Inventories: Cost Measurement and Flow Assumptions 7 hapter Inventories: Cost Measurement and Flow Assumptions 1 1 1 1

Objectives 1. Describe how inventory accounts are classified. 2. Explain the uses of perpetual and periodic inventory systems. 3. Identify how inventory quantities are determined. 4. Determine the cost of inventory. 5. Compute ending inventory and cost of goods sold under specific identification, FIFO, average cost, and LIFO. 2 2 2 4

Objectives 6. Explain the conceptual issues regarding alternative inventory cost flow assumptions. 7. Understand dollar-value LIFO. 8. Explain additional LIFO issues. 9. Understand inventory disclosures. 10. Record foreign currency transactions involving inventory (Appendix).

Flow of Inventory Costs Merchandising Company Accounts Payable (or Cash) Merchandise Inventory Cost of Goods Sold Goods Purchased Goods Sold

Flow of Inventory Costs Manufacturing Company Accounts Payable (or Cash) Raw Materials Inventory Materials Used in Production To Goods in Process Inventory Materials Purchased Continued

Flow of Inventory Costs Manufacturing Company Direct Labor Actual Direct Labor Labor Charged to Production To Goods in Process Inventory Manufacturing (Factory) Overhead Actual Mfg. Over-head Overhead Applied to Production To Goods in Process Inventory Continued

Flow of Inventory Costs Manufacturing Company Goods in Process Inventory Finished Goods Inventory Materials Used Direct Labor Overhead Applied Goods Finished (Manufactured) Goods Sold to Cost of Goods Sold

Alternative Inventory Systems A company using a perpetual system maintains a continuous record of the physical quantities in its inventory.

Alternative Inventory Systems A company using a periodic system does not maintains a continuous record of the physical quantities on hand.

Alternative Inventory Systems Purchases + Freight-in - Purchases Returns and Allowances - Purchases Discounts Taken = Net Purchases

Alternative Inventory Systems Perpetual Inventory System Periodic Inventory System Beginning inventory + Purchases (net) - Goods Sold = Ending Inventory Beginning inventory + Purchases (net) - Ending Inventory = Goods Sold

Goods being shipped included in inventory of buyer. FOB Shipping Point Fruit Express Goods being shipped included in inventory of buyer.

Goods being shipped included in inventory of seller. FOB Destination Fruit Express Goods being shipped included in inventory of seller.

Determination of Inventory Costs Price paid or consideration given Freight-in Receiving Unpacking Inspecting Storage Insurance Applicable taxes

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Gross Price Method To record the purchase Inventory (or Purchases) 1,000 Accounts Payable 1,000

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Gross Price Method To record payment within the discount period: Accounts Payable 1,000 Purchases Discounts Taken 10 Cash 990

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Gross Price Method To record payment after the discount period: Accounts Payable 1,000 Cash 1,000

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Net Price Method To record the purchase: Inventory (or Purchases) 990 Accounts Payable 990

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Net Price Method To record payment within the discount period: Accounts Payable 990 Cash 990

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Net Price Method To record payment after the discount period: Accounts Payable 990 Purchases Discounts Lost 10 Cash 1,000

A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts A company purchases $1,000 of goods under terms of 1/10, n/30. Net Price Method Adjusting entry at the end of period if discount has expired and invoice is unpaid: Purchases Discounts Lost 10 Accounts Payable 10

Specific Identification Apr. 1 Apr. 10 Apr. 20 100 units @ $10 per unit 80 units @ $11 per unit 70 units @ $12 per unit Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20 units from the April 20 purchase.

Specific Identification Apr. 1 Apr. 10 Apr. 20 20 units @ $10 per unit = $ 200 = 440 = 600 $1,240 40 units @ $11 per unit 50 units @ $12 per unit Ending inventory……………. Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20 units from the April 20 purchase. Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,240 = $1,480

First-In, First-Out (FIFO) Sold all Apr. 1 Apr. 10 Apr. 20 100 units @ $10 per unit 0 units @ $10 per unit Sold 40 40 units @ $11 per unit 80 units @ $11 per unit 70 units @ $12 per unit Sold 0 Sold 140 units during April.

