1. Inventories: Measurement8
Inventories: Measurement
Chapter 8: Inventories: Measurement
In this chapter we continue our study of assets by investigating the measurement and reporting inventories and the related expense – cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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    
$XX
$XX
Direct Labor  
Cost of Goods Sold
$XX
Manufacturing Overhead   
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. In the perpetual inventory system, cost of goods sold are recorded each time a sale is made to a customer.

5. Perpetual Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale to customers.
2011
Inventory ,000
Accounts payable ,000
Purchase of merchandise inventory on account
Lothridge Wholesale Beverage Company (LWBC) uses the perpetual inventory system. It begins the period with $120,000 of merchandise inventory on hand. During the period the company 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
During 2011, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers.
2011
Inventory ,000
Accounts payable ,000
Purchase of merchandise inventory on account.
2011 Accounts receivable 820,000
Sales revenue ,000
Record sales on account.
Cost of goods sold 540,000
Inventory ,000
Record cost of goods sold.
During 2011, 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 debit 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.
Under the perpetual inventory system, cost of goods sold is determined when a sale is made. The balance in the cost of goods sold account appears on the income statement at the end of the period. Inventory is updated after each sale and purchase of merchandise for resale.

7. Periodic Inventory System
The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period.
The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated after the physical inventory count at the end of the accounting period.
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
Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale to customers.
2011
Purchases ,000
Accounts payable ,000
Purchase of merchandise inventory on account
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.

9. Periodic Inventory System
During 2011, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000.
2011 Accounts receivable 820,000
Sales revenue ,000
Record sales on account.
No entry is made to record Cost of Goods Sold. A physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of 2011.
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.

10. Periodic Inventory System
We need the following adjusting entry to record cost of good sold.
December 31, 2011
Cost of goods sold 540,000
Inventory (ending) 180,000
Inventory (beginning) ,000
Purchases ,000
To adjust inventory, close purchases, and record 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 2011 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. When goods are shipped FOB shipping point, title to the goods transfers when the goods are given to the common carrier and are owned by the buyer. When goods are shipped FOB destination, the goods are owned by the seller until received by the buyer.
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 and Allowances
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 and allowances or purchase discounts.

14. Purchase Returns
On November 8, 2011, LWBC returns merchandise that had a cost to LWBC of $2,000, and a cost basis to the seller of 1,600.
Periodic Inventory Method
Perpetual Inventory Method
November 8, 2011
Accounts payable ,000 Accounts payable 2,000
Purchase returns and allowances 2, Inventory ,000
On November 8, 2011, LWBC returns merchandise that had a cost to LWBC of $2,000, and a cost basis to the seller of 1,600. If LWBC uses the periodic inventory system, the proper journal entry is to debit, or reduce, accounts payable and credit purchase returns for $2,000. If the company uses the perpetual inventory system, the journal entry is to debit accounts payable and credit inventory for $2,000.
Returns of inventory are credited to the Purchase Returns and Allowances account when using the periodic inventory method.
The returns are credited to Inventory using the perpetual inventory method.

15. Partial payment not made within the discount period
Purchase Discounts
Gross Method
Net Method
October 5, 2011
Purchases ,000 Purchases 19,600
Accounts payable 20,000 Accounts payable ,600
October 14, 2011
Accounts payable 14,000 Accounts payable 13,720
Purchase discounts Cash 13,720
Cash ,720
November 4, 2011
Accounts payable 6,000 Accounts payable 5,880
Cash ,000 Interest expense
Cash 6,000
LWBC 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 on the left side of your screen and the net method on the right side of your screen.
Under the gross method we begin by recording the purchase with the debit for $20,000 and credit accounts payable for $20,000 on October 5th. On October 14th, 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 ($14,000 times two-percent) and credit cash for $13,720.
LWBC pays the remaining $6,000 on November 4th, and is not eligible for the discount. The journal entry will be to debit accounts payable for $6,000 and credit cash for the same amount.
Under the net method, LWBC will debit purchases of the net amount owed to the supplier or $19,600 ($20,000 times 1 minus the discount offered) and credits accounts payable for the same amount. On October 14th, a the partial payment of $14,000 is made at its net amount of $13,720. On November 4th, the final payment is made on the purchase for the amount owed to the supplies of $6,000. LWBC missed a discount of $120 ($6,000 times two percent), and records this amount with a debit to interest expense.
The effect on the financial statements of the difference between the two methods usually is immaterial. Net income over time will be the same using either method.
Discount terms are 2/10, n/30.
$20,000 x $ $
Partial payment not made within the discount period
$14,000 x $

16. 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.

17. Last-In, First-Out Periodic Inventory System
Here is the September 30th ending inventory and cost of goods sold calculated under the perpetual average cost approach.

18. 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 (1,200 units)
Purchases (2,850 units)
Available
for Sale
(4,050 units)
Ending Inventory
(1,400 units)
Goods Sold
(2,650)
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 4,050 units available for sale, 2,650 were sold and 1,400 remain in ending inventory.
Part II
The weighted average cost is determined by dividing $100,350 by 4,050 units. The weighted average cost is $ (rounded).
$100,350 ÷ 4,050 = $ weighted-average per unit cost

19. Weighted-Average Periodic System
We multiply the 1,400 units in ending inventory by the weighted average cost to determine the cost of ending inventory of $34, (rounded). 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 2,650 units times the weighted average cost per unit to arrive at the total of $65,661.08

20. 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.

