Inventory Measurement

Inventory Measurement
Class #3 Inventory Measurement

Inventory Those assets that a company:
1. Intends to sell in the normal course of business. 2. Has in production (work in process) for future sale. For an item to be classified as inventory, the company must intend to sell it in the normal course of business. The item is either produced by the company or purchased by a supplier for resale. Raw materials inventory consists of the items that will be used in the production process. 3. Uses currently in the production of goods to be sold (raw materials).

Types of Inventories Types of Inventory Merchandise Inventory
Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods We will look at inventory for two classes of businesses. For merchandising companies like Wal-Mart, goods are acquired from a supplier for resale to the final consumer. In a manufacturing operation, the company normally has three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items that are being worked on, but are not yet complete. Finished goods inventory consists of items that are available for sale.

Manufacturing Overhead
Inventory Cost Flows Raw Materials Work in Process Finished Goods (1) $XX $XX (4) $XX $XX (7) $XX $XX (8) Direct Labor Cost of Good Sold (2) $XX $XX (5) Manufacturing Overhead $XX (3) $XX $XX (6) Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work in process transferred to finished goods Finished goods sold In this diagram, we see the typical inventory cost flow for a manufacturing company. The manufacturing company acquires raw materials, hires direct labor and incurs manufacturing overhead. As raw materials, direct labor and manufacturing overhead are used, they are transferred into work-in-process inventory. When an item in work-in-process inventory has been completed, it is transferred to finished goods inventory. Finally, finished goods are sold to the final customer, and transferred out of finished goods inventory and into cost of goods sold.

Inventory Methods Two accounting systems are used to record transactions involving inventory: Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle. We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the overwhelming majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting cycle which is usually at the end of the month or the end of the year.

Perpetual Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2013 Inventory ,000 Accounts payable ,000 To record the purchase of merchandise inventory. Lothridge Wholesale Beverage Company (LWBC) uses the perpetual inventory system. It begins the period with $120,000 of merchandise inventory on hand. During the period the company purchases $600,000 of merchandise for resale to its customers. The items were purchased on account. The journal entry required for this transaction is to debit inventory for $600,000 and credit accounts payable for $600,000. Inventory items that are returned to the supplier because they are damaged or defective will require an adjustment to the inventory account. Cash discounts applicable to the inventory items purchased will also require an adjustment to the inventory account. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

Perpetual Inventory System
During 2013, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers. 2013 Inventory ,000 Accounts payable ,000 To record the purchase of merchandise inventory. 2013 Accounts receivable 820,000 Sales revenue ,000 To record sales on account. Cost of goods sold 540,000 Inventory ,000 To record cost of goods sold. During 2013, Lothridge sold, on account, inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. In the perpetual inventory system any time we have a sale we have to record the cost of goods sold. The first entry is to record the sale. We debit accounts receivable for $820,000 and credit sales for the same amount. The second entry is to record the cost of goods sold for $540,000 and credit inventory for the same amount. Under the perpetual inventory system, cost of goods sold is determined when a sale is made. The balance in the cost of goods sold account appears on the income statement at the end of the period. Inventory is updated after each sale and purchase of merchandise for resale.

Periodic Inventory System
The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period. The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated after the physical inventory count at the end of the accounting period. Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts. The period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account. In the periodic inventory system, we use an equation to determine cost of goods sold. We take a beginning inventory, and add net purchases, to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold. The cost of goods sold equation assumes that all inventory quantities not on hand at the end of the period were sold. This may or may not be the case if some inventory items were either damaged or stolen.

Lothridge Wholesale Beverage Company (LWBC) begins 2013 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2013 Purchases ,000 Accounts payable ,000 To record the purchase of merchandise inventory. Let’s assume that the Lothridge Wholesale Beverage Company uses the periodic inventory system, and purchases $600,000 of merchandise for resale to customers. The merchandise was purchased on account. The journal entry to record this transaction is to debit an account called purchases and credit accounts payable. Remember that in a perpetual inventory system, we debited the inventory account rather than the purchases account. Purchase discounts and purchase returns are set up as two separate contra accounts, and are recorded separately from the purchases account.

