1. Intermediate Accounting James D. Stice Earl K. Stice
Chapter 9
Inventory and Cost of Goods Sold
19th Edition
Intermediate Accounting
James D. Stice Earl K. Stice
PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University
© 2014 Cengage Learning

2. What Is Inventory?
Inventory designates goods held for sale in the normal course of business or, for a manufacturer, also includes goods in production or to be placed into production.
For some businesses, inventory represents the most active element in business operations.
The terms raw materials, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

3. Raw Materials
Raw Materials are goods acquired to use in the production process.
The term direct materials is frequently used to refer to materials that will be physically incorporated in the products being manufactured.
The term indirect materials is then used to refer to auxiliary materials, that is, materials that are necessary in the production process but not directly incorporated into the product.

4. Work in Process
Work in Process (WIP) consists of materials partly processed and requiring further work before they can be sold.
Work in Process includes three cost elements.
Direct materials
Direct labor
Manufacturing overhead

5. Finished Goods
Finished goods are the manufactured products awaiting sale.
As products are completed, the costs accumulated in the production process are transferred from Work in Process to the Finished Goods Inventory account.

6. Inventory Systems
Two types of inventory systems that keep track of how much inventory has been sold and at what price are:
Periodic inventory system—requires a physical count of the inventory periodically, and at the point of sale only records the sale price.
Perpetual inventory system—at point of sale records selling price and type of item sold are recorded. Example: a bar code scanning system.

7. Whose Inventory Is It?
As a general rule, goods should be included in the inventory of the business holding legal title.
The passing of title is a legal term designating the point at which ownership changes.
Issues that develop:
Goods in transit
Goods on consignment

8. Goods on Consignment
Shipper retains title and includes the goods in inventory until their sale or use by the dealer or customer.
Consigned goods are properly reported by the shipper at the sum of their costs, and the shipping and handling costs incurred transfer to the dealer or customer.

9. Conditional Sales, Installment Sales, and Repurchase Agreements
Conditional sales and installment sales contracts may provide a retention of title by the seller until the sales price is fully recovered.
As a creative way to obtain cash on a short-term basis, firms sometimes sell inventory to another company but at the same time agree to repurchase the inventory at a future date.

10. Items Included in Inventory Cost
Inventory costs consist of all expenditures, both direct and indirect, relating to acquisition, preparation, and placement for sale.
Expenditures that are relatively small and difficult to allocate are period costs. These are recognized as expenses in the current period.
(continued)

11. Items Included in Inventory Cost
Costs that can be identified with the product being manufactured are called product or inventoriable costs.
Costs arising from idle capacity, excessive spoilage, and reprocessing are usually considered abnormal and are expensed in the current period.
(continued)

12. Items Included in Inventory Cost
Traditionally, manufacturing overhead costs have been allocated to products based on the amount of direct labor required in production.
Activity-based cost (ABC) systems strive to allocate overhead based on clearly identified cost drivers—characteristics of the production process that are known to create overhead costs.

13. Discounts as Reductions in Cost
Discounts associated with the purchase of inventory should be treated as a reduction in the cost assigned to the inventory.
Trade discounts refer to the difference between a catalog price and the price actually charged to a buyer.
Cost is defined as the list price less the trade discount.
(continued)

14. Discounts as Reductions in Cost
Cash discounts are discounts granted for payment of invoices within a limited time period.
Example: A purchase of $10,000 provides for payment on a 2/10, n/30 basis. If the buyer pays by the 10th day, $9,800 settles the invoice. After that, the full $10,000 is required.
(continued)

15. Discounts as Reductions in Cost
The net method records inventory at this discounted amount (i.e., the gross invoice prices less the allowable discount).
The net method reflects that discounts not taken are in effect a finance charge incurred for failure to pay within the discount period.

16. Discounts as Reductions in Cost
Under the gross method, cash discounts are booked only when they are taken.
While the net method tracks discounts not taken, the gross method provides no such information, and inventory records are maintained at the gross unit price.
The net method of accounting for purchases is strongly preferred.

