Chapter 8
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Chapter 8: Valuation of Inventories: A Cost Basis Approach
Course Objectives:
 Review the Accounting Cycle and Financial Statements: Chapters 1-5 √
 Introduce the Concept of the time value of money: Chapter 6 √
 Discuss accounting for:
o Cash: Chapter 7 √
o Receivables: Chapter 7 √
o Inventory: Chapter 8 and 9
1) Inventory Classification and Control:
a Classification (see financial statement presentation in Illustration 8-1, p369):
i) Inventory: goods available for resale. (For manufacturing company, inventory includes: Raw
Materials, Work-in-Process, and Finished Goods.)
b
ii) Merchandising Company: ___________________ goods/inventory ___________________.
(e.g., Walmart, Eddie Bauer, etc.)
iii) Manufacturing Company: ___________________goods/inventory ____________________.
(e.g., Boeing, ExxonMobil, BMW, etc.)
iv) Raw Materials Inventory: Items in inventory that will be components of a produced good.
v) Work in Process Inventory: Partially completed inventory units at the end of an accounting
period (e.g., a table without legs.) Includes total cost to date. That is, include direct material,
direct labor, and factory overhead (fixed and variable).
vi) Finished Goods Inventory: Amount of manufactured product on hand that awaits sale to
customers.
Control:
i) Perpetual System:
(1) Maintain continuous record of changes in inventory
(2)
(as a result of everything – e.g., purchases, freight-in, purchase returns and allowances, and
purchase discounts -- directly entering Inventory account.)
(3)
(4) Maintain subsidiary ledger showing quantity and cost of each type of inventory on hand.
Physical count compare to accounting records. Determine shortages or overages in
inventory.
If the physical inventory is lower than the inventory account, the following entry is made:
If the physical inventory is higher than the inventory account, the following entry is made:
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Perpetual inventory overages/shortages generally represent a misstatement of COGS. The
difference is the result of normal and expected shrinkage, breakage, shoplifting, incorrect
record keeping, etc. Inventory Over and Short would therefore be an adjustment to COGS.
In practice, the account Inventory Over and Short is sometimes reported in “Other
revenues and gains” or “Other expenses and losses” section of the income statement,
depending on its balance.
ii) Periodic System:
(1) Quantity of Inventory on hand is determined______________________.
(2) Purchases:
(3) Cost of Goods Available for Sales = Beginning Inventory + Purchases.
(4) Cost of Goods Sold = Cost of Goods Available for Sale – Ending Inventory. (Note:
COGS is a residual amount dependent upon a physical count of ending inventory.)
(5) Physical Inventory Count: Required under periodic system (also performed under
perpetual system.)
Should be taken as close to end of fiscal year as possible. (If not possible, it is acceptable
to use physical inventories taken close to year-end and keep detailed inventory records to
reconcile to year-end.)
(6)
There are no accounting records available against which to compare the physical count.
Thus, inventory overages and shortages are buried in COGS.
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iii) Comparison of Journal Entries for each method:
Periodic
To purchase inventory item:
Perpetual
To purchase inventory item:
To make a return:
To make a return:
To record a sale: (1 entry)
To record a sale: (2 entries)
End of the year:
End of the year:
Additional accounts:
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2) Basic Issues in Inventory Valuation:
a Formulas:
b
Valuation of inventories can be complex process that requires determining: (Each of the items
listed below is discussed in more detail in the following sections .)
i) Physical goods included in inventory:
(1) Goods in Transit.
(2) Consigned Goods.
(3) Special Sales Agreement.
ii) Cost of goods in inventory:
(1) Product vs. Period costs.
(2) Treatment of purchase discounts.
iii) Cost flow assumption adopted:
(1) Specific identification.
(2) Average cost.
(3) FIFO.
(4) LIFO.
(5) Retail.
