Intermediate Accounting
IFRS Edition
Kieso, Weygandt, Warfield
Fourth Edition
Chapter 8
Valuation of Inventories: A Cost-Basis Approach
Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
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Learning Objectives
After studying this chapter, you should be able to:
LO 1 Describe inventory classifications and different inventory
systems.
LO 2 Identify the goods and costs included in inventory.
LO 3 Compare the cost flow assumptions used to account for
inventories.
LO 4 Determine the effects of inventory errors on the financial
statements.
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PREVIEW OF CHAPTER 8
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Learning Objective 1
Describe inventory classifications and
different inventory systems.
LO 1
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Inventory Issues
Classification
Inventories are:
•
•
LO 1
asset items held for sale in the ordinary course of business,
or
goods to be used in the production of goods to be sold.
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Current Assets Presentation—
Merchandising Company
•
•
One inventory account.
Purchase merchandise in
a form ready for sale.
ILLUSTRATION 8.1
LO 1
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Current Assets Presentation—
Manufacturing Company
Three inventory accounts
• Raw Materials
• Work in Process
• Finished Goods
ILLUSTRATION 8.1
LO 1
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Flow of Costs through Manufacturing
and Merchandising Companies
ILLUSTRATION 8.2
LO 1
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Inventory Cost Flow
ILLUSTRATION 8.3
Two types of systems for maintaining inventory records —
perpetual system or periodic system.
LO 1
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Inventory Cost Flow
Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each
sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.
The perpetual inventory system provides a continuous record of
the balance in both the Inventory and Cost of Goods Sold
accounts.
LO 1
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Inventory Cost Flow
Periodic System
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
LO 1
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Comparing Perpetual and Periodic
Systems
Illustration: Fesmire Company had the following transactions during
the current year.
Record these transactions using the Perpetual and Periodic
systems.
LO 1
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Comparative Entries—Perpetual vs.
Periodic
ILLUSTRATION 8.4
LO 1
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Inventory Over and Short
Illustration: Assume that at the end of the reporting period, the
perpetual inventory account reported an inventory balance of
$4,000. However, a physical count indicates inventory of $3,800 is
actually on hand. The entry to record the necessary write-down is
as follows.
Inventory Over and Short
200
Inventory
200
Note: Inventory Over and Short adjusts Cost of Goods Sold. In
practice, companies sometimes report Inventory Over and Short in
the “Other income and expense” section of the income statement.
LO 1
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Inventory Control
All companies need periodic verification of the inventory
records
• by actual count, weight, or measurement, with
• counts compared with detailed inventory records.
Companies should take the physical inventory
• near the end of their fiscal year,
• to properly report inventory quantities in their annual
accounting reports.
LO 1
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Determining Cost of Goods Sold
Companies must allocate the cost of all the goods available for sale
(or use) between the goods that were sold or used and those that
are still on hand.
ILLUSTRATION 8.5
LO 1
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Learning Objective 2
Identify the goods and costs included in
inventory.
LO 2
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Goods and Costs Included in Inventory
•
•
LO 2
A company recognizes inventory and accounts payable at
the time it controls the asset.
Passage of title is often used to determine control
because the rights and obligations are established legally.
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Goods in Transit
Example: LG Electronics (KOR) determines ownership by applying
the “passage of title” rule.
• If a supplier ships goods to LG f.o.b. shipping point, title passes
to LG when the supplier delivers the goods to the common
carrier, who acts as an agent for LG.
• If the supplier ships the goods f.o.b. destination, title passes to
LG only when it receives the goods from the common carrier.
“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.
LO 2
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Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (USA) (the consignee), who
acts as Williams’ agent in selling the consigned goods.
• Sotheby’s agrees to accept the goods without any liability,
except to exercise due care and reasonable protection from loss
or damage, until it sells the goods to a third party.
• When Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred in accomplishing the
sale, to Williams.
Goods out on consignment remain the property of the consignor
(Williams).
LO 2
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Sales with Repurchase Agreements
Example: Hill Enterprises transfers (“sells”) inventory to Chase plc
and simultaneously agrees to repurchase this merchandise at a
specified price over a specified period of time. Chase then uses the
inventory as collateral and borrows against it.
• Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though
it transferred to Chase technical legal title to the merchandise.
• Often described in practice as a “parking transaction.”
• Hill should report the inventory and related liability on its
books.
LO 2
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Sales with High Rates of Return
Example: Quality Publishing Company sells textbooks to Campus
Bookstores with an agreement that Campus may return for full
credit any books not sold. Historically, Campus Bookstores returned
approximately 25 percent of the textbooks from Quality Publishing.
Quality Publishing does the following.
a) Record sales revenue at the amount it expects to receive from
the transaction. This transaction involves variable consideration
and therefore the transaction price is adjusted to recognize that
a portion of these textbooks will be returned.
b) Establish an estimated inventory return account to recognize
that some of its textbooks will be returned. The reason for
recording estimated inventory is that control over a significant
number of the textbooks has not passed to Campus Bookstore.
LO 2
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Costs Included In Inventory
Product Costs
Costs directly connected with bringing the goods to the
buyer’s place of business and converting such goods to a
salable condition.
Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the
goods.
LO 2
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Costs Included In Inventory
Period Costs
Costs that are indirectly related to the acquisition or
production of goods.
Period costs such as
• selling expenses and,
• general and administrative expenses
are not included as part of inventory cost.