First-In, First-Out (FIFO) Note that the ending inventory and the cost of goods sold under perpetual and periodic FIFO are identical. 100 units @ $10 per unit Apr. 1 Apr. 10 Apr. 20 80 units @ $11 per unit 40 units @ $11 per unit 0 units @ $10 per unit 70 units @ $12 per unit = $ 0 = 440 = 840 $1,280 Ending inventory…………….…… Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,280 = $1,440

Average Cost 100 units @ $10 per unit Apr. 1 = $1,000 Apr. 10 = 880 = $1,000 = 880 = 840 $2,720 250 units $2,720  250 units = $10.88 $10.88 x 110 units = ending inventory of $1,197 Sold 140 units during April. Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,197 = $1,523

Moving Average Apr. 1 Beginning Inventory 100 units @ $10 $1,000 Apr. 10 Purchases 80 units @ $11 880 Apr. 10 Balance 180 units @ $10.44 $1,880 Apr. 18 Sales -90 units @ $10.44 -940 Apr. 18 Balance 90 units @ $10.44 $ 940 Apr. 20 Purchases 70 units @ $12 840 Apr. 20 Balance 160 units @ $11.125 $1,780 $1,880  180 Apr. 27 Sales -50 units @ $11.125 -556 Apr. 30 Balance 110 units @ $11.125 $1,224 $1,780  160 Cost of Goods Sold (140 units) $940 + $556 $1,496 Ending Inventory (110 units @ $11.125) $1,224

Last-In, First-Out (LIFO) Periodic Inventory System Sold 0 Apr. 1 Apr. 10 Apr. 20 100 units @ $10 per unit Sold 70 10 units @ $11 per unit 80 units @ $11 per unit 0 units @ $12 per unit 70 units @ $12 per unit Sold all Sold 140 units during April.

Last-In, First-Out (LIFO) 100 units @ $10 per unit Apr. 1 Apr. 10 Apr. 20 80 units @ $11 per unit 10 units @ $11 per unit 70 units @ $12 per unit Periodic Inventory System 0 units @ $12 per unit = $1,000 = 110 = 0 $1,110 Ending inventory……………….. Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,110 = $1,610

Last-In, First-Out (LIFO) Perpetual Inventory System Apr. 1 Apr. 10 Apr. 20 90 units @ $10 per unit 100 units @ $10 per unit Sold 10 80 units @ $11 per unit 0 units @ $11 per unit 80 units @ $11 per unit Purchased 80 Sold 80 20 units @ $12 per unit 70 units @ $12 per unit Sold 50 Purchased 70

Last-In, First-Out (LIFO) 100 units @ $10 per unit 90 units @ $10 per unit Last-In, First-Out (LIFO) Apr. 1 Apr. 10 Apr. 20 80 units @ $11 per unit 70 units @ $12 per unit Perpetual Inventory System 20 units @ $12 per unit 0 units @ $11 per unit = $ 900 = 0 = 240 $1,140 Ending inventory……………….. Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,140 = $1,580

Comparison of Inventory Assumptions Cost of Goods Cost of Available Goods Ending for Sale Sold Inventory Cost Flow Assumption and Method FIFO, periodic $2,720 $1,440 $1,280 FIFO, perpetual 2,720 1,440 1,280 Weighted average 2,720 1,523 1,197 Moving average 2,720 1,496 1,224 LIFO, periodic 2,720 1,610 1,110 LIFO, perpetual 2,720 1,580 1,140

Alternative Cost Flow Assumptions Per Unit FIFO LIFO ($12) LIFO ($11) Revenue $30 $30 $30 Cost of goods sold (10) (12) (11) Gross profit $20 $18 $19 Holding gains (ex- cluded from income) 2 1 $20 $20

Liquidation of LIFO Layers 1997: 1998: 1999: 2000: 10,000 units at $20 per unit = $200,00 = 132,000 = 192,000 = 120,000 $644,000 6,000 units at $22 per unit 8,000 units at $24 per unit 4,000 units at $30 per unit Inventory, January 1, 2001…………. In 2001 the company purchases 50,000 units at $35 per unit and sells 60,000 units.

