1. INVENTORIES: MEASUREMENT
Chapter 8: Inventory measurement.

2. Recording and Measuring Inventory
Types of Inventory
Merchandise Inventory
Goods acquired for resale
Manufacturing Inventory
Raw Materials
Work-in-Process
Finished Goods
We will look at inventory for two classes of businesses. Wholesale and retail companies purchase goods that are primarily in finished form. These companies are intermediaries in the process of moving goods from the manufacturer to the end-user. The cost of merchandise inventory includes the purchase price plus any other costs necessary to get the goods in condition and location for sale.
In manufacturing, companies actually produce the goods they sell to the wholesaler, retailer or other manufacturers. These companies normally have three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items being worked on, but not yet complete. Work-in-process inventory includes the cost of raw materials used, the cost of labor that can be directly traced to the goods in process, and the allocated portion of other manufacturing costs, called manufacturing overhead. Overhead costs include electricity and other utility costs, depreciation of manufacturing equipment, and many other manufacturing costs that cannot be directly linked to the production of specific goods. Finished goods inventory consists of items that are available for sale.

3. Manufacturing Inventories
Raw Materials
Work in Process
Finished Goods
(1) $XX
$XX (4)
$XX
$XX (7)
$XX
$XX (8)
Direct Labor
Cost of Goods Sold
(2) $XX
$XX (5)
Manufacturing Overhead
$XX
(3) $XX
$XX (6)
Raw materials purchased
Direct labor incurred
Manufacturing overhead incurred
Raw materials used
Direct labor applied
Manufacturing overhead applied
Work in process transferred to finished goods
Finished goods sold
In this diagram, we see the typical inventory cost flow for a manufacturing company. The manufacturing company acquires raw materials, hires direct labor and incurs manufacturing overhead. As raw materials, direct labor and manufacturing overhead are used, they are transferred into work-in-process inventory. When an item in work-in-process inventory has been completed, it is transferred to finished goods inventory. Finally, finished goods are sold to the final customer, and transferred out of finished goods inventory and into cost of goods sold.

4. Inventory Systems
Two accounting systems are used to record transactions involving inventory:
Perpetual Inventory System
The inventory account is continuously updated as purchases and sales are made.
Periodic Inventory System
The inventory account is adjusted at the end of a reporting cycle.
We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. An important feature of a perpetual system is that it is designed to track inventory quantities from their acquisition to their sale.
In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting cycle which is usually at the end of the month or the end of the year.

5. Perpetual Inventory System
Lothridge Wholesale Beverage Company (LWBC)
purchases on account $600,000 of merchandise
for resale to customers.
GENERAL JOURNAL
Date
Description
Debit
Credit
Inventory
600,000
Accounts Payable
2009
Lothridge Wholesale Beverage Company (LWBC) uses the perpetual inventory system and purchases $600,000 of merchandise for resale to its customers. The items were purchased on account. The journal entry required for this transaction is to debit inventory for $600,000 and credit accounts payable for $600,000. Inventory items that are returned to the supplier because they are damaged or defective will require an adjustment to the inventory account. Cash discounts applicable to the inventory items purchased will also require an adjustment to the inventory account.
Returns of inventory are credited to the inventory account.
Discounts on inventory purchases can be recorded using the gross or net method.

6. Perpetual Inventory System
LWBC sold, on account, inventory with a
retail price of $820,000 and a cost basis of $540,000, to a customer.
GENERAL JOURNAL
Date
Description
Debit
Credit
Accounts Receivable
820,000
Sales
Cost of Goods Sold
540,000
Inventory
2009
Lothridge sold, on account, inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. In the perpetual inventory system any time we have a sale we have to record the cost of goods sold. The first entry is to record the sale. We credit accounts receivable for $820,000 and credit sales for the same amount. The second entry is to record the cost of goods sold for $540,000 and credit inventory for the same amount.

7. Periodic Inventory System
Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts. The period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account. In the periodic inventory system, we use an equation to determine cost of goods sold. We take a beginning inventory, and add net purchases, to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold.
The cost of goods sold equation assumes that all inventory quantities not on hand at the end of the period were sold. This may or may not be the case if some inventory items were either damaged or stolen.

