Inventories: Cost Measurement and Flow Assumptions C hapter 8 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

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

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

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

5 Computation of Net Purchases Purchases +Freight-in -Purchases Returns and Allowances -Purchases Discounts Taken =Net Purchases Purchases +Freight-in -Purchases Returns and Allowances -Purchases Discounts Taken =Net Purchases

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

7 Under the gross price method, a company records the purchase at the gross price, and records the amount of the discount in the accounting system only if the discount is taken. Under the net price method, a company records the purchase at its net price, and records the amount of the discount in the accounting system only if the discount is not taken. Purchases Discounts

8 Purchases Discounts- Gross Price Method To record the purchase Inventory (or Purchases)1,000 Accounts Payable1,000 A company purchases $1,000 of goods under terms of 1/10, n/30. To record payment within the discount period: Accounts Payable1,000 Purchases Discounts Taken10 Cash990 To record payment after the discount period: Accounts Payable1,000 Cash1,000

9 To record the purchase: Inventory (or Purchases)990 Accounts Payable990 A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts- Net Price Method To record payment within the discount period: Accounts Payable990 Cash990 To record payment after the discount period: Accounts Payable990 Purchases Discounts Lost10 Cash1,000 Purchases Discounts Lost are treated as a financing expense in the Other section of the income statement.

10 Net Price Method Adjusting entry at the end of period if discount has expired and invoice is unpaid: Purchases Discounts Lost10 Accounts Payable10 A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts

11 If the company does not pay promptly, it is forfeiting 2% in order to keep the money for an additional 20 days. A company purchases $1,000 of goods under terms of 2/10, n/30. What is the annual discount rate? The company can forfeit this discount 18 times during a year. 360 days/ 20 additional each time = 18 Annual Rate on Discounts 2% forfeited 18 times equals an annual interest rate of 36%

12 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit On April 27, sold 90 units from the beginning inventory, 50 units from the April 10 purchase.

13 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Apr. 20 $12 per unit $10 per unit Apr. 1 $11 per unit Apr. 10 $12 per unit $10 per unit $11 per unit $12 per unit Sold 90 Sold 50 Ending inventory = $ 100 =330 = 840 $1,270 Cost of Goods Sold $1,450 =$900 =550 =0 Sold 0

14 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Apr. 20 Apr. 1 Apr. 10 $12 per unit $10 per unit $11 per unit $12 per unit Ending inventory Goods available for sale = $ 1,000 =880 = 840 $2,720 = $ 100 =330 = 840 $1,270 Cost of Goods Sold…………. $ 1,480 Cost of Goods Sold

15 $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Sold 140 units during April. $11 per unit Sold all $10 per unit Sold 40 Sold 0 $12 per unit First-In, First-Out (FIFO)

16 Ending inventory…………….…… $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per $11 per unit $10 per unit $12 per unit Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold = $ 0 =440 = 840 $1,280 $1,000 + $1,720 - $1,280 = $1,440 First-In, First-Out (FIFO)

17 = $1,000 =880 = 840 $2,720 Average Cost $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit Sold 140 units during April. 250 units Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,197 = $1,523 $2,720  250 units = $10.88 $10.88 x 110 units = ending inventory of $1,197

18 $1,780  160 Apr. $ Apr. $10.44$ 940 Apr. 20Purchases $ $11.125$1,780 Moving Average Apr. 1Beginning $10$1,000 Apr.10Purchases $ $10.44$1,880 Apr. $ Apr. $11.125$1,224 Cost of Goods Sold (140 units) $940 + $556$1,496 Ending Inventory (110 $11.125)$1,224 $1,880  180

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

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

21 $10 per unit $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Purchased 80 $12 per unit Perpetual Inventory System Sold 80 $11 per unit $11 per unit Sold 10Purchased 70Sold 50 Sold 90 Last-in, First Out

22 Apr. 1 Apr. 10 Apr. 20 Perpetual Inventory System Ending inventory……………… Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold = $ 900 =0 = 240 $1,140 $1,000 + $1,720 - $1,140 = $1,580 $10 per unit $11 per unit $12 per unit Last-in, First Out

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

24 When a company initially changes to the LIFO method, the base year cost for the beginning of the year of change is the ending inventory for the prior year based on whatever method was used previously. Initial Adoption of LIFO

25 10,000units at $20 per unit 6,000units at $22 per unit 8,000units at $24 per unit 4,000units at $30 per unit =$200,000 =132,000 =192,000 = 120,000 $644,000 Inventory, January 1, 2007………… In 2007 the company purchases 50,000 units at $35 per unit and sells 60,000 units. 2003: 2004: 2005: 2006: Liquidation of Layers

26 10,000units at $20 per unit 6,000units at $22 per unit 8,000units at $24 per unit 4,000units at $30 per unit 2003: 2004: 2005: 2006: 2007: =$200,00 =132,000 =192,000 =120,000 =1,750,000 50,000units at $35 per unit 0units at $35 per unit Sold 50,000 Sold 4,000 Sold 6,000 0units at $30 per unit 2,000units at $24 per unit Liquidation of Layers In 2007 the company purchases 50,000 units at $35 per unit and sells 60,000 units.

