INTERMEDIATE
ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA; Grant MacEwan College
CHAPTER
8
Valuation of Inventories:
A Cost Basis Approach
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. Identify the items that should be included as
inventory cost.
Learning Objectives
5. Explain the difference between variable
costing and absorption costing in assigning
manufacturing costs to inventory.
6. Distinguish between the physical flow of
inventory and the cost flow assigned to
inventory.
7. Identify possible objectives for inventory
valuation decisions.
Learning Objectives
8. Describe and compare the flow assumptions
used in accounting for inventories.
9. Evaluate LIFO as a basis for understanding
the differences between the cost flow
methods.
10.Explain the importance of judgement in
selecting an inventory cost flow method.
Valuation of Inventories: A Cost
Basis Approach
Inventory
Physical Goods Costs
Classification and Included in
Included in
Control
Inventory
Inventory
Cost Flow
Assumptions
Evaluation
and Choice
Classification
Framework for
analysis
Advantages of
LIFO
Specific
identification
Disadvantages
of LIFO
Average cost
Summary
analysis
Management and
control
Basic valuation
Issues
Goods in transit Purchase
discounts
Consigned goods
Product costs
Special sales
agreements
Period costs
Inventory errors Manufacturing
costs
FIFO
Variable versus LIFO
absorption
Standard Costs
Which method
to select?
Consistency
Inventory Classification
• Inventory consists of:
- finished goods held for sale in the ordinary course of business
- goods held or consumed in the production of finished goods
• A merchandising concern has one inventory
account
– Merchandise Inventory
• A manufacturing concern will normally have three
inventory accounts:
– Raw materials
– Work in process
– Finished goods
Inventory Cost Flows
Merchandising Operations
Merchandise
Inventory
Purchases
COGS
Cost of goods
sold
$$$
Inventory Cost Flows
Manufacturing Operations
Raw Materials
Labour
Work in Process
Inventory
$$$
Mfg. Overhead
COGM
Finished
Goods
$$$
COGS
$$$
Inventory Control
• Inventory control is important for:
- ensuring availability of inventory items
- preventing excessive accumulation of
inventory items
• The perpetual system maintains a
continuous record of inventory changes
• The periodic system updates inventory
records only periodically
Perpetual System
• Purchases and sales of inventory recorded
directly to Inventory account
• Inventory purchases, freight, purchase returns
and discounts are debited to the Inventory
account
• Cost of Goods Sold (COGS) is debited and
Inventory is credited for each sale
• Subsidiary ledger is maintained for individual
inventory items
• Periodic inventory counts are still required to
ensure reliability
Periodic System
• Inventory purchases recorded as a debit to
Purchases account
• COGS is a calculation on the Income Statement
• Physical inventory is counted and verified
periodically
• Under both periodic and perpetual inventory
systems, physical counts of inventory are
conducted at least once a year
• Any differences in counted and recorded
quantities are posted to a separate account –
Inventory Over and Short
Perpetual and Periodic Systems:
Example
Fesmire Limited reports the following data for 2000:
Beginning Inventory :
100 units at $6
Purchases: (all credit)
March 12: 300 units at $6
July 6:
600 units at $6
Sales:
(all credit)
April 8:
200 units at $12
August 9: 400 units at $12
Ending Inventory:
400 units at $6
Provide all journal entries under each method.
Perpetual System
Date
Record Inventory Changes
March 12
Inventory
Accts Payable
1,800
1,800
April 8
Cost of goods sold
Inventory
(200 *$6)
1,200
180
July 6
Inventory
Accts Payable
3,600
3,600
August 9 Cost of goods sold
Inventory
(400 * $6)
2,400
2,400
Record Sales Revenue
Accts Receiv. 2,400
Sales
2,400
(200 * $12)
Accts Receiv. 4,800
Sales
4,800
(400 * $12)
Perpetual System
Inventory Stock Card (Subsidiary Ledger)
Date
Purchases
January 1
Opening
100 units
March 12
300 units
400
April 8
July 6
August 9
Sales
200 units
600 units
Balance
200
800
400 units
400 units
• Dollar amounts are optional
• Periodic inventory system would not normally maintain a
subsidiary ledger for inventory
Periodic System
Date
Record Inventory Changes
Record Sales Revenue
March 12 Purchases
1,800
Accts Payable
1,800
April 8
July 6
August 9
Dec. 31
No entry
Accts Receiv 2,400
Sales
2,400
Purchases
3,600
Accts Payable
3,600
No entry
Cost of goods sold 3,600
Inventory (ending) 2,400
Purchases
5,400
Inventory (beg)
600
Accts Receiv 4,800
Sales
4,800
Adjusting
Entry
Financial Statement Presentation
Perpetual
Net Sales
$,$$$
Cost of Goods Sold
$$$
Gross Profit
$,$$$
Periodic
Net Sales
$,$$$
Cost of Goods Sold:
Opening Inventory
$$$
Add: Net Purchases
$$$
Cost of Goods
Available for Sale
Less: Ending Inventory $$$
Cost of Goods Sold
$$$
Gross Profit
$,$$$
Items to Be Included in
Inventory
• Legal title to goods determines inclusion
• The following goods are included in the
seller’s inventory:
1
2
3
4
5
Goods in transit (if seller has title during shipment)
Goods on consignment with seller
Goods, sold under buyback agreements
Goods, sold with high rates of return
Instalment sales (if bad debts cannot be estimated)
Effect of Inventory Errors
Ending
Inventory
Effect on Income Effect on Balance Sheet
Statement Items
Items
Understated
COGS
(over) Retained Earnings (under)
Net Income (under) Working Capital (under)
Overstated
COGS
(under) Retained Earnings (over)
Net Income (over) Working Capital (over)
As an example, consider Brief Exercise BE8-4.
