Chapter 8
Inventories:
Measurement
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Overview
Inventory Overview
Inventory refers to the assets a company:
• Intends to sell in the normal course of business
• Has in production for future sale or
• Uses currently in production of goods to be sold
Cost of goods sold is the expense related to
inventory
08-02
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LO8-1
Types of Inventory
Inventory
Merchandising
Inventory
Manufacturing
Inventory
• Goods that are purchased
primarily in finished form
from wholesalers and
retailers
• Cost of merchandise
inventory includes:
Purchase price plus
Any other costs necessary
to get goods in condition
and location for sale
• Goods that are produced by
a manufacturing company
to be sold to wholesalers,
retailers, other
manufacturers, or
consumers
• Consists of:
Raw materials
Work-in-process
Finished goods
08-03
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LO8-1
Inventory for a Manufacturer Consists of:
Raw
materials
Work-inprocess
• Represent the cost of components purchased
from suppliers that will become part of the
finished product
• Example: Computer chips and memory modules
that will go into computers produced by HP
• Refers to the products that are not yet complete
• The cost of work in process includes:
The cost of
raw materials
The cost of labor that
can be directly traced
Manufacturing
overhead
• Example: Partially completed components in the
assembly lines of HP
Finished
goods
• Cost of goods that have been completed in the
manufacturing process but have not been sold
• Example: Computers produced by HP that are
intended for sale to customers
08-04
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LO8-1
Inventories Disclosure—
Intel Corporation
Manufacturing companies generally disclose, either in a
note or directly in the balance sheet, the dollar amount of
each inventory category.
($ in millions)
December 30, 2017
December 31, 2016
Raw materials
$ 1,098
$ 695
Work in process
3,893
3,190
Finished goods
1,992
1,668
$ 6,983
$ 5,553
Total inventories
08-05
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LO8-1
Inventory Components and Cost Flow
for a Manufacturing Company
Raw Materials
Raw materials Raw materials
used
purchased
Direct Labor
Direct labor
incurred
Direct labor
applied
Work in Process
Work in process
transferred
to finished goods
Finished Goods
Finished goods
sold
Manufacturing
Overhead
Manufacturing Manufacturing
overhead
overhead
applied
incurred
Cost of
Goods Sold
08-06
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LO8-1
Perpetual Inventory System
• Continually adjust the inventory account for each
change in inventory caused by a:
– Purchase,
– Sale, or
– Return of inventory
• Continually adjust the cost of goods sold account
each time goods are:
– Sold
– Returned by a customer
• Allows management to:
– Determine goods on hand on any date
– Determine the number of items sold during a period
08-07
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LO8-1
Perpetual Inventory System (continued)
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2021 with inventory of $120,000 on hand. The
following information relates to inventory transactions during
2021:
1. Additional soft drink inventory is purchased on account
at a cost of $600,000
2. Sales for the year, all on account, totaled $820,000
3. The cost of the soft drink inventory sold is $540,000
Lothridge uses the perpetual inventory system to keep track of
both inventory quantities and inventory costs. The system
indicates that the cost of inventory on hand at the end of the
year is $180,000.
08-08
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LO8-1
Perpetual Inventory System (concluded)
The following summary journal entries record the
inventory transactions for the Lothridge Company:
Credit
Debit
2021
600,000
Inventory
600,000
Accounts payable
To record the purchase of inventory
2021
Accounts receivable
Sales revenue
Debit
820,000
Credit
820,000
To record sales on account
Cost of goods sold
Inventory
To record the cost of sales
540,000
540,000
08-09
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LO8-1
Perpetual Inventory System Technology
• Nearly all major companies use a perpetual
inventory system to maintain a record of inventory
transactions
• Technological advances help reduce the burden of
physical inventory counts and manual record
keeping
• Automated systems allow for continuous tracking
of inventory
– Barcode scanning
– Radio frequency identification (RFID) tags
08-10
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LO8-1
Periodic Inventory System
• Adjusts the inventory account and records cost of
goods sold only at the end of each reporting period
• Records merchandise purchases, purchase returns,
purchase discounts, and freight-in in temporary
accounts
• Determines period’s cost of goods sold by combining
temporary accounts with the inventory account:
Cost of
=
goods sold
Beginning
inventory
Net
Ending
+
purchases – inventory
08-11
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LO8-1
Periodic Inventory System (continued)
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2021 with inventory of $120,000 on hand.
The following information relates to inventory transactions
during 2021:
1. Additional soft drink inventory is purchased on
account at a cost of $600,000
2. Sales for the year, all on account, totaled $820,000
Lothridge uses the periodic inventory system. After a physical
count of inventory at the end of the year, the cost of ending
inventory is determined to be $180,000.
