Chapter 3
inventory
1.
Describe how inventory accounts are classified.
2.
Explain the uses of perpetual and periodic inventory
systems.
3.
Identify how inventory quantities are determined.
4.
Determine the cost of inventory.
5.
Compute ending inventory and cost of goods sold under
specific identification, FIFO, average cost, and LIFO.
6.
Explain the conceptual issues regarding alternative
inventory cost flow assumptions.
7.
Understand dollar-value LIFO.
8.
Explain additional LIFO issues.
9.
Understand inventory disclosures.
10.
Understand the lower of cost or market method.
11.
Explain the conceptual issues regarding the lower of
cost or market method.
12.
Understand purchase obligations and product financing
arrangements.
13.
Explain the valuation of inventory above cost.
14.
Use the gross profit method.
15.
Understand the retail inventory method.
16.
Explain the conceptual issues regarding the retail
inventory method.
17.
Understand the dollar-value retail method.
18.
Understand the effects of inventory errors on the
financial statements.
Importance of Inventories
Typically represent the largest
current asset of manufacturing
and retail firms.
For many companies inventories
are a significant portion
of total assets as well.
Inventory methods and management
practices can become
profit-enhancing tools.
Inventory Categories

Merchandise inventory
Goods acquired for resale

Manufacturing inventory
Raw materials
Work-in-process
Finished goods
Manufacturing supplies

Miscellaneous inventory
Merchandising Company
Manufacturing Company
Flow of Inventory Costs
Merchandising Company
Accounts Payable
(or Cash)
Goods
Purchased
Merchandise
Inventory
Cost of
Goods Sold
Goods
Sold
Flow of Inventory Costs
Manufacturing Company
Accounts Payable
(or Cash)
Raw Materials
Inventory
Materials
Purchased
Materials
Used in
Production
Continued
To Work
in Process
Inventory
Flow of Inventory Costs
Manufacturing Company
Direct Labor
Actual
Direct
Labor
Manufacturing
(Factory)
Overhead
Actual
Mfg.
Overhead
To Work
in Process
Inventory
Labor Charged
to Production
To Work
in Process
Inventory
Overhead Applied
to Production
Continued
Flow of Inventory Costs
Manufacturing Company
Work in Process
Inventory
Materials Used
Direct Labor
Overhead
Applied
Finished Goods
Inventory
Goods Finished
(Manufactured)
Goods Sold to
Cost of Goods Sold
Items Included in Inventory
General Rule
All goods owned by the company on the inventory
date, regardless of their location.
Goods in transit depend on the FOB terms.
Goods on consignment.
Who Owns the Inventory?
Components of Inventory Cost

Invoice price

Freight-in

Purchase discounts

Other costs to get the inventory ready for sale
Purchases Discounts
Under the gross price method, a company
records the purchase at the gross price, and
records the amount of the discount in the
accounting system only if the discount is
taken.
Under the net price method, a company
records the purchase at its net price, and
records the amount of the discount in the
accounting system only if the discount is not
taken.
Purchases DiscountsGross Price Method
A company purchases $1,000 of goods
under terms of 1/10, n/30.
To record the purchase
Inventory (or Purchases)
1,000
Accounts Payable
1,000
To record payment within the discount period:
Accounts Payable
1,000
Purchases Discounts Taken
10
Cash
990
To record payment after the discount period:
Accounts Payable
1,000
Cash
1,000
Purchases DiscountsNet Price Method
A company
$1,000
of expense
Purchases Discounts
Lostpurchases
are treated as
a financing
in the
Other
sectionterms
of the of
income
goods
under
1/10,statement.
n/30.
To record the purchase:
Inventory (or Purchases)
990
Accounts Payable
990
To record payment within the discount period:
Accounts Payable
990
Cash
990
To record payment after the discount period:
Accounts Payable
990
Purchases Discounts Lost
10
Cash
1,000
Purchases Discounts
A company purchases $1,000 of
goods under terms of 1/10, n/30.
Net Price Method
Adjusting entry at the end of period if
discount has expired and invoice is unpaid:
Purchases Discounts Lost
Accounts Payable
10
10
Inventory Recording Methods
PERIODIC METHOD
vs.
PERPETUAL METHOD
Alternative Inventory Systems
A company using a periodic
system does not maintain a
continuous record of the
physical quantities on hand.
Calculating Cost of Goods Sold (COGS)
Beginning Inventory
+ Purchases (net)
= Cost of Goods Available for
Sale
- Ending Inventory
= Cost of Goods Sold
Comparison of Systems
Perpetual
Inventory System
Periodic
Inventory System
Beginning inventory
+ Purchases (net)
- Goods Sold
= Ending Inventory
Beginning inventory
+ Purchases (net)
- Ending Inventory
= Goods Sold
Periodic versus Perpetual
Transaction or Event
Periodic Inventory
Perpetual Inventory
Routine purchases of
various inventory items
Costs debited to
purchases account
Costs debited to
inventory account
Items removed from
inventory for use in
production
No accounting
entries made
Debit WIP inventory
and credit inventory
account
End-of-period
accounting entries and
related activities
Physical count of
inventory to
determine cost of
goods sold
No separate
determination of cost
of goods sold
necessary
Periodic System

At the end of the accounting period, calculate
COGS by closing:
Purchases,
Purchases Discount,
Purchase Returns and Allowances,
Beginning Inventory, and
Record Ending Inventory.

COGS is closed to Income Summary.
Periodic System
The following is a partial adjusted trial balance:
Account
Debit
Inventory 1/1/X6
$ 175,000
Purchases
350,000
Purchases Discount
Purchase Returns & Allowances
Sales
Advertising Expense
7,500
Salaries Expense
80,000
Utilities Expense
20,000
12/31/X6 ending inventory was $125,000
Prepare the closing entries.
Credit
$ 22,000
6,000
1,250,000
Periodic System
GENERAL JOURNAL
Page 1
Date
Description
PR
Debit
Credit
Periodic System
GENERAL JOURNAL
Page 1
Date
Description
PR
Debit
Cost of Goods Sold
372,000
Inventory, 12/31/X6
125,000
Purchases Discount
Purchase Returns & Allowances
Credit
22,000
6,000
Purchases
350,000
Inventory, 1/1/X6
175,000
To close accounts to COGS
Periodic System
GENERAL JOURNAL
Page 1
Date
Description
Sales
PR
Debit
Credit
1,250,000
Income Summary
1,250,000
To close account
Income Summary
Cost of Goods Sold
Advertising Expense
479,500
372,000
7,500
Salaries Expense
80,000
Utilities Expense
20,000
To close accounts
Periodic System
GENERAL JOURNAL
Page 1
Date
Description
Income Summary
Retained Earnings
To close account
PR
Debit
Credit
770,500
770,500
Periodic System