8. Periodic Inventory System
LWBC purchases on account $600,000 of merchandise for resale to customers.
GENERAL JOURNAL
Date
Description
Debit
Credit
Purchases
600,000
Accounts Payable
2009
Let’s assume that Lothridge Wholesale Beverage Company uses the periodic inventory system, and purchases $600,000 of merchandise for resale to customers. The merchandise was purchased on account.
The journal entry to record this transaction is to debit an account called purchases and credit accounts payable. Remember that in a perpetual inventory system, we debited the inventory account rather than the purchases account.
Purchase discounts and purchased returns are set up as two separate contra accounts, and are recorded separately from the purchases account.
Returns of inventory are credited to the Purchase Returns and Allowances account.
Discounts on inventory purchases can be recorded using the gross or net method.

9. Periodic Inventory System
LWBC sold on account, inventory with a
retail price of $820,000 and a cost basis of $540,000, to a customer.
GENERAL JOURNAL
Date
Description
Debit
Credit
Accounts Receivable
820,000
Sales
2009
Once again, let’s assume that Lothridge Wholesale Beverage Company sold inventory with the retail price of $820,000 and a cost basis of $540,000, to a customer. Under the periodic inventory system, we would debit accounts receivable for $820,000 and credit sales for the same amount; there would be no entry to record cost of goods sold. We would calculate the amount of cost of goods sold at the end of the accounting period.
No entry is made to record Cost of Goods Sold. Assuming Beginning Inventory of $120,000, a physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of the accounting period.

10. Periodic Inventory System
Adjusting entry to determine Cost of Goods Sold
Part I
Here is a typical calculation of cost of goods sold. Let’s assume a beginning inventory of $120,000 and net purchases of $600,000. Cost of goods available for sale would be $720,000. Now we subtract ending inventory of $180,000 to arrive at cost of goods sold of $540,000.
Part II
Under the periodic inventory system, we need to prepare an adjusting entry to determine cost of goods sold. The entry at the end of 2009 will be to debit cost of goods sold for $540,000, debit inventory for $180,000 (our ending inventory), credit inventory for $120,000 (our beginning inventory), and finally credit purchases for $600,000.
This entry has determined cost of goods sold for the income statement and has established the value of ending inventory on the balance sheet at $180,000.

11. Comparison of Inventory Systems
This chart summarizes all the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.

12. What is Included in Inventory?
General Rule
All goods owned by the company on the inventory date, regardless of their location.
Goods in Transit
Goods on Consignment
As a general rule, inventory should include all costs necessary to purchase the inventory item and get it to its intended location. All goods owned by the company should be included in inventory. There is a problem with goods in transit (goods that are en route from the supplier to our company). Technically, ownership of the goods depends upon whether they are shipped FOB shipping point or FOB destination.
Our company may have inventory out on consignment with another company. The consigned inventory still is owned by us and should be included in inventory.
Depends on FOB shipping terms.

13. Expenditures Included in Inventory
Invoice Price
Freight-in on Purchases +
Purchase Returns
Purchase Discounts
An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns or purchase discounts.

14. Purchase Discounts Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280
Partial payment not made within the discount period
Part I Let’s use the periodic inventory system to look at recording purchase discounts. A company purchased $20,000 of merchandise for resale subject to the credit terms, 2/10, net 30. Let’s look at the proper accounting using the gross method of recording purchases. We begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000. On October 14, within the discount period, the company makes a $14,000 payment on account. The journal entry is to debit accounts payable for $14,000, credit purchase discounts for $280 and credit cash for $13,720.
The company still owes the supplier $6,000. The $6,000 payment is made on November 14, well past the discount period, so the journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount.
Part II
Under the net method of recording purchases, the company will record its initial purchase at $19,600, that is, the company assumes it will take the discount. The $14,000 payment made within the discount period results in the debit to accounts payable for $13,720 and a credit to cash for the same amount. The final payment of $6,000 results in a discount lost of $120. The journal entry is to debit accounts payable for $5,880 and interest expense for $120. We’ll complete the entry with a credit to cash for $6,000.