3) Physical Goods Included in Inventory: (Make sure you understand each of these items from the
view of the seller AND the buyer.)
a Goods in Transit: Goods to which legal title has passed should be recorded as purchases of the
fiscal period on buyer’s books.
i) FOB Shipping Point:
Example: 12/31 FOB Shipping Point, you (the buyer) have not received goods that have been
delivered to common carrier: ___________________________________________________
ii) FOB Destination:
Example: 12/31 FOB Destination, you (the buyer) have not received goods that have been
delivered to common carrier:
__________________________________________________________________________
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iii) Example (Brief Exercise 8-3, page 400):
Mayberry Company took a physical inventory on December 31 and determined that goods
costing $200,000 were on hand. Not included in the physical count were $15,000 of goods
purchased from Taylor Corporation, f.o.b. shipping point, and $22,000 of goods sold to Mount
Pilot Company for $30,000, f.o.b. destination. Both the Taylor purchase and the Mount Pilot
sale were in transit at year-end. What amount should Mayberry report as its December 31
inventory?
b
c
d
Consigned Goods:
i) The owner (consignor) transfers physical goods to agent (consignee) for purposes of selling
without giving up ownership.
___________________________________________________________________________
ii) When consignee sells goods, the revenue, less a selling commission and expenses incurred in
accomplishing sale, is remitted to consignor.
Special Sales Agreements: See text pages 374 to 375.
i) Sales with Buyback Agreement:
ii) Sales with High Rates of Return:
iii) Sales on Installment:
If we are holding goods that customer has purchased and will pick up at his/her convenience, these
goods are NOT included in our inventory.
HOMEWORK: You should now be able to work E8-1, E8-2, and P8-1.
e
Effect of Inventory Errors:
i) Ending Inventory Misstated:
What would happen if beginning inventory and purchases are recorded correctly, but some
items are not included in ending inventory?
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See Illustration 8-6 included on page 375 and Illustration 8-7 in text on page 376.
In this situation, we would have the following effects on the financial statements at the end of
the period.
Note: U= understated, O= overstated, NE= no effect
BI
+ Purchases
= GAS
- EI
= COGS
Sales
- COGS
= Gross Profit
- Other expenses
= Net Income
Balance Sheet
Inventory (Assets)
Retained earnings
Beginning RE
+ NI
+Investments
- W/D
= Ending RE
Income Statement
Cost of goods sold
Net income
ii) Think of other situations where other items are misstated. How do these situations affect the
B/S and I/S?
For example, if ending inventory is overstated, the reverse of the above situation occurs.
Yr 1
BI
+ Purchases
= GAS
- EI
= COGS
Yr 2
Yr 1
Sales
- COGS
= Gross Profit
- Other expenses
= Net Income
Yr 2
Yr 1
Beginning RE
+ NI
+Investments
- W/D
= Ending RE
Yr 2
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iii) Purchases and Inventory Misstated: Suppose goods are not recorded as purchases and not
included in ending inventory. (Note net income is not affected b/c purchases and ending
inventory are both understated by the same amount the error thereby offsetting itself in cost of
goods sold.)
BI
+ Purchases
= GAS
- EI
= COGS
Sales
- COGS
= Gross Profit
- Other expenses
= Net Income
Beginning RE
+ NI
+Investments
- W/D
= Ending RE
Balance Sheet
Income Statement
Inventory
Cost of goods sold
Retained earnings
Net income
Accounts payable
Purchases
iv) Think of other situations where other items are misstated. How do these situations affect the
B/S and I/S?
For example, if both purchases (on account) and ending inventory are overstated, then the
effects on the balance sheet are exactly the reverse: Inventory and A/P are overstated. COGS
and net income are not affected b/c the errors offset one another.
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v) Example: The company uses the periodic system. A purchase of merchandise on account for
$1,000 in 2005 was not recorded until 2006, although the merchandise was included in 2005
ending inventory.