08-12
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LO8-1
Periodic Inventory System (concluded)
The following summary journal entries record the inventory
transactions for the Lothridge Company:
2021
Purchases
Accounts payable
Debit
600,000
600,000
To record the purchase of inventory
2021
Accounts receivable
Sales revenue
Credit
Debit
Credit
820,000
820,000
To record sales on account
No entry is recorded for the cost of inventory sold.
08-13
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LO8-1
Cost of Goods Sold
• Lothridge begins 2021 with merchandise inventory of $120,000
• During 2021, additional soft drink inventory was purchased on
account at a cost of $600,000
• Sales for the year, all on account, totaled $820,000
• A physical count determined the cost of inventory at the end of the
year to be $180,000
Beginning
inventory
+
Net
purchases
–
Ending
inventory
=
Cost of
goods sold
Beginning inventory
$120,000
600,000
Plus: Purchases
Cost of goods available for sale
720,000
Less: Ending inventory (per physical count) (180,000)
Cost of goods sold
$540,000
08-14
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LO8-1
Cost of Goods Sold (continued)
Beginning inventory
$120,000
600,000
Plus: Purchases
Cost of goods available for sale
720,000
Less: Ending inventory (per physical count) (180,000)
Cost of goods sold
$540,000
December 31, 2021
Debit
Cost of goods sold
Inventory (ending)
Inventory (beginning)
Purchases
540,000
180,000
Credit
120,000
600,000
To adjust inventory, close the purchases account, and record cost of goods sold.
08-15
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LO8-1
A Comparison of the Perpetual and Periodic
Inventory Systems
Perpetual Inventory Systems
Periodic Inventory Systems
• Cost of goods available for sale •
is allocated by decreasing
inventory and increasing cost of
goods sold each time goods are
sold
• Facilitates the preparation of
•
interim financial statements by
providing fairly accurate
information without the
necessity of a physical count of
inventory
• More expensive to implement •
• Involves the tracking of both
•
inventory quantities and costs
Allocates cost of goods
available for sale between
ending inventory and cost of
goods sold at the end of the
period
Requires a physical count
before ending inventory and
cost of goods sold can be
determined. This makes the
preparation of interim financial
statements more costly.
Less costly to implement
Can monitor only inventory
quantities
08-16
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LO8-1
Concept Check: Periodic-Cost of Goods Sold
The Golson Company uses the periodic inventory system.
Information for 2021 is as follows:
Sales
$1,325,000
Beginning inventory
340,000
Purchases
600,000
Purchase returns
6,000
Ending inventory
370,000
Cost of goods sold for 2021 is:
a.
b.
c.
d.
$761,000
$594,000
$570,000
$564,000
The correct answer is d: Cost of goods sold = $564,000.
$340,000 (beginning inventory)
+ 600,000 (purchases)
−
6,000 (purchase returns)
− 370,000 (ending inventory)
= $564,000 (cost of goods sold)
08-17
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LO8-1
Concept Check: Periodic-Ending Inventory
The Golson Company uses the periodic inventory system.
Information for 2021 is as follows:
Sales
$1,325,000
Beginning inventory
340,000
Purchases
600,000
Purchase returns
6,000
Cost of goods sold
564,000
Ending inventory for 2021 is:
a.
b.
c.
d.
$761,000
$594,000
$570,000
$370,000
The correct answer is d: Ending inventory = $370,000.
$340,000 (beginning inventory)
+ 600,000 (purchases)
−
6,000 (purchase returns)
−
X (ending inventory)
= $564,000 (cost of goods sold)
08-18
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LO8-2
Physical Units Included in Inventory
Items in the
Goods that are in
possession of the
transit
company
Physical Units
Included in
Inventory
Goods on
consignment
Anticipated sales
returns
08-19
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LO8-2
Goods in Transit
Refers to situations:
• Where the goods are on the way to their destination
• Between the suppliers and a company, or between
the company and its customers
Accounting for
goods in transit
Depends on
Ownership of
goods
08-20
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Goods in Transit (continued)
LO8-2
In December 2021, the Lothridge Wholesale Beverage Company
sold goods to the Jabbar Company. The goods were shipped
from Lothridge on December 29, 2021, but the goods didn’t
arrive at Jabbar until January 3, 2022.