17. Purchases Reported Using the Net Method
To record the purchase of merchandise priced at $10,000 with a cash discount of 2%:
Inventory 9,800
Accounts Payable 9,800
To record the payment of the invoice within discount period:
Accounts Payable 9,800
Cash 9,800
(continued)

18. Purchases Reported Using the Net Method
To record payment of the invoice after the discount period:
Accounts Payable 9,800
Discounts Lost 200
Cash 10,000
To record adjustment at the end of the period if invoice has not been paid and the discount period has lapsed:
Discounts Lost 200
Accounts Payable
(continued)

19. Purchases Reported Using the Gross Method
To record the purchase of merchandise priced at $10,000 with a cash discount of 2%:
Inventory 10,000
Accounts Payable 10,000
To record the payment of the invoice within discount period:
Accounts Payable 10,000
Inventory
Cash 9,800
(continued)

20. Purchases Reported Using the Gross Method
To record payment of the invoice after the discount period:
Accounts Payable 10,000
Cash 10,000
To record adjustment at the end of the period if invoice has not been paid and the discount period has lapsed:
No entry required

21. Purchase Returns and Allowances
Adjustments are also made when goods are damaged or are lesser in quality than ordered.
Sometimes the customer returns the goods.
Periodic Inventory System
Accounts Payable 400
Purchase Returns
and Allowances 400
Perpetual Inventory System
Accounts Payable 400
Inventory 400

22. Inventory Valuation Methods
Specific Identification
Average Cost
Cost Allocation Methods
First-in, first-out (FIFO)
Last-in, first-out (LIFO)

23. Specific Identification Method
This specific identification method requires a way to identify the historical cost of each individual unit of inventory.
From a theoretical standpoint, the specific identification method is very attractive, especially when each inventory item is unique and has a high cost.
This method opens the door to possible profit manipulation.

24. Average Cost Method
The average cost method assigns the same average cost to each unit.
This method is based on the assumption that goods sold should be charged at an average cost.
For periodic inventory, the unit cost is the weighted average for the entire period.

25. First-In, First-Out (FIFO) Method
The First-in, first out (FIFO) method is based on the assumption that the units sold are the oldest units on hand.
FIFO assumes a cost flow closely paralleling the usual physical flow of goods sold.
With FIFO, the units remaining in ending inventory are the most recently purchased units, so their reported cost would most closely match end-of-year replacement costs.

26. Last-In, First-Out (LIFO) Method
The last-in, first-out (LIFO) method is based on the assumption that the newest units are sold first.
There is no required connection between the actual physical flow of goods and the inventory valuation method used.
LIFO is the best method of matching current inventory costs with current revenues.

27. LIFO Layers
Each year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory.
Many companies that use LIFO report the amount of their LIFO reserve, either as a parenthetical note in the balance or the notes to the financial statements.

28. LIFO and Income Taxes
The LIFO inventory method was developed in the United States during the late 1930s as a method of reducing income taxes during periods of rising prices.
The LIFO conformity rule specifies that only those taxpayers who use LIFO for financial reporting purposes may use it for tax purposes. The rule has been relaxed.
(continued)

29. LIFO and Income Taxes
As a means of simplifying the valuation process and extending the applicability to more items, the IRS developed the technique of establishing LIFO inventory pools of substantially identical goods.
To further simplify the recordkeeping associated with LIFO and to eliminate the issues associated with new products replacing old products, the dollar-value LIFO inventory method was developed.

30. Income Tax Effects
If a company has large inventory levels, is experiencing significant inventory cost increases, and does not anticipate reducing inventory levels in the future, LIFO gives substantial cash flow benefits in terms of tax deferrals.
This is the primary reason for LIFO adoption by most firms.

31. Bookkeeping Costs
The bookkeeping associated with LIFO is a bit more complicated than with FIFO or average cost.
In dollars and cents, a LIFO system costs more to operate.
With information technology and with the simplification of LIFO pools and dollar-value LIFO, the incremental bookkeeping costs can be minimized.

32. Impact on Financial Statements
While LIFO gives tax benefits, it also gives reduced reported income and reduced reported inventory.
These negative financial statement effects can harm a company by scaring off stockholders, potential investors, and banks.
Supplement disclosure using FIFO or average cost might offset this problem.

33. International Accounting and Inventory Valuation
In 1992, the IASB decided to officially endorse FIFO and average cost, to kill the base stock method, and to let LIFO live on as a second-class “allowed alternative treatment.”
In 2003, the IASB adopted a revised version of IAS 2 and did away with LIFO once and for all.

