Chapter 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Sommers – Intermediate I

1. Chapter 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACHSommers – Intermediate I

2. Discussion Question Q8-6 • Goods out on approval to customers • Goods in transit that were recently purchased f.o.b. destination • Land held by a realty firm for sale • Raw Materials • Goods received on consignment • Manufacturing supplies

3. Transfer of ownership A company should record purchases when it obtains legal title to the goods.

4. Discussion Question Q8-3 What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

5. Comparison of Inventory Systems

6. 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) 120,000 Purchases 600,000 To adjust inventory, close purchases, and record cost of goods sold.

7. Inventory Notation Beginning Balance Purchases Cost of Goods Available for Sale Ending Balance Cost of Goods Sold ? ?

8. Choosing a Cost Flow Assumption Specific Identification --- Average Cost LIFO --- FIFO Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods Method adopted should be one that most clearly reflects periodic income.

9. Example 1: FIFO Periodic Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows: 8,000 units were on hand at the end of the month. Calculate January’s ending inventory and cost of goods sold for the month using FIFO, periodic system.

10. Example 1: FIFO Periodic Cost of Goods Sold: Ending Inventory:

11. Example 1: LIFO Periodic Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows: 8,000 units were on hand at the end of the month. Calculate January’s ending inventory and cost of goods sold for the month using LIFO, periodic system.

12. Example1: LIFO Periodic Cost of Goods Sold: Ending Inventory:

13. Example 1: LIFO Perpetual Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows: 8,000 units were on hand at the end of the month. Calculate January’s ending inventory and cost of goods sold for the month using LIFO, perpetual system.

14. Ex 1: LIFO Perpetual (January 5th Sale) Available: Cost of Goods Sold: Ending Inventory:

15. Ex 1: LIFO Perpetual (January 12th Sale) Available: Beg 3,000 units @ $8 = $24,000 Cost of Goods Sold: Ending Inventory:

16. P8-5 LIFO Perpetual (January 20th Sale) Available: Beg 3,000 units @ $ 8 = $ 24,000 Jan 10 3,000 units @ $ 9 = 27,000 Cost of Goods Sold: Ending Inventory:

17. Example 1: LIFO Perpetual (Summary) Cost of Goods Sold: Jan 5 3,000 units = $24,000 Jan 12 2,000 units = 18,000 Jan 20 4,000 units = 40,000 Total 9,000 units = $82,000 Ending Inventory: Beg 3,000 units @ $ 8 = $24,000 Jan 10 3,000 units @ $ 9 = 27,000 Jan 18 2,000 units @ $10 = 20,000 8,000 units $71,000

18. Example 1: Average Cost, Periodic Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows: 8,000 units were on hand at the end of the month. Calculate January’s ending inventory and cost of goods sold for the month using Average Cost, Periodic.

19. Example 1: Average Cost Periodic Cost of Goods Sold: Ending Inventory:

20. Example 1: Average Cost, Perpetual Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows: 8,000 units were on hand at the end of the month. Calculate January’s ending inventory and cost of goods sold for the month using Average Cost, Perpetual.

21. Ex 1: Average Cost Perpetual (Jan 5th Sale) Cost of Goods Sold: Ending Inventory:

22. Ex 1: Average Cost Perpetual (Jan 12th Sale) Cost of Goods Sold: Ending Inventory:

23. Ex 1: Average Cost Perpetual (Jan 20th Sale) Cost of Goods Sold: Ending Inventory:

24. Ex 1: Average Cost Perpetual (Summary) Cost of Goods Sold: Jan 5 3,000 units = $24,000 Jan 12 2,000 units = 17,250 Jan 20 4,000 units = 37,250 Total 9,000 units = $78,500 Ending Inventory: 8,000 units @ $9.3125 = $74,500

25. Example 1: Summary of Results

26. Supplemental LIFO Disclosures Tootsie Roll 2008 Balance Sheet20082007 Finished goods and work-in-process 34,862 37,031 Raw materials and supplies 20,722 20,371 Income Statement Product cost of goods sold 333,314 327,695 Footnote: Inventories are stated at cost, not to exceed market. The cost of substantially all of the Company’s inventories ($53,557 and $54,367 at December 31, 2008 and 2007, respectively) has been determined by the last-in, first-out (LIFO) method. The excess of current cost over LIFO cost of inventories approximates $12,432 and $11,284 at December 31, 2008 and 2007, respectively. The cost of certain foreign inventories ($2,027 and $3,036 at December 31, 2008 and 2007, respectively) has been determined by the first-in, first-out (FIFO) method. Rebates, discounts and other cash consideration received from a vendor related to inventory purchases is reflected as a reduction in the cost of the related inventory item, and is therefore reflected in cost of sales when the related inventory item is sold.

27. Supplemental LIFO Disclosures Tootsie Roll 2008 Balance Sheet20082007 Finished goods and work-in-process 34,862 37,031 Raw materials and supplies 20,72220,371 Total LIFO inventory 55,584 57,402 LIFO reserve 12,432 11,284 Total FIFO inventory 68,016 68,686 Income Statement Product cost of goods sold – LIFO 333,314 327,695 Product cost of goods sold – FIFO ? ?