If goods are shipped
f.o.b. shipping point:
If goods are shipped
f.o.b. destination:
• Title transfers at shipping point
• Title transfers at destination
• Lothridge records the sale on
December 29, 2021
• Lothridge includes the goods
in its 2021 ending inventory
and the sale is not recorded
until January 3, 2022, when
those goods reach Jabbar
• Jabbar includes these goods in
its 2021 ending inventory even
though the company is not in
physical possession of the
goods on the last day of 2021
• Jabbar waits until 2022 to
record the purchase 08-21
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LO8-2
Concept Check: Goods in Transit
Barrington Corporation uses the periodic inventory system. At December
31, 2021, the end of the company’s fiscal year, a physical count of inventory
revealed an ending inventory balance of $80,000. The following items were
not included in the physical count:
Merchandise shipped to a customer on 12/28 f.o.b. destination
(merchandise arrived at customer’s location on 1/5/19)
$3,000
Merchandise shipped to a customer on 12/29 f.o.b. shipping point
(merchandise arrived at customer’s location on 1/2/19)
1,500
Merchandise purchased from a supplier, shipped f.o.b. destination
on 12/26, arrived on January 4, 2022
6,000
Barrington’s 2021 ending inventory should be:
a.
b.
c.
d.
$80,000
$89,000
$83,000
$87,750
The correct answer is c:
$80,000 (ending inventory count)
+ $ 3,000 (f.o.b. destination shipment made 12/28)
= $83,000
08-22
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LO8-2
Goods on Consignment
Retains legal title
Transferor
(consignor)
physically transfers the goods
Consignee
(1) If buyer is not found—the goods are returned to
the consignor
(2) If buyer is found—the selling price (less commission
and approved expenses) is remitted to the consignor
Accounting treatment:
• Goods held on consignment are included in the
inventory of the consignor until sold by the consignee
• Sale is recorded by consignor only when the goods are
sold by the consignee and title passes to the third party
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Goods on Consignment (continued)
LO8-2
Suppose Pratt Clothing (consignor) ships merchandise to Regal
Outlets (consignee). The arrangement specifies that Regal will
attempt to sell the merchandise, and in return, Pratt will pay to
Regal a 10% sales commission on any merchandise sold. Any
inventory not sold within six months will be returned to Pratt.
• Regal obtains physical possession of the inventory and has
responsibility to sell to customers but,
• Pratt retains legal title to the inventory and risk of ownership
and therefore keeps this inventory in its own records until the
merchandise is sold to a customer
08-24
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LO8-2
Sales Returns
Sales Returns:
• When customers return merchandise:
1. Cost of goods sold is reduced
2. Inventory is increased
(Also sales revenue and accounts receivable are reduced)
• Same adjustment is made at the end of the period to
account for estimated sales returns in the future
• As a result, a company includes in ending inventory the
cost of merchandise sold that it anticipates will be
returned.
08-25
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LO8-3
Transactions Affecting Net Purchases
• Costs of inventory includes necessary expenditures to:
1. Acquire the inventory and
2. Bring it to its desired condition and location for
sale or for use in the manufacturing process
• Common costs included in inventory are freight
charges on incoming goods, as well as insurance costs
during transit and costs of unloading, unpacking, and
preparing merchandise inventory
• Purchase returns and purchase discounts reduce the
cost of net purchases
Net
purchases
=
Total
purchases
+
Freight and
other costs
−
Returns and
discounts
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LO8-3
Freight-in on Purchases
• Costs to get the inventory in location for sale or use
• In perpetual system:
– Freight costs are added to the inventory account
• In periodic system:
– Freight costs are added to a temporary account, called
freight-in or transportation-in, and later added to
purchases
Shipping charges on outgoing goods
• Costs are not included in the cost of inventory
– Treated as a part of cost of goods sold or as an
operating expense
– If not in cost of goods sold, amounts incurred and
income statement classification must be disclosed
08-27
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LO8-3
Purchase Returns
• A buyer views a purchase return as a reduction of
purchases
• In a perpetual inventory system, a return of inventory
previously purchased on account is recorded as:
– Reduction in both inventory and accounts payable
– If original purchase was for cash, then increase cash
for refund
• In a periodic system:
– The purchase returns account used to accumulate the
amount of the return
– Purchase returns are then subtracted from total
purchases to calculate net purchases
08-28
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LO8-3
Purchase Discounts
•
•
•
Represents reductions in the amount to be paid by the buyer if
remittance is made within a designated period of time
2/10, n/30—means a 2% discount if paid within 10 days, otherwise
full payment within 30 days
Recorded by either gross method or net method
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LO8-3
Inventory Transactions—Perpetual
and Periodic Systems
The Lothridge Wholesale Beverage Company purchases soft drinks from
producers and then sells them to retailers. The company began the year with
merchandise inventory of $120,000 on hand. During the year, additional
inventory transactions include:
• Purchases of merchandise on account totaled $620,000, with terms 2/10,
n/30.
• Freight charges paid by Lothridge were $16,000.
• Merchandise with a cost of $20,000 was returned to suppliers for credit.
• All purchases on account were paid within the discount period.
• Sales on account totaled $830,000.
• The cost of soft drinks sold was $550,000.
