Chapter 8
Valuation of Inventories:
A Cost-Basis Approach
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1. Introduction

Definition
◦ Assets held for sale in the ordinary course of business or goods that
will be consumed in production


Importance
Cost of inventory
◦ all expenditures necessary in acquiring goods and converting them to
saleable condition


Cutoff
Who owns inventory if “sale” is a(an)
 product financing arrangement, installment sale, consignment, sales with
high rates of return
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2. Inventory Systems

Periodic system
◦
◦
◦
◦
no running balance of inventory & CGS
purchases account used
beginning inv balance unchanged during year
take physical inventory at year-end and record
ending balance through adjusting entry
◦ CGS calculated

CGS format
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2a. Inventory Systems

Perpetual system
◦ keeps running balance of inventory & CGS
◦ no purchases account used
◦ all changes in inventory cost recorded in
inventory account
◦ take physical inventory at year-end & adjust
book balance to actual
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2b. Inventory Systems
Periodic & perpetual entries
 Net and gross methods of recording

1.
2.
3.
4.
purchase merchandise, $1,200; 2/10,n/30
return merchandise, $200
sell remainder for $1,800
pay above
a. within discount period
b. after discount period
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2c. Inventory Systems

Periodic inventory system YE adjusting
entry
◦ Account balances
Account
Balance
Inventory, January 1
1,000
Inventory, December 31
1,500
Purchases
4,000
Purchases Returns and
Allowances
300
Purchases Discounts
50
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2c. Inventory Systems

Periodic inventory system YE adjusting
entry
Account
Dr
Inventory, December 31
Cr
1,500
Purchases Returns and
Allowances
300
Purchases Discounts
50
CGS
3,150
Purchases
4,000
Inventory, January 1
1,000
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3. Inventory Cost Flow Assumptions

Problem
◦ purchases made at different prices


Flow of costs v. flow of goods
Four GAAP methods
◦
◦
◦
◦
specific identification
FIFO
LIFO
average
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3a. Inventory Cost Flow Assumptions

Specific identification
◦ only used if relatively small number of high
priced goods that can be easily distinguished
◦ can manipulate income
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3b. Inventory Cost Flow Assumptions

FIFO
◦ assume goods used in order purchased
◦ ending inventory approximately at current
costs
◦ CGS at old prices
◦ periodic and perpetual systems always give
same result
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3c. Inventory Cost Flow Assumptions

LIFO
◦ assumes last goods purchased are first sold
◦ advantages
 matches current costs with revenues
 tax benefits
 improved cash flow
◦ disadvantages





reduction in reported earnings
understatement of ending inventory on bal. sheet
does not reflect underlying physical flow of goods
causes poor buying habits
can manipulate income
◦ LIFO conformity rule
 must use LIFO for financial reporting if used for tax reporting
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3d. Inventory Cost Flow Assumptions

Average cost
◦ weighted average or moving average used
◦ values goods based on average cost of goods on
hand and acquired

Other methods
◦
◦
◦
◦
base stock
standard cost
NIFO
LIFO/FIFO
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3e. Inventory Cost Flow Assumptions

Comparison of methods
(during periods of rising prices)
Ending
Inventory
CGS
Net Income
FIFO
highest
lowest
highest
LIFO
lowest
highest
lowest
in middle
in middle
in middle
Method
Average
What would be the differences between the methods if all units had
the same cost?
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3f. Inventory Cost Flow Assumptions

Example of methods
Date
Action
Units
Unit Price
Total Price
Jan 1
Beg. Inv.
2,000
$ 9.775
$ 19,550
Jan 6
Purchase
1,500
$ 10.300
$ 15,450
Jan 7
Sale
1,800
Jan 26
Purchase
3,400
$ 10.750
$ 36,550
Jan 31
Sale
3,200
Total
$ 71,550
Calculate the value of ending inventory under FIFO, LIFO, and
average for both the periodic and perpetual systems.
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4. Special issues related to LIFO

Inventory Pools
◦ Unrealistic to assume only one product
◦ If multi product
 replace one item with another – loose base layer of
LIFO cost
◦ Pooled approach
 group similar items together
 reduces record keeping costs
 more difficult to erode old LIFO layers
◦ Number of pools?
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4. Special issues related to LIFO

LIFO reserves
◦ maintain internal records using FIFO
◦ adjust to LIFO at year end
Cost of goods sold
Allow to reduce
inventory to LIFO
xxx
xxx
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5. Dollar Value LIFO

Introduction
◦ emphasis is on dollar value of inventory
 not units of inventory
◦ greatly reduces problem of changes in mix of
inventory
◦ more practical method of valuing multi-product
inventory than unit LIFO
◦ allowed for financial reporting and tax
◦ LIFO conformity rule
 must use LIFO for financial reporting if used for tax
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5a. Dollar Value LIFO

Basics of method
1. when first adopt method (base year) value ending
inventory at current costs (FIFO)
2. end of each subsequent year, value ending inventory
at current costs (FIFO)
3. then restate current year-end cost to price level in
base year
4. a new layer formed when EI (in base year $)
exceeds base year cost of BI

increase priced at current costs
5. if EI (in BY$) is less than BI (in BY$), the decrease is
subtracted from most recent layer
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5b. Dollar Value LIFO

Price index
◦ company may calculate own
 double extension method or link-chain method
◦ may use published price indexes
 e.g., GNP implicit price deflator, CPI, or industry
specific index
◦ example using market basket approach
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5c. Dollar Value LIFO

Example
Year
End Inv (FIFO)
Price Index
2011
$ 300,000
100
2012
$ 363,000
110
2013
$ 420,000
120
2014
$ 430,000
125
Calculate ending inventory using dollar value LIFO for each
year.
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6. Effect of errors

Self-correcting errors
◦ most errors correct themselves over time
 e.g., inventory – this year’s ending inventory is next
year’s beginning inventory
 depreciable assets – over the life of the assets
◦ but each year is incorrect over that period

Permanent errors
◦ never will correct themselves
◦ e.g., expensing land, recording wrong amount
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6a. Inventory Errors

Overstatement of ending inventory
◦ Understates cost of goods sold
◦ Overstates income

Understatement of ending inventory
◦ Overstates cost of goods sold
◦ Understates income

Overstatement of beginning inventory
◦ Overstates cost of goods sold
◦ Understates income

Understatement of beginning inventory
◦ Understates cost of goods sold
◦ Overstates income
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6b. Effect of errors

Determining effect of errors
◦ determine effect for all accounts involved
◦ examples
 ending inventory overstated
 interest expense not accrued on N/P this year, next
year principle and interest paid in full
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