15. Inventory Cost Flow Assumptions
Specific identification
Average cost
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
How do we account for changes in the cost of inventory and cost of goods sold when we experience changes in the price of the items that we purchased during the period?
We will look at four methods to handle this problem. The first is the specific identification method, next is the average cost method, then the first-in first-out or FIFO method, and finally, we will look at the last-in, first- out or LIFO method.

16. Perpetual Average Cost
The following schedule shows the Frame inventory for Yore Frame, Inc. for September.
The physical inventory count at September 30 shows 600 frames in ending inventory.
Use the perpetual average cost method to determine:
(1) Ending inventory cost
(2) Cost of goods sold
The average cost method is reasonably popular, and is used by many businesses today.
If the company uses the periodic inventory method, we use a weighted average cost. The weighted average cost is determined by taking the total cost of goods available for sale and dividing it by the number of units available for sale.
It is more likely that a company will use the perpetual inventory method. Under the perpetual inventory system, we use a moving average unit cost that requires computing a new average cost each time we have a new purchase. This may seem like a daunting task when we do it by hand, but with today’s microcomputers the calculation is quite easy.
Let’s look at the application of the average cost method when a company is using the perpetual inventory system. We will determine the average cost of ending inventory and cost of goods sold for Yore Frame, Inc. A physical inventory was taken at September 30, and it was determined that 600 frames were in ending inventory.

17. Perpetual Average Cost
Part 1
In the perpetual inventory system, we have to calculate a new weighted average cost each time we have a new purchase.
Part 2
To accomplish this, we must know the date of each purchase along with the quantity purchased and the unit cost. In addition, we must know the date of each sale and the number of units sold.

18. Perpetual Average Cost
On September 1, we sold 600 units, and we used our weighted average cost associated with beginning inventory of $22 per unit. The cost of the units sold is $13,200 and the balance in inventory is $4,400.

19. Perpetual Average Cost
On September 3, we purchase 300 units, and we must calculate a new weighted average cost. The new weighted average cost is $ We calculate this cost by dividing the cost of goods available for sale of $11,600 by the units available for sale, 500.
$11, ÷ ( ) = $23.200

20. Perpetual Average Cost
This screen shows you the subsequent purchases along with the calculation of cost of goods sold for the sale of 450 units on September 30.
$27, ÷ ( ) = $26.181

21. Perpetual Average Cost
Sum
Total cost of goods sold in September is $31, Ending inventory has a cost of $15,

22. Weighted-Average Periodic System
Let’s use the same information to assign costs to ending inventory and cost of goods sold using the periodic system.
Beginning Inventory (800 units)
Purchases (1,150 units)
Available
for Sale
(1,950 units)
Ending Inventory
(600 units)
Goods Sold
(1,350)
Part I Let’s use the same information to assign costs to ending inventory and cost of goods sold assuming the company uses the periodic inventory system and applies it with a weight-average cost method. Of the 1,950 units available for sale, 1,350 were sold and 600 remain in ending inventory.
Part II
The weighted average cost is determined by dividing $47,650 by 1,950 units. The weighted average cost is $ (rounded).
$47,650 ÷ 1,950 = $ weighted-average per unit cost

23. Weighted-Average Periodic System
We multiply the 600 units in ending inventory by the weighted average cost to determine the cost of ending inventory of $14, Cost of goods sold can be determined in one of two ways. First, we can subtract ending inventory from goods available for sale to get cost of goods sold, or we can multiply the 1,350 units times the weighted average cost per unit to arrive at the total of $32,

24. First-In, First-Out (FIFO)
The FIFO method assumes that items are sold in the chronological order of their acquisition.
The cost of the oldest inventory items are charged to COGS when goods are sold.
The cost of the newest inventory items remain in ending inventory.
In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.

25. First-In, First-Out (FIFO)
Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . .
. . . COGS and Ending Inventory Cost are the same under both approaches.
Under the periodic or perpetual method, the cost of goods sold and ending inventory are the same under the first-in, first-out method.

26. First-In, First-Out (FIFO)
Let’s return to the Yore Frame example. Recall that ending inventory was determined by a physical count to be 600 units. Under the first-in, first-out method, we assign the most recent costs to ending inventory.
These are the 600 most recently acquired units.

27. First-In, First-Out (FIFO)
As you can see, the most recent costs per unit come from the purchases of September 21 and September 29, and total $16,600.