• Inventory remaining on hand at the end of the year totaled $174,000
The above transactions are recorded in summary form according to both the
perpetual and periodic inventory systems using the gross method:
08-30
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LO8-3
Inventory Transactions—Perpetual
and Periodic Systems (continued)
($ in thousands)
Perpetual System
Periodic System
Inventory
Accounts payable
620
Inventory
Cash
16
Accounts payable
Inventory
20
Accounts payable
Inventory
Cash
600
Purchases
Purchases
620
Accounts payable
Freight
Freight-in
16
Cash
Returns
Accounts payable
20
Purchase returns
Discounts
Accounts payable
12
Purchase discounts
588
Cash
620
620
16
16
20
20
600
12
588
08-31
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LO8-3
Inventory Transactions—Perpetual
and Periodic Systems (concluded)
($ in thousands)
Perpetual System
Periodic System
Sales
Accounts receivable
Sales revenue
830
Cost of goods sold
Inventory
550
No entry
Accounts receivable
830
Sales revenue
830
830
No entry
550
End of the period
Cost of goods sold
Inventory (ending)
Purchase returns
Purchase discounts
Inventory (beginning)
Purchases
Freight-in
550
174
20
12
120
620
16
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LO8-4
Illustration—Inventory Cost Flow
The Browning Company inventory information for 2021:
Beginning Inventory and Purchases During 2021
Date
Jan. 1 (Beg. Inventory)
Purchases:
Units
4,000
Unit Cost
$5.50
Total Cost
$22,000
Jan. 17
Mar. 22
Oct. 15
Goods available for sale
Sales
Date of Sale
Jan. 10
Apr. 15
Nov. 20
Total
1,000
3,000
3,000
11,000
$6.00
7.00
7.50
$ 6,000
21,000
22,500
$ 71,500
Units
2,000
1,500
3,000
6,500
What is the cost of
the 6,500 units sold?
08-33
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LO8-4
Allocation of Units Available
Beginning inventory
Plus: Purchases
Goods available for sale
4,000 units
7,000 units
11,000 units
On hand at the end of the period
4,500 units
Beginning
inventory
(4,000 units)
+
Purchases
(7,000 units)
Units available
for sale
(11,000)
Units on hand
at end of period
4,500
Units sold during
the period
6,500
Ending units + sold units = 11,000
08-34
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LO8-4
Allocation of Cost of Goods Available
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Goods available for sale (11,000 units)
Less: Ending inventory (4,500 units @ ?)
Cost of goods sold (6,500 units @ ?)
Beginning
inventory
($22,000)
+
Purchases
($49,500)
Cost of goods
available for sale
($71,500)
$22,000
49,500
$71,500
___?___
?
Cost of inventory
on hand at end
of period = ?
Cost of goods
sold during the
period = ?
Ending inventory + cost of goods sold = $71,500
08-35
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LO8-4
Specific Identification Method
• Refers to matching each unit sold during the period
or each unit on hand at the end of the period with its
actual cost
• Used by companies selling unique, expensive
products with low sales volume
– This makes it relatively easy and economically feasible
to associate each item with its actual cost
Example:
Automobiles have unique serial numbers that can be
used to match a specific auto with the invoice identifying
the actual purchase price
08-36
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LO8-4
Cost Flow Assumptions
• Companies can assume which units of inventory
have been sold and which remain in ending inventory
Cost flow assumptions
Average cost
•
•
First-In, First-Out
(FIFO)
Assumes
inventory cost is • Assumes units
first acquired are
a mix of all
sold first
goods available
• Ending inventory
for sale
consists of the
Average is
most recently
weighted by
acquired units
number of units
Last-In, First-Out
(LIFO)
• Assumes units
last acquired are
sold first
• Ending inventory
consists of first
acquired units
08-37
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LO8-4
Average Cost—Periodic
•
The weighted-average cost is calculated only at the end of
the period
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of goods available for sale (11,000 units)
$ 22,000
49,500
71,500
Less: Ending inventory (4,500 units @ $6.50)
(29,250)
$ 42,250
Cost of goods sold (6,500 units @ $6.50)
$71,500
Weighted-average unit cost = 11,000 units = $6.50
08-38
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LO8-4
Average Cost Method—Perpetual
Perpetual Average Cost
• Applied by computing a moving-average unit cost
each time additional inventory is purchased
• The new average is determined after each purchase
by:
Summing the cost of the previous inventory balance
and the cost of the new purchase
– Dividing this total cost by the number of units on hand
–
08-39
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Average Cost—Perpetual Inventory System
Date
Purchased
Beg. Inv.
