Valuation of Inventories:
A Cost Basis Approach
Chapter
Valuation of
Inventories:
Classification
A Cost Basis
Approach
rs
Erro
Perpetual v. Periodic
Flow
Cost
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Slide
8-1
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What is Inventory?
Slide
8-2
Manufacturing Companies
Asset items held for sale in the ordinary
course of business or ...
goods that will be used or consumed in the
production of goods to be sold.
Classification of inventories:
Raw Materials
z Work in Progress
z Finished Goods
z
Generally a significant asset
Generally a primary source of revenue
Impacts both balance sheet and income statement
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Slide
8-3
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Slide
8-4
Inventory- the basics
Inventory issues introduced
Four basic questions/ issues:
1.
What is it?
The costs necessary to make the product available for sale, including
costs of holding it once completed.
2.
Whose is it?
It belongs to the party with whom the risks and rewards lie.
3.
How many units are there?
Where does inventory go?
COS- Therefore Pretty important
If inventory is overstated, then what else is
impacted?
–
–
–
–
z
z
COS is understated (rollforward)
Net income AND gross profit are overstated
Various ratios impacted
Next year it reverses (COS is overstated etc.)
z
z
z
z
It is stated at Lower of Cost or Market (LCM)
Perpetual, OR
Periodic
How much did it cost?
Can be tricky, because prices change over time and consequently how
do you know which unit you sold and how you paid for it.
4.
Specific identification- no “methodology” or assumptions, but costly and
perhaps not possible;
Average or weighted average, can be moving average
FIFO (first in first out, aka last in still here)
LIFO (last in first out, aka first in still here)
z
Can result in some strange results when inventory levels are depleted (called LIFO
Liquidation). Consequently the following has been designed to mitigate:
z
z
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Slide
8-5
Items to be Included in Inventory
Specific goods pooled LIFO approach
Dollar Value LIFO
Items to be Included in Inventory
Purchase cost
Purchase cost
Goods in transit
Goods in transit
Consigned goods
Consigned goods
Sales with high
rates of return
Sales with high
rates of return
Sales with buyback
Sales with buyback
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Slide
8-7
Slide
8-6
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Product cost -z invoice cost, freight
in, labor, and other
direct production
costs (up to time of
sale)
Period costs -z selling, general, and
administrative
z not inventoriable
Slide
8-8
Items to be Included in Inventory
Purchase cost
Goods in transit
Consigned goods
Sales with high
rates of return
Items to be Included in Inventory
Purchase cost
Goods in transit
When title passes
z fob shipping
point
z fob destination
Consigned goods
Property of the
consignor
Sales with high
rates of return
Sales with buyback
Sales with buyback
ABC Freight Line
Slide
8-9
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Items to be Included in Inventory
Items to be Included in Inventory
Purchase cost
Purchase cost
Goods in transit
Goods in transit
Consigned goods
Consigned goods
Sales with high
rates of return
not to be removed
from seller’s
inventory acct.
Sales with high
rates of return
Sales with buyback
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Sales with buyback
Slide
8-11
Slide
8-10
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parking
transaction, no
sale should be
recorded
Slide
8-12
Perpetual vs. Periodic J/E’s
UPDATE- NEW LITERATURE
FASB issued new statement which
aligned US GAAP with International
Standards. As a result, “abnormal” costs
are NOT to be included as a cost of
inventory, and accordingly expensed as
incurred.
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Slide
8-13
Perpetual vs. Periodic J/E’s
Sale of 600 units @ $12:
Perpetual -Debit
Credit
Accounts receivable
7,200
Sales
7,200
Cost of goods sold
3,600
Inventory
3,600
Periodic -Accounts receivable
7,200
Sales
7,200
Under PERIODIC-COS entry delayed until
physical count, closing entries. Inventory is
overstated and COS understated, until count &
closing entry.
