Chapter 8:
Inventory Valuation
1
The Inventory Formula
Used to calculate Cost of Goods Sold (COGS) for the
Income Statement and Ending Inventory (EI) for the
balance sheet.
BI + Purchases (net) - EI = COGS
BI + Purchases (net) = EI + COGS
Purchases (net) =
Purchases (billed cost of inventory purchased)
+Freight-in (could be accounted for separately)
- Purchase Discounts (cash discounts for early
payment on account)
- Purchase Returns and Allowances (returns
reduce inventory when given back to seller;
allowances are a negotiated reduction in price of
inventory purchased).
2
Inventory Systems

Perpetual
– Up-to-date record in inventory account.
– Cost of goods sold computed for each sale.

Periodic
– Inventory purchases are recorded as incurred.
– Separate accounts used for the inventory components.
– Inventory and cost of goods sold determined at the end
of each period through physical count.
– Requires AJE to transfer costs to EI and COGS.

Costs and benefits
– Perpetual requires more bookkeeping but provides more
useful information.
– General application: Periodic used for external reporting;
perpetual used for internal tracking of units.
3
Acquiring Inventory

What items or units to include?
– General rule: record in inventory when
received, except:
– Consignments: belong to consignor, ownership
not based on physical possession.
– Goods in transit - FOB Shipping Point: belongs
to the purchaser while in transit (once inventory
leaves seller’s facilities). Note: FOB Destination
indicates seller’s inventory while in transit (until
inventory reaches purchaser’s facilities)
– Special sales agreements:
 Sales with buyback agreement.
 Sales with high rates of return.
 Sales on installment.
4
Goods in Transit
Seller
FOB Shipping Point
Belongs to Purchaser
Purchaser
Title
Transfers
Seller
FOB Destination
Belongs to Seller
Purchaser
Title
Transfers
5
Class Problem
Dallas Company had the following inventory
transactions at the end of 2012. Indicate whether
Dallas should show the inventory in its financials
as of 12/31/12.
1. On 12/28, purchased inventory, FOB Destination.
Shipped 12/28, did not arrive until Jan. 2.
2. On Dec. 29, purchased inventory, FOB Shipping
Point. Shipped 12/29, did not arrive until Jan. 2
3. On 12/28, sold inventory to Houston Company,
FOB Destination. Shipped 12/28; Houston
received on Jan. 2.
6
Class Problem
4. On 12/28, sold inventory to Amarillo Company,
FOB Shipping Point. Shipped 12/28; Amarillo
received on Jan. 2.
5. On 12/28, sold inventory to Amarillo Company,
FOB Shipping Point. Shipped 12/28; Amarillo
received on Dec. 29. This inventory included a
buyback agreement available for 60 days.
7
Inventory Errors

Inventory errors are unique in financial reporting
because they involve multiple accounts and
multiple periods.
 Because of the carryover nature of inventory,
some inventory errors reverse out by the end of
the second year involved.
 Other errors, particularly with purchases, may be
more complicated to analyze.
 To analyze, use basic inventory formula.
8
Class Problem-Inventory Error
Assume that the ending inventory of 2014 was
undervalued by $9,000. If the error goes
undetected in 2015, what effect would the
error have on the balance sheet and income
statement accounts for 2014 and 2015.
Analyze using the following relationships:
BI + P - EI = COGS
NI
A = L + SE
Note that the asset account in inventory error
analysis is ending inventory, and the
equity effect is retained earnings,
specifically the effect on net income.
9
Class Problem
Analysis (O = overstated, U = understated):
BI + P - EI = COGS
NI
A = L + SE
14:
15:
10
Journal Entries - Periodic System
1. When inventory purchased (gross method):
Purchases
xx
Cash or A/P
xx
2. Pay transportation on inventory:
Freight-in
xx
Cash
xx
3. If purchase discount is taken (gross method):
A/P
xx
Purchase discount
xx
4. If inventory returned:
A/P
xx
Purch. Returns & Allow.
xx
11
Journal Entries - Periodic System
Note that Purchase and Transportation-in are
created with Debits.
Purchase Discounts, Returns and Allowances are
created with a credit (contra to purchases).
At the end of the period, the balances in all of these
accounts (along with Beginning Inventory) are
transferred to Ending Inventory and COGS
(adjusting journal entry):
Cost of Goods Sold
xx (based on FIFO,LIFO,Avg.)
Inventory - Ending
xx (based on FIFO,LIFO,Avg.)
Purchase Discounts xx
Purchase Rt. & Allow. xx
Purchases
xx
Transportation-in
xx
Inventory - Beginning xx
12
Purchases – Gross versus Net
Purchase $100 on account. Terms 2/10, n/30.
Gross Method
Net Method
Purchase:
Purchases
100
Purchases
98
A/Pay
100
A/Pay
98
Payment within 10 days:
A/Pay
100
A/Pay
98
Cash
98
Cash
98
Purch. Discounts 2
Payment after 10 days:
A/Pay
100
A/Pay
98
Cash
100
P. Disc. Lost
2*
Cash
100
*Note: Purch. Discounts Lost is a financing charge and is
classified as a period expense in the I/S (like interest
expense). It is NOT part of COGS.
13
Journal Entries - Example
Example - assume the following balance in the
Unadjusted Trial Balance of Raider Co.:
DR
CR
Merch. Inv. (1/1/14)
2,600
Purchases
12,000
Freight-in
500
Purchase Discounts
900
Purchase R & A
1,400
At the end of 2014, Raider calculated its ending
inventory to be $1,900, based on the FIFO
technique.
14
Journal Entries - Periodic System
Part 1: What is the value of Cost of Goods Sold?
BI +
P (net)
EI = COGS
Part 2, AJE:
15
Journal Entries – Perpetual System
For perpetual system, all entries are directly to
and against the inventory account, rather
than the detail components. Instead of
debiting Purchases, the company debits
inventory. Instead of crediting Purchase
Discounts, the company credits Inventory.
Additionally, when inventory is sold, the
transaction is recorded immediately with a
debit to COGS and a credit to Inventory.
Thus, no AJE is needed at the end of the
period; all accounts are already updated.
16
Cost Flow Assumptions


