chapter 8 lecture

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Inventories:Measurement

8

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Recording and Measuring InventoryRecording and Measuring Inventory

Merchandise Inventory

Goods acquired for resale

Manufacturing Inventory

•Raw Materials•Work-in-Process•Finished Goods

Types of Inventory

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Manufacturing InventoriesManufacturing InventoriesRaw

MaterialsWork inProcess

FinishedGoods

Cost of Goods Sold

DirectLabor

ManufacturingOverhead

$XX $XX

$XX

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

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

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Inventory SystemsInventory Systems

Perpetual Inventory System

Perpetual Inventory System

The inventory account is

continuously updated as

purchases and sales are made.

The inventory account is

continuously updated as

purchases and sales are made.

Periodic Inventory System

Periodic Inventory System

The inventory The inventory account is adjusted account is adjusted

at the end of a at the end of a reporting cycle.reporting cycle.

The inventory The inventory account is adjusted account is adjusted

at the end of a at the end of a reporting cycle.reporting cycle.

Two accounting systems are used to record transactions involving inventory:

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Perpetual Inventory SystemPerpetual Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins

2011 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale

to customers.

Returns of inventory are credited to the inventory account.

Discounts on inventory purchases can be recorded using the gross or net method.

2011Inventory 600,000

Accounts payable 600,000Purchase of merchandise inventory on account

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Perpetual Inventory SystemDuring 2011, LWBC sold, on account, inventory with a retail

price of $820,000 and a cost basis of $540,000, to customers.

2011Inventory 600,000

Accounts payable 600,000Purchase of merchandise inventory on account.

2011Accounts receivable 820,000

Sales revenue 820,000Record sales on account.

Cost of goods sold 540,000Inventory 540,000

Record cost of goods sold.

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Periodic Inventory System

Beginning Inventory+ Net Purchases

Cost of Goods Available for Sale

- Ending Inventory= Cost of Goods Sold

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.

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Periodic Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins

2011 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale

to customers.

2011Purchases 600,000

Accounts payable 600,000Purchase of merchandise inventory on account

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Periodic Inventory System

No entry is made to record Cost of Goods Sold. A physical countof Ending Inventory shows a balance of $180,000. Let’s

calculate Cost of Goods Sold at the end of 2011.

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 820,000Record sales on account.

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Periodic Inventory System

Beginning inventory 120,000$ Plus: Purchases 600,000 Cost of goods available for sale 720,000 Less: Ending inventory (180,000) Cost of goods sold 540,000$

Calculation of Cost of Goods Sold

We need the following adjusting entry to record cost of good sold.December 31, 2011Cost of goods sold 540,000Inventory (ending) 180,000

Inventory (beginning) 120,000Purchases 600,000

To adjust inventory, close purchases, and record cost of goods sold.

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Comparison of Inventory Systems

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What is Included in Inventory?

General RuleAll goods owned by the company on the inventory

date, regardless of their location.

Goods in TransitGoods in Transit Goods on Consignment

Goods on Consignment

Depends on FOB shipping terms.

Depends on FOB shipping terms.

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Expenditures Included in InventoryExpenditures Included in Inventory

Invoice PriceInvoice Price

Freight-in on Purchases

Freight-in on Purchases

+

Purchase Returns and Allowances

Purchase Returns and Allowances

Purchase Discounts

Purchase Discounts

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Purchase Returns

November 8, 2011Accounts payable 2,000 Accounts payable 2,000 Purchase returns and allowances 2,000 Inventory 2,000

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.

Periodic Inventory Method Perpetual Inventory Method

Returns of inventory are credited to the Purchase Returns and Allowances account when using the periodic

inventory method.

The returns are credited to Inventory using the perpetual inventory method.

Returns of inventory are credited to the Purchase Returns and Allowances account when using the periodic

inventory method.

The returns are credited to Inventory using the perpetual inventory method.