During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000. 2013 Accounts receivable 820,000 Sales revenue ,000 To record sales on account. No entry is made to record cost of goods sold. A physical count of ending inventory shows a balance of $180,000. Let’s calculate cost of goods sold at the end of 2013. Once again, let’s assume that the Lothridge Wholesale Beverage Company sold inventory with the retail price of $820,000 and a cost basis of $540,000 to a customer. Under the periodic inventory system, we would debit accounts receivable for $820,000 and credit sales for the same amount; there would be no entry to record cost of goods sold. We would calculate the amount of cost of goods sold at the end of the accounting period.

We need the following adjusting entry to record cost of good sold. December 31, 2013 Cost of goods sold 540,000 Inventory (ending) 180,000 Inventory (beginning) ,000 Purchases ,000 To adjust inventory, close the purchases account, and record cost of goods sold. Here is a typical calculation of cost of goods sold. Let’s assume a beginning inventory of $120,000 and net purchases of $600,000. Cost of goods available for sale would be $720,000. Now we subtract ending inventory of $180,000 to arrive at cost of goods sold of $540,000. Under the periodic inventory system, we need to prepare an adjusting entry to determine cost of goods sold. The entry at the end of 2013 will be to debit cost of goods sold for $540,000, debit inventory for $180,000 (our ending inventory), credit inventory for $120,000 (our beginning inventory), and finally credit purchases for $600,000. This entry has determined cost of goods sold for the income statement and has established the value of ending inventory on the balance sheet at $180,000.

Comparison of Inventory Systems
This chart summarizes all of the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.

What is Included in Inventory?
General Rule All goods owned by the company on the inventory date, regardless of their location. Goods in Transit Goods on Consignment As a general rule, inventory should include all costs necessary to purchase the inventory item and get it to its intended location. All goods owned by the company should be included in inventory. There is a problem with goods in transit (goods that are en route from the supplier to our company). Technically, ownership of the goods depends upon whether they are shipped FOB shipping point or FOB destination. Our company may have inventory out on consignment with another company. The consigned inventory still is owned by us and should be included in our inventory. Depends on FOB shipping terms.

Expenditures Included in Inventory
Invoice Price Freight-in on Purchases + Purchase Returns Purchase Discounts An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns or purchase discounts.

Real World …the cost of warehousing and occupancy for our Wal-Mart segment distribution facilities are included in operating, selling and general and administrative expenses. Because we do not include the cost of our Wal-Mart segment distribution facilities in cost of sales, our gross profit and gross margin may not be comparable to those of other retailers that may include all costs related to their distribution facilities in costs of sales and in the calculation of gross profit and gross margin.

Purchase Returns On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000. Periodic Inventory Method Perpetual Inventory Method November 8, 2013 Accounts payable ,000 Accounts payable 2,000 Purchase returns 2, Inventory ,000 On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000. If LWBC uses the periodic inventory system, the proper journal entry is to debit, or reduce, accounts payable and credit purchase returns for $2,000. If the company uses the perpetual inventory system, the journal entry is to debit accounts payable and credit inventory for $2,000. Returns of inventory are credited to the Purchase Returns account when using the periodic inventory method. The returns are credited to Inventory using the perpetual inventory method.

Partial payment not made within the discount period
Purchase Discounts Gross Method Net Method October 5, 2013 Purchases ,000 Purchases 19,600 Accounts payable 20,000 Accounts payable ,600 October 14, 2013 Accounts payable 14,000 Accounts payable 13,720 Purchase discounts Cash 13,720 Cash ,720 November 4, 2013 Accounts payable 6,000 Accounts payable 5,880 Cash ,000 Interest expense Cash 6,000 LWBC purchased $20,000 of merchandise for resale subject to the credit terms, 2/10, net 30. Let’s look at the proper accounting using the gross method of recording purchases on the left side of your screen and the net method on the right side of your screen. Under the gross method we begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000 on October 5th. On October 14th, within the discount period, the company makes a $13,720 payment on account. The journal entry is to debit accounts payable for $14,000, credit purchase discounts for $280 ($14,000 times two percent), and credit cash for $13,720. LWBC pays the remaining $6,000 on November 4th, and is not eligible for the discount. The journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount. Under the net method, LWBC will debit purchases for the net amount owed to the supplier or $19,600 ($20,000 times 1 minus the discount offered) and credits accounts payable for the same amount. On October 14th, a partial payment of $14,000 is made at the net amount of $13,720. On November 4th, the final payment is made on the purchase for the amount owed to the supplies of $6,000. LWBC missed a discount of $120 ($6,000 times 2 percent), and records this amount with a debit to interest expense. The effect on the financial statements of the difference between the two methods usually is immaterial. Net income over time will be the same using either method. Discount terms are 2/10, n/30. $20,000 x $ ̵120 $ Partial payment not made within the discount period $14,000 x $

