Chapter
8-1
CHAPTER
8
VALUATION OF INVENTORIES:
A COST-BASIS APPROACH
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
8-2
Learning Objectives
1.
Identify major classifications of inventory.
2.
Distinguish between perpetual and periodic inventory systems.
3.
Identify the effects of inventory errors on the financial
statements.
4.
Understand the items to include as inventory cost.
5.
Describe and compare the cost flow assumptions used to account
for inventories.
6.
Explain the significance and use of a LIFO reserve.
7.
Understand the effect of LIFO liquidations.
8.
Explain the dollar-value LIFO method.
9.
Identify the major advantages and disadvantages of LIFO.
10. Understand why companies select given inventory methods.
Chapter
8-3
Valuation of Inventories:
Cost-Basis Approach
Inventory
Issues
Classification
Cost flow
Control
Basic inventory
valuation
Physical
Goods
Included in
Inventory
Goods in transit
Consigned
goods
Special sales
agreements
Inventory errors
Costs
Included
in Inventory
Product costs
Period costs
Purchase
discounts
Cost Flow
Assumptions
Specific
identification
Average cost
FIFO
LIFO
LIFO: Special
Issues
LIFO reserve
LIFO liquidation
Dollar-value
LIFO
Comparison of
LIFO approaches
Advantages of
LIFO
Disadvantages of
LIFO
Chapter
8-4
Basis for
Selection
Summary of
inventory
valuation
methods
Inventory Issues
Classification
Inventories are:
items held for sale, or
goods to be used in the production of goods to be sold.
Businesses with Inventory:
Merchandiser
Chapter
8-5
or
Manufacturer
LO 1 Identify major classifications of inventory.
Inventory Issues
Classification
Illustration 8-1
One inventory
account
Purchase goods
ready for sale
Chapter
8-6
LO 1 Identify major classifications of inventory.
Inventory Issues
Classification
Illustration 8-1
Three accounts
Raw materials
Work in process
Finished goods
Chapter
8-7
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Cost Flow
Chapter
8-8
Illustration 8-2
LO 1 Identify major classifications of inventory.
Inventory Issues
Inventory Cost Flow
Illustration 8-3
Companies use one of two types of systems for maintaining
inventory records — perpetual system or periodic system.
Chapter
8-9
LO 1 Identify major classifications of inventory.
Inventory Cost Flow
Perpetual System
1.
Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to
Inventory.
3. Cost of goods sold is debited and Inventory is credited for
each sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.
The perpetual inventory system provides a continuous
record of Inventory and Cost of Goods Sold.
Chapter
8-10
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Periodic System
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
Beginning inventory
Purchases, net
800,000
Goods available for sale
900,000
Ending inventory
125,000
Cost of goods sold
Chapter
8-11
$ 100,000
$ 775,000
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Illustration: Fesmire Company had the following
transactions during the current year.
Record these transactions using the Perpetual and Periodic
systems.
Chapter
8-12
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Illustration:
Chapter
8-13
Solution on
notes page
Illustration 8-4
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Cost Flow
Illustration: Assume that at the end of the reporting
period, the perpetual inventory account reported an
inventory balance of $4,000. However, a physical count
indicates inventory of $3,800 is actually on hand. The entry
to record the necessary write-down is as follows.
Inventory Over and Short
Inventory
200
200
Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice,
companies sometimes report Inventory Over and Short in the “Other revenues
and gains” or “Other expenses and losses” section of the income statement.
Chapter
8-14
LO 2 Distinguish between perpetual and periodic inventory systems.
Inventory Issues
Inventory Control
All companies need periodic verification of the inventory
records by actual count, weight, or measurement, with
the counts compared with the detailed inventory
records.
Companies should take the physical inventory near the
end of their fiscal year, to properly report inventory
quantities in their annual accounting reports.
Chapter
8-15
LO 2 Distinguish between perpetual and periodic inventory systems.
Basic Issues in Inventory Valuation
Valuation
Companies must allocate the cost of all the goods
available for sale (or use) between the goods that were
sold or used and those that are still on hand.
Illustration 8-5
Chapter
8-16
LO 2 Distinguish between perpetual and periodic inventory systems.
Basic Issues in Inventory Valuation
Valuation requires determining
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.).
Chapter
8-17
LO 2 Distinguish between perpetual and periodic inventory systems.
Physical Goods Included in Inventory
A company should record purchases when it obtains
legal title to the goods.
Illustration 8-6
Chapter
8-18
LO 2 Distinguish between perpetual and periodic inventory systems.
Effect of Inventory Errors
Ending Inventory Misstated
Illustration 8-7
The effect of an error on net income in one year (2009) will be
counterbalanced in the next (2010), however the income statement
will be misstated for both years.
Chapter
8-19
LO 3 Identify the effects of inventory errors on the financial statements.
Effect of Inventory Errors
Illustration: Jay Weiseman Corp. understates its ending inventory
by $10,000 in 2009; all other items are correctly stated.
Illustration 8-8
Chapter
8-20
LO 3
Effect of Inventory Errors
Purchases and Inventory Misstated
Illustration 8-9
The understatement does not affect cost of goods sold and net
income because the errors offset one another.