Given: BI + P (net) = EI + COGS
How to assign costs of inflows
[BI + P(net)] to EI and COGS?
Methods:
 Specific identification
 Average for both COGS and EI
 FIFO - (first-in, first-out) for COGS
– and LISH (last-in, still here) for EI

LIFO - (last-in, first-out) for COGS
– and FISH (first-in, still here) for EI

Note that these techniques may be used for either
periodic or perpetual systems; calculations for
perpetual are more cumbersome.
17
Class Problem - Cost Flows
Given the following activity for January:
Cost
Total
Units
per Unit Cost
Begin Inventory 20
$ 9.00 $180
Purchase 1/10
40
10.00 400
Purchase 1/22
30
11.00 330
Total available
90 units
$910
Sales on Jan. 12
Sales on Jan. 24
30 units
25 units
Total units sold:
Total units in EI
55
35
18
Periodic FIFO(LISH)

FIFO for COGS (top down)

LISH for EI (bottom up)
19
Periodic LIFO(FISH)

LIFO for COGS (bottom up)

FISH for EI (top down)
20
Average Periodic
First calculate average:
Goods available cost =
$910
Goods available units =
90 units
Avg. = $10.11 per unit
 Now COGS:
55 units x $10.11 per unit = $ 556
 Now EI:
35 units x $10.11 per unit = $354

21
Perpetual FIFO (not tested)
Units Per Unit EI
Begin Inv. 20 $ 9.00
Purch. 1/10 40 10.00
Sale 1/12 (30)
Balance
30
Purch. 1/22 30
Sale 1/24 (25)
Balance
5
30
Totals
COGS
20@9 = 180
10@10=100
10.00
11.00
25@10=250
10.00 = 50
11.00= 330____________
EI=380 COGS=530
22
Perpetual LIFO (not tested)
Units Per Unit EI
COGS
Begin Inv. 20 $ 9.00
Purch. 1/10 40 10.00
Sale 1/12 (30)
30@10 = 300
Balance
20
9.00
10 10.00
Purch. 1/22 30 11.00
Sale 1/24 (25)
25@11=275
Balance
20
9.00 = 180
10 10.00 = 100
5 11.00 = 55____________
Totals
EI = 335 COGS =575
23
Average Perpetual (not tested)
(calculate average before each sale)
Units Per Unit Total
EI
Begin Inv. 20 $ 9.00 = $180
Purch. 1/10 40 10.00 = 400
Average
60
580
9.67
Sale 1/12 (30) @ 9.67 = (290)
Balance
30
9.67 = 290
Purch. 1/22 30 11.00 = 330
Average
60 10.33
620
Sale 1/24 (25) 10.33 = (258)
Balance
35 10.33 = 362 $362
COGS
$290
258
$548
24
Comparison of FIFO, LIFO, and
Average

In times of rising prices:
highest COGS:
lowest COGS
highest EI
lowest EI
highest Net Income
lowest Net Income
25
LIFO Advantages/Disadvantages
Advantages:
Tax benefits - cash flow savings in times of rising
prices.
Matching on the income statement – current
revenues and current costs.
Minimize write downs of inventory (already at a
low cost).
Disadvantages:
Inventory may be significantly undervalued.
LIFO liquidation may cause significant increases
in income (and in taxes).
Difficulty in comparing LIFO firms to FIFO firms.
LIFO Layer Liquidation
If an old, low LIFO layer is liquidated (usually
when an product line or large segment is
eliminated), then current income may
increase significantly, as COGS absorbs
much lower costs.
This effect, in the past, had been another
technique that managers might use to
manipulate income (with a corresponding net
decrease in cash).
The SEC now requires that any income increases
from LIFO layer liquidation now be disclosed
separately in the financials.
LIFO Reserve
For companies that use LIFO for tax and
external financial reporting, a financial
statement disclosure is required that
indicates the calculated inventory(ies) at
FIFO. The difference between the FIFO
and LIFO inventories is called the LIFO
Reserve.
 This number may be used to convert LIFO
Inventory and COGS and Net Income to a
FIFO basis, to allow for comparison to
other companies.
 It also facilitates the calculation of the cash
flow savings from reduced taxes.

28
Dollar Value LIFO




Unit LIFO (from previous section) is
cumbersome and very difficult to implement for
any company with even a modest amount of
inventory.
Most companies that use LIFO choose to use
Dollar Value LIFO. In this technique, the
different groups of inventories are turned into
annual dollar layers.
First the units of EI are turned into dollars by
extending all the units at end of the year prices.
Then the dollars are added to create a single
layer of inventory costs, in dollars.
Each year the new layers are compared to old
layers (in common dollars), and inventory
change is calculated. See Handout for example.