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Slide
8-15
Beginning inventory 100 units @ $6 ($600):
Purchase 900 units @ $6:
Perpetual -Inventory
Accounts payable
Periodic -Purchases
Accounts payable
Debit
5,400
Credit
5,400
5,400
5,400
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Slide
8-14
Perpetual vs. Periodic J/E’s
Ending inventory 400 units @ $6:
Perpetual -Debit
Credit
No entries (all balance are correct)
Periodic – (remember there was $600 to start)
Inventory
5,400
Purchases
5,400
Inventory
3,600
Cost of good sold (plug) 3,600
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Slide
8-16
Cost Flow Assumptions
Cost Flow Assumptions
First-in-First-out (FIFO)
Balance = $ 45
Purchase 2/25/96
for $20
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
First-in-First-out (FIFO)
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
Balance = $ 35
$ 90
0
90
Purchase 2/25/96
for $20
14
12
7
33
57
17
40
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
Slide
8-17
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Cost Flow Assumptions
Purchase 2/25/96
for $20
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
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$ 90
10
80
14
12
7
33
47
14
33
Slide
8-18
Cost Flow Assumptions
Last-in-First-out (LIFO)
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
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Last-in-First-out (LIFO)
Balance = $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Balance = $ 25
Purchase 2/25/96
for $20
$ 90
0
90
Purchase 2/15/96
for $15
14
12
7
33
57
17
40
Purchase 2/2/96
for $10
Slide
8-19
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Young & Crazy Company
Income Statement
For the Month of Feb. 1996
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
Slide
8-20
Cost Flow Assumptions
Cost Flow Assumptions
Average Cost
Balance = $ 45
Purchase 2/25/96
for $20
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
Average Cost
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
Balance = $ 30
$ 90
0
90
Purchase 2/25/96
for $20
14
12
7
33
57
17
40
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
Slide
8-21
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Cost Flow Assumptions
Purchase 2/25/96
for $20
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
UCSB, Anderson
$ 90
15
75
14
12
7
33
42
12
30
Slide
8-22
Cost Flow Assumptions
Specific Identification
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
Sales
Cost of goods sold
Gross profit
Expenses:
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
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Specific Identification
Balance = $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 1996
Balance = $ 45
$ 90
0
90
Purchase 2/25/96
for $20
14
12
7
33
57
17
40
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
Slide
8-23
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Young & Crazy Company
Income Statement
Depends
which one is sold
For the Month of Jan. 1996
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
Slide
8-24
Trade Discounts
Cost Flow Assumptions
Same as we did for accounts rec./ sales
Income Statement Summary
FIFO
$
90
10
80
Sales
Cost of goods sold
Gross profit
Operating expenses:
Administrative
Selling
Interest
Total expenses
Income before taxes
Income tax expense
Net income
$
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
Inventory Balance
35
$
$
25
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30
– Gross (record full amount and treat discount
appropriately when it happens)
– Net (record net of discount and deal with any lost
discounts as an increase in COS when it happens)
GROSS METHOD
Purchase Cost $10,000 terms 2/10 net 30
Purchases
10,000
Accounts Payable
10,000
NET METHOD
Purchases
9,800
Accounts payable
Invoices of $4,000 paid within discount period
Accounts payable
4,000
Accounts payable
Purchase discount
80
Cash
Cash
3,920
Invoices of $6,000 paid after discount period
Accounts payable
6,000
Cash
6,000
Slide
8-25
9,800
3,920
3,920
Accounts payable
Purchase discounts lost
Cash
5,880
120
6,000
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Slide
8-26
More mechanics
Misc. Considerations
What happened during 2001:
Units
z
Interest typically not capitalized to
inventory
– Inventory should be “turning” quick
enough that this should not matter
– Long-term discreet projects do get interest
capitalized though.
Opening inventory
Purchases
Inventory available for sale
11
150
161
SOLD 140 UNITS
Ending inventory should be
(140)
21
Company erroneously records inventory at
Error
22
Unit Price
10
10
10
Value
110
1,500
1,610
(1,400) COGS SHOULD BE
210
220
(10)
The error overstates inventory. The only reasonable way that could occur is if the
Company understatrd COS.
What happens in 2002:
During 2002, the Company "catches up". In order to do so, they Must overstate
COS because their opening inventory is overstated.
Units
Unit Price
Value
Inventory count is made, there are 20 units
20
10
200
Bal Sheet should reflect
They made purchases of $1,600 and sold $1,610 (161 units), therefore they should record COS of $1,610right?
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Slide
8-27
Opening inventory
Purchases
Ending inventory
COS recorded to "get to" proper invent.
BUT the proper amount is
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220
1,600
(200)
1,620
1,610
(10)
THIS IS WHAT WE CALL THE "TURNAROUND
IMPACT"
Slide
8-28
DOLLAR VALUE LIFO MECHANIX
Dollar Value Lifo seeks to account for inflation by looking at the
change from year to year in “base year” dollars and then
converting THE CHANGE back to current dollars.
STEPS:
1)
Convert ending inventory to base year (divide ending by price
index)
2)
Compute change in base year dollars
3)
If increased, convert the increase back to current year by
multiplying the increase by the price index and adding to the
prior year balance
1)
4)
DOLLAR VALUE LIFO EXAMPLE (Text p. 388)
Inventory at
31-Dec
Year-end Prices
2001
200,000
2002
299,000
2003
300,000
2004
351,000
Price
Index
100
115
120
130
Inventory at
Base-year Price
200,000
260,000
250,000
270,000
Base Yr Convert
Change
Back
n/a
n/a
60,000
115
(10,000)
115
20,000
130
Base Yr
Layer
200,000
69,000
(11,500)
26,000
INVENTORY AT
YEAR END
200,000
269,000
257,500
283,500
In 2003, we "convert back" using the prior year index- BECAUSE there was a decline in the base year inventory,
meaning the inventory came out of the prior year…. If it was purchased in the prior year, then the proper index is from
the prior year.
If decreased, then subtract from the prior year base, recompute the
prior year change using the prior year price index.
Add Layers all back together to compute ending inventory.
Divide Subtract Multiply Add
Slide
8-29
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Cost Flow Assumptions
Last-in-First-out (LIFO)
Balance = $ 25
Purchase 2/25/96
for $20
Purchase 2/15/96
for $15
Purchase 2/2/96
for $10
27
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Young & Crazy Company
Income Statement
For the Month of Jan. 1996
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
10/13/96
Slide
8-31
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Slide
8-30