Chapter
8-21
LO 3 Identify the effects of inventory errors on the financial statements.
Costs Included in Inventory
Product Costs - costs directly connected with
bringing the goods to the buyer’s place of
business and converting such goods to a salable
condition.
Period Costs – generally selling, general, and
administrative expenses.
Purchase Discounts – Gross vs. Net Method
Chapter
8-22
LO 4 Understand the items to include as inventory cost.
Costs Included in Inventory
Treatment of Purchase Discounts
Illustration 8-11
**
*
* $4,000 x 2% = $80
** $10,000 x 98% = $9,800
Chapter
8-23
Solution on
notes page
LO 4 Understand the items to include as inventory cost.
Which Cost Flow Assumption to Adopt?
FIFO
LIFO
Cost Flow Assumption Adopted
does not need to equal
Physical Movement of Goods
Average Cost
Specific Identification
Answer: Method adopted should be one
that most clearly reflects periodic income.
Chapter
8-24
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
Example
Young & Crazy Company makes the following purchases:
1.
One item on 2/2/11 for $10
2.
One item on 2/15/11 for $15
3.
One item on 2/25/11 for $20
Young & Crazy Company sells one item on 2/28/11 for
$90. What would be the balance of ending inventory and
cost of goods sold for the month ended Feb. 2011,
assuming the company used the FIFO, LIFO, Average
Cost, and Specific Identification cost flow assumptions?
Assume a tax rate of 30%.
Chapter
8-25
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-26
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“First-In-First-Out (FIFO)”
Inventory
Balance = $ 35
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-27
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
10
80
14
12
7
33
47
14
$ 33
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-28
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Last-In-First-Out (LIFO)”
Inventory
Balance = $ 25
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-29
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
20
70
14
12
7
33
37
11
$ 26
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Average Cost”
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-30
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Average Cost”
Inventory
Balance = $ 30
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-31
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
15
75
14
12
7
33
42
12
$ 30
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Specific Identification”
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-32
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
“Specific Identification”
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10
Chapter
8-33
Young & Crazy Company
Income Statement
For the Month
Feb. 2007
Depends
whichof one
is sold
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
$ 90
0
90
14
12
7
33
57
17
$ 40
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
Financial Statement Summary
Sales
Cost of goods sold
Gross profit
Operating expenses:
Administrative
Selling
Interest
Total expenses
Income before taxes
Income tax expense
Net income
Inventory Balance
Chapter
8-34
FIFO
$ 90
10
80
LIFO
$ 90
20
70
Average
$ 90
15
75
14
12
7
33
47
14
33
14
12
7
33
37
11
26
14
12
7
33
42
12
30
$
35
$
25
$
30
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Cost Flow Assumptions
Illustration: Call-Mart Inc. had the following transactions
in its first month of operations.
Calculate Goods Available for Sale
Beginning inventory (2,000 x $4)
$ 8,000
Purchases:
6,000 x $4.40
2,000 x 4.75
Goods available for sale
Chapter
8-35
26,400
9,500
$43,900
LO 5
Specific Identification
Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from the
March 15 purchase, and 2,000 from the March 30 purchase.
Compute the amount of ending inventory and cost of goods sold.
Illustration 8-12
Solution on
Chapter
notes page
8-36
Average Cost
Weighted-Average
Chapter
8-37
Solution on
notes page
Illustration 8-13
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Average Cost
Moving-Average
Illustration 8-14
In this method, Call-Mart computes a new average unit
cost each time it makes a purchase.
Chapter
8-38
Solution on
notes page
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
First-In, First-Out (FIFO)
Periodic Method
Illustration 8-15
Determine cost of ending inventory by taking the cost of the most recent
purchase and working back until it accounts for all units in the inventory.
Chapter
8-39
Solution on
notes page
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
First-In, First-Out (FIFO)
Perpetual Method
Illustration 8-16
In all cases where FIFO is used, the inventory and cost of goods sold
would be the same at the end of the month whether a perpetual or
periodic system is used.
Chapter
8-40
Solution on
notes page
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Last-In, First-Out (LIFO)
Periodic Method
Illustration 8-17
The cost of the total quantity sold or issued during the month comes
from the most recent purchases.
Chapter
8-41
Solution on
notes page
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
Last-In, First-Out (LIFO)
Perpetual Method
Illustration 8-18
The LIFO method results in different ending inventory and cost of goods
sold amounts than the amounts calculated under the periodic method.
Chapter
8-42
Solution on
notes page
LO 5 Describe and compare the cost flow assumptions
used to account for inventories.
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
2. Record keeping easier
3. Profit-sharing or bonus arrangements
4. LIFO troublesome for interim periods
1.
Chapter
8-43
LO 6 Explain the significance and use of a LIFO reserve.
Special Issues Related to LIFO
LIFO Reserve is the difference between the
inventory method used for internal reporting purposes
and LIFO.
FIFO value per books
$160,000
Example:
LIFO value
145,000
LIFO Reserve
$ 15,000
Journal entry to reduce inventory to LIFO:
Cost of goods sold
15,000
Allowance to reduce inventory to LIFO
15,000
Companies should disclose either the LIFO reserve or the replacement
cost of the inventory.
