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1 Valuation of Inventories: A Cost-Basis Approach.

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1 1 Valuation of Inventories: A Cost-Basis Approach

2 2 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

3 3 1.Physical Goods included in Inventory 2.Costs Included in Inventory 3.Inventory: Periodic vs. Perpetual 4.Purchase Discounts Gross versus Net 5.Cost Flow Assumptions 1.Specific Identification, Average Cost, FIFO, LIFO 6.Specific Issues Related to LIFO 1.LIFO Reserve 2.LIFO Liquidation 3.Dollar-Value LIFO 4.Major advantages/disadvantages Learning Objectives

4 Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by the enterprise. Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for the organization. Inventories are also significant because of their impact on both the balance sheet and the income statement. Inventory

5 5 Inventories are: items held for sale, or goods to be used in the production of goods to be sold. Inventory Classification and Systems LO 1 Identify major classifications of inventory. Classification MerchandiserManufacturer Businesses with Inventory: or

6 6 Flow of Costs Inventory Classification and Systems Illustration 8-2 LO 1 Identify major classifications of inventory.

7 7 Two systems for maintaining inventory records: Inventory Classification and Systems Control Perpetual system Periodic system

8 Purchases are debited to Inventory account Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in Inventory account. Debit COGS and credit Inventory account for each sale. Purchases are debited to Purchases account. Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in their respective accounts. COGS is computed only periodically : COGAS – Ending Inventory = COGS Perpetual MethodPeriodic Method Inventory Systems

9 9 Inventory Classification and Systems Perpetual SystemPeriodic Systemvs.

10 10 Requires the following: Basic Issues in Inventory Valuation Valuation of Inventories The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). The costs to include (product vs. period costs). The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

11 11 A company should record purchases when it obtains legal title to the goods. Physical Goods Included in Inventory Physical Goods The following goods are included in “seller’s” inventory: Goods in transit (FOB Destination) Goods on consignment with consignee Goods, sold under buy back agreements Goods, sold with high rates of return Installment sales (if bad debts can not be estimated)

12 Guidelines for Determining Ownership

13 13 Costs Included in Inventory Product Costs Period Costs Purchase Discounts – Gross vs. Net Method

14 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. Costs Included in Inventory

15 If the gross method is used, purchase discounts should be reported as a deduction from purchases (purchase discounts) 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. Purchase Discounts: Two methods

16 16 Example: Treatment of Purchase Discounts Gross Method Net Method vs.

17 17 Example: E8-3 Assuming each of the amounts is material, state whether the merchandise should be included in the client’s inventory at 12/31/2007. (1) A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the shipping room on 12/31/07. The customer was billed on that date and the machine excluded from inventory although it was shipped on 1/4/2008.

18 18 Example: E8-3 (2) Merchandise costing 2,800 was received on 1/3/2008, and the related purchase invoice recorded The invoice showed the shipment was made on 12/29/2007 f.o.b. destination.

19 19 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

20 20 Example: E8-3 (3) A packing case containing a product costing 3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer's order was dated 12/18/2007, but that the case was shipped and customer billed on 1/10/2008. The product was a stock item of your client.

21 21 Example: E8-3 (4) Merchandise received on 1/6/2008, costing Rs680 was entered in the purchase journal on 1/7/2008. The invoice showed shipment was made f.o.b. supplier’s warehouse on 12/31/2007. Because it was not on hand at 12/31, it was not included in inventory.

22 22 Example: E8-3 (5) Merchandise costing Rs720 was received on 12/28/2007, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was market “on consignment.”

23 23 Cost Flow Assumption Adopted Physical Movement of Goods does not need to equal FIFO What Cost Flow Assumption to Adopt? LIFO Average CostSpecific Identification – High-ticket items: Automobiles, Jewelry, Real estate

24 24 Young & Crazy Company makes the following purchases: 1. One item on 2/2/07 for Rs10 2. One item on 2/15/07 for Rs15 3. One item on 2/25/07 for Rs20 Young & Crazy Company sells one item on 2/28/07 for Rs90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. Example Cost Flow Assumptions

25 25 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 45 Young & Crazy Company Income Statement For the Month of Feb Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Cost Flow Assumptions “First-In-First-Out (FIFO)”

26 26 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Cost Flow Assumptions Inventory Balance = Rs 35 Young & Crazy Company Income Statement For the Month of Feb Sales Rs Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 14 Rs 33 Net Income Rs 33 “First-In-First-Out (FIFO)”

27 27 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 45 Young & Crazy Company Income Statement For the Month of Feb Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Cost Flow Assumptions “Last-In-First-Out (LIFO)”

28 28 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Cost Flow Assumptions Inventory Balance = Rs 25 Purchase on 2/25/07 for Rs20 Young & Crazy Company Income Statement For the Month of Feb Sales Rs Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 11 Rs 26 Net Income Rs 26 “Last-In-First-Out (LIFO)”

29 29 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 45 Young & Crazy Company Income Statement For the Month of Feb Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Cost Flow Assumptions “Average Cost”

30 30 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 30 Cost Flow Assumptions Young & Crazy Company Income Statement For the Month of Feb Sales Rs Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses Income before tax Taxes 12 Rs 30 Net Income Rs 30 “Average Cost”

31 31 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 45 Young & Crazy Company Income Statement For the Month of Feb Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Cost Flow Assumptions “Specific Identification”

32 32 Purchase on 2/2/07 for Rs10 Purchase on 2/15/07 for Rs15 Purchase on 2/25/07 for Rs20 Inventory Balance = Rs 45 Young & Crazy Company Income Statement For the Month of Feb Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Cost Flow Assumptions “Specific Identification” Depends which one is sold

33 33 Many companies use LIFO for tax and external financial reporting purposes FIFO, average cost, or standard cost system for internal reporting purposes. Reasons: Special Issues Related to LIFO LIFO Reserve 1. Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. LIFO troublesome for interim periods

34 34 Special Issues Related to LIFO LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Example: FIFO value per booksRs160,000 LIFO value 145,000 LIFO ReserveRs 15,000 Cost of goods sold 15,000 LIFO reserve 15,000 Journal entry to reduce inventory to LIFO: Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

35 35 Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. Special Issues Related to LIFO LIFO Liquidation Illustration 8-20

36 36 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. Special Issues Related to LIFO Dollar-Value LIFO

37 37 Special Issues Related to 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 Dollar-Value LIFO

38 38 Special Issues Related to LIFO LO 8 Explain the dollar-value LIFO method. Exercise 8-26 Solution

39 39 Matching Tax Benefits/Improved Cash Flow Future Earnings Hedge Special Issues Related to LIFO Advantages Reduced earnings Inventory understated Physical flow Involuntary Liquidation / Poor Buying Habits Disadvantages

40 40 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.


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