1. Chapter 8: Valuation of Inventories: A Cost Basis Approach
Intermediate Accounting, 10th Edition
Kieso, Weygandt, and Warfield
Chapter 8: Valuation of Inventories: A Cost Basis Approach
Prepared by
Krishnan Ranganathan, Angelo State University,
San Angelo, Texas

2. Inventory Classification and Control
Part 1:
Inventory Classification
and Control
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

3. Inventory Classification
Inventory consists of:
finished goods held for sale in the ordinary course of business
goods held or consumed in the production of finished goods
A merchandising concern has finished goods only
A manufacturing concern may have:
raw materials, work in process and finished goods
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

4. Inventory Cost Flows Merchandising Operations Merchandise Inventory
Purchases
C/G/Sold
Cost of goods
sold
$$$
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

5. Inventory Cost Flows Manufacturing Operations Work in Process
Raw Materials
Labor
Manu Overhead
Work in Process
Inventory
$$$
C/G/Mfd
Finished
Goods
$$$
Cost of goods
sold
$$$
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

6. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Inventory Control
Inventory control is important for:
ensuring availability of inventory items
preventing excessive accumulation of inventory items
The perpetual system maintains a continuous record of inventory changes
The periodic system updates inventory records only periodically
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

7. Perpetual and Periodic Systems: Example
Fesmire reports the following data for 2000:
Beginning Inventory ( ): 10 units at $10
Purchases: (all credit) March 12: 30 units at $10 July 6: 25 units at $10
Sales: (all credit) April 8: 18 units at $16 August 9: 24 units at $18
Provide journal entries
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

8. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Perpetual System
Date Record Inventory Changes Record Sales Revenue
Mar 12 Inventory Dr
Accts Payable
Apr 8 Cost of goods sold Accts Receiv 288
Inventory Sales
Jul 6 Inventory Dr
Accts Payable
Aug 9 Cost of goods sold Accts Receiv 432
Inventory Sales
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

9. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Periodic System
Date Record Inventory Changes Record Sales Revenue
Mar 12 Inventory Dr
Accts Payable
Apr 8 No entry Accts Receiv 288
Sales
Jul 6 Inventory Dr
Accts Payable
Aug 9 No entry Accts Receiv 432
Sales
Dec 31 Cost of goods sold Dr 420
Inventory (ending) Adjusting
Purchases Entry
Inven (beg)
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

10. Physical Goods Included in Inventory
Part 2:
Physical Goods Included
in Inventory
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

11. Items to be included in Inventory
Legal title to goods determines inclusion.
The following goods are included in seller’s inventory:
Goods in transit (if seller has title during shipment)
Goods on consignment with seller
Goods, sold under buy back agreements
Goods, sold with high rates of return
Installment sales (if bad debts can not be estimated)
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

12. Effect of Inventory Errors
Ending Effect on Effect on
inventory Income Balance sheet
Items Items
Under- C/G/sold (over)
stated Net income (under) Retained Earn (under)
Work capital (under)
Over- C/G/sold (under)
stated Net income (over) Retained Earn (over)
Work capital (over)
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

13. Costs Included in Inventory
Part 3:
Costs Included in Inventory
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

14. Costs included in Inventory
Costs included in inventory are called “inventoriable costs”
These costs include:
product costs (direct materials, direct labor and manufacturing overhead)
purchase net costs, and freight-in
Period costs (selling and administrative) are not inventoriable costs
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

15. Inventory Valuation: Variable costing
Under variable costing, inventory costs include only the following manufacturing costs:
direct materials used,
direct labor, and
variable manufacturing overhead
Fixed manufacturing overhead is ignored
All period costs are ignored.
Variable costing is appropriate for internal decision-making.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

16. Inventory Valuation: Absorption costing
Under absorption costing, inventory costs include all manufacturing costs as follows:
direct materials used in production, direct labor cost, variable manufacturing overhead, and fixed manufacturing overhead
All period costs are ignored.
Absorption costing is required for external reporting.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

17. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Part 4:
Inventory Cost Flow
Assumptions
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

18. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Cost Flow Assumptions
The objective is to most clearly reflect periodic income.
Cost flow assumptions need not be consistent with physical flow of goods.
The cost flow assumptions are:
specific identification
average cost
first-in, first-out and
last-in, first-out
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

