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Chapter 8 Valuation of Inventories: A Cost-Basis Approach ACCT-30301.

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Presentation on theme: "Chapter 8 Valuation of Inventories: A Cost-Basis Approach ACCT-30301."— Presentation transcript:

1 Chapter 8 Valuation of Inventories: A Cost-Basis Approach ACCT-30301

2 1. Introduction Definition ◦ Assets held for sale in the ordinary course of business or goods that will be consumed in production Importance Cost of inventory ◦ all expenditures necessary in acquiring goods and converting them to saleable condition Cutoff Who owns inventory if “sale” is a(an) product financing arrangement, installment sale, consignment, sales with high rates of return ACCT-30302

3 2. Inventory Systems Periodic system ◦ no running balance of inventory & CGS ◦ purchases account used ◦ beginning inv balance unchanged during year ◦ take physical inventory at year-end and record ending balance through adjusting entry ◦ CGS calculated CGS format ACCT-30303

4 2a. Inventory Systems Perpetual system ◦ keeps running balance of inventory & CGS ◦ no purchases account used ◦ all changes in inventory cost recorded in inventory account ◦ take physical inventory at year-end & adjust book balance to actual ACCT-30304

5 2b. Inventory Systems Periodic & perpetual entries Net and gross methods of recording 1.purchase merchandise, $1,200; 2/10,n/30 2.return merchandise, $200 3.sell remainder for $1,800 4.pay above a.within discount period b.after discount period ACCT-30305

6 2c. Inventory Systems Periodic inventory system YE adjusting entry ◦ Account balances ACCT AccountBalance Inventory, January 11,000 Inventory, December 311,500 Purchases4,000 Purchases Returns and Allowances 300 Purchases Discounts50

7 2c. Inventory Systems Periodic inventory system YE adjusting entry ACCT AccountDrCr Inventory, December 311,500 Purchases Returns and Allowances 300 Purchases Discounts50 CGS3,150 Purchases4,000 Inventory, January 11,000

8 3. Inventory Cost Flow Assumptions Problem ◦ purchases made at different prices Flow of costs v. flow of goods Four GAAP methods ◦ specific identification ◦ FIFO ◦ LIFO ◦ average ACCT-30308

9 3a. Inventory Cost Flow Assumptions Specific identification ◦ only used if relatively small number of high priced goods that can be easily distinguished ◦ can manipulate income ACCT-30309

10 3b. Inventory Cost Flow Assumptions FIFO ◦ assume goods used in order purchased ◦ ending inventory approximately at current costs ◦ CGS at old prices ◦ periodic and perpetual systems always give same result ACCT

11 3c. Inventory Cost Flow Assumptions LIFO ◦ assumes last goods purchased are first sold ◦ advantages  matches current costs with revenues  tax benefits  improved cash flow ◦ disadvantages  reduction in reported earnings  understatement of ending inventory on bal. sheet  does not reflect underlying physical flow of goods  causes poor buying habits  can manipulate income ◦ LIFO conformity rule  must use LIFO for financial reporting if used for tax reporting ACCT

12 3d. Inventory Cost Flow Assumptions Average cost ◦ weighted average or moving average used ◦ values goods based on average cost of goods on hand and acquired Other methods ◦ base stock ◦ standard cost ◦ NIFO ◦ LIFO/FIFO ACCT

13 3e. Inventory Cost Flow Assumptions Comparison of methods (during periods of rising prices) ACCT Method Ending Inventory CGSNet Income FIFOhighestlowesthighest LIFOlowesthighestlowest Averagein middle What would be the differences between the methods if all units had the same cost?

14 3f. Inventory Cost Flow Assumptions Example of methods ACCT DateActionUnitsUnit PriceTotal Price Jan 1Beg. Inv.2,000$ 9.775$ 19,550 Jan 6Purchase1,500$ $ 15,450 Jan 7Sale1,800 Jan 26Purchase3,400$ $ 36,550 Jan 31Sale3,200 Total$ 71,550 Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems.

15 4. Special issues related to LIFO Inventory Pools ◦ Unrealistic to assume only one product ◦ If multi product  replace one item with another – loose base layer of LIFO cost ◦ Pooled approach  group similar items together  reduces record keeping costs  more difficult to erode old LIFO layers ◦ Number of pools? ACCT

16 4. Special issues related to LIFO LIFO reserves ◦ maintain internal records using FIFO ◦ adjust to LIFO at year end Cost of goods soldxxx Allow to reduce inventory to LIFO xxx ACCT

17 5. Dollar Value LIFO Introduction ◦ emphasis is on dollar value of inventory  not units of inventory ◦ greatly reduces problem of changes in mix of inventory ◦ more practical method of valuing multi-product inventory than unit LIFO ◦ allowed for financial reporting and tax ◦ LIFO conformity rule  must use LIFO for financial reporting if used for tax ACCT

18 5a. Dollar Value LIFO Basics of method 1.when first adopt method (base year) value ending inventory at current costs (FIFO) 2.end of each subsequent year, value ending inventory at current costs (FIFO) 3.then restate current year-end cost to price level in base year 4.a new layer formed when EI (in base year $) exceeds base year cost of BI  increase priced at current costs 5.if EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer ACCT

19 5b. Dollar Value LIFO Price index ◦ company may calculate own  double extension method or link-chain method ◦ may use published price indexes  e.g., GNP implicit price deflator, CPI, or industry specific index ◦ example using market basket approach ACCT

20 5c. Dollar Value LIFO Example ACCT YearEnd Inv (FIFO)Price Index 2011$ 300, $ 363, $ 420, $ 430, Calculate ending inventory using dollar value LIFO for each year.

21 6. Effect of errors Self-correcting errors ◦ most errors correct themselves over time  e.g., inventory – this year’s ending inventory is next year’s beginning inventory  depreciable assets – over the life of the assets ◦ but each year is incorrect over that period Permanent errors ◦ never will correct themselves ◦ e.g., expensing land, recording wrong amount ACCT

22 6a. Inventory Errors Overstatement of ending inventory ◦ Understates cost of goods sold ◦ Overstates income Understatement of ending inventory ◦ Overstates cost of goods sold ◦ Understates income Overstatement of beginning inventory ◦ Overstates cost of goods sold ◦ Understates income Understatement of beginning inventory ◦ Understates cost of goods sold ◦ Overstates income ACCT

23 6b. Effect of errors Determining effect of errors ◦ determine effect for all accounts involved ◦ examples  ending inventory overstated  interest expense not accrued on N/P this year, next year principle and interest paid in full ACCT


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