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Purchase Discounts

October 5, 2011Purchases 20,000 Purchases 19,600

Accounts payable 20,000 Accounts payable 19,600

October 14, 2011Accounts payable 14,000 Accounts payable 13,720

Purchase discounts 280 Cash 13,720Cash 13,720

November 4, 2011Accounts payable 6,000 Accounts payable 5,880

Cash 6,000 Interest expense 120Cash 6,000

Discount terms are 2/10, n/30.

$14,000x 0.02$ 280

Partial payment not made within the discount period

Gross Method Net Method

$20,000x 0.02$ 400 -120$ 280

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Inventory Cost Flow Assumptions

• Specific identification

• Average cost

• First-in, first-out (FIFO)

• Last-in, first-out (LIFO)

• Specific identification

• Average cost

• First-in, first-out (FIFO)

• Last-in, first-out (LIFO)

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Perpetual Average Cost

Picture This, LLC, uses a standard frame size for all pictures to hold down product costs. The

following schedule shows the frame inventory for Picture This, LLC, for September.

The physical inventory count at September 30 shows 1,400 frames in ending inventory.

Use the perpetual average cost method to determine:

(1) Ending inventory cost

(2) Cost of goods sold

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Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory (1,400) - Cost of Goods Sold 2,650

Perpetual Average Cost

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Perpetual Average Cost

Date Average Cost BalanceBeg. Inv. 1,200 x 22.00$ = 26,400 22.00$ 26,400.00$

9/3 900 x 24.00 = 21,600 22.86 48,000.00 9/15 550 x 25.00 = 13,750 23.30 61,750.00 9/15 1000 x 23.30 = 23,300.00 38,450.00

Purchased Sold

$61,750 ÷ (1,200 + 900 + 550) = $23.30 rounded

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Perpetual Average Cost

[(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded[(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded

Date Average Cost BalanceBeg. Inv. 1,200 x 22.00$ = 26,400 22.00$ 26,400.00$

9/3 900 x 24.00 = 21,600 22.86 48,000.00 9/15 550 x 25.00 = 13,750 23.30 61,750.00 9/15 2,650 1000 x 23.30 = 23,300.00 38,450.00 9/21 600 27.00 16,200 24.29 54,650.00 9/22 700 24.29 17,003.00 37,647.00

Purchased Sold

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Perpetual Average Cost

Date Average Cost BalanceBeg. Inv. 1,200 x 22.00$ = 26,400 22.00$ 26,400.00$

9/3 900 x 24.00 = 21,600 22.86 48,000.00 9/15 550 x 25.00 = 13,750 23.30 61,750.00 9/15 2,650 1000 x 23.30 = 23,300.00 38,450.00 9/21 600 x 27.00 = 16,200 24.29 54,650.00 9/22 700 x 24.29 = 17,003.00 37,647.00 9/29 800 x 28.00 = 22,400 25.55 60,047.00 9/30 950 x 25.55 = 24,272.50 35,774.50

Purchased Sold

1,550 × 24.29$ = 37,650$ 800 × 28.00 = 22,400

2,350 60,050$ Weighted Average Cost 25.55$

Ending inventory = 1,400 units × $25.55 = $35,770Rounding error

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Last-In, First-OutPeriodic Inventory System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 35,774.50 Cost of Goods Sold 2,650 64,575.50$

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Weighted-Average Periodic System

Let’s use the same information to assign costs to ending inventory and cost of goods sold using the

periodic system.

Available for Sale

(4,050 units)

Available for Sale

(4,050 units)

Ending Inventory(1,400 units)

Goods Sold(2,650)

$100,350 ÷ 4,050 = $24.7778 weighted-average per unit cost

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Weighted-Average Periodic System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory (1,400) 24.7778$ (34,688.92) Cost of Goods Sold 2,650 24.7778$ 65,661.08$

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First-In, First-Out (FIFO)

• 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.

• 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.

