Chapter 8: Valuation of Inventories: A Cost Basis Approach Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 8: Valuation of Inventories: A Cost Basis Approach Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

Inventory Classification and Control Part 1: Inventory Classification and Control 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Inventory Classification Inventory consists of: finished goods held for sale in the ordinary course of business goods held or consumed in the production of finished goods A merchandising concern has finished goods only A manufacturing concern may have: raw materials, work in process and finished goods 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Inventory Cost Flows Merchandising Operations Merchandise Inventory Purchases C/G/Sold Cost of goods sold $$$ 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Inventory Cost Flows Manufacturing Operations Work in Process Raw Materials Labor Manu Overhead Work in Process Inventory $$$ C/G/Mfd Finished Goods $$$ Cost of goods sold $$$ 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Inventory Control Inventory control is important for: ensuring availability of inventory items preventing excessive accumulation of inventory items The perpetual system maintains a continuous record of inventory changes The periodic system updates inventory records only periodically 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Perpetual and Periodic Systems: Example Fesmire reports the following data for 2000: Beginning Inventory (1.1.2000): 10 units at $10 Purchases: (all credit) March 12: 30 units at $10 July 6: 25 units at $10 Sales: (all credit) April 8: 18 units at $16 August 9: 24 units at $18 Provide journal entries 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Perpetual System Date Record Inventory Changes Record Sales Revenue Mar 12 Inventory Dr 300 Accts Payable 300 Apr 8 Cost of goods sold 180 Accts Receiv 288 Inventory 180 Sales 288 Jul 6 Inventory Dr 250 Accts Payable 250 Aug 9 Cost of goods sold 240 Accts Receiv 432 Inventory 240 Sales 432 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Periodic System Date Record Inventory Changes Record Sales Revenue Mar 12 Inventory Dr 300 Accts Payable 300 Apr 8 No entry Accts Receiv 288 Sales 288 Jul 6 Inventory Dr 250 Accts Payable 250 Aug 9 No entry Accts Receiv 432 Sales 432 Dec 31 Cost of goods sold Dr 420 Inventory (ending) 230 Adjusting Purchases 550 Entry Inven (beg) 100 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Physical Goods Included in Inventory Part 2: Physical Goods Included in Inventory 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Items to be included in Inventory Legal title to goods determines inclusion. The following goods are included in seller’s inventory: Goods in transit (if seller has title during shipment) Goods on consignment with seller Goods, sold under buy back agreements Goods, sold with high rates of return Installment sales (if bad debts can not be estimated) 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Effect of Inventory Errors Ending Effect on Effect on inventory Income Balance sheet Items Items Under- C/G/sold (over) stated Net income (under) Retained Earn (under) Work capital (under) Over- C/G/sold (under) stated Net income (over) Retained Earn (over) Work capital (over) 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Costs Included in Inventory Part 3: Costs Included in Inventory 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Costs included in Inventory Costs included in inventory are called “inventoriable costs” These costs include: product costs (direct materials, direct labor and manufacturing overhead) purchase net costs, and freight-in Period costs (selling and administrative) are not inventoriable costs 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Inventory Valuation: Variable costing Under variable costing, inventory costs include only the following manufacturing costs: direct materials used, direct labor, and variable manufacturing overhead Fixed manufacturing overhead is ignored All period costs are ignored. Variable costing is appropriate for internal decision-making. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Inventory Valuation: Absorption costing Under absorption costing, inventory costs include all manufacturing costs as follows: direct materials used in production, direct labor cost, variable manufacturing overhead, and fixed manufacturing overhead All period costs are ignored. Absorption costing is required for external reporting. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Part 4: Inventory Cost Flow Assumptions 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Cost Flow Assumptions The objective is to most clearly reflect periodic income. Cost flow assumptions need not be consistent with physical flow of goods. The cost flow assumptions are: specific identification average cost first-in, first-out and last-in, first-out 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Cost Flow Assumptions: Example Call-Mart reports the following transactions for 2000: Date Purchases Purchase Cost May 12 100 units $1,000 Aug 14 200 units $2,200 Sep 18 120 units $1,800 On December 31, the company had 20 units on hand. Determine the cost of goods sold and the cost of ending inventory. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Average (weighted) method Date Purchases Purchase Cost May 12 100 units $1,000 Aug 14 200 units $2,200 Sep 18 120 units $1,800 420 units $5,000 Unit cost = $5,000/ 420 = $11.91 $5,000 Cost of goods available 400 * 11.91 = 4,762 Cost of goods sold 20 * 11.91 = $238 Ending inventory 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