34. Inventory Accounting Change
When a company changes its method of valuing inventory, the change is accounted for as a change in accounting principle.
change to
Average Cost or FIFO
LIFO
Report the effect of changing methods on the financial statements.
(continued)

35. Inventory Accounting Change
If the change is to LIFO from another method, a company’s records are generally not complete enough to reconstruct the prior years’ inventory layer.
change to
Any Method
LIFO
No adjustment to financial statements for change to LIFO, but special disclosure required.

36. Applying the Lower of Cost or Market Method
Define pertinent values: historical cost, floor (NRV ‒ normal profit), replacement cost, ceiling (NRV).
Determine “market” (replacement cost as constrained by ceiling and floor limits).
Compare cost with market (as defined in step 2 above), and select the lower amount.

37. Lower of Cost or Market
Fezzig Company sells six products identified with the letters A through F. For each product, the selling price per unit is $1.00, selling expenses are $0.20 per unit, and the normal profit is 25% of sales, or $0.25 per unit.
(continued)

38. Lower of Cost or Market Ceiling: $0.80 $0.70 $0.70 $0.65 Floor: $0.55
CASE A
Market
$0.70
$0.70
Range
Floor: $0.55
$0.65
Historical Cost
LCM = $0.65
(continued)

39. Lower of Cost or Market Ceiling: $0.80 $0.60 $0.60 $0.65 Floor: $0.55
CASE B
Market
$0.60
$0.60
Range
Floor: $0.55
$0.65
Historical Cost
LCM = $0.60
(continued)

40. Lower of Cost or Market Ceiling: $0.80 $0.50 $0.55 $0.50 $0.65
CASE C
Market
$0.50
$0.55
$0.50
Range
Floor: $0.55
$0.65
Historical Cost
LCM = $0.55
(continued)

41. Lower of Cost or Market Ceiling: $0.80 $0.45 $0.55 $0.45 $0.50
CASE D
Market
$0.45
$0.55
$0.45
Range
Floor: $0.55
$0.50
Historical Cost
LCM = $0.50
(continued)

42. Lower of Cost or Market Ceiling: $0.80 $0.85 $0.80 $0.75 Floor: $0.55
CASE E
Market
$0.85
$0.80
Range
Floor: $0.55
$0.75
Historical Cost
LCM = $0.75
(continued)

43. Lower of Cost or Market Ceiling: $0.80 $1.00 $0.80 $1.00 $0.90
CASE F
Market
$1.00
$0.80
$1.00
Range
Floor: $0.55
$0.90
Historical Cost
LCM = $0.80

44. Lower of Cost or Market Applied Individually versus as a Whole
The journal entry to record the write-down of the inventory on an individual item basis is usually made as follows:
Loss from Decline in Value of Inventory 250
Inventory 250
($4,100 ‒ $3,850)
Once an individual item is reduce to a lower market price, the new market price is considered to be the item’s cost for future inventory valuations.

45. Allowance Method
Rather than reducing the inventory directly, the inventory account can be maintained at cost, and an allowance account can be used to record the decline in value.
Loss from Decline in Value of Inventory 100
Allowance for Decline in Value
of Inventory 100
($4,100 ‒ $4,000)

46. Gross Profit Method
The gross profit method is based on the observation that the relationship between sales and cost of goods sold is usually fairly stable.
The gross profit percentage [(Sales – Cost of goods sold)/Sales] is applied to sales to estimate cost of goods sold.
To be useful, the gross profit percentage must be a reliable measure of current experience.
(continued)

47. Retail Inventory Method
Like the gross profit method, the retail inventory method can be used to generate a reliable estimate of inventory position whenever desired.
The retail inventory method is more flexible than the gross profit method in that it allows estimates to be based on FIFO, LIFO, or average cost assumptions.

48. Effects of Errors in Recording Inventory
Failure to correctly report inventory results in misstatements on both the balance sheet and the income statement. There are three typical inventory errors:
Overstatement of ending inventory through an improper physical count
Understatement of ending inventory through an improper physical count
Understatement of ending inventory through delay in recording a purchase until the following year

49. Using Inventory Information for Financial Analysis
Consider the financial information relating to inventories for Deere & Co. provided below.