The FIFO method

assumes that items are sold

in the chronological order of their acquisition.

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First-In, First-Out (FIFO)

Even though the periodic and the perpetual

approaches differ in the timing of adjustments to

inventory . . .

. . . COGS and Ending Inventory Cost are the

same under both approaches.

Even though the periodic and the perpetual

approaches differ in the timing of adjustments to

inventory . . .

. . . COGS and Ending Inventory Cost are the

same under both approaches.

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Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 38,600.00 Cost of Goods Sold 2,650 31,050.00$

First-In, First-Out (FIFO)Periodic Inventory System

These are the 1,400 most recently

acquired units.

These are the 1,400 most recently

acquired units.

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Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 38,600.00 Cost of Goods Sold 2,650 61,750.00$

First-In, First-Out (FIFO)Periodic Inventory System

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Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 38,600.00 Cost of Goods Sold 2,650 61,750.00$

First-In, First-Out (FIFO)Periodic Inventory System

These are the first 2,650 units acquired.

These are the first 2,650 units acquired.

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Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 38,600.00 Cost of Goods Sold 2,650 61,750.00$

First-In, First-Out (FIFO)Periodic Inventory System

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Last-In, First-Out (LIFO)

• 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.

• 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.

The LIFO method

assumes that the newest

items are sold first, leaving the

older units in inventory.

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Last-In, First-Out (LIFO)

Unlike FIFO, using the LIFO method may

result in COGS and Ending Inventory Cost that differ

under the periodic and perpetual approaches.

Unlike FIFO, using the LIFO method may

result in COGS and Ending Inventory Cost that differ

under the periodic and perpetual approaches.

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Last-In, First-OutPerpetual Inventory System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 Cost of Goods Sold 2,650

These are the oldest units in

inventory and are most likely to

remain in inventory when using LIFO.

These are the oldest units in

inventory and are most likely to

remain in inventory when using LIFO.

Date Sales Units9/15 1,000 9/22 700 9/30 950

2,650

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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.

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.

Date BalanceBeg. Inv. 1,200 x 22.00 = 26,400 26,400.00$

9/3 900 x 24.00 = 21,600 48,000.00 9/15 550 x 25.00 = 13,750 61,750.00

2,650 550 x 25.00 = 13,750.00 450 x 24.00 = 10,800.00

1,000 24,550.00 37,200.00

Purchased Sold

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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.

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.

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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 unit

and (200 × $24.00) for a total cost of ending inventory of $31,200.

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 unit

and (200 × $24.00) for a total cost of ending inventory of $31,200.

Date BalanceBeg. Inv 1,200 x 22.00 = 26,400 26,400.00$

9/3 350 x 24.00 = 8,400 34,800.00 9/29 800 x 28.00 = 22,400 57,200.00 9/30 800 x 28.00 = 22,400.00

150 x 24.00 = 3,600.00 950 26,000.00 31,200.00

Purchased Sold

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Last-In, First-OutPeriodic Inventory System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 Cost of Goods Sold 2,650

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Last-In, First-OutPeriodic Inventory System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 31,200.00 Cost of Goods Sold 2,650 69,150.00$

Units Unit Cost Total CostBeginning inventory 1,200 22.00$ 26,400$ Purchase of September 3 200 24.00 4,800 Cost of goods available for sale 1,400 31,200

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Last-In, First-OutPerpetual Inventory System

Picture This, LLCFrame Inventory

Date Units $/Unit TotalBeg. Inventory 1,200 22.00$ 26,400.00$

9/3 900 24.00 21,600.00 9/15 550 25.00 13,750.00 9/21 600 27.00 16,200.00 9/29 800 28.00 22,400.00

Goods Available for Sale 4,050 100,350.00$ Ending Inventory 1,400 31,200.00 Cost of Goods Sold 2,650 69,150.00$

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When Prices Are Rising . . .

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.

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U. S. GAAP vs. IFRS

• 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.

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.

