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Inventories: Measurement. Objectives of this Chapter. Discuss the importance of inventory valuation. Study perpetual and periodic inventory systems and the ending period adjustments for inventory. Study and compare the inventory cost flow assumptions. Explain the effect of LIFO liquidations.
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Objectives of this Chapter • Discuss the importance of inventory valuation. • Study perpetual and periodic inventory systems and the ending period adjustments for inventory. • Study and compare the inventory cost flow assumptions. • Explain the effect of LIFO liquidations. Inventories: Measurement
Objectives of this Chapter (contd.) • Identify the items that should be included in the inventory count. • Discuss the lower of cost or market (LCM) rule. • Study the accounting treatment of changing to LIFO cost flow assumption and the use of LIFO reserve account. • LIFO Inventory Pools • Dollar-value LIFO technique. Inventories: Measurement
1. Inventories: the Importance of Inventory Valuation • How would the valuation and cost flow assumptions of inventory affect the income measurement? • Valuation Methods: Historical Cost, Current Exist Value, Current Entry Value, Present Value, LCM. • Cost Flow Assumptions: LIFO, FIFO, Average, Specific Identification. • CGS = Beginning Inventory + Net Purchase - Ending Inventory Inventories: Measurement
Inventories: the Importance of Inventory Valuation (contd.) • Different valuation methods and different cost flow assumptions will result in different cost of ending inventories and therefore different cost of goods sold. Inventories: Measurement
The Impact of Valuation of Ending Inventory on The CGS & Income Year 1 IncomeCGS = Beg. Inv. + Net Pur. - End. Inv. under over under a over under over b Year 2 over under under under over over a. either understating the units or the value b. either overstating the units or the value Inventories: Measurement
Impact on Omitting Goods from Purchases CGS = Beg. Inventory + N.P. - End. Inventory B/S I/S Ending Inv. understated Purchase understated R/E no effect CGS no effect A/P under N/I no effect Working Capital no effect Inventory (End.) understated Current Ratio overstatinga a. When CA > CL Inventories: Measurement
Defining Inventory 1. Assets held for resale purpose in a normal course of business 2. Assets used to produce products for resale purpose • Merchandising Firms: Merchandise • Manufacturing Firms: Raw materials Work-in-process Finished Goods Inventories: Measurement
How to Determine Inventory Value Presented on the Balance Sheet? • Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories. • Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory account. Inventories: Measurement
2. Inventory Systems and Ending Period Adjustments • Types of Inventory Systems • A. Perpetual Inventory System • B. Periodic Inventory System Inventories: Measurement
A. Perpetual Inventory System • Purchase: Inventory xxx A/P xxx • Sale: CGS xxx Inventory xxx A/R xxx Sales xxx Inventories: Measurement
Perpetual Inventory System (contd.) • Inventory account is used for the purchase and sale transactions. • CGS account is used to record the CGS of a sale. Therefore, the CGS is also known at all time. • CGS is determined by selecting a cost flow assumption. Inventories: Measurement
Perpetual Inventory SystemExample a. Sales price is $10 per unit. b. Sales price is $11 per unit. Inventories: Measurement
Example (contd.) - Journal Entries (Perpetual vs. Periodic) 3/5 Inventory 900 3/5 Purchases 900 Cash 900 Cash 900 3/7 Cash 2,000 3/7 Cash 2,000 Sales Rev. 2,000 Sales Rev. 2,000 CGS 1,100 Inventory 1,100 3/14 Inventory 700 3/14 Purchases 700 Cash 700 Cash 700 3/28 Cash 330 Cash 330 Sales Rev. 330 Sales Rev. 330 CGS 180 Inventory 180 Perpetual (FIFO) Periodic Inventories: Measurement
Inventory (LIFO) 500 1150 900 210 700 740 Inventory (WA) 500 1120 900 195.9 700 784.1 Inventory a (FIFO) B.B.500 1100 900 180 700 E.B.820 Perpetual Inventory SystemExample (contd.) a. The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement
CGS (FIFO) 3/7...1100 3/28...180 1280 CGS (LIFO) 1150 210 1360 CGS (W-A) 1120 195.9 1315.9 Perpetual Inventory SystemExample (contd.) The balance of cost of goods sold account1: 1.The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement
Ending Period AdjustmentsPerpetual Inventory System a. Adjustments for lost units. b. Adjustments for LCM valuation. Inventories: Measurement
a. Adjustments for Lost Units(Perpetual Inventory System) Assuming ending units = 110 units. On 3/31, the lost units = 10. Cost of 10 lost units => $6 x 10 = $60 (FIFO) $7 x 10 = $70 (LIFO) $6.53 x 10 = 65.3 (W-A) Adjusting Entry: 3/31 Loss on Inventory Units a 60 Inventory 60 a. or use the account of Inventory over and short Inventories: Measurement
LCM =$600 b. Adjustments for LCM Valuation(Perpetual Inventory System) Inventory (FIFO) B.B 500 1,100 900 180 700 820 60 -- 3/31 (Adj. for lost units) 760 • Ending Inv. Cost (on 3/31, FIFO) = $760 • Assuming market price = $600 LCM = $600 Inventories: Measurement
Adjustments for LCM Valuation (contd.) • Adjusting entry => Given that Allowance for Declining in Market Value of inventory has a beginning balance of zero: Allowance 3/31 0 -- 3/1 Loss Due to Market Value 160 Decline of Inventory 160 160 -- 3/31 Allowance to Reduce Inventory to Market 160 B/S (3/31) Inventory 760 Allowance (160) Inv. At LCM 600 Inventories: Measurement
An Alternative of LCM Adjustment • Many companies (i.e., Cisco Systems, inc. 2001, source: Spiceland, etc.)record the adjustment of LCM follows: • Cost of Goods Sold 160 • Inventory 160 • Note: Recording the loss as an increase in CGS will have the same impact on earnings as reporting it as a loss from value decline in the holding inventory. However, this treatment will distort the gross profit. Inventories: Measurement
Adjustments for LCM Valuation (contd.) • If the allowance account had a beginning balance of $20, the adjusting entry would be: Allowance 20 -- 3/1 Loss 140 140 Allowance 140 160 -- 3/31 Inventories: Measurement
Adjustments for LCM Valuation (contd.) • If the Allowance account had a beginning balance of 200, the adjusting entry would be: • Allowance Allowance 40 • 40 200 Gain from Recovery • 160 of M.V. of Inventory 40 Inventories: Measurement
B. Periodic Inventory System • At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and cost of goods sold: 1. Do an inventory count. 2. Applying a cost flow assumption to determine the cost of ending inventory. 3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.a a. No adjusting entries are required. Inventories: Measurement
Periodic Inventory SystemaExample • Using the example on Page 10 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7 100 + $6 5 = $730 a. For journal entries, see page 14. Inventories: Measurement
Inventory Data: UnitsCost 3/1 (B.B) 100 $5 3/5 Pur. 150 $6 3/14 Pur. 100 $7 The CGS under FIFO is: $500 + 1,600 - 730 = $1,370. If a LIFO assumption is used, the cost of end. Inv. is: $5 x 100 + $6 x 5 = $530. The CGS is: $500 + 1600 - 530 = $1,570. Periodic Inventory SystemExample (contd.) Inventories: Measurement
Ending Period Adjustments (Periodic Inventory System) 1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS). Inventories: Measurement
Ending Period Adjustments (Periodic Inventory System) 2.Adjustment for the LCM valuation assuming FIFO: Cost of E.I. = $730 LCM Allowance Market = $600 = $600 0 -- 3/1(assumed) 130 130 --3/31 • Adjusting entry: • Loss Due to Market Decline of Inv. 130 • Allowance to Reduce Inv. to Market 130 Inventories: Measurement
3. Comparison of FIFO vs. LIFODuring an Inflation Period Inventories: Measurement
Survey: (Source: Accounting Trends & Techniques) a, b,c Inventories: Measurement
Survey: (Source: Accounting Trends & Techniques) (contd.) • Sample firms are 600 firms. Most companies adopt more than one inventory method. • Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s. • IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries. • The number of disclosures. Inventories: Measurement
Switching to LIFODuring an Inflation Period • Reason of switching to LIFO: Tax savings. Inventories: Measurement
Income Manipulation When LIFO Is Used (assuming price is rising) 1. To increase income (by decreasing CGS): • Strategy: 2.To decrease income (by increasing CGS): • Strategy: Inventories: Measurement
Advantages of FIFO a. Less likely to be subject to management manipulation; b. Produce higher income during an inflation period; c. Inventory cost reported on the B/S is close to the replacement cost. Inventories: Measurement