4,000 @ $5.50 = $22,000
Jan. 10
Jan. 17
Sold
LO8-4
Balance
4,000 @ $5.50 = $22,000
2,000 @ $5.50 =
$ 11,000
2,000 @ $5.50 = $11,000
$11,000 + $6,000 = $17,000
2,000 + 1,000 = 3,000 units
1,000 @ $6.00 = $6,000
Average cost per unit: $17,000 ÷ 3,000 units = $5.667/unit
Mar. 22
3,000 @ $7.00
= $21,000
$17,000 + $21,000 = $38,000
3,000 + 3,000 = 6,000 units
Average cost per unit: $38,000 ÷ 6,000 units = $6.333/unit
Apr. 15
Oct. 15
1,500 @ $6.333
= $ 9,500
3,000 @ $7.50
= $22,500
4,500 @ $6.333 = $28,500
$28,500 + $22,500 = $51,000
4,500 + 3,000 = 7,500 units
Average cost per unit: $51,000 ÷ 7,500 units = $6.80/unit
Nov. 20
3,000 @ $6.80 =
$ 20,400
4,500 @ $6.80 = $30,600
Total cost of goods sold = $40,900
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LO8-4
First-In, First-Out (FIFO)—Periodic
• Assume first units acquired
are sold first
Units
Available
Beginning 4,000 @ $5.50 First
6,500
Jan. 17
1,000 @ $6.00 units
Mar. 22
1,500 @ $7.00 sold
Mar. 22
Oct. 15
Total
1,500 @ $7.00 4,500
3,000 @ $7.50 units
remaining
11,000
Units
4,000
1,000
1,500
6,500
Unit Cost of
Cost Goods Sold
$5.50 $22,000
$6.00
6,000
7.00
10,500
$38,500
Unit Ending
Cost Inventory
Units
1,500 $7.00 $10,500
22,500
3,000 7.50
4,500
$33,000
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FIFO—Perpetual Inventory System
Date
Purchased
Sold
Beginning
Inventory
4,000 @ $5.50
= $22,000
Jan. 10
LO8-4
Balance
4,000 @ $5.50 = $22,000
2,000 @ $5.50 =$ 11,000
2,000 @ $5.50 = $11,000
Jan. 17
1,000 @ $6.00
= $6,000
2,000 @ $5.50
1,000 @ $6.00
Mar. 22
3,000 @ $7.00
= $21,000
2,000 @ $5.50
1,000 @ $6.00
$38,000
3,000 @ $7.00
Apr. 15
Oct. 15
Nov. 20
1,500 @ $5.50 = $ 8,250
3,000 @ $7.50
= $22,500
500 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
= $19,250
$17,000
500 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$29,750
500 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
3,000 @ $7.50
$52,250
1,500 @ $7.00
3,000 @ $7.50
$33,000
Total cost of goods sold = $38,500
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LO8-4
Last-In, First-Out (LIFO)—Periodic
• Assume last units
acquired are sold first
Units
Available
Beginning 4,000 @ $5.50
Jan. 17
500 @ $6.00
Jan. 17
Mar. 22
Oct. 15
Total
500 @ $6.00
3,000 @ $7.00
3,000 @ $7.50
11,000
4,500
units
remaining
Last
6,500
sold
Unit Ending
Cost Inventory
Units
4,000 $5.50 $22,000
3,000
500 6.00
4,500
$25,000
Units
500
3,000
3,000
6,500
Unit Cost of
Cost Goods Sold
$6.00 $ 3,000
$7.00 21,000
7.50
22,500
$46,500
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LIFO—Perpetual Inventory System
Date
Purchased
Sold
Beginning
Inventory
4,000 @ $5.50
= $22,000
Jan. 10
Balance
4,000 @ $5.50 = $22,000
2,000 @ $5.50 =$ 11,000
2,000 @ $5.50 = $11,000
Jan. 17
1,000 @ $6.00
= $6,000
2,000 @ $5.50
1,000 @ $6.00
Mar. 22
3,000 @ $7.00
= $21,000
2,000 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
Apr. 15
Oct. 15
Nov. 20
LO8-4
1,500 @ $7.00 = $ 10,500
3,000 @ $7.50
= $22,500
3,000 @ $7.50 = $22,500
$17,000
$38,000
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
$27,500
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
3,000 @ $7.50
$50,000
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
$27,500
Total cost of goods sold = $44,000
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LO8-4
Comparison of Cost Flow Methods
Cost of goods sold
Ending inventory
Goods available for sale
Average
$ 42,250
29,250
$ 71,500
FIFO
$38,500
33,000
$ 71,500
LIFO
$46,500
25,000
$71,500
• The average cost method produces amounts that fall in
between the FIFO and LIFO amounts for both cost of goods
sold and ending inventory
• During rising costs:
– FIFO results in a lower cost of goods sold and higher
ending inventory than LIFO
• During declining costs:
– FIFO will result in a higher cost of goods sold and lower
ending inventory than LIFO
08-45
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Inventory Cost Flow
LO8-4
Disclosure
• FIFO, LIFO, and average are all permissible under GAAP
• Companies need not use the same method for entire inventory
• Companies must identify in a disclosure note method(s) used
In Practice:
# Companies
% Companies
FIFO
312
47%
LIFO
163
24
Average
133
20
Other* and not disclosed
61
9
669
100%
Total
* “Other” includes the specific identification method and misc. less popular
methods
08-46
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LO8-4
Concept Check: FIFO Method
Fulbright Corp. uses the periodic inventory system. During its first
year of operations, Fulbright made the following purchases (listed in
chronological order of acquisition):
160 units at $50
280 units at $40
680 units at $30
Sales for the year totaled 1,080 units, leaving 40 units on hand at the
end of the year. Ending inventory using the FIFO method is:
a.