BE8-4
Given for the year 2002:
COGS
= $1.4 million
Retained Earnings (R/E) = $5.2 million
December 31st inventory errors:
2001: overstated by $110,000
2002: overstated by $45,000
Calculate correct COGS and R/E for December 31, 2002.
BE 8-4
COGS (as originally stated)
Add: December 31, 2001 overstatement error
Less: December 31, 2002 overstatement error
Corrected COGS
Retained Earnings (original)
Less: correction to COGS
Retained Earnings (restated)
$1,400,000
110,000
1,510,000
45,000
$1,465,000
$5,200,000
65,000
$5,265,000
Costs Included in Inventory
• Costs included in inventory are known
as “inventoriable costs”
• These costs include:
1 product costs (direct materials, direct
labour and manufacturing overhead)
2 purchase net costs, and freight-in
• Period costs (selling and administrative)
are not inventoriable costs
Inventory Valuation:
Variable costing
• Under variable costing, inventory costs
include only the following manufacturing
costs:
1 direct materials used
2 direct labour
3 variable manufacturing overhead
• Fixed manufacturing overhead is treated as a
period cost
• All period costs are ignored
• Variable costing is appropriate for internal
decision-making
Inventory Valuation:
Absorption Costing
•
Under absorption costing, inventory costs
include all manufacturing costs as follows:
1.
2.
3.
4.
direct materials used in production
direct labour cost
variable manufacturing overhead
fixed manufacturing overhead
•
All other costs are period costs and are
ignored
•
Absorption costing is required for external
reporting
Cost Flow Assumptions
•
•
•
The objective is to most clearly reflect
periodic income
Cost flow assumptions need not be
consistent with physical flow of goods
Objectives of choosing an inventory
valuation method are to:
1. realistically match expenses against revenue
2. report inventory at a realistic amount
3. minimize income taxes
Cost Flow Assumptions
• The cost flow assumptions are:
1
2
3
4
Specific identification
Average cost
First-in, First-out (FIFO)
Last-in, First-out (LIFO)
Cost Flow Assumptions: Example
• Call-Mart
March
Date
1
2
15
19
30
reports the following transactions for
Purchases (Sold)
Balance
beginning inventory (@$3.80)
500
1,500 units (@$4.00)
2,000
6,000 units (@$4.40)
8,000
(4,000 units sold)
4,000
2,000 units (@$4.75)
6,000
Determine the cost of goods sold and the cost of
ending inventory, under each cost flow assumption.
Specific Identification
• Items sold and purchased are individually
identified as to cost
• Works best with items that are unique, high
cost, with small numbers held as inventory
• Advantage:
– Matches revenues and actual costs
• Disadvantages:
– May be costly to implement and maintain
– May lead to income manipulation
Average (weighted) Method
Date
March 1
March 2
Aug 14
Sep 18
Purchases
500 units
1,500 units
6,000 units
2,000 units
Unit Cost
$3.80
$4.00
$4.40
$4.75
10,000 units
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$43,800
Unit cost = $43,800  10,000 = $4.38
Cost of goods available
$43,800
Cost of goods sold
4,000 X $4.38 = 17,520
Ending inventory
6,000 X $4.38 = $26,280
First-in, First-out Method
Date
March 1
March 2
Aug 14
Sep 18
Purchases
500 units
1,500 units
6,000 units
2,000 units
Ending inventory
Cost of goods available
Cost of goods sold
Unit Cost
$3.80
$4.00
$4.40
$4.75
6,000 units
2,000 @ $4.75 =
4,000 @ $4.40 =
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$ 9,500
17,600
$27,100
$43,800
$43,800 - $27,100 = $16,700
Last-in, First-out Method
Date
March 1
March 2
Aug 14
Sep 18
Purchases
500 units
1,500 units
6,000 units
2,000 units
Ending inventory
Cost of goods available
Unit Cost
$3.80
$4.00
$4.40
$4.75
6,000 units
500 @ $3.80 =
1,500 @ $4.00 =
4,000 @ $4.40 =
Purchase Cost
$ 1,900
$ 6,000
$26,400
$ 9,500
$ 1,900
6,000
17,600
$25,500
$43,800
Cost of goods sold
$43,800 - $25,500 = $18,300
2,000 @ $4.40 = $ 8,800
2,000 @ $4.75 = 9,500
$18,300
Cost Flow Assumptions:
Notes
• The ending inventory in units is the same in
all three methods: the cost is different
• The cost of goods sold and the cost of ending
inventory are different
• The cost of goods available is the same in all
three methods
• LIFO would result in the smallest reported net
income (with rising prices)
Advantages of LIFO Method
• LIFO matches more recent costs with current
revenues
• With increasing prices, LIFO yields the lowest
taxable income (assuming inventory does not
decrease)
• With reduced taxes, cash flow is improved
• Under LIFO, the need to write down inventory
to market is minimized
Disadvantages of LIFO
Method
• LIFO yields the lowest net income and therefore
reduced earnings
• Under LIFO, the ending inventory is understated
• LIFO does not approximate the physical flow of
goods except in special situations
• LIFO liquidation may result in income that is
detrimental from a tax view
• LIFO may cause poor buying habits (because of
the layer liquidation problem)
• Not acceptable for tax purposes
• Current (replacement) cost measurement lost
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