Purchases discount and purchase returns and
allowances are contra-purchases accounts, i.e.,
they have a credit balance.
Purchases can be recorded using the gross or
net method.
Perpetual System
The inventory account is continuously updated
for:
Perpetual System
Returns of inventory are
credited to the
inventory account.
Discounts on inventory
purchases can be
recorded using the
gross or net method.
Perpetual System
Cable TV, Inc. used the gross method to
record a purchase on March 23 for $50,000
with terms of 2/10,n/30. Payment was
made on April 1. Which of the following is
included on the April 1 entry?
a.
b.
c.
d.
Credit Purchases Discount $1,000
Debit Purchases Discount $1,000
Credit Inventory $1,000
Debit Inventory $1,000
Perpetual System
Cable TV, Inc. used the gross method to
record a purchase on March 23 for $50,000
with terms of 2/10,n/30. Payment was
made on April 1. Which of the following is
included on the April 1 entry?
a.
b.
c.
d.
Credit Purchases Discount $1,000
Debit Purchases Discount $1,000
Credit Inventory $1,000
Debit Inventory $1,000
Perpetual System
GENERAL JOURNAL
Page 1
Date
3/23
Description
Inventory
PR
Debit
Credit
50,000
Accounts Payable
50,000
To record purchase at gross
4/1
Accounts Payable
Inventory
Cash
To record payment
50,000
1,000
49,000
Periodic System
Cable TV, Inc. used the net method to
record a purchase on March 23 for $50,000
with terms of 2/10,n/30. Payment was
made on April 5. Which of the following is
included on the April 5 entry?
a.
b.
c.
d.
Credit Purchases Discount $1,000
Debit Purchases Discount $1,000
Credit Purchases Discounts Forfeited $1,000
Debit Purchases Discounts Forfeited $1,000
Periodic System
Cable TV, Inc. used the net method to
record a purchase on March 23 for $50,000
with terms of 2/10,n/30. Payment was
made on April 5. Which of the following is
included on the April 5 entry?
a.
b.
c.
d.
Credit Purchases Discount $1,000
Debit Purchases Discount $1,000
Credit Purchases Discounts Forfeited $1,000
Debit Purchases Discounts Forfeited $1,000
Periodic System
GENERAL JOURNAL
Page 1
Date
3/23
Description
PR
Purchases
Debit
Credit
49,000
Accounts Payable
49,000
To record purchase at net
4/5
Accounts Payable
49,000
Purchases Discounts Forfeited
Cash
To record payment
1,000
Represents a finance
charge and is included
with misc. expenses
50,000
Perpetual System
Cost of Goods Sold is
closed to Income
Summary during the
usual closing entries at
the end of the period.
Inventory Values - Unit Cost

Cost basis

Departures from cost
Lower of cost or market (LCM)
Net realizable value
Replacement cost
Current cost
Selling price
Inventory Cost Flow Methods
Specific cost identification
Average cost
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Specific Cost Identification


Specific cost of each
inventory item must be
known.
Opportunity to
manipulate income by
selection of items at
time of sale.
Specific Identification
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
80 units @ $11 per unit
70 units @ $12 per unit
On April 27, sold 90 units from the beginning
inventory, 50 units from the April 10 purchase.
Specific Identification
$ Sold
100 90
Sold
330 50
80 units @ $11 per unit
30
70 units @ $12 per unit
840
Ending inventory . . . . . . . . . $1,270
Apr. 1
Apr. 10
Apr. 20
100
10 units @ $10 per unit
=
=
=
Apr. 1
90 units @ $10 per unit
=
$900
Apr. 10
Apr. 20
50 units @ $11 per unit
=
550
0 units @ $12 per unit
=
0
Cost of Goods Sold . . . . . . . . $1,450
Specific Identification
Apr. 1
Apr. 10
Apr. 20
= $ 1,000
880
80 units @ $11 per unit =
840
70 units @ $12 per unit =
Goods available for sale . . . . . . . $2,720
100 units @ $10 per unit
= $ 100
=
330
Apr. 10
840
Apr. 20
70 units @ $12 per unit =
Ending inventory . . . . . . . . . . . . . $1,270
Cost of Goods Sold . . . . . . . . . . . $ 1,480
Apr. 1
10 units @ $10 per unit
30 units @ $11 per unit
Average Cost Method


The periodic inventory system uses the
weighted-average unit cost method.
The perpetual inventory system uses the
moving-average unit cost method.
Weighted-Average
Periodic Method
Weighted-average cost (WAC) per unit
Beginning inventory cost + Current purchase cost
Beginning inventory units + Current purchase units
Ending Inventory
Ending Inv. = Units in Ending Inv. x WAC per Unit
Cost of Goods Sold
COGS = Units Sold x WAC per Unit
Weighted-Average
Periodic Method
The following schedule shows the mouse pad
inventory for Computers, Inc. for September.
The physical inventory count shows 800
mouse pads in ending inventory.
Use the weighted-average periodic method to
determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
Weighted-Average
Periodic Method
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inventory
9/3
9/15
9/21
9/29
Goods Available for
Sale
Ending Inventory
Cost of Goods Sold
Units
1,000
100
150
200
100
1,550
800
$/Unit
$5.25
5.30
5.60
5.80
5.90
Total
$5,250.00
530.00
840.00
1,160.00
590.00
$8,370.00
Weighted-Average
Periodic Method
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inventory
9/3
9/15
9/21
9/29
Goods Available for
Sale
Ending Inventory
Cost of Goods Sold
Units
1,000
100
150
200
100
1,550
800
750
$/Unit
$5.25
5.30
5.60
5.80
5.90
Total
$5,250.00
530.00
840.00
1,160.00
590.00
GAS 1,550
$8,370.00
-EI
(800)
COGS
750
Weighted-Average
Periodic Method
Computer, Inc.
Mouse Pad Inventory
Date
Units
$/Unit
Total
Beg. Inventory
1,000
$5.25
$5,250.00
9/3
100
5.30
530.00
9/15
150
5.60
840.00
9/21
200
5.80
1,160.00
9/29
5.90
590.00
$8,370 ÷1,550100= $5.40 weighted-average
Goods Available for
Sale
1,550
$8,370.00
Ending Inventory
800
Cost of Goods Sold
750
Weighted-Average
Periodic Method
Computer, Inc.
Mouse Pad Inventory
Date
Units
$/Unit
Total
Beg. Inventory
1,000
$5.25
$5,250.00
9/3
100
5.30
530.00
9/15
150
5.60
840.00
9/21
200
5.80
1,160.00
$8,370 ÷1,550 = $5.40 weighted-average
9/29
100
5.90
590.00
Goods Available for
Sale
1,550
$8,370.00
Ending Inventory
800 ÷
5.4
4,320.00
Cost of Goods Sold
750 ÷
5.4
$4,050.00
Moving-Average
Perpetual Example
The following schedule shows the mouse pad
inventory for Computers, Inc. for September.
The physical inventory count shows 800
mouse pads in ending inventory.
Use the moving-average periodic method to
determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
Moving-Average
Perpetual Example
A new average unit cost must be calculated
after each purchase. We will update
Computer, Inc.’s inventory after each
purchase and sale.
Moving-Average
Perpetual Example
Computer, Inc.
Mouse Pad Inventory
Date
BI
9/3
9/15
9/21
9/29
Goods available
for sale
Ending inventory
Cost of goods sold
Units
1,000
100
150
200
100
1,550
800
750
Unit Cost
$ 5.25
5.30
5.60
5.80
5.90
Total
$ 5,250.00
530.00
840.00
1,160.00
590.00
$ 8,370.00
Moving-Average
Perpetual Example
The 750 units were sold as follows:
◦
◦
◦
◦
9/1
9/10
9/30
UNITS SOLD
300
200
250
750
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
Total
$ 5,250.00
(1,575.00)
3,675.00
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Purchase 9/3
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
100
5.30
800
Total
$ 5,250.00
(1,575.00)
3,675.00
530.00
4,205.00
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Purchase 9/3
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
100
5.30
800
5.25625
$4,205.00 ÷800 = $5.25625/unit
Total
$ 5,250.00
(1,575.00)
3,675.00
530.00
4,205.00
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Purchase 9/3
Available for sale
Sale 9/10
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
100
5.30
800
5.25625
(200)
5.25625
600
5.25625
Total
$ 5,250.00
(1,575.00)
3,675.00
530.00
4,205.00
(1,051.25)
3,153.75
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Purchase 9/3
Available for sale
Sale 9/10
Available for sale
Purchase 9/15
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
100
5.30
800
5.25625
(200)
5.25625
600
5.25625
150
5.60
750
5.325
Total
$ 5,250.00
(1,575.00)
3,675.00
530.00
4,205.00
(1,051.25)
3,153.75
840.00
3,993.75
$3,993.75 ÷750 = $5.325
Moving-Average
Perpetual Example
Explanation
Beg. Inventory
Sale 9/1
Available for sale
Purchase 9/3
Available for sale
Sale 9/10
Available for sale
Purchase 9/15
Available for sale
Purchase 9/21
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
1,000
$ 5.25
(300)
5.25
700
5.25
100
5.30
800
5.25625
(200)
5.25625
600
5.25625
150
5.60
750
5.325
200
5.80
950
5.425
Total
$ 5,250.00
(1,575.00)
3,675.00
530.00
4,205.00
(1,051.25)
3,153.75
840.00
3,993.75
1,160.00
5,153.75
Moving-Average
Perpetual Example
Hey, we need a little more room!
Moving-Average
Perpetual Example
Explanation
Available for sale
Purchase 9/21
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
750
$ 5.325
200
5.80
950
5.425
That’s better.
Total
$ 3,993.75
1,160.00
5,153.75
Moving-Average
Perpetual Example
Explanation
Available for sale
Purchase 9/21
Available for sale
Purchase 9/29
Available for sale
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
750
$ 5.325
200
5.80
950
5.425
100
5.90
1,050
5.47024
Total
$ 3,993.75
1,160.00
5,153.75
590.00
5,743.75
Moving-Average
Perpetual Example
Explanation
Available for sale
Purchase 9/21
Available for sale
Purchase 9/29
Available for sale
Sale 9/30
Ending inventory
Computer, Inc.
Mouse Pad Inventory
Units
Cost/Unit
750
$ 5.325
200
5.80
950
5.425
100
5.90
1,050
5.47024
(250)
5.47024
800
5.47024
Total
$ 3,993.75
1,160.00
5,153.75
590.00
5,743.75
(1,367.56)
4,376.19
Ending inventory is $4,376.19. Let’s summarize
cost of goods sold during September.
Moving-Average
Perpetual Example
Computer, Inc.
Cost of Goods Sold in September
Date of sale
Units
Cost/Unit
9/1
300
$ 5.25
$
9/10
200
5.25625
9/30
250
5.47024
Total
750
Cost of ending inventory
Cost of goods sold
Goods available for sale
Total
1,575.00
1,051.25
1,367.56
3,993.81
$ 4,376.19
3,993.81
$ 8,370.00
Average Cost Evaluation