Net Method Using Perpetual and Periodic
Notice that under the perpetual method of accounting for inventory, the purchase returns and freight-in are adjustments to inventory. Freight-in of $160 increases inventory and purchase returns and allowances of $200 reduce inventory. Every time a sale is made under the perpetual method, cost of goods sold is also recorded. Under the periodic inventory method, we do not use the inventory account, but rather, the purchases account. Freight-in is recorded in a separate account account as are purchase returns and allowances. On the right hand side of your screen, you can see the computation of cost of goods sold in a periodic system assuming a beginning inventory of zero.

Inventory Cost Flow Methods
Specific cost identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) How do we account for changes in the cost of inventory and cost of goods sold when we experience changes in the price of the items that we purchased during the period? We will look at four methods to handle this problem. The first is the specific identification method, next is the average cost method, then the first-in first-out or FIFO method, and finally, we will look at the last-in, first- out or LIFO method.

Real World – Wal-Mart The Company uses the retail last-in, first-out (LIFO) method for general merchandise within the Wal-Mart Stores segment, cost LIFO for the SAM’S CLUB segment and grocery items within the Wal-Mart Stores segment, and other cost methods, including the retail first-in, first-out (FIFO) and average cost methods, for the International segment. Inventories are not recorded in excess of market value.

Specific Cost Identification
Items are added to inventory at cost when they are purchased. COGS for each sale is based on the specific cost of the item sold. The specific cost of each inventory item must be known. Only for items with serial #’s or other identity means. Part I First, let’s consider the specific identification method. Items are added to inventory at cost when they are purchased. Cost of goods sold for each sale is based on the specific cost of the items sold. That means that the company must know the cost of each individual item in its inventory, and when it was sold. Part II Knowing the specific cost of each item in a relatively large inventory is a difficult task in the specific identification method, and it is relatively easy to manipulate income. Specific identification is rarely used in practice today.

Perpetual Average Cost
In the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase. To accomplish this, we must know the date of each purchase along with the quantity purchased and the unit cost. In addition, we must know the date of each sale and the number of units sold.

($20, ,750) ÷ (2, ) = $10.25 On September 7, we sold 500 units, and we used our weighted average cost associated with goods available for sale of $10.25 per unit. The cost of the units sold is $5,125 (500 units sold times $10.25 average cost per unit) the cost of ending inventory, at this point, is $25,625 ($30, 750 minus $5,125, or 2,500 units in inventory times average cost per unit of $10.25).

($25, ,950) ÷ (2, ,000) = $10.45 On September 21, we purchase 1,000 units, and we must calculate a new weighted average cost of $ We calculate the new average cost of $10.45 ($25,625+10,950) ÷ (2,500+1,000). This new average cost will be assigned to all 3,500 in inventory on September 21.

On September 29th we sold 1,500 of the remaining 3,500 frames at our new average cost of $10.45 ($15,675). The total cost of these frames sold in September is $20,800, and the cost remaining in ending inventory to start the next period is $20,900. 3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.

Weighted-Average Periodic System
Let’s use the same information to assign costs to ending inventory and cost of goods sold using the periodic system. Beginning Inventory (2,000 units) Purchases (2,000 units) Available for Sale (4,000 units) Ending Inventory (2,000 units) Goods Sold (2,000) Let’s use the same information to assign costs to ending inventory and cost of goods sold assuming the company uses the periodic inventory system and applies it with a weighted-average cost method. Of the 4,000 units available for sale, 2,000 were sold and 2,000 remain in ending inventory. The weighted average cost is determined by dividing $41,700 by 4,000 units. The weighted-average cost is $ $41,700 ÷ 4,000 = $ weighted-average per unit cost

Weighted-Average Periodic System
We multiply the 2,000 units in ending inventory by the weighted-average cost to determine the cost of ending inventory of $20,850. Cost of goods sold can be determined in one of two ways. First, we can subtract ending inventory from goods available for sale to get cost of goods sold, or we can multiply the 2,000 units times the weighted-average cost per unit to arrive at the total of $20,850.

