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Inventories: Measurement Chapter 8. Recording and Measuring Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials.

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Presentation on theme: "Inventories: Measurement Chapter 8. Recording and Measuring Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials."— Presentation transcript:

1 Inventories: Measurement Chapter 8

2 Recording and Measuring Inventory Merchandise Inventory Goods acquired for resale Manufacturing Inventory Raw Materials Work-in-Process Finished Goods Types of Inventory

3 Manufacturing Inventories (ACCT 322) Raw Materials Work-in- Process Finished Goods Cost of Goods Sold Direct Labor Manufacturing Overhead $XX 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 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                

4 Inventory Systems Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System (NOT COVERED) The inventory account is adjusted at the end of a reporting period. Two accounting systems are used to record transactions involving inventory:

5 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. Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method Inventory600,000 Accounts payable 600,000 To record the purchase of merchandise inventory.

6 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 Inventory600,000 Accounts payable 600,000 To record the purchase of merchandise inventory Accounts receivable820,000 Sales revenue 820,000 To record sales on account. Cost of goods sold540,000 Inventory 540,000 To record cost of goods sold.

7 Exercise 1

8 Periodic Inventory System (NOT COVERED) 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.

9 Periodic Inventory System (Not Covered) 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 Purchases600,000 Accounts payable 600,000 To record the purchase of merchandise inventory.

10 Periodic Inventory System (Not Covered) 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 During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540, Accounts receivable820,000 Sales revenue 820,000 To record sales on account.

11 Periodic Inventory System (Not Covered) We need the following adjusting entry to record cost of good sold. December 31, 2013 Cost of goods sold540,000 Inventory (ending)180,000 Inventory (beginning) 120,000 Purchases 600,000 To adjust inventory, close the purchases account, and record cost of goods sold.

12 Comparison of Inventory Systems

13 What is Included in Inventory? Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods Damaged or Obsolete Goods on Consignment 5-13

14 FOB Destination Point Public Carrier SellerBuyer Goods in Transit Public Carrier Seller Buyer FOB Shipping Point Ownership passes to the buyer here. 5-14

15 Transportation Costs FOB shipping point (buyer pays) FOB destination (seller pays) Merchandise Seller Buyer P1 4-15

16 Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns and Allowances Purchase Discounts

17 Exercise 6 Exercise 7 Exercise 8

18 Purchase Returns November 8, 2013 Accounts payable 2,000 Inventory 2,000 On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000. The returns are credited to Inventory using the perpetual inventory method. Perpetual Inventory Method

19 Purchase Discounts October 5, 2013 Inventory 20,000 Accounts payable 20,000 October 14, 2013 Accounts payable 14,000 Inventory 280 Cash 13,720 November 4, 2013 Accounts payable 6,000 Cash 6,000 Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280 Partial payment not made within the discount period Gross Method $20,000 x 0.02 $ 400 ̵ 120 $ 280

20 Exercise 9

21 Inventory Cost Flow Assumptions  Specific identification (Self Study)  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)  Specific identification (Self Study)  Average cost  First-in, first-out (FIFO)  Last-in, first-out (LIFO)

22 Perpetual Average Cost Picture This, LLC, is in the process of determining the cost of goods sold for frame number 759 for the month of September. The physical inventory count on September 30 shows 2,000 frames in ending inventory. Use the perpetual AVERAGE or FIFO or LIFO cost methods to determine: (1) Ending inventory cost (2) Cost of goods sold

23 Picture This, LLC Inventory of frame number 759

24 Perpetual Average Cost Picture This, LLC, is in the process of determining the cost of goods sold for frame number 759 for the month of September. The physical inventory count on September 30 shows 2,000 frames in ending inventory. Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold

25 Perpetual Average Cost

26 ($20, ,750) ÷ (2, ) = $10.25

27 Perpetual Average Cost ($25, ,950) ÷ (2, ,000) = $10.45

28 Perpetual Average Cost 3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.

29 First-In, First-Out (FIFO)  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.  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. The FIFO method assumes that items are sold in the chronological order of their acquisition.

30 First-In, First-Out (FIFO) Perpetual Inventory System These 2,000 units come from the beginning inventory (first-in, first-out).

31 First-In, First-Out (FIFO) Perpetual Inventory System

32 Last-In, First-Out (LIFO)  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.  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. The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.

33 Last-In, First-Out Perpetual Inventory System These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.

34 Last-In, First-Out Perpetual Inventory System 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).

35 Last-In, First-Out Perpetual Inventory System 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,

36 Last-In, First-Out Perpetual Inventory System

37 Exercise 14

38 When Prices Are Rising... LIFO  Matches high (newer) costs with current (higher) sales.  Inventory is valued based on low (older) cost basis.  Results in lower pre-tax income. FIFO  Matches low (older) costs with current (higher) sales.  Inventory is valued at approximate replacement cost.  Results in higher pre-tax income.

39 U. S. GAAP vs. IFRS  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. 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.  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.

40 Decision Makers’ Perspective Factors Influencing Method Choice How are income taxes affected by inventory method choice? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues?

41 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:

42 LIFO Liquidation LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. When prices rise... If inventory declines, these “out of date” costs may be charged to current earnings. This LIFO liquidation results in “paper profits.” This LIFO liquidation results in “paper profits.”

43 Exercise 18

44 Inventory Management Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average inventory The higher the ratio, the higher the markup a company is able to achieve on its products. (Beginning inventory + Ending inventory 2 Designed to evaluate a company’s effectiveness in managing its investment in inventory

45 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.

46 Methods of Simplifying LIFO 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 Inventory Pools minimizes the probability of LIFO layer liquidation. LIFO Inventory Pools

47 Example The replacement inventory differs from the old inventory on hand. We just create a new layer. 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. DVL minimizes the probability of LIFO 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.

48 DOLLAR-VALUE LIFO (DVL) Many LIFO applications are based on this approach. DVL extends the concept of inventory pool by allowing companies to combine large variety of goods into one pool (layer). Physical units are not used to calculate inventory pool (layer). Inventory is viewed as a quantity of value($) instead of a physical quantity of goods. Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years. An inventory pool is identified in terms of economic similarity rather than physical similarity (subject to the same cost change pressures). DVL simplifies the recordkeeping procedures because no information is needed about unit flows. DVL minimizes the probability of the liquidation of LIFO inventory layers, through the aggregation of many types of inventory into larger pools.

49 DOLLAR-VALUE LIFO (DVL) Under unit LIFO we determine whether a new LIFO layer was added by comparing the ending quantity with the beginning quantity. Under DVL we determine whether a new LIFO layer was added by comparing the ending dollar amount with the beginning dollar amount. COST INDEXES However, if the cost level has changed, we need a way to determine whether an increase observed is a real increase or one caused by an increase in costs. So before we compare the beginning and ending inventory amounts, we need to deflate the ending inventory amount by any increase in costs so that both the beginning and ending amounts are based on the same level of costs. We accomplish this by using cost indexes.

50 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 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. 1a. Compute a Cost Index for the year. The cost index for the base year (the year DVL is initially adopted) is set at 100.

51 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and cost index information. Let’s look at the solution to this example.

52 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information.

53 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year:

54 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory from last period.

55 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 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.

56 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Sum all the layers to arrive at ending inventory at DVL cost. Convert each layer’s base year cost to layer year cost by multiplying times the cost index.

57 Exercise 22 Exercise 23

58 End of Chapter 8


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