Disadvantage of FIFO a. Bad matches of sales revenue and CGS; match current sales revenue with old costs; b. Producing higher income during an inflation period results in paying more income tax. Inventories: Measurement
Advantages of LIFO a. Good match of sales revenue with CGS. b. Produce lower income during an inflation period; result in tax savings. Inventories: Measurement
Disadvantages of LIFO a. Inventory cost presented on the B/S is not fair. b. Subject to management manipulation. Note: International Accounting Standard No. 2 does not allow LIFO. Inventories: Measurement
IRS 1. Does not allow firms to use LCM if firms are using LIFO. 2.LIFO conformity rule. The non-LIFO income numbers are allowed on the supplementary reports since 1981. Inventories: Measurement
IRS (contd.) 3. LIFO is not acceptable by the IRS till 1939. Inventories: Measurement
4. LIFO Liquidations • A LIFO Liquidation profit can occur when units purchased are less than units sold in the period. Inventories: Measurement
An Example of LIFO Liquidation Profit 20x5 Beg. Inv. 400 $5 Pur. 300 $6 Pur. 500 $7 Pur. 600 $8 During 20x5, 1,700 units were sold. What is the LIFO liquidation profit? Total purchases of 20x5 are 1,400 units. The LIFO liquidationprofit is: (1,700-1,400) x ($8-$5) = $900 Inventories: Measurement
Choice of Inventory Cost-Flow Assumptions and Conversion of FIFO to LIFO for Comparison Purposes • Choice of inventory cost-flow assumptions. • Inventory Management (JIT system, Inventory turnover rate, etc.): the example of Dell Inc. • Adjustment of inventory cost-flow assumption on the same basis before making comparison of financial statements. Inventories: Measurement
Adjustment of Inventory Cost-Flow Assumption – An Example Information: ABC is currently adopting FIFO assumption. IF LIFO were adopted, cost of ending inventory would be $1,000 and $3,000 lower for x1 and x2, respectively. Question: How much would the CGS and income be different when LIFO is adopted rather than FIFO? Inventories: Measurement
Adjustment of Inventory Cost-Flow Assumption- An Example (contd.) CGS = Beg. Inv. + Net Pur. – End. Inv. Impact => -1000 -3000 of LIFO (LIFO Reserve) Thus, CGS should be increased by $2,000 and income before tax would be decreased by $2,000. Inventories: Measurement
LIFO Reserve: An Account Used to Adjust Ending Inventory Value from FIFO to LIFO • The difference in the value of inventory between the inventory method used for internal reporting purposes (i.e., FIFO) and LIFO is referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO . • The change in the balance of LIFO Reserve from one period to another is referred as the LIFO Effect (i.e.,impact on income). Inventories: Measurement
LIFO Reserve - Example • Assume Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. On 12/31/x5, the LIFO Reserve balance was $20,000. However, the value of ending inventory on 12/31/x6 under LIFO is $50,000 less than that of FIFO. • Inventory on 12/31/x5 at FIFO = $320,000 • Inventory on 12/31/x6 at FIFO =$360,000 Inventories: Measurement
LIFO Reserve – Example (contd.) (Inventory Disclosure, note D)12/31/x6 12/31/x5 • Inventory at FIFO $360,000 $320,000 • LIFO Reserve(50,000) (20,000) • Inventory at LIFO $310,000 $300,000 • Thus, $30,000 should be added to the LIFO Reserve account. The LIFO effect (impact on income) for 20x6 is $30,000. Inventories: Measurement
LIFO Reserve - Example (contd.) J.E. to adjust inventory from FIFO to LIFO: Cost of Goods Sold 30,000 LIFO Reserve a 30,000 (or Allowance to Reduce Inventory to LIFO) a.reported as a contra account to inventory or a deduction from inventory Inventories: Measurement
Inventory Presentation and Footnote Disclosure Inventories, net of adjustment to LIFO Reserve (Note D) $310,000 Note D (contd.):Inventories. Inventories are valued at the lower of cost or market determined principally by the LIFO method. If the FIFO cost method had been used, inventories would have been $50,000 higher. Inventories: Measurement
5. Items to Be Included in Inventory • Any goods with the legal title transferred to the buyer should be included in the inventory of the buyer (including goods in transit with a F.O.B. shipping point term). Inventories: Measurement