First-In, First-Out (FIFO)
The FIFO method assumes that items are sold in the chronological order of their acquisition. The cost of the oldest inventory items are charged to COGS when goods are sold. The cost of the newest inventory items remain in ending inventory. In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.

First-In, First-Out (FIFO)
Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . . . . . COGS and Ending Inventory Cost are the same under both approaches. Under the periodic or perpetual method, the cost of goods sold and ending inventory are the same under the first-in, first-out method. Let’s look at the calculations when using the periodic inventory system in a FIFO environment.

First-In, First-Out (FIFO) Periodic Inventory System
Let’s return to the Picture This example. Recall that ending inventory was determined by a physical count to be 2,000 units. Under the first-in, first-out method, we assign the costs of the first goods in to inventory to cost of goods sold. The 2,000 units sold come from the beginning inventory and carry a cost of $10 each. These 2,000 units come from the beginning inventory (first-in, first-out).

Cost of goods sold is calculated to be $20,000 (2,000 units times $10.00 per unit).

As you can see, the most recent costs per unit come from the purchases of September 21 and September 3 (for a total of 2,000 units), and total cost of $21,700.

Last-In, First-Out (LIFO)
The LIFO method assumes that the newest items are sold first, leaving the older units in inventory. The cost of the newest inventory items are charged to COGS when goods are sold. The cost of the oldest inventory items remain in inventory. Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory. The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remain in inventory.

Last-In, First-Out (LIFO)
Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. When we use last-in, first out, the periodic and perpetual inventory systems yield different ending inventories and different costs of goods sold.

Last-In, First-Out Perpetual Inventory System
Recall that the oldest inventory cost remained in inventory. The units associated with those old costs are likely to remain in inventory when a company uses the LIFO method. It is important that we know when sales were made during the period. A block of 500 units was sold on September 7 and a second block of 1,500 units was sold on September 29. Let’s look at an example of accounting for LIFO inventory in a perpetual inventory system. These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.

For the sale on September 7, the last goods in the inventory are the first goods sold. We begin by selling the units from the September 3 purchase (1,000 units at $10.75 per unit), for a total of $5,375. Let’s continue with the example. The inventory now contains 2,000 units at a unit cost of $10.00, 500 units at a unit cost of $ At the close of business on September 7, the inventory consists of 2,000 units at a unit cost of $10.00, and 500 units at a unit cost of $10.75, for a total cost of $25,375. The Cost of Goods Sold for the September 7 sale come from the purchase of September 3, so we record the cost of goods sold at $5,375 (500 units times $10.75).

The Cost of Goods Sold for the September 29 sale come from the purchase of September 3 (500 remaining units) plus 1,000 units from the purchase of September 21, for a total of 1,500 units, For the sale on September 7, the last goods in the inventory are the first goods sold. We begin by selling the units from the September 3 purchase (1,000 units at $10.75 per unit), for a total of $5,375. At the close of business on September 7, the inventory consists of 2,000 units at a unit cost of $10.00, and 500 units at a unit cost of $10.75, for a total cost of $25,375. Let’s continue the example.

The 1,500 units sold on September 29, have a total cost of $16,325. Ending inventory is composed of 1,000 at $10.00 per unit or $20,000. Cost of goods sold for September for frame number 759 is $21,700.

Last-In, First-Out Periodic Inventory System
When using the periodic inventory system in a LIFO system we take a different approach to the determination of cost of goods sold and ending inventory. First, we calculate the total cost of goods available for sale, which are $41,700.

Last-In, First-Out Periodic Inventory System
When using the periodic inventory system in a LIFO system we take a different approach. We determine the cost of ending inventory by picking the oldest unit in inventory at the end of the period and including them in ending inventory. In our case you can see that there are 2,000 units in ending inventory at $10 per unit. To the determination of cost of goods sold we subtract ending inventory from cost of goods available for sale. In our example, we obtained the same amount whether using periodic or perpetual inventory system. This is not always the case.

When Prices Are Rising . . . FIFO
Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher pre-tax income. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower pre-tax income. Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher pre-tax income, and LIFO results in lower pre-tax income.

U. S. GAAP vs. IFRS LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will impose a serious impediment to convergence. LIFO is permitted and used by U.S. Companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories. LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will impose a serious impediment to convergence. From the perspective of the FASB, LIFO is permitted and used by U.S. companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. However, IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories.

