Valuation of Inventories: A Cost-Basis Approach Chapter 10 Valuation of Inventories: A Cost-Basis Approach ACCT-3030

1. Introduction Definition Importance Cost of inventory Cutoff 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-3030

2. Inventory Systems Periodic system CGS format 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-3030

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-3030

2b. Inventory Systems Periodic & perpetual entries Net and gross methods of recording purchase merchandise, $1,200; 2/10,n/30 return merchandise, $200 sell remainder for $1,800 pay above within discount period after discount period ACCT-3030

2c. Inventory Systems Periodic inventory system YE adjusting entry Account balances Account Balance Inventory, January 1 1,000 Inventory, December 31 1,500 Purchases 4,000 Purchases Returns and Allowances 300 Purchases Discounts 50 ACCT-3030

2c. Inventory Systems Periodic inventory system YE adjusting entry Account Dr Cr Inventory, December 31 1,500 Purchases Returns and Allowances 300 Purchases Discounts 50 CGS 3,150 Purchases 4,000 Inventory, January 1 1,000 ACCT-3030

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-3030

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-3030

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-3030

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-3030

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-3030

3e. Inventory Cost Flow Assumptions Comparison of methods (during periods of rising prices) Method Ending Inventory CGS Net Income FIFO highest lowest LIFO Average in middle What would be the differences between the methods if all units had the same cost? ACCT-3030

3f. Inventory Cost Flow Assumptions Example of methods Date Action Units Unit Price Total Price Jan 1 Beg. Inv. 2,000 $ 9.775 $ 19,550 Jan 6 Purchase 1,500 $ 10.300 $ 15,450 Jan 7 Sale 1,800 Jan 26 3,400 $ 10.750 $ 36,550 Jan 31 3,200 Total $ 71,550 Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems. ACCT-3030

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-3030

4. Special issues related to LIFO LIFO reserves maintain internal records using FIFO adjust to LIFO at year end Cost of goods sold xxx Allow to reduce inventory to LIFO xxx ACCT-3030

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-3030

5a. Dollar Value LIFO Basics of method when first adopt method (base year) value ending inventory at current costs (FIFO) end of each subsequent year, value ending inventory at current costs (FIFO) then restate current year-end cost to price level in base year a new layer formed when EI (in base year $) exceeds base year cost of BI increase priced at current costs if EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer ACCT-3030

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-3030

5c. Dollar Value LIFO Example Year End Inv (FIFO) Price Index 2011 $ 300,000 100 2012 $ 363,000 110 2013 $ 420,000 120 2014 $ 430,000 125 Calculate ending inventory using dollar value LIFO for each year. ACCT-3030

6. Effect of errors Self-correcting errors Permanent 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-3030

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 Understatement of beginning inventory ACCT-3030

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-3030

Inventories: Additional Valuations Issues ACCT-3030

1. Lower of Cost or Market Required by GAAP Theory Inventory must be reported at LCM Theory should not report inventory at a value higher than benefits to be received from selling it ACCT-3030

1a. Lower of Cost or Market Definition of market cost to replace the item (replacement cost) really “lower of cost or constrained market” Ceiling market can’t exceed NRV NRV = selling price – selling costs Floor market can’t be lower than NRV less normal profit floor = NRV – normal profit margin Can apply to individual items, groups of items, or whole inventory Does not apply to damaged or deteriorated goods ACCT-3030

1b. Lower of Cost or Market Example Selling price $60 Additional selling costs $10 Normal profit margin 40% (of selling price) Cost $36 Current replacement cost Case A $58 Case B $37 Case C $21 ACCT-3030

3. Inventory Estimation Methods Gross profit method based on relationship between sales and gross profit not acceptable for financial reporting or taxes Retail method used by large volume retailers dollar based method – not unit based method acceptable for financial reporting and taxes ACCT-3030

4. Gross Profit Method Based on assumptions that gross profit is constant from period-to-period sales mix of products is constant Used to estimate inventory value ACCT-3030

4a. Gross Profit Method Example Sales $200 Cost of goods sold $120 GP % = 80/200 = 40% CGS% = 120/200 = 60% GP% on sales = 80/200 = 40% GP% on cost = 80/120 = 66⅔% GP on Sales = GP on Costs 1 + GP on Costs ACCT-3030

4a. Gross Profit Method Example A hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000 Purchases $400,000 Sales $600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory. ACCT-3030

4a. Gross Profit Method Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales $600,000 Less: Estimated gross profit of 30% (180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000 ACCT-3030

5. Retail Method Method is based on the pattern between the cost and retail value of the goods Method requires: total costs of goods purchased total retail value of goods available for sale total sales Companies always keep 1 & 3 with this method also must keep 2 ACCT-3030

5a. Retail Method Basic method Cost Retail Beginning Inventory 600 1,000 Net Purchases 5,000 8,000 Goods Available for Sale 5,600 9,000 Cost Ratio: 5,600/9,000 = .62222 Sales 7,500 Ending Inventory at Retail 1,500 End Inv at Cost (1,500 x .62222) 933 ACCT-3030

5c. Retail Method Retail terminology Net markups and net markdowns Meaning Initial markup Original markup reflected in sales price Additional markup Additional increase in selling price after original markup Markup cancellation Elimination of additional markup Markdown Reduction in selling price below original selling price Markdown cancellation Elimination of markdown Net markups and net markdowns ACCT-3030

5b. Retail Method Ratios – computed as: cost of goods available for sale retail value of goods available for sale Based on how ratio computed, can be used to approximate following methods: average – include everything LCM – exclude markdowns (conventional retail method) FIFO – exclude beginning inventory LIFO – compute separate ratio for each layer ACCT-3030

5d. Retail Method Cost Retail Beginning Inventory + Purchases Purchases Returns - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost ACCT-3030

5e. Retail Method Avg. method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost Avg. method ACCT-3030

5f. Retail Method LCM method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost LCM method ACCT-3030

5g. Retail Method FIFO method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost FIFO method ACCT-3030

5h. Retail Method Example Cost Retail Beginning Inventory 195,000 400,000 Net Purchases 300,000 450,000 Net Markups 50,000 Net Markdowns <20,000> Available for Sale 495,000 880,000 Net Sales 407,000 Ending Inventory at Retail 473,000 Ending Inventory at Cost ACCT-3030