are priced at current cost If the ending inventory, stated at base-year costs, is less than beginning inventory, the decrease is subtracted from the most recently added layer The dollar-value method is a more practical way of valuing a complex, multiple-item inventory than the traditional LIFO method 23 A price index for the current year is computed by using the double-extension method by dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory for the Period at Base-Year Costs Advantages and Disadvantages of LIFO 24 (L.O 9) Proponents of the LIFO method advocate its use on the basis of its (a) proper matching of recent costs with current revenue, (b) tax benefits, (c) improved cash flow, and (d) future earnings hedge Those opposed to the LIFO method claim that it (a) lowers reported earnings in periods of rising prices, (b) reports outdated costs on the balance Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-9 sheet, (c) is contrary to normal physical flow, (d) creates involuntary liquidation problems, and (e) invites poor buying habits Selection of Inventory Method 25 (L.O 10) LIFO is generally preferable to FIFO when: (a) selling prices and revenues have been increasing faster than costs, and (b) LIFO has been traditional, such as its use by department stores and industries where a fairly constant “base stock” is present LIFO would not be preferable when: (a) prices tend to lag behind costs, (b) specific identification is traditional, and (c) unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide 8-10 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LECTURE OUTLINE This chapter can be covered in three to four class sessions Students should have previous exposure to inventory accounting topics except for dollar-value LIFO and the modified perpetual system (perpetual records kept in units only) A (L.O 1) Inventory Classification Among the most significant assets of many enterprises, inventories are asset items held for sale in the ordinary course of business, or goods that will be used or consumed in the production of goods to be sold For manufacturing companies the inventory amount is separated into raw materials, work in process, and finished goods a A Supplies Inventory account is often used for indirect materials B (L.O 2) Inventory Cost Flow Flow of costs—Beginning inventory plus the cost of goods purchased equals the cost of goods available for sale The cost of goods available for sale consists of the cost of goods sold plus the cost of the ending inventory T EACHING T IP Contrast the accounting procedures under the perpetual and periodic inventory systems by using Illustration 8-1 This example is based on Illustration 8-4 in the textbook Perpetual inventory system—The costs of purchases and sales are recorded directly in the Inventory account (perpetual record kept in units and dollars) The changes in inventory are continually tracked Periodic inventory system—The cost of purchases is recorded in a Purchases (nominal or temporary) account The balance in the Inventory account remains unchanged during the period No record is kept at the time of sale of the number or cost of the units sold At the end of the period, the quantity of goods on hand is determined by physical count and the cost per unit is assigned to each item in ending inventory to determine the ending inventory cost Cost of goods sold is determined by adding the beginning inventory to the purchases and deducting the ending inventory Modified perpetual inventory system—The cost of purchases is recorded directly in the Inventory account The cost of sales is not recorded at the time of sale, but a record is kept of the number of units sold (perpetual record kept in units only) Inventory control—Because all companies need inventory verification, a physical inventory which involves an actual inventory count, should be performed at least once annually Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-11 C (L.O 2) Basic Issues in Inventory Valuation These include the determination of the (1) physical goods to be include in inventory, (2) the costs to include in inventory, and (3) the cost flow assumption to adopt D (L.O 3) Goods to be Included in Inventory Technically, purchases should be recorded when legal title passes to the buyer The following items require careful judgment: Goods in Transit: If the goods are shipped f.o.b shipping point, title passes to the buyer when the seller delivers the goods to the common carrier If the goods are shipped f.o.b destination, title passes when the buyer receives the goods Consigned Goods: Goods out on consignment remain the property of the consignor The consignee makes no entry to its inventory account for goods received on consignment Special Sales Agreements involve the transfer of legal title that is not accompanied by a transfer of the risks of ownership T EACHING T IP The concept of revenue realization can be discussed in connection with these special arrangements a Sales with buyback agreement (1) In essence, the “seller” finances the cost of the inventory by transferring legal title to a third party from which the seller receives “payment.” The “seller” then agrees to “buy” the inventory back at a specified price over a specified future period (2) These