LO 2
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Costs Included In Inventory
Treatment of Purchase Discounts
Purchase or trade discounts are reductions in the selling
prices granted to customers.
IASB requires these discounts to be recorded as a reduction
from the cost of inventories.
LO 2
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Treatment of Purchase Discounts
Entries Under Gross and Net Methods
ILLUSTRATION 8.6
LO 2
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Learning Objective 3
Compare the cost flow assumptions
used to account for inventories.
LO 3
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Which Cost Flow Assumptions to
Adopt?
Cost Flow Methods
•
Specific Identification
or
•
LO 3
Two cost flow assumptions
o
First-in, First-out (FIFO) or
o
Average Cost
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Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart SpA had
the following transactions in its first month of operations.
Calculate Goods Available for Sale
LO 3
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Cost Flow Methods
Specific Identification
•
•
•
•
Method may be used only in instances where it is
practical to separate physically the different purchases
made. Cost of goods sold includes costs of the specific
items sold.
Used when handling a relatively small number of costly,
easily distinguishable items.
Matches actual costs against actual revenue.
Cost flow matches the physical flow of the goods.
May allow a company to manipulate net income.
LO 3
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Specific Identification Method
Illustration: Call-Mart’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15
purchase, and 2,000 from the March 30 purchase. Compute the
amount of ending inventory and cost of goods sold.
ILLUSTRATION 8.7
LO 3
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Cost Flow Methods
Average-Cost
•
•
•
LO 3
Prices items in the inventory on the basis of the average
cost of all similar goods available during the period.
Not as subject to income manipulation.
Measuring a specific physical flow of inventory is often
impossible.
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Weighted-Average Method—Periodic
Inventory
ILLUSTRATION 8.8
LO 3
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Moving-Average Method—Perpetual
Inventory
ILLUSTRATION 8.9
In this method, Call-Mart computes a new average unit cost
each time it makes a purchase.
LO 3
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Cost Flow Methods
First-In, First-Out (FIFO)
•
•
•
•
LO 3
Assumes goods are used in the order in which they are
purchased.
Approximates the physical flow of goods.
Ending inventory is close to current cost.
Fails to match current costs against current revenues on the
income statement.
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FIFO Method—Periodic Inventory
ILLUSTRATION 8.10
Determine cost of ending inventory by taking the cost of the most
recent purchase and working back until it accounts for all units in
the inventory.
LO 3
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FIFO Method—Perpetual Inventory
ILLUSTRATION 8.11
In all cases where FIFO is used, the inventory and cost of goods
sold would be the same at the end of the month whether a
perpetual or periodic system is used.
LO 3
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Inventory Valuation Methods—Summary
Analysis
Comparison assumes periodic inventory procedures and the
following selected data.
LO 3
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Comparative Results of Average-Cost
and FIFO Methods
ILLUSTRATION 8.12
LO 3
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Balances of Selected Items under
Alternative Inventory Valuation Methods
When prices are rising, average-cost results in the higher cash
balance at year-end (because taxes are lower).
ILLUSTRATION 8.13
LO 3
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Learning Objective 4
Determine the effects of inventory errors
on the financial statements.
LO 4
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Effect of Inventory Errors
Ending Inventory Misstated
ILLUSTRATION 8.14
The effect of an error on net income in one year will be counterbalanced in the
next, however the income statement will be misstated for both years.
LO 4
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Effect of Ending Inventory Error on Two
Periods
Illustration: Yei Chen Ltd. understates its ending inventory by HK$10,000
in 2022; all other items are correctly stated.
ILLUSTRATION 8.15
LO 4
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Financial Statement Effects of Misstated
Purchases and Inventory
ILLUSTRATION 8.16
The understatement does not affect cost of goods sold and net income
because the errors offset one another.
LO 4
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Learning Objective 5
Describe the LIFO cost flow
assumption.
LO 5
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LIFO Cost Flow Assumption
Under IFRS, LIFO is not permitted for financial reporting
purposes.
Nonetheless, LIFO is permitted for financial reporting
purposes in the United States, it is permitted for tax purposes
in some countries, and its use can result in significant tax
savings.
In this appendix, we provide an expanded discussion of LIFO
inventory procedures.
LO 5
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Last-In, First-Out (LIFO)
Recall that Call-Mart Inc. had the following transactions in its
first month of operations.
LO 5
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LIFO Method—Periodic Inventory
ILLUSTRATION 8A.1
The cost of the total quantity sold or issued during the month comes
from the most recent purchases.
LO 5
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LIFO Method—Perpetual Inventory
ILLUSTRATION 8A.2
LIFO results in different ending inventory and cost of goods sold
amounts than the amounts calculated under the periodic method.
LO 5
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Inventory Valuation Methods—
Summary Analysis Including LIFO
Comparison assumes periodic inventory procedures and the
following selected data.
LO 5
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Comparative Results of Average-Cost,
FIFO, and LIFO Methods
ILLUSTRATION 8A.3
Notice that gross profit and net income are lowest under LIFO, highest under
FIFO, and somewhere in the middle under average-cost.
LO 5
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Balances of Selected Items Under Alternative
Inventory Methods Including LIFO
ILLUSTRATION 8A.4
LIFO results in the highest cash balance at year-end (because taxes are lower).
This example assumes that prices are rising. The opposite result occurs if
prices are declining.
LO 5
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