b.
c.
d.
$1,300
$2,000
$1,414
$1,200
The correct answer is d:
40 units × $30 = $1,200
08-47
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LO8-4
Concept Check: LIFO Method
Fulbright Corp. uses the periodic inventory system. During its first
year of operations, Fulbright made the following purchases (listed in
chronological order of acquisition):
160 units at $50
280 units at $40
680 units at $30
Sales for the year totaled 1,080 units, leaving 40 units on hand at the
end of the year. Ending inventory using the LIFO method is:
a.
b.
c.
d.
$1,300
$2,000
$1,414
$1,200
The correct answer is b:
40 units × $50 = $2,000
08-48
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LO8-5
Decision Makers’ Perspective:
Choosing Appropriate Inventory Method
• Choices are a combination of:
Inventory cost
flow assumption
Depreciation
Pension
method
assumptions
Other
choices
To meet a particular objective
• Managers sometimes make these choices to
maximize their own personal benefits rather than
those of the company or its external constituents
08-49
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LO8-5
Factors Influencing Method Choice
Physical Flow
Example:
• Companies often attempt to sell the oldest goods in
inventory first
•
– FIFO best suits the physical flow in these situations
– If inventory sold comes from a mixture of goods
acquired at various times, such as with a liquid, the
average cost method would more closely correspond
to actual physical flow
– There are very few inventories that flow in a LIFO
manner
It is not mandatory to choose the method that
approximates actual physical flow
08-50
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LO8-5
Factors Influencing Method Choice
(continued)
Income Taxes and Net Income
•
•
If the unit cost of inventory changes, the method chosen
will have an impact on
– Amount of income reported to external parties
– The amount of taxes paid to:
•
The Internal Revenue Service (IRS)
•
State and local taxing authorities
When inventory costs rise and inventory quantities are
not decreasing:
– LIFO produces a higher cost of goods sold and therefore
lower net income than the other methods
– Lower taxable income is reported and lower taxes paid
08-51
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LO8-5
Factors Influencing Method Choice
(concluded)
Income Taxes and Net Income
• Many companies choose LIFO in order to reduce
income taxes in periods when prices are rising
• Taxes are not reduced permanently, only deferred
• The IRS requires companies to follow the LIFO
conformity rule
• LIFO conformity rule:
If a company uses LIFO to measure taxable income, it
also must use LIFO for external financial reporting
08-52
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LO8-5
Concept Check: Method Choice
Which of these is not a factor that motivates companies to choose
one method over the other?
a. How closely reported costs reflect the actual physical flow of
inventory
b. The timing of reported income and income tax expense
c. How well costs are matched with associated revenues
d. To make it easier for managers to maximize their own personal
benefits rather than those of the company or its external
constituents
The correct answer is d. Although many believe managers
sometimes make choices to maximize their own personal benefits
rather than those of the company or its external constituents, it is
not one of the reasons companies choose to use one method over
the other.
08-53
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LO8-6
LIFO Reserves
LIFO
Reserves
Inventory account
= balance under LIFO
for external
reporting and
income tax purposes
̶
Inventory account
balance under FIFO or
average cost used to
maintain internal
records
•
The LIFO reserve (or LIFO allowance) is reported as a “contra
account” to adjust the balance of inventory from the
internal method to the LIFO method for external reporting
Reasons to maintain internal records other than LIFO
1. The high recordkeeping costs for LIFO
2. Contractual agreements such as bonus or profit sharing plans
that calculate net income with a method other than LIFO
3. Using FIFO or average cost information for pricing decisions
08-54
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LO8-6
LIFO Reserves Journal Entry
The Doubletree Corporation began 2021 with a balance of
$475,000 in its LIFO reserve account. This balance means that
at the beginning of the year, the inventory balance under LIFO
is $475,000 lower than it would be under FIFO. By the end of
2021, assume the difference between LIFO and FIFO inventory
balances is then $535,000. The LIFO reserve is adjusted to
reflect the increase in the reserve. The LIFO reserve has a
normal credit balance, so the entry to increase its balance is:
Cost of goods sold
LIFO reserve ($535,000 − 475,000)
60,000
60,000
08-55
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LO8-6
Disclosure of the LIFO Reserve—
Books-A-Million
Illustration 8–10 provides a disclosure note of McKesson
Corporation. The note shows the company’s inventories valued
at FIFO (the internal method), less the LIFO reserve, to arrive at
the LIFO amount reported in the company’s balance sheet.