transactions are often described as “parking transactions” because the seller simply parks the inventory on another firm’s balance sheet and uses it as a financing device (3) In these arrangements, the inventory and related liability from the repurchase agreement should remain on the “seller’s” books No sale should be recorded b Sales with high rates of return (1) The goods should be considered sold by the seller only if the amount of returns can be reasonably estimated In this case, the seller must establish a return liability for the amount of estimated returns (2) If returns are unpredictable, the goods should not be removed from the seller’s inventory accounts 8-12 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) (L.O 3) Effect of inventory errors a The two most common types of inventory errors: (1) Ending inventory misstated Consists of the correct recording of purchases, but incorrect computing and recording of ending inventory count 2) Purchases and inventory misstated Consists of a failure to include an item as a recorded purchase combined with failure to include and record the item in the ending inventory count b Corrections of inventory errors may involve two procedures: (1) Preparation of correcting journal entries Generally, a purchase is recorded when the invoice arrives If this does not coincide with passage of legal title by the end of the accounting period, correcting entries may be required to prevent “cut-off errors.” (See Exercises 8-4 and 8-5 in the textbook) (2) Computation of the correct amounts of inventory and related items including purchases, cost of goods sold, net income, retained earnings, accounts payable, working capital, and the current ratio T EACHING T IP Reinforce the understanding of the basic inventory equation: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold Point out the obvious, but useful fact that the ending inventory of one period is the beginning inventory of the next period Discuss the impact of inventory errors on the affected accounts Illustration 8-2 illustrates the effects of inventory errors on the income statement by emphasizing the debit or credit balance of the affected items Illustration 8-3 summarizes the effects of inventory errors on the income statement and the balance sheet E (L.O 4) Costs Included in Inventory Distinguish between product costs and period costs a Product costs are those costs directly connected with bringing goods to the buyer’s place of business and converting them to a saleable condition They are recorded in the Inventory account and then transferred to Cost of Goods Sold when a transfer of title occurs Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-13 b Period costs such as selling and general and administrative expenses are not considered to be directly related to the acquisition or production of goods They are recorded as non-product costs and expensed when incurred Manufacturing Costs. Includes all costs which are traceable to the production of the product These costs are classified as direct materials, direct labor, and manufacturing overhead Interest costs associated with getting inventories ready for sale are usually expensed as incurred However, the FASB ruled that companies should capitalize interest costs related to construction of discrete projects (such as ships or real estate projects) for sale or lease Purchase Discounts. Discuss the gross and net methods a Gross method. Purchases and accounts payable are recorded at the gross amount Purchase discounts taken are credited to the Purchase Discounts account which is reported in the income statement as a reduction of Purchases b Net method (considered more appropriate than the gross method) Purchases and accounts payable are recorded at the net amount Purchase discounts not taken are debited to the Purchase Discounts Lost account which is reported in the other expense section of the income statement F (L.O 5) Choice of Cost Flow Assumption This problem arises when numerous purchases have been made at different prices and it is necessary to identify which goods remain on hand and which have been sold T EACHING T IP Illustration 8-4 provides a comparison of ending inventory and cost of goods sold computations under FIFO, LIFO, and average cost under periodic and perpetual systems Specific Identification: Used where a small number of costly, distinctive items are sold It matches actual costs against actual revenue, but offers the opportunity to manipulate income The cost flow matches the physical flow of goods Average Cost: Items in the ending inventory and items sold are priced at the average cost of goods available during the period Either weighted-average (periodic) or moving-average (perpetual) procedures may be used First-In, First-Out: Assumes goods are used/sold in the order purchased While this method presents ending inventory at approximately current cost, it does not match current costs against current revenues a 8-14 Ending inventory and cost of goods sold will be the same under both periodic and perpetual inventory systems Last-In, First-Out: Assumes that the last goods purchased are used or sold first Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) G (L.O 6) LIFO Reserve Used when a company maintains a FIFO, average