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Decision Makers’ Perspective

Factors Influencing Method Choice

How are income taxes affected by inventory method

choice?

How closely do reported

costs reflect actualflow of inventory?

How well are costs matched against

related revenues?

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Inventory Management

Gross profit ratio =Gross profitNet sales

Inventory turnover ratio = Cost of goods soldAverage inventory

The higher the ratio, the higher is the markup a company is able to achieve on its products.

(Beginning inventory + Ending inventory2

Designed to evaluate a company’seffectiveness in managing its

investment in inventory

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Quality of Earnings

Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).

Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

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Methods of Simplifying LIFO

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.

LIFO Inventory Pools

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Example

The replacement inventory differs from the old inventory on

hand. We just create a new layer.

Methods of Simplifying LIFODollar-Value LIFO (DVL)

DVL inventory pools are viewed as layers of value, rather than layers of similar units.DVL inventory pools are viewed as layers

of value, rather than layers of similar units.

DVL simplifies LIFO record-keeping.

DVL simplifies LIFO record-keeping.

DVL minimizes the probability of layer

liquidation.

DVL 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.

At the end of the period, we determine if a new inventory layer

was added by comparing ending

inventory to beginning inventory.

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase

in inventory.

We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase

in inventory.

1a. Compute a Cost Index for the

year.

1a. Compute a Cost Index for the

year.

Cost index in layer

year =

Cost in layer year

÷Cost in base year

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

1b. Deflate the ending

inventory value using

the cost index.

1b. Deflate the ending

inventory value using

the cost index.

1c. Compare ending

inventory (at base year cost) to

beginning inventory.

1c. Compare ending

inventory (at base year cost) to

beginning inventory.

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

Next, identify the layers in ending inventory and the years they were created.

Next, identify the layers in ending inventory and the years they were created.

Sum all the layers to arrive at Ending Inventory at DVL

cost.

Sum all the layers to arrive at Ending Inventory at DVL

cost.

Convert each layer’s base year cost to layer

year cost by multiplying times the

cost index.

Convert each layer’s base year cost to layer

year cost by multiplying times the

cost index.

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

Masterwear reports the following inventoryMasterwear reports the following inventoryand general price information. Let’s look at the and general price information. Let’s look at the

solution to this example.solution to this example.

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

12/31Ending

inventoryPrice index

Inventory at base-year

prices

2011 150,000$ 100% 150,000$

2012 168,000 105% 160,000

168,000 ÷ 1.05 = 160,000

Masterwear reports the following inventoryMasterwear reports the following inventoryand general price information. and general price information.

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

First, determine the LIFO layer forFirst, determine the LIFO layer forthe current year . . .the current year . . .

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Methods of Simplifying LIFODollar-Value LIFO (DVL)

At the LIFO layer at end of period prices to theAt the LIFO layer at end of period prices to theending LIFO inventory from last period. ending LIFO inventory from last period.

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Supplemental LIFO Disclosures

Many companies use LIFO for external reporting and income tax purposes but maintain internal records using

FIFO or average cost.

The conversion from FIFO or average cost The conversion from FIFO or average cost to LIFO takes place at the end of the to LIFO takes place at the end of the

period. The conversion may look like this:period. The conversion may look like this:

2011 2010

Total inventories at FIFO 15,429$ 15,387$ Less: LIFO allowance (1,508) (1,525) Inventories, at LIFO cost 13,921$ 13,862$

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LIFO Liquidation

LIFO inventory costs in the balance sheet are “out of date” because they

reflect old purchase transactions.

LIFO inventory costs in the balance sheet are “out of date” because they

reflect old purchase transactions.

When prices rise . . .

If inventory declines, these “out of date” costs

may be charged to current earnings.

If inventory declines, these “out of date” costs

may be charged to current earnings.

This LIFOliquidation results in

“paper profits.”

This LIFOliquidation results in

“paper profits.”

End of Chapter 8