Chapter
8-44
LO 6 Explain the significance and use of a LIFO reserve.
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: Basler Co. has 30,000 pounds of steel in
its inventory on December 31, 2010, with cost
determined on a
specific goods
LIFO approach.
Chapter
8-45
LO 7 Understand the effect of LIFO liquidations.
Special Issues Related to LIFO
LIFO Liquidation
Illustration: At the end of 2011, only 6,000 pounds of
steel remained in inventory.
Illustration 8-21
Chapter
8-46
LO 7 Understand the effect of LIFO liquidations.
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.
Chapter
8-47
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Dollar-Value LIFO
Exercise 8-26 (partial): The following information relates
to the Choctaw Company.
Use the dollar-value LIFO method to compute the ending
inventory for 2007 through 2009.
Chapter
8-48
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Exercise 8-26 Solution
Inventory at
Inventory at
End-of-Year
Base-Year
Base
Index
Prices
Layers
70,000
1.00
$ 70,000
88,200
1.05
84,000
Year
2007
2008
2009
Prices
$
95,120
1.16
Balance Sheet
Inventory
LIFO Reserve
Journal entry
Cost of goods sold
Lifo reserve
Chapter
8-49
82,000
Dec. 31
2007
$
70,000
$
70,000
$ Value
$ Value
LIFO
LIFO
Index
LIFO
TOTAL
Reserve
$ 70,000
1.00
$ 70,000
$ 70,000
70,000
1.00
70,000
14,000
1.05
14,700
70,000
1.00
70,000
12,000
1.05
12,600
Dec. 31
2008
$
88,200
(3,500)
$
84,700
Dec. 31
2009
$
95,120
(12,520)
$
82,600
3,500
(3,500)
9,020
(9,020)
$
-
84,700
3,500
82,600
12,520
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Exercise 8-26 Solution
Inventory at
Inventory at
End-of-Year
Base-Year
Base
Index
Prices
Layers
70,000
1.00
$ 70,000
88,200
1.05
84,000
Year
2007
2008
2009
Prices
$
95,120
1.16
Balance Sheet
Inventory
LIFO Reserve
Journal entry
Cost of goods sold
Lifo reserve
Chapter
8-50
82,000
Dec. 31
2007
$
70,000
$
70,000
$ Value
$ Value
LIFO
LIFO
Index
LIFO
TOTAL
Reserve
$ 70,000
1.00
$ 70,000
$ 70,000
70,000
1.00
70,000
14,000
1.05
14,700
70,000
1.00
70,000
12,000
1.05
12,600
Dec. 31
2008
$
88,200
(3,500)
$
84,700
Dec. 31
2009
$
95,120
(12,520)
$
82,600
3,500
(3,500)
9,020
(9,020)
$
-
84,700
3,500
82,600
12,520
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Exercise 8-26 Solution
Inventory at
Inventory at
End-of-Year
Base-Year
Base
Index
Prices
Layers
70,000
1.00
$ 70,000
88,200
1.05
84,000
Year
2007
2008
2009
Prices
$
95,120
1.16
Balance Sheet
Inventory
LIFO Reserve
Journal entry
Cost of goods sold
Lifo reserve
Chapter
8-51
82,000
Dec. 31
2007
$
70,000
$
70,000
$ Value
$ Value
LIFO
LIFO
Index
LIFO
TOTAL
Reserve
$ 70,000
1.00
$ 70,000
$ 70,000
70,000
1.00
70,000
14,000
1.05
14,700
70,000
1.00
70,000
12,000
1.05
12,600
Dec. 31
2008
$
88,200
(3,500)
$
84,700
Dec. 31
2009
$
95,120
(12,520)
$
82,600
3,500
(3,500)
9,020
(9,020)
$
-
84,700
3,500
82,600
12,520
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Comparison of LIFO Approaches
Specific-goods LIFO - costing goods on a unit basis
is expensive and time consuming.
Specific-goods Pooled LIFO approach
reduces record keeping and clerical costs.
more difficult to erode the layers.
using quantities as measurement basis can lead to
untimely LIFO liquidations.
Dollar-value LIFO is used by most companies.
Chapter
8-52
LO 8 Explain the dollar-value LIFO method.
Special Issues Related to LIFO
Advantages
Matching
Reduced earnings
Tax Benefits/Improved
Cash Flow
Inventory understated
Future Earnings Hedge
Chapter
8-53
Disadvantages
Physical flow
Involuntary Liquidation /
Poor Buying Habits
LO 9 Identify the major advantages and disadvantages of LIFO.
Basis for Selection of Inventory Method
LIFO is generally preferred:
1.
if selling prices are increasing faster than costs and
2. if a company has a fairly constant “base stock.”
LIFO is not appropriate:
1.
if prices tend to lag behind costs,
2. if specific identification
traditionally used, and
3. when unit costs tend to
decrease as production
increases.
Chapter
8-54
LO 10 Understand why companies select given inventory methods.
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Chapter
8-55