Liquidation of LIFO Layers 1997: 1998: 1999: 2000: 2001: 10,000 units at $20 per unit = $200,00 = 132,000 = 192,000 = 120,000 = 1,750,000 6,000 units at $22 per unit Sold 6,000 6,000 units at $24 per unit 8,000 units at $24 per unit Sold 4,000 4,000 units at $30 per unit 4,000 units at $30 per unit Sold 50,000 50,000 units at $35 per unit 50,000 units at $35 per unit In 2001 the company purchases 50,000 units at $35 per unit and sells 60,000 units.

Liquidation of LIFO Layers 1997: 1998: 1999: 10,000 units at $20 per unit 6,000 units at $22 per unit 2,000 units at $24 per unit 6,000 units at $24 per unit = $ 144,000 = 120,000 = 1,750,000 $2,014,000 1999: 2000: 2001: 4,000 units at $30 per unit 50,000 units at $35 per unit 50,000 units at $35 per unit Cost of goods sold…………

Difficulties in Applying Simple LIFO The LIFO method requires a company to keep numerous detailed records. Fluctuations in the physical quantities of similar inventory items may occur. As technological changes take place, inventory made up with one material is replaced by inventory made with substitute materials or an outdated design is replaced by a newer design.

Dollar-Value LIFO Step 1: Value the total ending inventory at current-year costs. 01/1/00 $10,000 12/31/00 $12,100 12/31/01 $13,125 12/31/02 $16,800 12/31/03 $12,360

Ending Inventory at Current Cost Dollar-Value LIFO Step 2: Convert the ending inventory cost to base-year cost: 12/31/00 $12,100 12/31/01 $13,125 12/31/02 $16,800 12/31/03 $12,360 x 100/110 = $11,000 x 100/125 = $10,500 x 100/140 = $12,000 x 100/120 = $10,300 Base Year Cost Index 12/31/00 Ending Inventory at Current Cost x Current Cost Index

Dollar-Value LIFO Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 - $10,000 12/31/00 12/31/01 12/31/02 12/31/03 $11,000 $10,500 $12,000 $10,300 $1,000 Base year, $10,000 12/31/00 1/1/00

Dollar-Value LIFO Step 4a: If there has been an increase, convert this increase to current-year costs. $1,000 x 110/100 = $ 1,100 x 100/100 = 10,000 Base year, $10,000 $11,100 Ending inventory, 12/31/00 12/31/00

Ending Inventory at Current Cost Dollar-Value LIFO Step 2: Convert the ending inventory cost to base-year cost: 12/31/00 $12,100 12/31/01 $13,125 12/31/02 $16,800 12/31/03 $12,360 x 100/110 = $11,000 x 100/125 = $10,500 x 100/140 = $12,000 x 100/120 = $10,300 Base Year Cost Index 12/31/01 Ending Inventory at Current Cost x Current Cost Index

Dollar-Value LIFO Step 3: Compute the change in the inventory level for the year at base-year costs. 12/31/00 12/31/01 12/31/02 12/31/03 $11,000 $10,500 $12,000 $10,300 $11,000 - $10,500 $1,000 $500 $1,000 Base year, $10,000 12/31/01

Dollar-Value LIFO Step 4b: If there is a decrease, this decrease reduces the inventory. $500 x 110/100 = $ 550 x 100/100 = 10,000 Base year, $10,000 $10,550 Ending inventory, 12/31/01 12/31/01