First-in, First-out method Date Purchases Purchase Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 Cost of goods sold (FIFO) $1,000 $2,200 $1,500 (100 sold; 20 end inv) 420 units $5,000 $4,700 $5,000 Cost of goods available $4,700 Cost of goods sold 20 * $15 = $300 Ending inventory 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Last-in, First-out method Date Purchases Purchase Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 Cost of goods sold (LIFO) $ 800 (80 sold; 20, end inv) $2,200 $1,800 420 units $5,000 $4,800 $5,000 Cost of goods available $4,800 Cost of goods sold 20 * $10 = $200 Ending inventory 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Cost Flow Assumptions: Notes The ending inventory in units is the same in all three methods: the cost is different. The cost of goods sold and the cost of ending inventory are different, but The cost of goods available is the same in all three methods. LIFO would result in the smallest reported net income (with rising prices). 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) Part 5: LIFO Special Issues 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) LIFO Reserve LIFO Reserve (Allowance) account is used, when: LIFO is used for external reporting and a non-LIFO basis is used for internal reporting. An Allowance to Reduce Inventory to LIFO is used to reduce the cost to a LIFO basis. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Adjust the cost of ending inventory to the LIFO basis LIFO Reserve: Example Amco Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2000: $50,000 Inventory (LIFO basis) on Dec 31, 2000: $20,000 Adjust the cost of ending inventory to the LIFO basis Cost of goods sold Dr. $30,000 Allowance to Reduce Inventory to LIFO $30,000 Balance Sheet (Assets): Inventory (FIFO) $50,000 less: Allowance to Reduce Inventory ($30,000) Inventory (LIFO) basis $20,000 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) LIFO Layers Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when: earlier costs are matched against current sales. Such matching results in distorted income. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Methods to Alleviate Layer Liquidation Problems Use the specific goods pooled LIFO approach: a pool is a combination of similar items. reductions in one item, compensated by increases in other items. Use dollar-value LIFO changes in pools are determined in terms of dollars, not quantities 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Dollar Value LIFO: example Given: Base layer (Dec 31, 2001): $20,000 Inventory (current prices) on Dec 31, 2002: $26,400 Prices increased 20% during 2002. Determine dollar value LIFO at Dec 31, 2002 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Dollar Value LIFO: example Price increase, 20% Dec 31, 2001 Dec 31, 2002 Current $: $26,400 $26,400 / 1.20 At base $: $22,000 Net increase at base $: $22,000 less $20,000 $20,000 plus $2,400 Dollar value LIFO Restate at current $: $2,400 $2,000 * 1.20 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Dollar Value LIFO: Notes When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices): the decrease must be subtracted from the most recently added layer Once a layer is eliminated (peeled off), it can not be rebuilt. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Advantages of LIFO method LIFO matches more recent costs with current revenues. With increasing prices, LIFO yields the lowest taxable income (assuming inventory does not decrease) With reduced taxes, cash flow is improved. Under LIFO, the need to write down inventory to market is minimized 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Disadvantages of LIFO method LIFO does not approximate the physical flow of goods except in special situations LIFO yields the lowest net income and therefore reduced earnings Under LIFO, the ending inventory is understated LIFO involuntary liquidation may result in income that is detrimental from a tax view. LIFO may cause poor buying habits (because of the layer liquidation problem) 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.) COPYRIGHT Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 11/17/2018 Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)