28. First-In, First-Out (FIFO)
Under the first-in, first-out method, the oldest costs are assigned to cost of goods sold.
These are the first 1,350 units acquired.

29. First-In, First-Out (FIFO)
The oldest costs associated with the 1,350 units total $31,050. An easier way to calculate cost of goods sold is to subtract ending inventory from cost of goods available for sale.

30. Last-In, First-Out
The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.
The cost of the newest inventory items are charged to COGS when goods are sold.
The cost of the oldest inventory items remain in inventory.
Part I Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory.
Part II
The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remained in inventory.

31. Last-In, First-Out
Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches.
When we use last-in, first out, the periodic and perpetual inventory systems yield different ending inventories and different costs of goods sold.

32. When Prices Are Rising . . . FIFO
Matches low (older) costs with current (higher) sales.
Inventory is valued at approximate replacement cost.
Results in higher taxable income.
LIFO
Matches high (newer) costs with current (higher) sales.
Inventory is valued based on low (older) cost basis.
Results in lower taxable income.
Not permitted by international accounting standards.
Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher taxable income, and LIFO results in lower taxable income.
It is important to note that LIFO is generally not permitted by international accounting standards.

33. Supplemental LIFO Disclosures
Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost.
The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this:
Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures, allowing a company to report in a note the effect of using another method on inventory valuation rather than LIFO.

34. Decision Makers’ Perspective
Factors Influencing Method Choice
How closely do reported
costs reflect actual
flow of inventory?
How well are costs
matched against
related revenues?
A company is free to select its inventory costing method, but once selected, it should stay with that method. Some of the factors to consider when selecting an inventory costing method are: how closely does the method reflect the actual cost of inventory flow; how are income taxes affected by inventory method choice?
How are income taxes affected by inventory method choice?

35. When prices rise . . . LIFO Liquidation
LIFO inventory costs in the balance
sheet are “out of date” because they reflect
old purchase transactions.
If inventory declines, these “out of date” costs may be charged to current earnings.
This LIFO
liquidation results in “paper profits.”
We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as “paper profits.”

36. This measure indicates how much
Inventory Management
Gross profit ratio
Gross profit
Net sales =
This measure indicates how much
of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.
The gross margin percentage tends to be more stable for retailing companies because cost of goods sold excludes fixed costs.

37. Inventory Management
Inventory
turnover ratio
Cost of goods sold
Average inventory =
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
If a company’s inventory turnover is less than its industry average, it may experience difficulties in generating sales because of obsolete or slow-moving inventory items.
The inventory turnover is computed by dividing cost of goods sold by average inventory for the period. Average inventory is generally computed by adding the beginning inventory to the ending inventory and dividing the total by 2.
It measures how many times a company’s inventory has been sold and replaced during the year.
It should increase for companies that adopt just-in-time methods.
It should be interpreted relative to a company’s industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly.
If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

38. Earnings Quality
Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
Many financial analysts believe that inventory write-downs or arbitrary changes in inventory methods represent manipulation of the earnings by management. Such a manipulation is considered to impair the earnings quality of the company.

39. Methods of Simplifying LIFO
LIFO Inventory Pools consist of inventory units grouped according to similarities.
Using Inventory Pools with LIFO simplifies record keeping.
For example, all similar units purchased at the same time can be “pooled” and assigned an average unit cost.
Keeping detailed records of LIFO, inventory cost flows can be extremely time consuming. To cut down on the record-keeping work when using LIFO, companies often develop a LIFO inventory pool. The LIFO pool contains similar inventory items, and when these items are purchased at approximately the same time, the company may use an average cost in connection with the LIFO pool.

40. Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
DVL inventory pools are viewed as layers of value, rather than layers of similar units.
DVL simplifies LIFO record-keeping.
Example
The replacement inventory differs from the old inventory on hand. We just create a new layer.
At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory.
Dollar-value LIFO is an attempt to simplify record-keeping even more than the use of LIFO pools. When using dollar-value LIFO, a company minimizes the probability of dipping into the beginning LIFO layer. We view the LIFO pools as layers of value rather than layers of units. We adjust the layers of value for changes in prices during the period.
DVL minimizes the probability of layer liquidation.