1. Valuation of Inventories: A Cost-Basis Approach

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3. Learning Objectives Physical Goods included in Inventory
Costs Included in Inventory
Inventory: Periodic vs. Perpetual
Purchase Discounts
Gross versus Net
Cost Flow Assumptions
Specific Identification, Average Cost, FIFO, LIFO
Specific Issues Related to LIFO
LIFO Reserve
LIFO Liquidation
Dollar-Value LIFO
Major advantages/disadvantages
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Inventory
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.

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

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

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

8. COGAS – Ending Inventory = COGS
Inventory Systems
Perpetual Method
Periodic Method
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
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.

9. Inventory Classification and Systems
Perpetual System
vs.
Periodic System

10. Basic Issues in Inventory Valuation
Valuation of Inventories
Requires the following:
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. Physical Goods Included in Inventory
A company should record purchases when it obtains legal title to the 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. Costs Included in Inventory
Product Costs
Period Costs
Purchase Discounts – Gross vs. Net Method

14. Costs Included in Inventory
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.

15. Purchase Discounts: Two methods
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.

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

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. 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.

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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/ The product was a stock item of your client.

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

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

24. Cost Flow Assumptions Example
Young & Crazy Company makes the following purchases:
One item on 2/2/07 for Rs10
One item on 2/15/07 for Rs15
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%.

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

26. “First-In-First-Out (FIFO)”
Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Inventory Balance = Rs 35
Young & Crazy Company
Income Statement
For the Month of Feb
Sales Rs 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income Rs 33
Purchase on 2/25/07 for Rs20
Purchase on 2/15/07 for Rs15
Purchase on 2/2/07 for Rs10

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

28. “Last-In-First-Out (LIFO)”
Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Inventory Balance = Rs 25
Young & Crazy Company
Income Statement
For the Month of Feb
Sales Rs 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income Rs 26
Purchase on 2/25/07 for Rs20
Purchase on 2/15/07 for Rs15
Purchase on 2/2/07 for Rs10

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

30. Cost Flow Assumptions “Average Cost” Inventory Balance = Rs 30
Young & Crazy Company
Income Statement
For the Month of Feb
Sales Rs 90
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income Rs 30
Purchase on 2/25/07 for Rs20
Purchase on 2/15/07 for Rs15
Purchase on 2/2/07 for Rs10

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

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

33. Special Issues Related to 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

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 books Rs160,000
LIFO value ,000
LIFO Reserve Rs 15,000
Journal entry to reduce inventory to LIFO:
Cost of goods sold 15,000
LIFO reserve 15,000
Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

35. Special Issues Related to 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

36. Special Issues Related to 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.

37. Special Issues Related to 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.

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

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

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.