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

2. 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

3. 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

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-3030

5. 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

6. 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

7. 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

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-3030

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-3030

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-3030

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-3030

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-3030

13. 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

14. 3f. Inventory Cost Flow Assumptions
Example of methods
Date
Action
Units
Unit Price
Total Price
Jan 1
Beg. Inv.
2,000 $
$ 19,550
Jan 6
Purchase
1,500 $
$ 15,450
Jan 7
Sale
1,800
Jan 26
3,400 $
$ 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

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-3030

16. 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

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-3030

18. 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

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-3030

20. 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

21. 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

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
Understatement of beginning inventory
ACCT-3030

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-3030

24. Inventories: Additional Valuations Issues
ACCT-3030

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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 %
Required: Estimate the cost of the destroyed inventory.
ACCT-3030

32. 4a. Gross Profit Method Example — Solution
Beginning inventory (from records) $220,000
Plus: Net purchases (from records) ,000
Cost of goods available for sale ,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

33. 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

34. 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 =
Sales
7,500
Ending Inventory at Retail
1,500
End Inv at Cost (1,500 x )
933
ACCT-3030

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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