cost, or standard cost system for internal reporting purposes and LIFO for tax and external reporting purposes The difference between inventory cost using a company’s internal reporting method and the LIFO cost is the reported as the Allowance to Reduce Inventory to LIFO, known as the LIFO reserve a The change in the allowance balance from one period to the next is the LIFO effect H (L.O 7) Effect of LIFO Liquidations LIFO Liquidations. A frequent occurrence when a specific-goods approach to LIFO is used When the inventory balance declines (liquidated), the cost of the old inventory layers is included in cost of goods sold, resulting in higher net income Specific-goods pooled LIFO approach. Inventory items are combined in pools of similar items This approach may help prevent LIFO liquidations because decreases in one quantity may be offset by increases in another quantity I (L.O 8) Dollar-value LIFO. This differs from specific-goods pooled LIFO in that increases and decreases in a pool are measured in terms of the total dollar value and not the physical quantity of goods in the inventory pool Discuss the steps involved in the dollar-value LIFO approach T EACHING T IP Illustration 8-5, which is based on the Bismark Company data in the textbook, shows a straightforward approach of the dollar-value LIFO computations a Compute the quantity of ending inventory at current cost (This approximates FIFO.) b Divide (a) by the current price index to obtain the ending inventory at base-year cost c Split (b) into layers depending on the year the items were acquired d Multiply each layer in (c) by the appropriate price index (price index in the year of acquisition) to obtain the ending inventory at dollar-value LIFO cost T EACHING T IP Under certain circumstances, the dollar-value LIFO approach produces the same inventory cost as the specific goods LIFO approach This can be demonstrated by using the example in Illustration 8-6 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-15 Computation of a price index a Many companies may be able to use published external price indices b Some companies must compute internal price indices The double-extension method is used to determine indices internally The price index for the current year is: Ending Inventory for the Period at Current Cost Ending Inventory for the Period at Base-Year Cost J (L.O 9) Major Advantages and Disadvantages of LIFO Advantages of LIFO a Matching. LIFO matches more recent costs against current revenues to provide a better measure of current earnings b Tax benefits/Improved cash flow. During times of rising prices, LIFO provides a deferral of income taxes payable, which allows companies to hold onto cash longer c Future earnings hedge With LIFO, future price declines will not substantially affect a company’s future reported earnings Disadvantages of LIFO a Reduced earnings. During times of rising prices, reported earnings under LIFO are less than they would be under FIFO However, under the relaxed requirements of the LIFO conformity rule by the IRS, companies are permitted to make supplementary disclosure of non-LIFO income numbers in the financial statements b Inventory understated. Under LIFO, the oldest costs (which are the lowest costs if prices are rising) remain in inventory c Physical flow. LIFO does not approximate the actual physical flow of items except in unusual situations d Involuntary liquidation. If layers of old costs are eliminated, distortions in re ported income can occur e Poor buying habits. A company may adopt an uneconomic pattern of purchases in order to avoid the liquidation problem or in order to manipulate net income K (L.O 10) Basis for selection of inventory methods 8-16 LIFO will be the preferred method if: a Selling prices and revenues have been increasing faster than costs, and b A company has a fairly constant “base stock.” Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) LIFO would not be the preferred method if: a Prices tend to lag behind costs b Specific identification is traditional c Unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide The LIFO conformity rule states that a company employing LIFO for tax purposes must use LIFO for book purposes as well Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-17 ILLUSTRATION 8-1 INVENTORY RECORDING SYSTEMS 8-18 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-2 ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-19 ILLUSTRATION 8-3 EFFECT OF INVENTORY ERRORS 8-20 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-4 COMPUTATION OF ENDING INVENTORY Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-21 ILLUSTRATION 8-5 DOLLAR-VALUE LIFO 8-22 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-6 COMPARISON OF UNIT LIFO AND DOLLAR-VALUE LIFO Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-23 ... Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-21 ILLUSTRATION 8-5 DOLLAR-VALUE LIFO 8-22 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, ... Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 8-17 ILLUSTRATION 8-1 INVENTORY RECORDING SYSTEMS 8-18 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate. .. Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-2 ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting,