Agenda

1. Agenda • Quiz 3 Due Wednesday Feb 18 • Midterm 2 Monday 2/23: Chapters 7-9 & 18 • Wrap up chapter 7 examples • Notes Receivable • Transfers of Receivables • Chapter 8: Inventory • Weighted Average/FIFO/LIFO • Dollar Value LIFO

2. Inventory Reporting Report inventory at the lower of cost or market (conservatism) “Cost” – the historical cost of the inventory: • Retail – the cost to get items in location and in condition for sale (i.e. purchase price, purchase discounts, purchase returns, transportation in) • Manufacturing: • Raw materials – cost of materials on hand but not yet placed in production. • Work-in-process – cost of goods on which production has been started but not yet completed (i.e. raw materials used, direct labor, manufacturing overhead). • Finished good – cost of goods complete but not yet sold.

3. Merchandise Inventory Purchases C/G/Sold Cost of goods sold $$$ Inventory Cost Flows Merchandising Operations

4. Flow of Costs through Manufacturing and Merchandising Companies

5. Inventory Control Inventory control is important for: • Ensuring availability of inventory items • Preventing excessive accumulation of inventory items • Preventing waste, spoilage, or theft

6. Purchases are debited to Inventory account Freight-in, Purch. Returns & Allowances and Purch. Disc. are recorded in Inventory account. Debit COGS and credit Inventory account for each sale. Purchases are debited to Purchases account. Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts. COGS is computed only periodically: COGA – EI = COGS Inventory Systems Perpetual Method Periodic Method

7. Inventory System - Perpetual • Purchases are debited to Inventory account • Freight-in, Purch. Returns & Allowances and Purch. Disc. are recorded in Inventory account. • Debit COGS and credit Inventory account for each sale. J/E, Perpetual System: Purchase of Inventory: Dr. Inventory 1,000 Cr. A/P, Cash, etc. 1,000 Sale of Inventory: Dr. Cost of Goods Sold 1,000 Cr. Inventory 1,000 Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: no j/e required, unless errors are found in inventory count

8. Inventory System - Periodic • Purchases are debited to Purchases account. • Freight-in, Purchase Returns & Allowances and Purchase Discounts are recorded in their respective accounts. • COGS is computed only periodically: COGA – EI = COGS J/E, Periodic System: Purchase of Inventory: Dr. Purchases 1,000 Cr. A/P, Cash, etc. 1,000 Sale of Inventory: Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: Dr. Ending Inventory (determined by count) 38,000 Dr. Cost of Sales (plug) 283,000 Cr. Purchases 286,000 Cr. Opening Inventory (carried forward from prior year) 35,000

9. Inventory Valuation Basic Issues: • Physical goods to be included • Goods in transit (FOB Destination) • Goods on consignment with consignee • Goods sold under buy back agreements • Goods sold with high rates of return (if unable to estimate returns) • Installment sales (if unable to estimate bad debts) • Costs to be included in inventory (product (RM) vs. period costs (office supplies) • Cost flow assumption used (specific identification, average cost, FIFO, LIFO, etc.)

10. Effect of Inventory Errors Error in Effect on Effect on Ending Income Balance sheet Inventory Items Items Under- COGS (over) Inventory (under) stated Net income (under) Retained Earn (under) Over- COGS (under) Inventory (over) stated Net income (over) Retained Earn (over)

11. Effect of Inventory Errors (O/S Ending)

12. Cost Flow Assumptions Cost flow assumptions need not be consistent with physical flow of goods. The objective is to most clearly reflect periodic income. The cost flow assumptions are: • Specific identification • Average cost • First-in, first-out (FIFO) and • Last-in, first-out (LIFO) (prohibited under IFRS)

13. Cost Flow Assumptions: Example Spaworld reports the following transactions for 2004 (assume no opening inventory): Date Purchases Purchase Cost May 12 100 units $1,000 Aug 14 200 units 2,200 Sep 18 120 units1,800 420 units $5,000 On December 31, the company had 20 units on hand and uses the periodic inventory system. What are the cost of goods sold and the cost of ending inventory?

14. Average Cost Method Given Data: Date Purchases Cost May 12 100 units $1,000 Aug 14 200 units $2,200 Sep 18 120 units$1,800 420 units $5,000 • Steps: • Calculate per unit average cost: $5,000/420 = $11.905 • Apply this per unit average cost to units sold to get COGS: 400 x $11.905 = $4,762 • Apply the per unit average cost to units remaining in inventory to determine Ending inventory: 20 x $11.91 = $238

15. Average Cost Method Journal Entries: Dr. Cost of Sales 4,762 Dr. Ending Inventory 238 Cr. Opening Inventory 0 Cr. Purchases 5,000

16. Cost of goods available $4,700 $5,000 Cost of goods sold 20 X $15 = $300 Ending inventory First-In, First-Out (FIFO) Method Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 Cost of goods sold (FIFO) $1,000 (100 sold) $2,200 (200 sold) $1,500 (100 sold; 20 end inv) $4,700 “Count” from one direction and “plug” the other Note: FIFO = LISH (Last In Still Here)

17. Cost of goods available $4,800 $5,000 Cost of goods sold 20 X $10 = $200 Ending inventory Last-In, First-Out (LIFO) Method Cost of goods sold (LIFO) $ 800 (80 sold; 20, end inv) $2,200 (200 sold) $1,800 (120 sold) $4,800 Given data: Date Purchases Cost May 12 100 units @ $10 $1,000 Aug 14 200 units @ $11 $2,200 Sep 18 120 units @ $15 $1,800 420 $5,000 LIFO = FISH (First In Still Here)

18. Cost Flow Assumptions: Notes • The ending inventory in units is the same in all three methods: the cost is different • The cost of goods available is the same for all methods • The cost of goods sold and the cost of ending inventory are different • In periods of rising prices, LIFO would result in the smallest reported net income.

19. 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). • Under LIFO, there is less need to write down inventory down to market

20. Disadvantages of LIFO Method • LIFO yields the lowest net income and therefore reduced earnings (with increasing prices) • Under LIFO, the ending inventory is understated relative to current costs • LIFO liquidation (reduction of quantities of inventory during a period – results in “costing” items at older prices): • May result in income that is detrimental from a tax view • May cause poor buying habits (because of the layer liquidation problem) • LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also.

21. Periodic vs. Perpetual • FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems • BUT – LIFO, Weighted Average will give you different numbers • Under perpetual LIFO, with each sale, you cut into only existing layers (so you must stop and calculate the cost of goods sold at each sale) • Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale

22. Same Example - Perpetual Basis

23. Same Example - Perpetual Basis

24. 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. SEC reporting requirements – disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet

25. Dr. Cost of goods sold $30,000 Cr. Allowance to Reduce Inventory to LIFO $30,000 LIFO Reserve: Example Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004: $50,000 Inventory (LIFO basis) on Dec 31, 2004: $20,000 Adjust the cost of ending inventory to the LIFO basis Balance Sheet (Assets): Inventory (FIFO) $50,000 less: Allowance to Reduce Inventory ($30,000) Inventory (LIFO) basis $20,000

26. 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 due to a reduction of quantities of inventory during a period (results in “costing” items at older prices) • Such matching results in distorted income.

27. Dollar Value LIFO • Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units • Used for external purposes (i.e., financial statements and taxes) • Advantages over regular LIFO: • Reduces record keeping (maximum of one layer per year). • Mitigates likelihood of eroding old layers (some decreases in goods in the pool are offset by increases in other goods in the pool). • Price index – a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year • Internal = Ending inventory quantities X current year costs Ending inventory quantities X base year costs • External – calculated by the Bureau of Labor Statistics

28. Dollar Value LIFO Calculation Steps Compare ending inventory at base year prices to beginning of year inventory, also at base year prices – if there is an increase – we add a new LIFO layer at CY prices: • Calculate EI at current year costs - FIFO • Calculate current year price index. • Calculate EI at base year costs - FIFO • Calculate the change in inventory at base year costs – FIFO (this represents the quantity change in base year prices) • Calculate the EI at dollar value LIFO: • If the change in inventory at base year FIFO is positive, add a layer to BI at current year cost (i.e. price this real dollar quantity increase at current prices) • If the change in inventory at base year FIFO is zero, BI equals EI • If the change in inventory at base year FIFO is negative, peel off layer(s) from BI

29. Dollar Value LIFO: Example Given: Base layer (Dec 31, 2003): $20,000 Inventory (current prices) Dec 31, 2004: $26,400 Prices increased 20% during 2004. Determine dollar value LIFO at Dec 31,2004

30. At base $: $22,000 $26,400 / 1.20 At EOY prices: $26,400 Dollar value LIFO Inventory Net increase at base $: Restate at current $: $2,400 (layer added) $20,000 plus $2,400 = $22,400 $22,000 less $20,000 $2,000 * 1.20 Dollar Value LIFO: Example Price increase, 20% Dec 31, 2003 Dec 31, 2004

31. Dollar Value LIFO: Notes When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000): • the decrease must be subtracted from the most recently added layer. • Once a layer is eliminated (peeled off), it cannot be rebuilt.