28. LIFO to FIFO Conversion – Tootsie Roll LIFO FIFO 57,402 331,496 388,898 55,584 333,314 Inventory Turnover:

29. Discussion Question Explain why proponents of LIFO argue that it provides a better match of revenue and expenses. In what situation would it not provide a better match? Proponents of LIFO argue that it provides a better match of revenues and expenses because cost of goods sold includes the costs of the most recent purchases. These are matched with sales that reflect a current selling price. On the other hand, inventory costs in the balance sheet generally are out of date because they are derived from old purchase transactions. It is conceivable that a company’s LIFO inventory balance could be based on unit costs actually incurred several years earlier. When inventory quantity declines during a period, then these out-of-date inventory layers will be liquidated and cost of goods sold will match noncurrent costs with current selling prices.

30. Discussion Questions Q8–18 Explain the following terms: (a) LIFO Layer (b) LIFO Reserve (c) LIFO Effect

31. Simplifying LIFO with LIFO Inventory Pools • The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. • For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. • LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.

32. Dollar Value LIFO (DVL) • DVL extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO record-keeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. When using DVL we think in terms of inventory layers rather than inventory pools. • The goal of DVL is to determine if an increase in ending inventory over beginning inventory is due to a price increase of a real increase in inventory.

33. Dollar-Value LIFO (DVL) 1a. Compute a Cost Index for the year. 1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory (at base year cost) to beginning inventory.

34. Dollar-Value LIFO (DVL) • Next, identify the layers in ending inventory and the years they were created. • Convert each layer’s base year cost to layer year cost by multiplying times the cost index. • Sum all the layers to arrive at Ending Inventory at DVL cost. You are totally lost so let’s do this!

35. Example 2: Dollar Value LIFO Method On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2013 are as follows: Calculate Taylor’s ending inventory for 2011, 2012, and 2013.

36. Example 2: Continued On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 is as follows: Calculate Taylor’s ending inventory for 2011.

37. Example 2: Continued Adjust 2011 inventory to 2010 base-year prices: $441,000 / 1.05 = $420,000 Calculate current year LIFO layer: $420,000 – $400,000 = $20,000 Add the new LIFO layer at end of period prices to prior year LIFO inventory: $400,000 * 1.00 = $400,000 20,000 * 1.05 = 21,000 $421,000

38. Example 2: Continued On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2012 are as follows: Calculate Taylor’s ending inventory for 2012.

39. Example 2: Continued Adjust 2012 inventory to 2010 base-year prices: $487,200 / 1.12 = $435,000 Calculate current year LIFO layer: $435,000 – $420,000 = $15,000 Add the new LIFO layer at end of period prices to prior year LIFO inventory: $400,000 * 1.00 = $400,000 20,000 * 1.05 = 21,000 15,000 * 1.12 = 16,800 $437,800

40. Example 2: Continued On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2013 are as follows: Calculate Taylor’s ending inventory for 2013.

41. Example 2: Continued Adjust 2013 inventory to 2010 base-year prices: $510,000 / 1.20 = $425,000 Calculate current year LIFO layer: $425,000 – $435,000 = ($10,000) Layer liquidation Calculate LIFO layers at end of period prices: $400,000 * 1.00 = $400,000 20,000 * 1.05 = 21,000 5,000 * 1.12 = 5,600 $426,600

42. LIFO Liquidation Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. • Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2012, with cost determined on a specific-goods LIFO approach.

43. LIFO Liquidation Example Continued At the end of 2013, only 6,000 pounds of steel remained in inventory.

44. LIFO Liquidation When prices rise ... • 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.” Could this be a source of abuse?

45. Example 3: LIFO Liquidation The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 55,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 11,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011. Cost of goods sold: • 54,000 units x $8.50 = $459,000

46. Example 3: LIFO Liquidation Continued The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 50,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 6,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011. Cost of goods sold: • 50,000 units x $8.50 = $425,0004,000 units x $7.00 = 28,000 $453,000 COGS is $6,000 lower because we did not buy inventory!

47. Example 3: LIFO Liquidation Continued From a financial reporting perspective, what problem is created by the use of LIFO in this situation? Describe the disclosure required to report the effects of this problem. When inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $6,000 [4,000 units liquidated x $1.50 ($8.50 current year cost per unit - $7 LIFO layer cost per unit)].

48. 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? • How are income taxes affected by inventory method choice?

49. LIFO Disadvantages Advantages • Matching • Tax Benefits/Improved Cash Flow • Future Earnings Hedge • Reduced Earnings • Inventory Understated • Physical Flow • Involuntary Liquidation / Poor Buying Habits

50. Basis for Selection of Inventory Method • LIFO is generally preferred: • if selling prices are increasing faster than costs and • if a company has a fairly constant “base stock.” • LIFO is not appropriate: • if prices tend to lag behind costs, • if specific identification traditionally used, and • when unit costs tend to decrease as production increases.