Inventories: Measurement

1. Inventories:Measurement

2. Learning Objectives 1. Explain the difference between a perpetual inventory system and a periodic inventory system. PERIODIC INVENTORY SYSTEM IS NOT COVERED 2. Explain which physical quantities of goods should be included in inventory. 3. Determine the expenditures that should be included in the cost of inventory. 4. Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold. 5. Discuss the factors affecting a company’s choice of inventory method. 6. Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income. 7. Calculate the key ratios used by analysts to monitor a company’s investment in inventories. 8. Determine ending inventory using the dollar-value LIFO inventory method. 9. Discuss the primary difference between U.S. GAAP and IFRS with respect to determining the cost of inventory.

3. Merchandise Inventory Manufacturing Inventory Goods acquired for resale • Raw Materials • Work-in-Process • Finished Goods Recording and Measuring Inventory Types of Inventory

4. Manufacturing Inventories RawMaterials FinishedGoods Work inProcess     $XX $XX DirectLabor   Cost of Goods Sold $XX ManufacturingOverhead    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       

5. Perpetual Inventory System Periodic Inventory System (Not Covered) The inventory account is continuously updated as purchases and sales are made. The inventory account is adjusted at the end of a reporting cycle. Inventory Systems Two accounting systems are used to record transactions involving inventory:

6. Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resaleto customers. 2011 Inventory 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method.

7. Perpetual Inventory System During 2011, LWBC sold, on account, inventory with a retailprice of $820,000 and a cost basis of $540,000, to customers. 2011 Inventory 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account. 2011Accounts receivable 820,000 Sales revenue 820,000 Record sales on account. Cost of goods sold 540,000 Inventory 540,000 Record cost of goods sold.

8. 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.

9. Periodic Inventory System (Not Covered) Lothridge Wholesale Beverage Company (LWBC) begins2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resaleto customers. 2011 Purchases 600,000 Accounts payable 600,000 Purchase of merchandise inventory on account

10. Periodic Inventory System During 2011, LWBC sold, on account, inventory with a retailprice of $820,000 to customers, and a cost basis of $540,000. 2011Accounts receivable 820,000 Sales revenue 820,000 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.

11. 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.

12. Comparison of Inventory Systems

13. General Rule All goods owned by the company on the inventory date, regardless of their location. What is Included in Inventory? Goods in Transit Goods on Consignment Depends on FOB shipping terms.

14. FOB Shipping Point Public Carrier Seller Buyer Ownership passes to the buyer here. Public Carrier Seller Buyer FOB Destination Point Goods in Transit 5-14

15. Determining Inventory Items C 1 Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Items requiring special attention include: Goods in Transit Goods Damaged or Obsolete Goods on Consignment 5-15

16. Invoice Price Purchase Returns and Allowances + Freight-in on Purchases Purchase Discounts Expenditures Included in Inventory

17. Exercise 8

18. Purchase Returns (Perpetual) 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. Perpetual Inventory Method November 8, 2011 Accounts payable 2,000 Inventory 2,000 The returns are credited to Inventory using the perpetual inventory method.

19. Exercise 1

20. Purchase Discounts (2/10, n/30) Gross Method Net Method October 5, 2011 Inventory 20,000 Inventory 19,600 Accounts payable 20,000 Accounts payable 19,600 October 14, 2011 Accounts payable 14,000 Accounts payable 13,720 Inventory 280 Cash 13,720 Cash 13,720 November 4, 2011 Accounts payable 6,000 Accounts payable 5,880 Cash 6,000 Interest expense 120 Cash 6,000 Discount terms are 2/10, n/30. $20,000x 0.02$ 400 -120$ 280 Partial payment not made within the discount period $14,000x 0.02$ 280

21. Exercise 9 (Req. 3)

22. Specific identification Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) Inventory Cost Flow Assumptions

24. Perpetual Average Cost

25. Perpetual Average Cost $61,750 ÷ (1,200 + 900 + 550) = $23.30 rounded

26. Perpetual Average Cost [(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded

27. Perpetual Average Cost Ending inventory = 1,400 units × $25.55 = $35,770 Rounding error

28. Exercise 14 (3)

29. 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. First-In, First-Out (FIFO) The FIFO method assumes that items are sold in the chronological order of their acquisition.

30. First-In, First-Out (FIFO)Perpetual Inventory System These are the 1,400 most recently acquired units.

31. First-In, First-Out (FIFO)Perpetual Inventory System

32. First-In, First-Out (FIFO)Perpetual Inventory System These are the first 2,650 units acquired.

33. First-In, First-Out (FIFO)Perpetual Inventory System

34. Exercise 14 (1)

35. 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. Last-In, First-Out (LIFO) The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.

36. Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. Last-In, First-Out (LIFO)

37. Last-In, First-OutPerpetual Inventory System These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.

38. Last-In, First-OutPerpetual 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.

39. Last-In, First-OutPerpetual Inventory System 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.

40. Last-In, First-OutPerpetual 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 unitand (200 × $24.00) for a total cost of ending inventory of $31,200.

41. Last-In, First-OutPerpetual Inventory System

42. Exercise 14 (2)

44. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income. FIFO Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher taxable income. When Prices Are Rising . . .

45. 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. ThisLIFO liquidation results in “paper profits.”

46. 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. 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 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.

47. Methods of Simplifying LIFO 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 lumber company might pool its inventory into rough-cut lumber,hardwood, framing lumber, paneling, and so on. 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. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately.

48. Methods of Simplifying LIFO LIFO Inventory Pools But the benefits of LIFO Inventory Pools may not be achieved in most cases. For example, when a company discontinues a certain productincluded in one of its pools. The old costs that existed in prior layers of inventory would be recognized as cost of goods sold and produce LIFO liquidation profit. Even if the product is replaced with another product, the replacement may not be similar enough to be included in the same inventory pool. In fact, the process itself of having to periodically redefine pools as changes in product mix occur can be expensive and time consuming. The dollar-value LIFO approach helps overcome these problems.

49. Methods of Simplifying LIFO Dollar Value LIFO 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. Instead of layers of units from different purchases, the DVL inventory pool is viewed as layers of dollar value from different years. Because the physical characteristics of inventory items are not relevant to DVL, an inventory pool is identified in terms of economic similarity rather than physical similarity. Specifically, a pool should consist of those goods that are likely to be subject to the same cost change pressures.

50. Methods of Simplifying LIFODollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. Example The replacement inventory differs from the old inventory on hand. We just create a new layer. DVL minimizes the probability of layer liquidation.