Valuation of Inventories: A Cost-Basis Approach

Valuation of Inventories: A Cost-Basis Approach

JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

Learning Objectives • Physical Goods included in Inventory • Costs Included in Inventory • Inventory: Periodic vs. Perpetual • Purchase Discounts • Gross versus Net • Cost Flow Assumptions • Specific Identification, Average Cost, FIFO, LIFO • Specific Issues Related to LIFO • LIFO Reserve • LIFO Liquidation • Dollar-Value LIFO • Major advantages/disadvantages

Inventory Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by the enterprise. Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for the organization. Inventories are also significant because of their impact on both the balance sheet and the income statement.

Inventory Classification and Systems Classification • Inventories are: • items held for sale, or • goods to be used in the production of goods to be sold. Businesses with Inventory: Merchandiser Manufacturer or LO 1 Identify major classifications of inventory.

Inventory Classification and Systems Flow of Costs Illustration 8-2 LO 1 Identify major classifications of inventory.

Inventory Classification and Systems Control Two systems for maintaining inventory records: • Perpetual system • Periodic system

Purchases are debited to Inventory account Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in Inventory account. Debit COGS and credit Inventory account for each sale. Purchases are debited to Purchases account. Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in their respective accounts. COGS is computed only periodically : COGAS – Ending Inventory = COGS Inventory Systems Perpetual Method Periodic Method

Inventory Classification and Systems Perpetual System vs. Periodic System

Basic Issues in Inventory Valuation Valuation of Inventories Requires the following: • The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). • The costs to include (product vs. period costs). • The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

Physical Goods Included in Inventory Physical Goods The following goods are included in “seller’s” inventory: • Goods in transit (FOB Destination) • Goods on consignment with consignee • Goods, sold under buy back agreements • Goods, sold with high rates of return • Installment sales (if bad debts can not be estimated) A company should record purchases when it obtains legal title to the goods.

Guidelines for Determining Ownership

Costs Included in Inventory • Product Costs • Period Costs • Purchase Discounts – Gross vs. Net Method

Costs Included in Inventory • Product costsare those costs that "attach" to the inventory and are recorded in the inventory account. These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. • Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs. The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process.

Purchase Discounts: Two methods If the gross method is used, purchase discounts should be reported as a deduction from purchases (purchase discounts) on the income statement. If the net method is used, purchase discounts lost should be considered a financial expense and reported in the "other expense and loss" section of the income statement.

Example: Treatment of Purchase Discounts Net Method vs. Gross Method

Example: E8-3 Assuming each of the amounts is material, state whether the merchandise should be included in the client’s inventory at 12/31/2007. (1) A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the shipping room on 12/31/07. The customer was billed on that date and the machine excluded from inventory although it was shipped on 1/4/2008.

Example: E8-3 (2) Merchandise costing 2,800 was received on 1/3/2008, and the related purchase invoice recorded 1.5.08. The invoice showed the shipment was made on 12/29/2007 f.o.b. destination.

Example: E8-3 (3) A packing case containing a product costing 3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer's order was dated 12/18/2007, but that the case was shipped and customer billed on 1/10/2008. The product was a stock item of your client.

Example: E8-3 (4) Merchandise received on 1/6/2008, costing Rs680 was entered in the purchase journal on 1/7/2008. The invoice showed shipment was made f.o.b. supplier’s warehouse on 12/31/2007. Because it was not on hand at 12/31, it was not included in inventory.

Example: E8-3 (5) Merchandise costing Rs720 was received on 12/28/2007, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was market “on consignment.”

What Cost Flow Assumption to Adopt? FIFO LIFO Cost Flow Assumption Adopted does not need to equal Physical Movement of Goods Average Cost • Specific Identification – • High-ticket items: Automobiles, Jewelry, Real estate

Cost Flow Assumptions Example • Young & Crazy Company makes the following purchases: • One item on 2/2/07 for Rs10 • One item on 2/15/07 for Rs15 • One item on 2/25/07 for Rs20 • Young & Crazy Company sells one item on 2/28/07 for Rs90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%.

Cost Flow Assumptions “First-In-First-Out (FIFO)” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Inventory Balance = Rs 45 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “First-In-First-Out (FIFO)” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 47 Taxes 14 Net Income Rs 33 Inventory Balance = Rs 35 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Last-In-First-Out (LIFO)” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Inventory Balance = Rs 45 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Last-In-First-Out (LIFO)” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 Taxes 11 Net Income Rs 26 Inventory Balance = Rs 25 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Average Cost” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Inventory Balance = Rs 45 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Average Cost” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 Taxes 12 Net Income Rs 30 Inventory Balance = Rs 30 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Specific Identification” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Inventory Balance = Rs 45 Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Cost Flow Assumptions “Specific Identification” Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40 Inventory Balance = Rs 45 Depends which one is sold Purchase on 2/25/07 for Rs20 Purchase on 2/15/07 for Rs15 Purchase on 2/2/07 for Rs10

Special Issues Related to LIFO LIFO Reserve • Many companies use • LIFO for tax and external financial reporting purposes • FIFO, average cost, or standard cost system for internal reporting purposes. • Reasons: • Pricing decisions • Record keeping easier • Profit-sharing or bonus arrangements • LIFO troublesome for interim periods

Special Issues Related to LIFO LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. Example: FIFO value per books Rs160,000 LIFO value 145,000 LIFO Reserve Rs 15,000 Journal entry to reduce inventory to LIFO: Cost of goods sold 15,000 LIFO reserve 15,000 Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

Special Issues Related to LIFO LIFO Liquidation Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes. Illustration 8-20

Special Issues Related to LIFO Dollar-Value LIFO • Changes in a pool are measured in terms of total dollar value, not physical quantity. • Advantage: • Broader range of goods in pool. • Permits replacement of goods that are similar. • Helps protect LIFO layers from erosion.

Special Issues Related to LIFO Dollar-Value LIFO Exercise 8-26 The following information relates to the Jimmy Johnson Company. Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005.

Special Issues Related to LIFO Exercise 8-26 Solution LO 8 Explain the dollar-value LIFO method.

Special Issues Related to LIFO Disadvantages Advantages • Matching • Tax Benefits/Improved Cash Flow • Future Earnings Hedge • Reduced earnings • Inventory understated • Physical flow • Involuntary Liquidation / Poor Buying Habits

Valuation of Inventories: A Cost-Basis Approach