Entry NOT made:
Beginning Inventory
+ Purchases
= GAS
- EI
= COGS
2005
2006
NE
O $1,000
O $1,000
NE
O $1,000
Sales
- COGS
= GP
- Other exp
= NI
NE
O $1,000
U $1,000
NE
U $1,000
ASSETS
LIABILITIES
Owners’ EQUITY
NE (EI is ok)
NE
NE
Beginning OE (yr 1)
Beginning A/P (yr 1)
+ Net Income (yr 2)
A/P (yr 2)
Ending OE
End A/P
vi) Example: A company using a perpetual system failed to record a sale of $1,000 on account in
2005. Mark-up on cost is 100%.
Error – Entry Not Made:
Assets:
Income:
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Example (Brief Exercise 8-4, page 400):
Gavin Bryars Enterprises reported cost of goods sold for 2007 of $1,400,000 and retained
earnings of $5,200,000 at December 31, 2007. Gavin Bryars later discovered that its ending
inventories at December 31, 2006 and 2007, were overstated by $110,000 and $45,000,
respectively. Determine the corrected amounts for 2007 cost of goods sold and December 31,
2007, retained earnings.
Cost of goods sold as reported
$1,400,000
12/31/07 retained earnings as reported
$5,200,000
‘06
‘07
‘06
‘07
‘06
BI
Sales
Beginning RE
+ Purchases
- COGS
+ NI
= GAS
= Gross Profit
+Investments
- EI
- Other expenses
- W/D
= COGS
= Net Income
= Ending RE
‘07
HOMEWORK: You should now be able to work E8-10 and E8-12.
4) Costs Included in Inventory:
a Product Costs: Costs to purchase/produce inventory and bring it to a condition and location for
sale. (For example: freight in, labor, storage costs, handling charges)
b Period Costs: Selling expenses and G&A expenses not directly related to acquisition or
production of goods.
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c
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Treatment of Purchase Discounts:
i) Purchase Discounts:
ii) Purchase Discounts Lost:
In this case, the failure to take a purchase discount within the discount period is recorded in a
Purchases Discounts Lost account (for which mgmt is responsible.) Purchase Discounts Lost
is an expense in the “Other expenses and losses” section of the income statement.
See journal entries on page 379, Illustration 8-10.
HOMEWORK: You should now be able to work E8-7, E8-8, and P8-3.
5) What Cost Flow Assumption Should Be Adopted?
a Specific Identification: Cost of specific items sold is in COGS and cost of specific items on hand
is in inventory. Typically used for small quantity inventory, high priced items (e.g., jewelry, cars).
Average Cost, FIFO, and LIFO are common methods. Does not necessarily reflect physical flow
of goods. Method selected should (does not have to) reflect how Income is actually earned (e.g.,
bakery  FIFO.)
EXAMPLE: This example will be used for each of the methods.
January 1
January 8
January 10
January 25
January 29
January 31
Beginning
Inventory
Purchases
Sale
Purchases
Purchases
Sale
Goods Available
for Sale (BI +
Purchases)
COGS
Ending
Inventory (GAS
– COGS)
# Units
200
1,000
900
300
400
300
1,900
1,200
700
Cost
$7
Total
$1,400
$8
$8,000
$9
$10
$2,700
$4,000
$16,100
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b
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Average Cost: Prices items in inventory based on average cost of all similar goods available
during the period.
i) Periodic: example uses weighted average.
Note: When we use weighted average, we must wait until the end of the period to determine
price.
ii) Perpetual: example uses moving average.
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c
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First-In, First-Out (FIFO):
Advantages: EI valued at most recent costs. If rising prices, Net Income is higher.
Disadvantages: Fails to match current costs with current revenue. If Net Income higher, higher
taxes, too.
*NOTE:
i) Periodic:
ii) Perpetual:
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d
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Last-In, First-Out (LIFO):
Few physical flows of goods actually match this method (e.g., gravel company, coal mining
company)
Advantages: Matches current costs with current revenues. Periods of rising prices = higher
COGS  lower Net Income  lower taxes.
Disadvantages: Inventory valued using outdated costs (affect financial ratios). Allows income
manipulation.
(See further discussion of Advantages/Disadvantages in section 6 below.)
i) Periodic:
ii) Perpetual:
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e
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Using the examples above, what types of relationships can we see in this period of rising
costs? Obviously, the relationships would be the opposite in periods of declining costs.
i)
ii)
f
Example (Brief Exercise 8-5, p 400): Note: Use the same info for BE8-6 and BE8-7.