Inventories (in part)
($ in millions)
2017
2016
Inventories (at FIFO)
$16,283
$16,347
Less: LIFO reserve
(1,005)
(1,012)
Net inventories (at LIFO)
$15,278
$15,335
In 2017, the LIFO reserve decreased from $1,012 million to
$1,005 million. The $7 million decrease is recorded with a
debit to the LIFO reserve. At the same time, we decrease (or
credit) cost of goods sold, thereby increasing reported profit.
08-56
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LO8-6
LIFO Liquidations
• Under LIFO, the last units purchased are assumed to be
sold first
• In some periods, the number of units sold will be greater
than the number of units purchased
• In these instances, previous years’ layers of inventory are
recorded as sold
• These instances are known as LIFO liquidations
• LIFO liquidations result in old costs being matched with
current selling prices
• If costs have been increasing (decreasing), LIFO
liquidations produce higher (lower) net income
08-57
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LO8-6
LIFO Liquidation
Example: National Distributors, Inc. uses the LIFO inventory method.
The company began the year with inventory of 20,000 units that cost
$16 per unit. During the year, 30,000 units were purchased for $20
each. The cost of goods available for sale is determined as:
Beginning Inventory 20,000 units @ $16 per unit =
Purchases
30,000 units @ $20 per unit =
$320,000
$600,000
Goods avail. for sale 50,000
$920,000
By the end of the year, 45,000 units were sold. Under the LIFO
assumption, cost of goods sold is determined as:
From Beg. Inventory 15,000 units @ $16 per unit =
From Purchases
30,000 units @ $20 per unit =
$240,000
$600,000
45,000
$840,000
Cost of Goods Sold
Ending inventory equals $80,000 (= 5,000 units of beginning inventory
@ $16 per unit).
08-58
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LO8-6
Concept Check: LIFO vs. FIFO
Doyle Corp. adopted the LIFO inventory method in 2021, its first year. Doyle
disclosed that if FIFO had been used, inventory at the end of 2021 would
have been $36 million higher than the inventory determined using the LIFO
method. Assuming Doyle’s income tax rate is 40%:
a.
b.
c.
d.
Its reported cost of goods sold for 2021 would have been $21.6 million
higher if it had used FIFO rather than LIFO for its financial statements
Its reported net income for 2021 would have been $21.6 million higher
if it had used FIFO rather than LIFO for its financial statements
Its reported net income for 2021 would have been $36 million higher if
it had used FIFO rather than LIFO for its financial statements
Its reported cost of goods sold for 2021 would have been $36 million
higher if it had used FIFO rather than LIFO for its financial statements
The correct answer is b:
$36 million × (1 − 0.40) = $21.6 million
08-59
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LO8-7
Decision Makers’ Perspective—
Inventory Management
• Inventory levels are closely monitored to:
– Ensure that the inventories needed to sustain
operations are available
– Hold the cost of ordering and carrying inventories to
the lowest possible level
• Conflicts:
– Companies must maintain sufficient quantities of
inventory to meet customer demand
• Maintaining inventory is costly
• Tools used to balance these conflicting objectives
– Computerized inventory control systems
– Outsourcing of inventory component production
– Just-in-time (JIT) system
08-60
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LO8-8
Methods of Simplifying LIFO
• Limitations of LIFO:
– Recordkeeping costs of unit LIFO can be significant:
• When a company has numerous individual units of
inventory
• When unit costs change often during a period
– Probability of LIFO inventory layers being liquidated
Techniques to Simplify
LIFO
LIFO inventory
pools
Dollar-value
LIFO method
08-61
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LO8-8
LIFO Inventory Pools
• Grouping inventory units into pools based on physical
similarities of the individual units
• Within pools, all purchases during a period are
considered to have been made at the same time and at
the same cost
• Individual unit costs are converted to an average cost
for the pool
• If the quantity of ending inventory for the pool
increases:
Ending
inventory
Beginning
inventory
Single layer added
during the period at the
avg. cost of the pool
08-62
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LO8-8
LIFO Inventory Pools (continued)
Diamond Lumber Company has a rough-cut lumber
inventory pool that includes three types: pine, oak, and
maple. The beginning inventory consisted of the following:
Pine
Oak
Maple
Quantity (Board Feet) Cost (Per Foot) Total Cost
16,000
$2.20
$35,200
10,000
3.00
30,000
14,000
2.40
33,600
40,000
$98,800
Average cost for =
the pool
= $2.47 per board foot
08-63
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LIFO Inventory Pools (cont. 2)
LO8-8
During the next reporting period Diamond purchased 50,000
board feet of lumber. Diamond sold 46,000 board feet during
this period.