21. 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. Let’s look at the calculations when using the periodic inventory system in a FIFO environment.

22. First-In, First-Out (FIFO) Periodic Inventory System
Let’s return to the Picture This example. Recall that ending inventory was determined by a physical count to be 1,400 units. Under the first-in, first-out method, we assign the most recent costs to ending inventory.
These are the 1,400 most recently acquired units.

23. First-In, First-Out (FIFO) Periodic Inventory System
As you can see, the most recent costs per unit come from the purchases of September 21 and September 29, and total $38,600. Cost of goods sold is calculated to be $61,750.

24. First-In, First-Out (FIFO) Periodic Inventory System
Under the first-in, first-out method, the oldest costs are assigned to cost of goods sold.
These are the first 2,650 units acquired.

25. First-In, First-Out (FIFO) Periodic Inventory System
The oldest costs associated with the 2,650 units total $61,750. An easier way to calculate cost of goods sold is to subtract ending inventory from cost of goods available for sale.

26. Last-In, First-Out (LIFO)
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.
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.
The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remained in inventory.

27. Last-In, First-Out (LIFO)
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.

28. Last-In, First-Out Perpetual Inventory System
These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.
Recall that the oldest inventory cost remained in inventory. The units associated with those old costs are likely to remain in inventory when a company uses the LIFO method. It is important that we know when sales were made during the period. Look at the upper right corner of your screen and notice that the first sale of 1,000 units took place on September 15th. Let’s look at an example of accounting for LIFO inventory in a perpetual inventory system.

29. Last-In, First-Out Perpetual Inventory System
The Cost of Goods Sold for the September 15 sale is $24,550.
After this sale, there are 1,650 units in inventory at various costs per unit.
For the sale on September 15th, the last goods in the inventory are the first goods sold. We begin by selling the units from the September 15th purchase (550 units at $25.00 per unit), next we remove the 450 units from the September 3rd purchase (450 units at $24.00), We now have 1,650 units at various unit prices. We have our 1,200 units from beginning inventory of 1,200 units and 450 units from the purchase of September 15th, Let’s continue with the example.

30. Last-In, First-Out Perpetual Inventory System
On September 21st, the company purchased an additional 600 units at a unit cost of $ The balance in the inventory account is $16,200.
On September 22nd, 700 units were sold. Under the LIFO method, we take the last units purchased on September 21st (600 units times $27.00 equals $16,200). We need an additional 100 units to complete the sale, so we get those units from purchase on September 3rd. The cost of goods sold for the September 22nd sale is $18,600. After the sale there are 1,550 units in inventory at various units costs.
The Cost of Goods Sold for the September 15 sale is $18,600.
After this sale, there are 1,550 units in inventory at various per unit cost.

31. Last-In, First-Out Perpetual Inventory System
The Cost of Goods Sold for the September 30 sale is $26,000.
After this sale, there are 1,400 units in inventory (1,200 × $22.00) per unit and (200 × $24.00) for a total cost of ending inventory of $31,200.
For the 950 units sold on September 30th, 800 units were taken first at $28 per unit for a total cost of $22,400. We still need 150 units to complete the sale and these units come from the purchase on September 3rd, so 150 units at $24 per unit for a total cost of $3,600. Total cost of goods sold is $26,000, and there are 1,400 units remaining in inventory at the end of September.

32. Last-In, First-Out Periodic Inventory System
When using the periodic inventory system in a LIFO system we take a different approach to the determination of cost of goods sold and ending inventory. First, let’s calculate the total cost of purchases during the month of September.

33. Last-In, First-Out Periodic Inventory System
When using the periodic inventory system in a LIFO system we take a different approach. We determine the cost of ending inventory by picking the oldest unit in inventory at the end of the period and including them in ending inventory. In our case you can see that there are 1,400 units in ending inventory made up of $1,200 from beginning inventory at $22 per unit plus 200 units from the purchase of September 3rd at $24 per unit. To the determination of cost of goods sold we subtract ending inventory from cost of goods available for sale. In our example, we obtained the same amount whether using periodic or perpetual inventory system. This is not always the case.

34. Last-In, First-Out Perpetual Inventory System
At the end of September the inventory is composed of 1,400 units. Total cost of goods sold is equal to $69,150.

35. 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.
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.

36. U. S. GAAP vs. IFRS
LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence.
LIFO is permitted and used by U.S. Companies.
If used for income tax reporting, the company must use LIFO for financial reporting.
Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter.
IAS No. 2, Inventories, does not permit the use of LIFO.
Because of this restriction, many U.S. companies use LIFO only for domestic inventories.
LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence.
From the perspective of the FASB,
LIFO is permitted and used by U.S. Companies.
If used for income tax reporting, the company must use LIFO for financial reporting.
Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter.
However,
IAS No. 2, Inventories, does not permit the use of LIFO.
Because of this restriction, many U.S. companies use LIFO only for domestic inventories.

37. 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 well are costs matched against related revenues; and how are income taxes affected by inventory method choice? Companies usually stay with the method they select, but sometimes companies switch for tax reporting purposes or other economic reasons.
How are income taxes affected by inventory method choice?

38. When prices rise . . . LIFO Liquidation
LIFO inventory costs in the balance
sheet are “out of date” because they reflect old purchase transactions.
LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older lower prices creating increase 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 “LIFO liquidation profit.” A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements.
If inventory declines, these “out of date” costs may be charged to current earnings.
This LIFO
liquidation results in “paper profits.”