Decision Makers’ Perspective
Factors Influencing Method Choice How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues? A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how well are costs matched against related revenues; and how are income taxes affected by inventory method choice? Companies usually stay with the method they select, but sometimes companies switch for tax reporting purposes or other economic reasons. How are income taxes affected by inventory method choice?

Supplemental LIFO Disclosures
Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this: Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures, allowing a company to report in a note the effect of using another method on inventory valuation rather than LIFO.

LIFO Liquidation When prices rise . . .
LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. If inventory declines, these “out of date” costs may be charged to current earnings. LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older, lower prices creating increased profits. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as LIFO liquidation profit. A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements. This LIFO liquidation results in “paper profits.”

Inventory Management The higher the ratio, the higher the markup a company is able to achieve on its products. Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average inventory Managers closely monitor inventory levels to (1) ensure that the inventories needed to sustain operations are available, and (2) hold the cost of ordering and carrying inventories to the lowest possible level. One useful profitability indicator that involves cost of goods sold is gross profit or gross margin, which highlights the important relationship between net sales revenue and cost of goods sold. The gross profit ratio is calculated by dividing gross profit by net sales. The higher the ratio, the higher the markup a company is able to achieve on its products. Another important ratio, the inventory turnover ratio, is designed to evaluate a company’s effectiveness in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell or turn over its inventory, the lower its investment in inventory must be for a given level of sales. Anytime we have an income statement account in the numerator of an equation and a balance sheet account in the denominator, we need to calculate an average for the balance sheet account. In this case, average inventory is determined by adding together beginning and ending inventory and dividing the total by 2. (Beginning inventory + Ending inventory 2 Designed to evaluate a company’s effectiveness in managing its investment in inventory

Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

Methods of Simplifying LIFO
LIFO Inventory Pools The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately. The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.

Methods of Simplifying LIFO Dollar-Value LIFO (DVL)
DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO recordkeeping. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory dollar amount to beginning inventory dollar amount. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. Dollar-Value LIFO (DVL) extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO recordkeeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory dollar amount to beginning inventory dollar amount. When using DVL we think in terms of inventory layers rather than inventory pools. DVL minimizes the probability of layer liquidation.

We need to determine if the increase in ending inventory over beginning inventory was due to a cost increase or an increase in inventory quantity. The goal of dollar-value LIFO is to determine if an increase in ending inventory over beginning inventory is due to a cost increase of a real increase in inventory. The first step in the process is to compute the cost index. This can be done in a number of ways. One method is shown on your screen, others include the use of industry-specific general price indexes. 1a. Compute a Cost Index for the year.

1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory at base year cost to beginning inventory at base year cost. The second step in the process is to deflate the ending inventory valued at year-end cost using the cost index. This is sometimes difficult for students to understand. We are attempting to state beginning and ending inventory is common dollar amounts. Next, we compare the ending inventory, at base year cost to beginning inventory at base year cost, to determine the amount of the inventory layer created in the current period.

Next, identify the layers in ending inventory and the years they were created. Convert each layer’s base year cost to layer year cost by multiplying times the cost index. Sum all the layers to arrive at ending inventory at DVL cost. Finally, we convert the year’s layer into end of period dollars and add the adjusted layer to the beginning inventory. We always keep the beginning inventory and layers created in subsequent years separately. Let’s look at an example.

Masterwear reports the following inventory and cost index information. Let’s look at the solution to this example. Masterwear reports the following inventory and cost index information. The company uses dollar-value LIFO for determining inventory values. Let’s see how the process works for the first year cost. Ending inventory at December 31, 2013, is stated at base-year costs when the cost index is 100 percent. At the end of 2014, the ending inventory at year-end costs is $168,000, but there was 5 percent inflation during While it looks like the inventory increased by $18,000, this simple computation ignores inflation. Let’s begin the DVL process.

Masterwear reports the following inventory and general price information. First, we deflate the 2014 ending inventory by the rate of inflation. We determine that the ending inventory in base-year cost is $160,000.

First, determine the LIFO layer for the current year: The 2013 ending inventory and the 2014 ending inventory are stated in common, or base-year costs. We see that there has been a $10,000 LIFO layer added in 2014, stated at base-year costs.

At the LIFO layer at end of period prices to the ending LIFO inventory from last period. We now reinflate the $10,000 layer to 2014 prices by multiplying the layer by the cost index in 2014, and arrive at an adjusted layer of $10,500. The inventory at the end of 2014 is reported in the balance sheet at $160,500.

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