Objective and
consistent.
Match average, rather
than latest costs, with
current sales revenues.
First-In, First-Out


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


Periodic ending inventory cost equals
perpetual ending inventory cost.
Periodic COGS equals perpetual COGS.
Evaluation of FIFO
Advantages



Easy to apply.
Inventory value
approximates current cost.
Flow of costs tends to be
consistent with usual
physical flow of goods.

Systematic and objective.

Not subject to manipulation.
Evaluation of FIFO
Advantages



Easy to apply.
Disadvantages

Inventory value
approximates current cost.
Flow of costs tends to be
consistent with usual
physical flow of goods.

Systematic and objective.

Not subject to manipulation.


Does not match current cost
of goods sold with current
revenues.
Inventory (or phantom)
profits.
In periods of rising prices,
pay higher income taxes.
FIFO - Example
Which of the following statements is true
concerning the use of the FIFO inventory costing
method?
a. Ending inventory includes costs from
the most recent purchases.
b. COGS includes costs from the oldest
purchases.
c. FIFO can be used even if the actual
flow of the inventory is not on a FIFO
basis.
d. All of the above statements are true.
FIFO - Example
Which of the following statements is true
concerning the use of the FIFO inventory costing
method?
a. Ending inventory includes costs from
the most recent purchases.
b. COGS includes costs from the oldest
purchases.
c. FIFO can be used even if the actual
flow of the inventory is not on a FIFO
basis.
d. All of the above statements are true.
FIFO - Example
The following schedule shows the mouse pad
inventory for Computers, Inc. for September.
The physical inventory count shows 800
mouse pads in ending inventory.
Use the FIFO method to determine:
(1) Ending inventory cost
(2) Cost of goods sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
BI
9/3
9/15
9/21
9/29
Goods available
for sale
Ending inventory
Cost of goods sold
Units
1,000
100
150
200
100
1,550
800
750
Unit Cost
$ 5.25
5.30
5.60
5.80
5.90
Total
$ 5,250.00
530.00
840.00
1,160.00
590.00
$ 8,370.00
FIFO - Example
Computer,
Inc.
Remember: FIFO
ending inventory
Inventory
is calculatedMouse
using Pad
the cost
of the
newest purchases. Start with 9/29
Units
Unit Cost
and then Date
add other purchases
until
BI
1,000
$ 5.25
you reach the number of units in
9/3
100
5.30
ending inventory.
9/15
150
5.60
9/21
9/29
Goods available
for sale
Ending inventory
Cost of goods sold
200
100
1,550
800
750
5.80
5.90
Total
$ 5,250.00
530.00
840.00
1,160.00
590.00
$ 8,370.00
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
9/29
Units
Beg. Inv.
Purchases
100@$5.90
End Inv.
100@$5.90
100
Cost of
Goods Sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
9/21
9/29
Units
Beg. Inv.
Purchases
200@$5.80
100@$5.90
End Inv.
200@$5.80
100@$5.90
300
Cost of
Goods Sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
9/15
9/21
9/29
Units
Beg. Inv.
Purchases
150@$5.60
200@$5.80
100@$5.90
End Inv.
150@$5.60
200@$5.80
100@$5.90
450
Cost of
Goods Sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
9/3
9/15
9/21
9/29
Units
Beg. Inv.
Purchases
100@$5.30
150@$5.60
200@$5.80
100@$5.90
End Inv.
100@$5.30
150@$5.60
200@$5.80
100@$5.90
550
Cost of
Goods Sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
9/15
9/21
9/29
Units
Purchases
100@$5.30
150@$5.60
200@$5.80
100@$5.90
End Inv.
250@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
800
Cost of
Goods Sold
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
9/15
9/21
9/29
Units
Costs
Purchases
100@$5.30
150@$5.60
200@$5.80
100@$5.90
Cost of Goods Available for Sale
End Inv.
250@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
800
$ 4,432.50
Cost of
Goods Sold
750@$5.25
750
$ 3,937.50
$8,370.00
FIFO - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
9/15
9/21
9/29
Units
Costs
Purchases
100@$5.30
150@$5.60
200@$5.80
100@$5.90
Cost of Goods Available for Sale
End Inv.
250@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
800
$ 4,432.50
Cost of
Goods Sold
750@$5.25
750
$ 3,937.50
$8,370.00
Last-In, First-Out
Any questions
before we run into
LIFO?
Last-In, First-Out
Unit Cost Approach



The cost of the newest inventory items are
charged to COGS when goods are sold.
The cost of the oldest inventory items remain
in ending inventory.
The actual physical flow of inventory items
may differ from the LIFO cost flow
assumptions.
Last-In, First-Out Results


Periodic ending inventory cost may be
different from perpetual ending inventory
cost.
Periodic COGS may be different from
perpetual COGS.
Evaluation of LIFO


Advantages
In periods of rising
prices, pay less taxes.
Matches latest
inventory costs with
current revenues.



Disadvantages
LIFO conformity rule for
tax and book purposes.
Cost of record keeping
higher.
Inventory valuation is at
older costs.
LIFO Periodic - Example
The following schedule shows the mouse pad
inventory for Computers, Inc. for September.
The physical inventory count shows 800
mouse pads in ending inventory.
Use the LIFO periodic method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
BI
9/3
9/15
9/21
9/29
Goods available
for sale
Ending inventory
Cost of goods sold
Units
1,000
100
150
200
100
1,550
800
750
Unit Cost
$ 5.25
5.30
5.60
5.80
5.90
Total
$ 5,250.00
530.00
840.00
1,160.00
590.00
$ 8,370.00
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Units
Unit Cost
BI
1,000
$ 5.25
9/3
100
5.30
9/15
150
5.60
Remember: LIFO ending inventory
9/21
200
5.80
is calculated
using the100
cost of the
9/29
5.90
oldest
purchases.
Goods
available Start with
beginning
for sale inventory and
1,550then add
other
purchases
Ending
inventoryuntil you
800 reach the
Cost ofofgoods
750
number
unitssold
in ending
inventory.
Total
$ 5,250.00
530.00
840.00
1,160.00
590.00
$ 8,370.00
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
Units
Purchases
End Inv.
800@$5.25
800
Cost of
Goods Sold
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
Purchases
End Inv.
800@$5.25
Cost of
Goods Sold
200@$5.25
Units
800
200
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
Units
Purchases
End Inv.
800@$5.25
Cost of
Goods Sold
200@$5.25
100@$5.30
100@$5.30
800
300
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
9/15
9/21
9/29
Units
Purchases
End Inv.
800@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
800
Cost of
Goods Sold
200@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
750
LIFO Periodic - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Inv.
BI
1000@$5.25
9/3
9/15
9/21
9/29
Units
Costs
Purchases
End Inv.
800@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
Cost of goods available for sale
800
$ 4,200.00
Cost of
Goods Sold
200@$5.25
100@$5.30
150@$5.60
200@$5.80
100@$5.90
750
$ 4,170.00
$8,370.00
LIFO Perpetual - Example
In our new example, Computers, Inc. has 1,200
units in inventory on November 30.
The company uses the LIFO perpetual method
to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
LAST-IN, FIRST-OUT
To calculate the LIFO cost for ending inventory
and COGS under the perpetual method, we
must know when each unit was sold.
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
Purchases
On November 3rd, 300
units were purchased
at $5.30 per unit. We need
to update the inventory.
Balance
1,000@$5.25
Cost of
Goods Sold
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
Purchases
300@$5.30
Balance
1,000@$5.25
300@$5.30
Cost of
Goods Sold
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
Purchases
300@$5.30
Balance
1,000@$5.25
300@$5.30
On November 5th, 100
units were sold. We need
to update the inventory.
Cost of
Goods Sold
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
On November 10th, 150
units were purchased
at $5.60 per unit. We need
to update the inventory.
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
150@$5.60
150@$5.60
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
150@$5.60
On November 14th, 200
units were purchased
at $5.80 per unit. We need
to update the inventory.
150@$5.60
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
150@$5.60
200@$5.80
150@$5.60
200@$5.80
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
Purchases
300@$5.30
Balance
1,000@$5.25
200@$5.30
Cost of
Goods Sold
100@$5.30
150@$5.60
200@$5.80
150@$5.60
200@$5.80
On November 17th, 400
units were sold. We need
to update the inventory.
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
11/17
Purchases
300@$5.30
150@$5.60
200@$5.80
Balance
1,000@$5.25
150@$5.30
Cost of
Goods Sold
100@$5.30
50@$5.30
150@$5.60
200@$5.80
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
11/17
Purchases
300@$5.30
Balance
1,000@$5.25
150@$5.30
150@$5.60
200@$5.80
On November 23rd, 100
units were sold. We need
to update the inventory.
Cost of
Goods Sold
100@$5.30
50@$5.30
150@$5.60
200@$5.80
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
11/17
11/23
Purchases
300@$5.30
150@$5.60
200@$5.80
Balance
1,000@$5.25
50@$5.30
Cost of
Goods Sold
100@$5.30
50@$5.30
150@$5.60
200@$5.80
100@$5.30
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
11/17
11/23
Purchases
300@$5.30
150@$5.60
200@$5.80
On November 30th, 150
units were purchased
at $5.90 per unit. We need
to update the inventory.
Balance
1,000@$5.25
50@$5.30
Cost of
Goods Sold
100@$5.30
50@$5.30
150@$5.60
200@$5.80
100@$5.30
LIFO Perpetual - Example
Computer, Inc.
Mouse Pad Inventory
Date
Beg. Bal.
BI
1,000@$5.25
11/3
11/5
11/10
11/14
11/17
11/23
11/30
Total Units
Total Dollars
Purchases
300@$5.30
Balance
1,000@$5.25
50@$5.30
100@$5.30
50@$5.30
150@$5.60
200@$5.80
100@$5.30
150@$5.60
200@$5.80
150@$5.90
Cost of
Goods Sold
150@$5.90
1,200
$
6,400
$
600
3,325
In Periods of Rising Prices. . .



LIFO
Matches high (newer)
costs with current
(higher) sales.
Values inventory on low
(older) cost basis.
Results in lower taxable
income.



FIFO
Matches low (older)
costs with current
(higher) sales.
Values inventory
approximating higher
current costs.
Results in higher
taxable income.
Comparison of Inventory Assumptions
Cost Flow
Assumption
and Method
FIFO, periodic
FIFO, perpetual
Weighted average
Moving average
LIFO, periodic
LIFO, perpetual
Cost of Goods
Available
for Sale
Cost of
Goods
Ending
Sold
Inventory
$2,720
2,720
2,720
2,720
2,720
2,720
$1,440
1,440
1,523
1,496
1,610
1,580
$1,280
1,280
1,197
1,224
1,110
1,140
114
LIFO Reserve

LIFO Reserve (Allowance) account is used,
when:
LIFO is used for external reporting and a nonLIFO basis is used for internal reporting.

An Allowance to Reduce Inventory to LIFO
is used to reduce the cost to a LIFO basis.
115
LIFO Reserve - Example
Jeppo Inc reports the following balances:
Inventory (FIFO basis) on Dec 31, 2004: $50,000
Inventory (LIFO basis) on Dec 31, 2004: $20,000
Adjust the cost of ending inventory to the LIFO basis
Cost of goods sold
30,000
Allowance to Reduce Inventory to LIFO
Balance Sheet (Assets):
Inventory (FIFO)
less: Allowance to Reduce Inventory
Inventory (LIFO) basis
30,000
$50,000
($30,000)
$20,000
116
Liquidation of Layers
Under the LIFO approach, a business may
build up layers of inventory from prior
periods.
A layer liquidation occurs, when:

Earlier costs are matched against current sales.

Such matching results in distorted income.
Liquidation of Layers
2003:
10,000 units at $20 per unit
= $200,000
= 132,000
2004:
6,000 units at $22 per unit
= 192,000
2005:
8,000 units at $24 per unit
= 120,000
2006:
4,000 units at $30 per unit
Inventory, January 1, 2007………… $644,000
In 2007 the company purchases 50,000
units at $35 per unit and sells 60,000 units.
Liquidation of Layers
2003:
10,000 units at $20 per unit
2004:
6,000 units at $22 per unit
2005:
8,000 units at $24 per unit
2,000
2006:
4,0000 units at $30 per unit
2007:
50,0000 units at $35 per unit
= $200,00
= 132,000
=Sold
192,000
6,000
=Sold
120,000
4,000
=1,750,000
Sold 50,000
In 2007 the company purchases 50,000
units at $35 per unit and sells 60,000 units.
Liquidation of Layers
Inventory Layers
2003:
10,000 units at $20 per unit
2004:
6,000 units at $22 per unit
2005:
2,000 units at $24 per unit
6,000 units at $24 per unit = $ 144,000
4,000 units at $30 per unit = 120,000
2006:
2007: 50,000 units at $35 per unit = 1,750,000
$2,014,000
Cost of goods sold………
2005:
LIFO Liquidation


Each pool represents a group of different, but
related, inventory items that are considered
as a single entity for inventory accounting
purposes.
Uses the average cost for the entire pool to
determine COGS and cost of ending inventory.
Pooled LIFO - Question
Select all the true statements.
a. Pooled LIFO reduces the risk of a LIFO
liquidation in particular items.
b. Pooled LIFO is best suited for use with a
mix of unrelated inventory items.
c. Since pooled LIFO uses average cost,
individual layers of inventory are
meaningless.
d. Each purchase, sale, or use of the pooled
inventory should be in the same general
proportions.
Pooled LIFO - Question
Select all the true statements.
a. Pooled LIFO reduces the risk of a LIFO
liquidation in particular items.
b. Pooled LIFO is best suited for use with a
mix of unrelated inventory items.
c. Since pooled LIFO uses average cost,
individual layers of inventory are
meaningless.
d. Each purchase, sale, or use of the pooled
inventory should be in the same general
proportions.
Dollar Value (DV) LIFO
. . . uses price indexes related to the inventory
instead of units and unit costs.
. . . is applied to inventory pools rather than
individual items.
. . . approximates LIFO results used for income
tax and external reporting purposes.
Dollar Value (DV) LIFO
Inventory Pools
Single pool
Used when overall operations constitute a so-called
natural business unit.
Multiple pools
Separate inventory pools are formed for each natural
business unit.
Dollar Value (DV) LIFO
Step 1: Value the total ending inventory at currentyear costs.
Date
Ending Inventory
Cost
at Current Costs
Index
01/1/06
$10,000
100
12/31/06
$12,100
110
12/31/07
$13,125
125
12/31/08
$16,800
140
12/31/09
$12,360
120
Dollar Value (DV) LIFO
Step 2: Convert the ending inventory cost to baseyear cost:
12/31/06
$12,100
12/31/07
$13,125
12/31/08
$16,800
12/31/09
$12,360
12/31/06
x
Ending
Inventory at x
Current Cost
100/110 = $11,000
Base Year
Cost Index
Current
Cost Index
Dollar Value (DV) LIFO
Step 3: Compute the change in the inventory level
for the year at base-year costs.
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/08
$10,300
12/31/06
$11,000 - $10,000
$1,000
Base year, $10,000
1/1/06
Dollar Value (DV) LIFO
Step 4a: If there has been an increase, convert this
increase to current-year costs.
x 110/100 = $ 1,100
$1,000
Base year, $10,000
12/31/06
x 100/100 = 10,000
$11,100
Ending inventory,
12/31/06
Dollar Value (DV) LIFO
Step 2: Convert the ending inventory cost to baseyear cost:
12/31/06
$12,100
x
100/110 = $11,000
12/31/07
$13,125
x
100/125 = $10,500
12/31/08
$16,800
12/31/09
$12,360
12/31/07
Ending
Inventory at x
Current Cost
Base Year
Cost Index
Current
Cost Index
Dollar Value (DV) LIFO
Step 3: Compute the change in the inventory level
for the year at base-year costs.
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/09
$10,300
12/31/07
$11,000 - $10,500
$1,000
Base year, $10,000
Dollar Value (DV) LIFO
Step 3: Compute the change in the inventory level
for the year at base-year costs.
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/09
$10,300
12/31/07
$500
Base year, $10,000
Dollar Value (DV) LIFO
Step 4b: If there is a decrease, this decrease
reduces the inventory.
x 110/100 = $ 550
$500
Base year, $10,000
12/31/07
x 100/100 = 10,000
$10,550
Ending inventory,
12/31/07
Dollar Value (DV) LIFO
Step 2: Convert the ending inventory cost to baseyear cost:
12/31/06
$12,100
x
110/100 = $11,000
12/31/07
$13,125
x
100/125 = $10,500
12/31/08
$16,800
x
100/140 = $12,000
12/31/09
$12,360
12/31/08
Ending
Inventory at x
Current Cost
Base Year
Cost Index
Current
Cost Index
Dollar Value (DV) LIFO
Step 3: Compute the change in the inventory level
for the year at base-year costs.
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/09
$10,300
12/31/08
$500
Base year, $10,000
Dollar Value (DV) LIFO
Step 3: Compute the change in the inventory level
for the year at base-year costs.
12/31/06
$11,000
12/31/07
$10,500
$1,500
12/31/08
$12,000
$500
12/31/09
$10,300
12/31/08
Base year, $10,000
Dollar Value (DV) LIFO
Step 4a: Convert increase to current-year costs.
$1,500
$500
Base year, $10,000
x 140/100 = $ 2,100
x 110/100 =
550
x 100/100 = 10,000
$12,650
12/31/08
Ending inventory,
12/31/08
Dollar Value (DV) LIFO
Step 2: Convert the ending inventory cost to baseyear cost:
12/31/06
$12,100
x
110/100 = $11,000
12/31/07
$13,125
x
100/125 = $10,500
12/31/08
$16,800
x
100/140 = $12,000
12/31/09
$12,360
x
100/120 = $10,300
12/31/09
Ending
Inventory at x
Current Cost
Base Year
Cost Index
Current
Cost Index
Dollar Value (DV) LIFO
12/31/06
$11,000
12/31/07
$10,500
$1,500
12/31/08
$12,000
$500
12/31/09
$10,300
12/31/09
Base year, $10,000
Dollar Value (DV) LIFO
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/09
$10,300
12/31/09
$500
Base year, $10,000
Dollar Value (DV) LIFO
12/31/06
$11,000
12/31/07
$10,500
12/31/08
$12,000
12/31/09
$10,300
12/31/09
$300
Base year, $10,000
Dollar Value (DV) LIFO
Step 4a: Convert increase to current-year costs.
$300
x 110/100 =
$
Base year, $10,000
x 100/100 =
10,000
$10,330
12/31/09
330
Ending inventory,
12/31/09
Example
Current
Costs
Current cost at
base year prices
12/31/06 $12,100 X 100 = 11,000
110
12/31/07 $13,125 X 100 = 10,500
125
Historical
Cost
$10,000 X
100 = $10,000
100
1,000 X
110 = 1,100
100
$11,100
$10,000 X
100 = $10,000
100
500
X 110 =
100
550
$10,550
Continue
Example
Current
Costs
Current cost at
Historical
base year prices
Cost
$10,000 X 100 =$10,000
100
12/31/08 $16,800 X 100 = 12,000
140
500 X 110
=
550
100
1,500 X 140
100
=
2,100
$12,650
12/31/09 $12,360 X 100 = $10,300
120
$10,000 X 100
100
300 X 110
100
= $10,000
=
330
$10,330
Determination of Cost Index
Cost Index =
Sample of Ending Inventory
at Current -Year Costs
Sample of Ending Inventory
at Base-Year Costs
Double-Extension Method
x 100
Determination of Cost Index
Cost Index =
Sample of Ending Inventory
at Current -Year Costs
Sample of Ending Inventory
at Previous-Year Costs
Link-Chain Method
Previousx Year Cost
Index
Determination of Cost Index
If an internal index cannot be determined, use
an external index provided by the Bureau of
Labor Statistics.
Dollar Value LIFO Example
Bandy Company started using DV LIFO for income
tax and external reporting purposes in 19X3. The
company still uses FIFO for internal reporting.
Using the following information calculate ending
inventory values for 19X3 and 19X4 under DV LIFO.
Dollar Value LIFO Example
2002 FIFO*
Item X
Item Y
Ending Inventory
Units Cost
Total
2,000 $23
1,500 20
3,500
$ 46,000
30,000
$ 76,000
* 2002 is the base year.
2003 FIFO
Item X
Item Y
2,500 $26
1,700 24
$ 65,000
40,800
Ending Inventory
4,200
$ 105,800
2004 FIFO
Item X
Item Y
2,200 $27
1,600 25
$ 59,400
40,000
Ending Inventory
3,800
$ 99,400
Dollar Value LIFO Example
2003 Ending Inventory at Base Year Prices
Units Cost
Total
Item X
2,500 $ 23 $ 57,500
Item Y
1,700 20
34,000
Ending Inventory 4,200
$ 91,500
Dollar Value LIFO Example
2003 Ending Inventory at Base Year Prices
Units Cost
Total
Item X
2,500 $ 23 $ 57,500
Item Y
1,700 20
34,000
Ending Inventory 4,200
$ 91,500
2003 Ending Inventory at 19X3 Prices
2003 Ending Inventroy at Base Year Prices
Price Index ($105,800/$91,500)
$ 105,800
91,500
1.156
Dollar Value LIFO Example
2003
Base
2003
2003
2003
Ending Inventory at Base Year Prices
Year Inventory Layer
Layer at Base Year Prices
Price Index
Layer at 19X3 Prices
2003 DV LIFO Inventory:
Base Year Layer
2003 Layer
DV LIFO Ending Inventory
$ 91,500
(76,000)
15,500
×
1.156
$ 17,918
Index
$ 76,000 1.000
17,918 1.156
$ 93,918
Dollar Value LIFO Example
2003
Base
2003
2003
2003
Ending Inventory at Base Year Prices
Year Inventory Layer
Layer at Base Year Prices
Price Index
Layer at 19X3 Prices
2003 DV LIFO Inventory:
Base Year Layer
2003 Layer
DV LIFO Ending Inventory
$ 91,500
(76,000)
15,500
×
1.156
$ 17,918
Index
$ 76,000 1.000
17,918 1.156
$ 93,918
Dollar Value LIFO Example
When total inventory decreases (as in 19X4),
some of the prior years’ layers of inventory
are used.
The used layers are removed on a LIFO basis.
Dollar Value LIFO Example
2004 Ending Inventory at Base Year Prices
Units Cost
Total
Item X
2,200 $ 23 $ 50,600
Item Y
1,600 20
32,000
Ending Inventory 3,800
$ 82,600
Dollar Value LIFO Example
2004 Ending Inventory at Base Year Prices
Base Year Inventory Layer
Adj. 2003 Layer at Base Year Prices
2003 Price Index
Adj. 2003 Layer at 19X3 Prices
2004 DV LIFO Inventory:
Base Year Layer
Adj. 2003 Layer
DV LIFO Ending Inventory
Index
$ 76,000 1.000
7,630 1.156
$ 83,630
$ 82,600
(76,000)
6,600
1.156
$ 7,630
Dollar Value LIFO Example
2004 Ending Inventory at Base Year Prices
Base Year Inventory Layer
Adj. 2003 Layer at Base Year Prices
2003 Price Index
Adj. 2003 Layer at 19X3 Prices
2004 DV LIFO Inventory:
Base Year Layer
Adj. 2003 Layer
DV LIFO Ending Inventory
Index
$ 76,000 1.000
7,630 1.156
$ 83,630
$ 82,600
(76,000)
6,600
1.156
$ 7,630
Dollar Value (DV) LIFO
Evaluation



Advantages
Reduces probability of
liquidating LIFO layers.
Reduces accounting
costs of using LIFO.
FIFO or average cost
used for internal
reporting.


Disadvantages
Establishing
appropriate price index.
Subjective makeup of
inventory pools.
Cool,
No?
Lower of Cost or Market (LCM)
General Rule
Inventories must be carried at cost or current
market value, whichever is lower.
Cost
Market
Lower of Cost or Market (LCM)


Market is the current replacement cost of an
item in inventory.
Net Realizable Value (NRV)
◦ Estimated selling price less the costs of completion
and disposal. Market may not be more than NRV.
Called the Ceiling.

NRV Reduced by a Normal Profit Margin
◦ Called the Floor,--market may not be less than this
amount.
Selecting the Proper Market Value



If replacement cost is below the floor, floor =
market.
If replacement cost is above the ceiling, ceiling
= market.
If replacement cost falls between the ceiling
and floor, replacement cost = market.
Selecting the Proper Market Value
Let’s see how we apply LCM.
Lower of Cost or Market
Example
Diego, Inc. has one item in inventory that is currently
carried at historical cost of $20 per unit. At the
Balance
Sheet date we gather the following per unit
information:
◦
◦
◦
◦
current replacement cost $21.50;
selling price $30;
cost to complete and dispose $4; and
normal profit margin of $5.
How would Diego value the inventory item on its
Balance Sheet?
Lower of Cost or Market
Example
Estimated current selling price
$ 30.00
Estimated cost to complete and dispose
4.00
Net realizable value - Ceiling
$ 26.00
Normal profit margin
5.00
NRV reduced by normal profit - Floor
$ 21.00
Lower of Cost or Market
Example
Estimated current selling price
$ 30.00
Estimated cost to complete and dispose
4.00
Net realizable value - Ceiling
$ 26.00
Normal profit margin
5.00
NRV reduced by normal profit - Floor
$ 21.00
Current replacement cost of $21.50 falls between the
ceiling ($26.00) and the floor ($21.00), so current
replacement cost becomes market for comparison with cost.
Lower of Cost or Market
Example
Market is $21.50
Cost is $20.00
Cost is below market, so the inventory item
will be valued on the Balance Sheet at its
historical cost of $20.00.
Lower of Cost or Market
Example
Let’s modify our original example by changing
only the estimated selling price from $30.00
to $25.00. Remember, all other values remain
the same.
How would Diego value the inventory item on
its Balance Sheet?
Lower of Cost or Market
Example
Estimated current selling price
$ 25.00
Estimated cost to complete and dispose
4.00
Net realizable value - Ceiling
$ 21.00
Normal profit margin
5.00
NRV reduced by normal profit - Floor
$ 16.00
Replacement cost of $21.50 is above the ceiling.
Replacement cost must fall between the ceiling
and the floor. We select Ceiling ($21.00) as market.
Lower of Cost or Market
Example
Market is $21.00
Cost is $20.00
Cost is below market, so the inventory item will
be valued at $20.00 on Diego’s Balance Sheet.
Lower of Cost or Market
Example
Diego, Inc. has another inventory item currently carried
at an historical cost of $95.00 per unit. At the Balance
Sheet date the following per unit information is
available:
◦ Current replacement cost $90.00;
◦ NRV of $100.00 and
◦ NRV reduced by normal profit of $70.00.
How would Diego value this item on its Balance
Sheet?
Lower of Cost or Market
Example
$100.00 Ceiling (NRV)
Replacement Cost = $90.00
$70.00 Floor
Because replacement cost falls between the ceiling
and floor, replacement cost becomes market.
Lower of Cost or Market
Example
$100.00 Ceiling (NRV)
Cost = $95.00
Market = $90.00
$70.00 Floor
Because market is below cost, the item
will be valued at $90.00 (market value).
Application of LCM
Compare cost and market
separately for each:
Item of Inventory
Class of inventory items
Application of LCM
Or you could compare
Total
Cost
Total
Market
For the entire inventory
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market Individual Items
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $600$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
$ 700
1,200
2,000
2,200
$6,100
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $200$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
Category
$2,000
4,500
$6,500
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $100$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
Total
$6,600
$6,600
Reporting LCM
Direct Inventory Reduction Method
Record and report inventory holding loss each
accounting period.
Inventory Allowance Method
Record holding loss in a contra inventory account,
Allowance to Reduce Inventory to LCM.
Lower of Cost or Market
Recording the Reduction of Inventory to Cost
December 31, 2006
December 31, 2007
December 31, 2008
Cost
$20,000
25,000
30,000
Market
$20,000
22,000
28,000
Assume the company uses a
perpetual system.
Lower of Cost or Market
Direct Method--December 31, 2007
Cost of Good Sold
Inventory
3,000
3,000
Direct Method--December 31, 2008
Cost of Good Sold
Inventory
2,000
2,000
Lower of Cost or Market
Allowance Method—December 31, 2007
Loss due to Market Valuation
3,000
Allowance to Reduce Inventory to Market
3,000
Allowance Method—December 31, 2008
Allowance to Reduce Inventory to Market 1,000
Loss due to Market Valuation
1,000
Estimating Inventory


Because of the cost and time required to take
a complete physical inventory, it is sometimes
necessary to estimate the cost of ending
inventory.
Two popular methods are . . .
◦ Gross Margin Method
◦ Retail Method
Gross Margin Method


Assumes that the historical gross margin rate
is reasonably constant in the short run.
We must know the following:
Net sales for the period.
Cost of beginning inventory.
Net purchases for the period.
The historical gross margin rate.
Gross Margin Method
Steps to Follow
1. Estimate historical gross margin rate.
2. Add beginning inventory and net purchases to get
cost of goods available for sale(COGAS).
3. Multiply sales by the gross margin rate to get
estimated gross margin in dollars.
4. Subtract gross margin in dollars from net sales to
get cost of goods sold(COGS).
5. Subtract COGS from COGAS to get the estimated
cost of ending inventory.
Gross Margin Method
Example
NoteCo, Inc. uses the gross margin method to
estimate end of month inventory value. At the
end of May the controller develops the following
information: Gross margin 43% of sales;
Inventory at May 1 $237,400; net purchases for
May $728,300; net sales for May $1,213,000.
Let’s estimate Inventory at May 31.
Gross Margin Method
Example
Step 2
Beginning inventory, May 1
Net purchases for May
Cost of goods available for sale
$
$
237,400
728,300
965,700
Gross Margin Method
Example
Step 2
Beginning inventory, May 1
Net purchases for May
Cost of goods available for sale
$
Net sales for May
Estimated gross margin percentage
Estimated gross margin
$ 1,213,000
43%
$
521,590
$
237,400
728,300
965,700
Step 3
Gross Margin Method
Example
Step 2
Beginning inventory, May 1
Net purchases for May
Cost of goods available for sale
$
Net sales for May
Estimated gross margin percentage
Estimated gross margin
$ 1,213,000
43%
$ 521,590
Net sales for May
Estimated gross margin
Estimated cost of goods sold
$ 1,213,000
521,590
$ 691,410
$
237,400
728,300
965,700
Step 3
Step 4
Gross Margin Method
Example
Step 2
Beginning inventory, May 1
Net purchases for May
Cost of goods available for sale
$
Net sales for May
Estimated gross margin percentage
Estimated gross margin
$ 1,213,000
43%
$ 521,590
Net sales for May
Estimated gross margin
Estimated cost of goods sold
$ 1,213,000
521,590
$ 691,410
Cost of goods available for sale
Less: Estimated cost of goods sold
Estimated inventory, May 31
$
$
237,400
728,300
965,700
Step 3
Step 4
Step 5
$
965,700
691,410
274,290
Gross Margin Method
Example
Proof of Estimate
Sales for May
Cost of goods sold:
Beginning inventory
Net purchases
Cost of goods available for sale
Estimated ending inventory
Cost of goods sold
Gross margin for May
$ 1,213,000
$ 237,400
728,300
965,700
274,290
$
691,410
521,590
Expressing Gross Profit Percentages
Divide gross profit by
sales to calculate profit as
a percentage of sales.
Gross Profit
Sales
=
Gross Profit as a
Percentage of Sales
Expressing Gross Profit Percentages
If the gross margin
percentage is expressed as a
percentage of cost it must be
converted to a gross margin
as a percentage of sales
Gross Profit as a % of Cost
=
Cost + Gross Profit as a % of Cost
Gross Profit as a
% of Sales
Enhancing the Accuracy of the Gross Profit
Method
1.
2.
3.
A company should adjust the gross profit rate
for known changes in the relationship between
its gross profit and net sales.
A company may use a separate gross profit
rate for each department or type of inventory
that has a different markup percentage.
A company may use an average gross profit
rate based on several past periods to average
out period-to-period fluctuations.
Retail Method



This method was developed for retail
operations like department stores.
Uses both the retail value and cost of items for
sales to calculate a cost-to- retail-ratio.
Convert ending inventory at retail to ending
inventory at cost.
Retail Method
To use this method we must know:
Sales for the period.
Beginning inventory at retail and cost.
Net purchases at retail and cost.
Adjustments to the original retail price:
 Additional markups and markdowns,
 Markup and markdown cancellations,
 Employee discounts.
Retail Method
Steps to Follow
1. Determine cost of goods sold and retail value of
goods sold.
2. Calculate the cost-to-retail percentage.
3. Subtract retail value of goods available for sale from
sales to get ending inventory at retail.
4. Multiply the cost-to-retail percentage times ending
inventory at retail to get ending inventory at cost.
Retail Method Example
Webb Clothiers, Inc. uses the retail method to
estimate inventory at the end of each month. For
the month of May the controller gathers the
following information: Beginning inventory at
cost $60,000, at retail $92,000, net purchases at
cost $200,000, at retail $308,000; net sales for
May $300,000.
Let’s estimate inventory at May 31.
Retail Method Example
Inventory, May 1
Net purchases for May
Goods available for sale
Cost
$ 60,000
200,000
260,000
Retail
$
92,000
308,000
400,000
Retail Method Example
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio (260,000 ÷ 400,000)
65%
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at cost
Cost
$ 60,000
200,000
260,000
Retail
$
92,000
308,000
400,000
$
$ 65,000
300,000
100,000
65%
Retail Method Example
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio (260,000 ÷ 400,000)
65%
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at cost
Cost
$ 60,000
200,000
260,000
Retail
$
92,000
308,000
400,000
$
$ 65,000
300,000
100,000
65%
Retail Method Example
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio (260,000 ÷ 400,000)
65%
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at cost
Cost
$ 60,000
200,000
260,000
Retail
$
92,000
308,000
400,000
$
$ 65,000
300,000
100,000
65%
Retail Method
Markups and Markdowns





Markup - original amount by which item is
marked up above cost.
Additional Markup - Increase in sales price
above the original sales price.
Additional Markup Cancellation - cancellation of
some or all of an additional markup.
Markdown - reduction in original sales price.
Markdown Cancellation - increase in sales price
after a markdown.
Retail Inventory Method Terminology
Increased selling
price to $11
Original
selling price
($10)
Cost ($6)
Additional
Markup
Markup
Retail Inventory Method Terminology
Reduced selling
price to $10.25
Markup
Cancella
-tion
Cost ($6)
Net markup =Total additional markups total markup cancellations
Retail Inventory Method Terminology
Reduced selling
price to $9
Cost ($6)
Markup
Cancella
-tion
Markdown
Retail Inventory Method Terminology
Net markdown =Total additional markdowns total markdown cancellations
Increased selling
price to $9.60
Cost ($6)
Markdown
Cancellation
Retail Inventory Method
For methods using cost,
such as average cost,
FIFO and LIFO, the net
markdowns are included
in calculating the ratio.
Retail Method - FIFO
Markups and Markdowns
Estimating Inventory on a FIFO Basis
Exclude beginning inventory from the cost ratio.
Cost of net purchases
FIFO cost ratio =
Retail value of (net purchases +
net markups - net markdowns)
Retail Method - FIFO Example
Webb Clothiers, Inc. uses retail FIFO to estimate
inventory at the end of each month. For the
month of May the controller gathers the
following information: Beginning inventory at
cost $60,000, at retail $92,000, net purchases at
cost $200,000, at retail $308,000; net markups
$8,000; net markdowns $4,000; and net sales for
May $300,000.
Let’s estimate inventory at May 31.
Retail Method - FIFO Example
Inventory, May 1
Net purchases for May
Net markups
Net markdowns
Purchases, markups & markdowns
Cost ratio (200,000 ÷ 312,000)
64.103%
Goods available for sale
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at FIFO cost
Cost
Retail
$ 60,000 $
92,000
200,000
308,000
8,000
(4,000)
312,000
260,000
$
$ 66,667
404,000
300,000
104,000
64.103%
Retail Method - FIFO Example
Inventory, May 1
Net purchases for May
Net markups
Net markdowns
Purchases, markups & markdowns
Cost ratio (200,000 ÷ 312,000)
64.103%
Goods available for sale
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at FIFO cost
Cost
Retail
$ 60,000 $
92,000
200,000
308,000
8,000
(4,000)
312,000
260,000
$
$ 66,667
404,000
300,000
104,000
64.103%
Retail Method - FIFO Example
Inventory, May 1
Net purchases for May
Net markups
Net markdowns
Purchases, markups & markdowns
Cost ratio (200,000 ÷ 312,000)
64.103%
Goods available for sale
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at FIFO cost
Cost
$ 60,000
200,000
Retail
$
92,000
308,000
8,000
(4,000)
312,000
260,000
404,000
300,000
104,000
64.103%
$
$ 66,667
Retail Method - FIFO Example
Inventory, May 1
Net purchases for May
Net markups
Net markdowns
Purchases, markups & markdowns
Cost ratio (200,000 ÷ 312,000)
64.103%
Goods available for sale
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at FIFO cost
Cost
$ 60,000
200,000
Retail
$
92,000
308,000
8,000
(4,000)
312,000
260,000
404,000
300,000
104,000
64.103%
$
$ 66,667
Retail Inventory Method--Average Cost
The average cost method includes
the beginning inventory in
determining the cost-to-retail
ratio.
Average
Cost
Retail Method -Average Cost
Markups and Markdowns
Average Cost Basis
Average
cost
=
ratio
Cost of (beginning inventory + net purchases)
Retail value of (beginning inventory + net
purchases + net markups - net markdowns)
Retail Inventory Method--Average Cost
Cost
$20
40
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale $60
Less sales
Ending inventory at retail
$60
= 0.545
$110
Retail
$ 35
80
5
(10)
$110
(66)
$ 44
Ending inventory, average cost (0.545 x $44) =
$23.98
Retail Method
Markups and Markdowns
Lower-of-Cost-or-Market Basis
LCM
cost =
ratio
Cost of (beginning inventory + net purchases)
Retail value of (beginning inventory
+ net purchases + net markups)
Exclude net markdowns from the ratio.
Retail Inventory Method--LCM
Cost
$20
40
Beginning inventory
Purchases
Net markups
$60
$60
= 0.50
Net markdowns
$120
Goods available for sale $60
Less sales
Ending inventory at retail
Retail
$ 35
80
5
$120
(10)
$110
(66)
$ 44
Ending inventory at LCM (0.50 x $44) = $22
Retail Method - Example
Retail
Goods available for sale:
Beginning inventory
$ 900
Net purchases during period
8,900
Additional markups during period
Less: Additional markup cancellations
Net additional markups
200
Markdowns
Less: Markdown cancellations
Net markdowns
(500)
Total goods available for sale
9,500
Deduct:
Sales
(8,500)
Ending inventory:
At Cost
At
$ 550
6,290
$ 225
(25)
(600)
100
6,840
Retail Method - LIFO Example
Steps to follow:
Estimate ending inventory at FIFO cost.
Cost of net purchases
FIFO cost ratio = Retail value of (net purchases +
net markups - net markdowns)
Convert to LIFO Cost
◦ Compute an internal conversion price index for the
current period.
◦ Adjust current layer and each prior layer for change in
price.
Retail Method - LIFO Example
Let’s build on our last example. Remember that Webb
Clothier used Retail FIFO to estimate its inventory at the
end of each month. Keep the given information the
same but now assume that Webb uses DV LIFO to
estimate its ending inventory. The only new
information is that the price index was 100 at the
beginning of May (LIFO base) and 102 at the end of the
month.
We begin by estimating ending inventory using DV
LIFO.
Retail Method - LIFO Example
Inventory, May 1
Net purchases for May
Net markups
Net markdowns
Purchases, markups & markdowns
Cost ratio (200,000 ÷ 312,000)
64.103%
Goods available for sale
Sales for May
Ending inventory at retail
Cost ratio
Ending inventory at FIFO cost
Cost
$ 60,000
200,000
Retail
$
92,000
308,000
8,000
(4,000)
312,000
260,000
404,000
300,000
104,000
64.103%
$
$ 66,667
This is our solution to the Webb Retail FIFO example
Retail Method - LIFO Example
May 31 inventory at FIFO retail
May 31 conversion price index
×
May 31 inventory at base-period retail
$ 104,000
102%
101,961
Ending inventory is still shown at retail, but now
it is stated at beginning of month prices.
Retail Method - LIFO Example
May 31 inventory at FIFO retail
May 31 conversion price index
×
May 31 inventory at base-period retail
Retail
(a)
May 1, base layer
$ 92,000
May additional layer
9,961
$ 101,961
Price
Index
(b)
100%
102%
*BI cost ratio = ($60,000 ÷$92,000) = 65.217%
$ 104,000
102%
101,961
Cost
DV LIFO
Ratio*
Cost
(c)
(a ×b ×c)
65.217% $ 60,000
64.103%
6,513
$ 66,513
Other Inventory Issues

Valuing inventory at
Current replacement cost
Net realizable value
Selling price

Losses on purchase commitments

Effect of inventory errors
Purchase Obligations
To lock in prices and assure sufficient quantities of
materials, companies often contract with suppliers
to purchase a specified quantity of materials in the
future at an agreed upon unit cost.
Purchase Obligations


Formal, non-cancelable purchase contracts
are not recognized in the accounts but
should be disclosed.
If it is expected that execution of the contract
will result in a loss, then recognition of the
loss is appropriate.
Purchasing Obligations and Product
Arrangements
A company entered
into a noncancelable
commitment to
purchase inventory at
a fixed price of
$500,000 and the
market price at the
end of the year is
$450,000.
Purchasing Obligations and Product
Arrangements
Year-end adjusting entry:
Loss on Purchase Commitments
50,000
Accrued Loss on Purchase Commitments
50,000
When the goods are purchased:
Inventory (or Purchases)
450,000
Accrued Loss on PurchaseCommitments 50,000
Accounts Payable
500,000
Inventory Errors
If we make an error in inventory, how will
it impact the financial statements?
Inventory Errors

Overstatement of ending inventory
Understates cost of goods sold and
Overstates pretax income.

Understatement of ending inventory
Overstates cost of goods sold and
Understates pretax income.
Inventory Errors

Overstatement of beginning inventory
Overstates cost of goods sold and
Understates pretax income.

Understatement of beginning inventory
Understates cost of goods sold and
Overstates pretax income.
Inventory Errors

Overstatement of purchases
Overstates cost of goods sold and
Understates pretax income.

Understatement of purchases
Understates cost of goods sold and
Overstates pretax income.
Inventory Errors
Opti, Inc. reported sales of $18,000 during 19X7.
Beginning inventory was $5,000, ending inventory
was $5,500 and purchases were recorded at
$12,000. We learn the Purchases were incorrectly
recorded. The correct amount is $11,000
(Purchases were overstated by $1,000). This was
the only error in Opti’s books.
Let’s look at the effect of the error.
Inventory Errors
Partial Income Statement as reported
Sales revenue
$
Cost of goods sold:
Beginning inventory
$
5,000
Purchases (the error)
12,000
Cost of goods available for sale
17,000
Ending inventory
5,500
Cost of goods sold
Gross margin
$
18,000
11,500
6,500
Inventory Errors
Partial Income Statement as corrected
Sales revenue
$
Cost of goods sold:
Beginning inventory
$
5,000
Purchases (corrected)
11,000
Cost of goods available for sale
16,000
Ending inventory
5,500
Cost of goods sold
Gross margin
$
18,000
10,500
7,500
Inventory Errors
Wick, Co. reported sales of $22,000 during 19X7.
Beginning inventory was incorrectly reported as
$5,000. The correct amount is $5,200 (BI
understated by $200), ending inventory was $5,300
and purchases were recorded at $12,500. This was
the only error in Wick’s books.
Let’s look at the effect of the error.
Inventory Errors
Partial Income Statement as reported
Sales revenue
$
Cost of goods sold:
Beginning inventory (the error)
$
5,000
Purchases
12,500
Cost of goods available for sale
17,500
Ending inventory
5,300
Cost of goods sold
Gross margin
$
22,000
12,200
9,800
Inventory Errors
Partial Income Statement as corrected
Sales revenue
$
Cost of goods sold:
Beginning inventory (corrected)
$
5,200
Purchases
12,500
Cost of goods available for sale
17,700
Ending inventory
5,300
Cost of goods sold
Gross margin
$
22,000
12,400
9,600
Inventory Errors
Vickers, Inc. reported sales of $17,000 during 19X7.
Beginning inventory was reported as $5,000, ending
inventory was incorrectly reported as $5,300, the
correct amount is $5,500 (ending inventory is
understated by $200) and purchases were recorded
at $12,500. This was the only error in Vickers?books.
Let’s look at the effect of the error.
Inventory Errors
Partial Income Statement as reported
Sales revenue
$
Cost of goods sold:
Beginning inventory
$
5,000
Purchases
12,500
Cost of goods available for sale
17,500
Ending inventory (the error)
5,300
Cost of goods sold
Gross margin
$
17,000
12,200
4,800
Inventory Errors
Partial Income Statement as corrected
Sales revenue
$
Cost of goods sold:
Beginning inventory
$
5,000
Purchases
12,500
Cost of goods available for sale
17,500
Ending inventory (corrected)
5,500
Cost of goods sold
Gross margin
$
17,000
12,000
5,000
Chapter 3
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