27 10,000units at $20 per unit 6,000units at $22 per unit 6,000units at $24 per unit 4,000units at $30 per unit 2003: 2004: 2005: =$ 144,000 =120,000 = 1,750,000 $2,014,000 50,000units at $35 per unit 2,000units at $24 per unit 2005: 2006: 2007: Cost of goods sold……… Liquidation of Layers Inventory Layers

28 1.The LIFO method requires a company to keep numerous detailed records. 2.Fluctuations in the physical quantities of similar inventory items may occur. 3.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. Difficulties in Applying Simple LIFO

29 Step 1: Value the total ending inventory at current- year costs. 01/1/06$10,000 12/31/06$12,100 12/31/07$13,125 12/31/08$16,800 12/31/09$12,360 Dollar-Value LIFO

30 Step 2: Convert the ending inventory cost to base- year cost: 12/31/06$12,100 12/31/07$13,125 12/31/08$16,800 12/31/09$12,360 Ending Inventory at Current Cost x Base Year Cost Index Current Cost Index x100/110 = $11,000 12/31/06 Dollar-Value LIFO

31 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 Base year, $10,000 $11,000 - $10,000 $1,000 1/1/06 12/31/06 Dollar Value LIFO

32 Step 4a:If there has been an increase, convert this increase to current-year costs. Base year, $10,000 $1,000$1,000 12/31/06 x 110/100 =$ 1,100 x 100/100 =10,000 $11,100 Ending inventory, 12/31/06 Dollar-Value LIFO

33 Step 2: Convert the ending inventory cost to base- year cost: 12/31/06$12,100 12/31/07$13,125 12/31/08$16,800 12/31/09$12,360 Ending Inventory at Current Cost x Base Year Cost Index Current Cost Index x100/110 = $11,000 x 100/125 = $10,500 12/31/07 Dollar-Value LIFO

34 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/07 $1,000 $11,000 - $10,500 Dollar-Value LIFO

35 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/07 $500 Dollar-Value LIFO

36 Step 4b: If there is a decrease, this decrease reduces the inventory. Base year, $10,000 $500 12/31/07 x 110/100 =$ 550 x 100/100 =10,000 $10,550 Ending inventory, 12/31/07 Dollar-Value LIFO

37 Step 2: Convert the ending inventory cost to base- year cost: 12/31/06$12,100 12/31/07$13,125 12/31/08$16,800 12/31/09$12,360 x110/100 = $11,000 x 100/125 = $10,500 x100/140 = $12,000 12/31/08 Dollar-Value LIFO Ending Inventory at Current Cost x Base Year Cost Index Current Cost Index

38 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/08 $500 $12,000 - $10,500 = $1,500 Dollar-Value LIFO

39$500 $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/08 $1,500 Step 3: Compute the change in the inventory level for the year at base-year costs. Dollar-Value LIFO

40 Step 4a:Convert increase to current-year costs. Base year, $10,000 12/31/08 x 140/100 =$ 2,100 x 110/100 = 550 x 100/100 =10,000 $12,650 Ending inventory, 12/31/08 $500 $1,500 Dollar-Value LIFO

41 Step 2: Convert the ending inventory cost to base- year cost: 12/31/06$12,100 12/31/07$13,125 12/31/08$16,800 12/31/09$12,360 x110/100 = $11,000 x 100/125 = $10,500 x100/140 = $12,000 x100/120 = $10,300 12/31/09 Dollar-Value LIFO Ending Inventory at Current Cost x Base Year Cost Index Current Cost Index

42$500 $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/09 $1,500 Dollar-Value LIFO

43$500 $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/09 Dollar-Value LIFO

44$300 $11,000 $10,500 $12,000 $10,300 12/31/06 12/31/07 12/31/08 12/31/09 Base year, $10,000 12/31/09 Dollar-Value LIFO

45 Step 4a:Convert increase to current-year costs. Base year, $10,000 12/31/09 x 110/100 = $ 330 x 100/100 =10,000 $10,330 Ending inventory, 12/31/09 $300 Dollar-Value LIFO

46ContinueContinue Example 8-12 Current Current cost at Historical Costs base year prices Cost 12/31/06 $12,100 X = 11,000 $10,000 X =$10,000 1,000X =1,100 $11,100 12/31/07 $13,125 X = 10,500 $10,550 $10,000 X =$10, X =550

47 12/31/08 $16,800 X = 12, X =550 $12,650 $10,000 X =$10,000 1,500 X =2,100 12/31/09 $12,360 X = $10,300 $10,330 $10,000 X = $10, X = 330 Example 8-12 Current Current cost at Historical Costs base year prices Cost

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

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

50 1. 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. 2. 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: ContinuedContinued Foreign Currency Transactions Involving Inventory

51 Foreign Currency Transactions Involving Inventory 3.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. 4.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. RMB

52 A U.S. company purchases inventory of electronic components from a Japanese company for 50 million yen (¥) when the exchange rate is $ ¥50,000,000 x $0.008 = $400,000 Inventory (or Purchases)400,000 Cash400,000 Foreign Currency Transactions Involving Inventory

53 Assume that the exchange rate on the date of payment is $ The U.S. company has to pay only $390,000. ¥50,000,000 x $ = $390,000 Accounts Payable400,000 Cash390,000 Exchange Gain10,000 Foreign Currency Transactions Involving Inventory

54 A U.S. company sells computer equipment (cost, $200,000) to a German Company on account and the agreed price is 300,000 euros. On the date of the sale, the exchange rate is $1.20 (1 euro = $1.20). €300,000 x $1.20 = $360,000 Accounts Receivable360,000 Sales Revenue360,000 Cost of Goods Sold200,000 Inventory200,000 Foreign Currency Transactions Involving Inventory

55 If the exchange rate is $1.18 when German Company pays the amount owed, the U.S. company can convert those euros into only $354,000. €300,000 x $1.18 = $354,000 Cash354,000 Exchange Loss6,000 Accounts Receivable360,000 Foreign Currency Transactions Involving Inventory

56 C hapter 8 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.