19. Cost Flow Assumptions: Example
Call-Mart reports the following transactions for 2000:
Date Purchases Purchase Cost May units $1,000 Aug units $2,200 Sep units $1,800
On December 31, the company had 20 units on hand. Determine the cost of goods sold and the cost of ending inventory.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

20. Average (weighted) method
Date Purchases Purchase Cost
May units $1,000
Aug units $2,200
Sep units $1,800
420 units $5,000
Unit cost = $5,000/ 420 = $11.91
$5,000
Cost of goods
available
400 * = 4,762
Cost of goods sold
20 * = $238
Ending inventory
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

21. First-in, First-out method
Date Purchases Purchase Cost
May $10 $1,000
Aug $11 $2,200
Sep $15 $1,800
Cost of goods sold (FIFO)
$1,000
$2,200
$1,500 (100 sold; 20 end inv)
420 units $5,000
$4,700
$5,000
Cost of goods
available
$4,700
Cost of goods sold
20 * $15 = $300
Ending inventory
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

22. Last-in, First-out method
Date Purchases Purchase Cost
May $10 $1,000
Aug $11 $2,200
Sep $15 $1,800
Cost of goods sold (LIFO)
$ (80 sold; 20, end inv)
$2,200
$1,800
420 units $5,000
$4,800
$5,000
Cost of goods
available
$4,800
Cost of goods sold
20 * $10 = $200
Ending inventory
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

23. Cost Flow Assumptions: Notes
The ending inventory in units is the same in all three methods: the cost is different.
The cost of goods sold and the cost of ending inventory are different, but
The cost of goods available is the same in all three methods.
LIFO would result in the smallest reported net income (with rising prices).
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

24. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
Part 5:
LIFO Special Issues
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

25. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
LIFO Reserve
LIFO Reserve (Allowance) account is used, when:
LIFO is used for external reporting and
a non-LIFO basis is used for internal reporting.
An Allowance to Reduce Inventory to LIFO is used to reduce the cost to a LIFO basis.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

26. Adjust the cost of ending inventory to the LIFO basis
LIFO Reserve: Example
Amco Inc reports the following balances:
Inventory (FIFO basis) on Dec 31, 2000: $50,000
Inventory (LIFO basis) on Dec 31, 2000: $20,000
Adjust the cost of ending inventory to the LIFO basis
Cost of goods sold Dr. $30,000
Allowance to Reduce Inventory
to LIFO $30,000
Balance Sheet (Assets):
Inventory (FIFO) $50,000
less: Allowance to Reduce Inventory ($30,000)
Inventory (LIFO) basis $20,000
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

27. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
LIFO Layers
Under the LIFO approach, a business may build up layers of inventory from prior periods.
A layer liquidation occurs, when:
earlier costs are matched against current sales.
Such matching results in distorted income.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

28. Methods to Alleviate Layer Liquidation Problems
Use the specific goods pooled LIFO approach:
a pool is a combination of similar items.
reductions in one item, compensated by increases in other items.
Use dollar-value LIFO
changes in pools are determined in terms of dollars, not quantities
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

29. Dollar Value LIFO: example
Given:
Base layer (Dec 31, 2001): $20,000
Inventory (current prices) on Dec 31, 2002: $26,400
Prices increased 20% during
Determine dollar value LIFO at Dec 31, 2002
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

30. Dollar Value LIFO: example
Price increase, 20%
Dec 31, 2001
Dec 31, 2002
Current $:
$26,400
$26,400 / 1.20
At base $:
$22,000
Net increase
at base $:
$22,000 less
$20,000
$20,000
plus
$2,400
Dollar value
LIFO
Restate at
current $:
$2,400
$2,000 * 1.20
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

31. Dollar Value LIFO: Notes
When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices):
the decrease must be subtracted from the most recently added layer
Once a layer is eliminated (peeled off), it can not be rebuilt.
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

32. Advantages of LIFO method
LIFO matches more recent costs with current revenues.
With increasing prices, LIFO yields the lowest taxable income (assuming inventory does not decrease)
With reduced taxes, cash flow is improved.
Under LIFO, the need to write down inventory to market is minimized
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

33. Disadvantages of LIFO method
LIFO does not approximate the physical flow of goods except in special situations
LIFO yields the lowest net income and therefore reduced earnings
Under LIFO, the ending inventory is understated
LIFO involuntary liquidation may result in income that is detrimental from a tax view.
LIFO may cause poor buying habits (because of the layer liquidation problem)
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)

34. Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)
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Intermediate Accounting, 10th Edition, Ch. 8 (Kieso et al.)