Pine
Oak
Maple
Quantity (Board Feet) Cost (Per Foot) Total Cost
20,000
$2.25
$ 45,000
14,000
3.00
42,000
16,000
2.50
40,000
$127,000
50,000
Average cost =
= 2.54
Quantity
(Board Feet)
Beginning inventory
LIFO layer added
Ending inventory
40,000
4,000
44,000
50,000 − 46,000 = 4,000
Cost (Per Foot) Total Cost
$2.47
$ 98,800
2.54
10,160
$108,960
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LO8-8
Dollar-Value LIFO
• The DVL inventory pool is viewed as comprising
layers of dollar value from different years
• A pool that is made up of items that are likely to face
the same cost change pressures
• The inventory is viewed as a quantity of value
instead of a physical quantity of goods
• Companies are allowed to combine a large variety of
goods into one pool
08-65
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LO8-8
Dollar-Value LIFO (continued)
Cost Indexes:
• Objective: To deflate inventory amounts by any increase
in prices so that both the beginning and ending amounts
are measured in terms of the same price level
Cost index in layer year =
Cost in layer year
Cost in base year
08-66
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The DVL Inventory Estimation
Technique
LO8-8
Three-step process
Step 1: Convert ending inventory to base year
costs
Step 2: Identify the layers of ending inventory
created each year
Step 3: Restate each layer using the cost index in
the year acquired
08-67
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LO8-8
The DVL Inventory Estimation
Technique (continued)
Hanes Company adopted the dollar-value LIFO method on
January 1, 2021, when the inventory cost was $400,000. The
2021 ending inventory valued at year-end costs is $462,000,
and the cost index for the year is 1.05 (105%).
Step 1: Convert ending inventory to base year cost.
Ending inventory at base year cost
=
$462,000
1.05
=
$440,000
08-68
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LO8-8
Illustration: The DVL Inventory
Estimation Technique
Step 2: Identify layers of ending inventory created each year.
Ending Inventory at
Date
Base Year Cost
1/1/2021
$400,000
40,000
2021 layer
$440,000
Step 3: Restate each layer using cost index in year acquired.
Ending Inventory at
Ending Inventory
Date
× Cost Index = at DVL Cost
Base Year Cost
1/1/2021
2021 layer
$400,000
$ 40,000
$440,000
×
×
1.00
1.05
=
=
$400,000
42,000
$442,000
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LO8-8
Concept Check: Dollar-Value LIFO
On December 31, 2021, the Burroughs Company adopted the
dollar-value LIFO inventory method. Inventory at the end of
2021 for its only inventory pool was $600,000. At the end of
2022, inventory at year-end cost is $806,400 and the cost index
is 1.05. Inventory at the end of 2022 at dollar-value LIFO cost
is:
a.
b.
c.
d.
$750,000
$768,000
$806,400
$776,400
The correct answer is d:
Step 1: End-of-2022 inventory at end-of-2021 year cost =
$768,000 ($806,400 ÷ 1.05).
Step 2: The increase in the end-of-2021 inventory at endof-2021 dollars is $168,000 ($768,000 − 600,000).
Step 3: Restating layers using cost index in year acquired:
$600,000 × 1.00 = $600,000
$168,000 × 1.05 = $176,400
$776,400
08-70
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LO8-8
Dollar-Value LIFO Advantages
Advantages:
• Simplifies the recordkeeping procedures
• Minimizes the probability of the liquidation of LIFO
inventory layers
• The acquisition of the new items is viewed as
replacement of the dollar value of the old items
08-71
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LO8-9
International Financial Reporting
Standards
U.S. GAAP
IFRS
Inventory Cost Flow Assumptions
LIFO is an acceptable
inventory valuation method
IAS No. 2 does not permit the
use of LIFO
Disclosure note of General Mills providing an example
between U.S. GAAP and IFRS:
Inventories (in part)
All inventories in the United States other than grain are valued at the lower of
cost, using the last-in, first-out (LIFO) method, or market. Inventories outside of
the United States generally are valued at the lower of cost, using the first-in, firstout (FIFO) method, or net realizable value.
08-72
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End of Chapter 8
08-73
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