50. Inventory Turnover
Appropriateness of inventory size and position can be measured by calculating the inventory turnover ratio.
Cost of Goods Sold $16,255
Average Inventory $2,719.5 =
($2,397 + $3042)/2 = $2,719.5
= 5.98 times
(continued)

51. Inventory Turnover = = 4.03 times
If Deere & Co. had used FIFO instead of LIFO, inventory turnover for 2009 would have been 4.03 (instead of 5.98 under LIFO), computed as follows:
= 4.03 times
FIFO Cost of Goods Sold $16,212
FIFO Average Inventory $4,020 =
$16,255 +($1,324 – $1,367) = $16,212
(continued)

52. Inventory Turnover = = 4.03 times
If Deere & Co. had used FIFO instead of LIFO, inventory turnover for 2009 would have been 4.03 (instead of 5.98 under LIFO), computed as follows:
FIFO Cost of Goods Sold $16,212
FIFO Average Inventory $4,020 =
($3,674 + $4,366)/2 = $4,020
= 4.03 times

53. Number of Days’ Sales in Inventory
($3,042 + $2,397)/2
Average Inventory
Average Daily Cost of Goods Sold =
$2,719.5
$44.534
$16,255/365
Number of days’ sales in inventory = 61.0
(continued)

54. Number of Days’ Sales in Inventory
Deere’s number of days’ sales in inventory results mean that, on average, Deere & Co. has enough inventory to continue operations for 61.0 days using just its existing inventory.

55. Retail Inventory Method
The retail inventory method is widely employed by retail firms to arrive at reliable estimates of inventory position whenever desired.
This method permits the estimation of an inventory amount without the time and expense of taking a physical inventory or maintaining detailed perpetual inventory records.

56. Retail Inventory Method
One Cost Percentage
Inventory, Jan. 1 $30,000 $50,000 Purchases in January 30, ,000
Goods available for sale $60,000 $90,000
Cost Retail
Cost percentage ($60,000 ÷
$90,000) = 66.7%
Deduct sales for January ,000
Inventory, January 31, at retail $25,000
Inventory, January 31, at estimated
cost ($25,000  66.7%) $16,675
(continued)

57. Retail Inventory Method
Multiple Cost Percentages
Inventory, Jan. 1 $30,000 $50,000 Purchases in January 30, ,000
Goods available for sale $60,000 $90,000
Cost Retail
Cost percentage:
Beg. inventory ($30,000 + $50,000) = 60.0%
Purchases ($30,000 + $40,000) = 75.0%
Deduct sales for January ,000
Inventory, January 31, at retail $25,000
Inventory, January 31, at estimated cost:
FIFO ($25,000  75.0%) $18,750
LIFO ($25,000  60.0%) $15,000
(continued)

58. Retail Inventory Method: Lower of Cost or Market
Frequently, retail prices change after they are originally set. The following terms are used to describe these changes.
Original retail—the initial sales price, including the original increase over cost referred to as the initial markup.
Markups—increases that raise sales prices above original retail.
Markdowns—decreases that reduce sales prices below original retail.

59. Dollar-Value LIFO
Under dollar-value LIFO, LIFO layers are determined based on total dollar changes rather than quantity changes.
With dollar-value LIFO, the unit of measurement is the dollar.
All goods in the inventory pool to which dollar-value LIFO is to be applied are viewed as though they are identical items.

60. Purchase Commitments
Extreme fluctuations in the price of inventory purchases can expose a company to excessive risk.
Of the different ways to manage this risk, the simplest is a purchase commitment that locks in the inventory purchase price in advance.
Accounting question: Should the company committing to the future purchase record an asset and a liability at the commitment date?
(continued)

61. Purchase Commitments
A purchase commitment is an exchange of promises about future action and is known as an executory contract.
Rollins Oat Company entered into a purchase commitment on November 1, 2012, for 100,000 bushes of wheat at $3.40 per bushel to be delivered on March At the end of 2012, the market price for wheat had dropped to $3.20 per bushel.
(continued)

62. Purchase Commitments Dec. 31 Loss on Purchase Commitments 20,000
2012
Dec. 31 Loss on Purchase Commitments 20,000
Estimated Loss on Purchase
Commitments 20,000
(100,000 bushels  $0.20 per bushel)
2013
Mar. 31 Estimated Loss on Purchase
Commitments 20,000
Purchases 320,000
Accounts Payable 340,000

63. Foreign Currency Inventory Transactions
Only transactions denominated in currencies other than the U.S. dollar are foreign currency transactions for U.S. companies.
If the transaction contract is written in terms of U.S. dollars, there is no foreign currency risk whether the other company is based in Azerbaijan or Zimbabwe.

64. Chapter 9 ₵
The End $