Ending Inventory at Current Cost Dollar-Value LIFO Step 2: Convert the ending inventory cost to base-year cost: 12/31/00 $12,100 12/31/01 $13,125 12/31/02 $16,800 12/31/03 $12,360 x 110/100 = $11,000 x 100/125 = $10,500 x 100/140 = $12,000 x 100/120 = $10,300 Base Year Cost Index 12/31/02 Ending Inventory at Current Cost x Current Cost Index

Dollar-Value LIFO Step 3: Compute the change in the inventory level for the year at base-year costs. 12/31/00 12/31/01 12/31/02 12/31/03 $11,000 $10,500 $12,000 $10,300 $12,000 - $10,500 = $1,500 $1,000 $500 $1,000 Base year, $10,000 12/31/02

Dollar-Value LIFO 12/31/00 12/31/01 12/31/02 12/31/03 $11,000 $10,500 $12,000 $10,300 $1,500 $500 Base year, $10,000 12/31/02

Dollar-Value LIFO Step 4a: Convert increase to current-year costs. $1,500 x 140/100 = $ 2,100 x 110/100 = 550 x 100/100 = 10,000 $12,650 $500 Base year, $10,000 12/31/02 Ending inventory, 12/31/02

Determination of Cost Index Sample of Ending Inventory at Current -Year Costs x 100 Cost Index = Sample of Ending Inventory at Base-Year Costs Double-Extension Method

Determination of Cost Index Sample of Ending Inventory at Current -Year Costs Previous-Year Cost Index x Cost Index = Sample of Ending Inventory at Previous-Year Costs Link-Chain Method

Disclosure of Inventory Values and Methods Methods: Number of Companies First-in, first-out (FIFO) 415 Last-in, first-out (LIFO) 326 Average cost 188 Other 32 961 1997

Disclosure of Inventory Values and Methods Use of LIFO Number of Companies All inventories 17 50% or more inventories 170 Less than 50% of inventories 99 Not determinable 40 Not used 274 600 1997

Foreign Currency Transactions Involving Inventory A U.S. company purchases inventory of electronic components from a Japanese company for 50 million yen (¥) when the exchange rate is $0.007. ¥50,000,000 x $0.007 = $350,000 Inventory (or Purchases) 350,000 Cash 350,000 Click button to skip Appendix material.

Foreign Currency Transactions Involving Inventory An exchange gain occurs when the exchange rate declines between the date a payable is recorded as a result of a purchase of inventory and the date of the cash payment. An exchange gain occurs when the exchange rate increases between the date a receivable is recorded as a result of a sale of inventory and the date of the cash receipt. When exchange rates are stated in terms of $ per unit of foreign currency, exchange gains and losses occur for purchases or sales on account as follows: Continued

Foreign Currency Transactions Involving Inventory An exchange loss occurs when the exchange rate increases between the date a payable is recorded as a result of a purchase of inventory and the date of the cash payment. An exchange loss occurs when the exchange rate declines between the date a receivable is recorded as a result of a sale of inventory and the date of the cash receipt.

Foreign Currency Transactions Involving Inventory Assume that the exchange rate on the date of payment is $0.0068. The U.S. company has to pay only $340,000. ¥50,000,000 x $0.0068 = $340,000 Accounts Payable 350,000 Cash 340,000 Exchange Gain 10,000

Foreign Currency Transactions Involving Inventory A U.S. company sells computer equipment (cost, $100,000) to Swiss Company on account and the agreed price is 300,000 francs. On the date of the sale, the exchange rate is $0.69. 300,000 x $0.69 = $207,000 Accounts Receivable 207,000 Sales Revenue 207,000 Cost of Goods Sold 100,000 Inventory 100,000

Foreign Currency Transactions Involving Inventory If the exchange rate is $0.67 when Swiss Company pays the amount owed, the U.S. company can convert those francs into only $201,000. 300,000 x $0.67 = $201,000 Cash 201,000 Exchange Loss 6,000 Accounts Receivable 207,000

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