Jose Zorilla Company uses a periodic inventory system. For April, when the company sold 700
units, the following information is available.
Units Cost Total Cost
April 1 inventory
250 $10
$2,500
April 15 purchase
400 $12
$4,800
April 23 purchase
350 $13
$4,550
1,000
$11,850
Compute the April 30 inventory and the April COGS using the average cost method.
Weighted Average Cost Per Unit:
Ending Inventory: 300 units (1,000 – 700)
Cost of goods available for sale
Deduct ending inventory
COGS
g
Example (Brief Exercise 8-6, p400):
Data for Jose Zorilla Company are presented in BE8-5. Compute the April 30 inventory and the
April COGS using FIFO method.
Sold 700 units; start with 1st units when calculating sales under FIFO:
Units Sold
COGS
Ending Inventory
4/1
250
4/15 400
4/23 350
Total COGS
Total EI
h
Example (Brief Exercise 8-7, p400):
Data for Jose Zorilla Company are presented in BE8-5. Compute the April 30 inventory and the
April COGS using LIFO method.
Sold 700 units; start with last units when calculating sales under LIFO.
Units Sold
COGS
Ending Inventory
4/1
250
4/15 400
4/23 350
Total COGS
Total EI
HOMEWORK: You should now be able to work E8-13, E8-16, E8-20, P8-4, and P8-5.
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6) Special Issues Related to LIFO:
a LIFO Reserve (or Allowance to Reduce Inventory):
i) LIFO effect: Change in the allowance balance from one period to the next. The LIFO effect is
the adjustment that must be made to the accounting records in a given year.
Example Entry:
ii) Reporting:
b
c
iii) Disclosure: Either the LIFO reserve or the replacement cost of inventory should be disclosed.
LIFO Liquidation:
i) Prior discussion of LIFO has focused on specific goods approach to costing LIFO inventories.
ii) LIFO Liquidation defined: Erosion of the LIFO inventory, which often leads to distortions of
net income and substantial tax payments. When a company uses LIFO, the most recent layer
(e.g., current year) is liquidated first, followed by the preceding year, etc.  If we get to the
“old” years, costs from prior periods are being matched against sales revenues reported in
current dollars. This distorts net income and causes higher taxes.
iii) Specific Goods Pooled LIFO Approach: A pool of similar units/products are combined and
accounted for together. Under this method, LIFO liquidations are less likely.
Disadvantages:
(1) Most companies continually change product mix. As a result of these changes, pools
would need to be redefined on a regular basis. This is costly and time consuming.
(2) Erosion (LIFO liquidation) of layers often still results and much of LIFO costing benefits
are lost.
Dollar-Value LIFO:
i) General: Increases/Decreases in pool are determined and measured in terms of total dollar
value, not the physical quantity of goods in inventory pool.
(1) Advantages over specific goods pooled approach:
(a) A broader range of goods may be included in dollar-value LIFO pool.
(b) Replacement is permitted if it is a similar material/similar in use/interchangeable.
(Under the pooled method, an item may be replaced only with an item that is
substantially identical.)
(2) Helps protect LIFO layers from erosion.
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ii) Dollar-Value LIFO Illustration: Book example on page 388.
Information Given:
Dollar-value LIFO adopted on 12/31/06
Beginning Inventory $20,000
Inventory valued at current prices, 12/31/07
Ending Inventory
$26,400
Assume prices have increased 20%
Calculations:
Ending Inventory at beginning of the year prices:
Increase in Inventory quantity:
Price real-dollar quantity increase:
First layer - (beginning inventory) in terms of ____
Second layer - (2007 increase) in terms of ____
Dollar-value LIFO inventory, 12/31/07
NOTE: A layer is formed only when the ending inventory at base-year prices exceeds the
beginning inventory at base-year prices. A new index must be computed only when a new
layer is formed.
iii) Comprehensive Dollar-Value LIFO Illustration: Refer to text pages 389 - 390. KNOW
HOW TO WORK THIS PROBLEM!!!
iv) Example (Brief Exercise 8-8, p400):
Easy-E Company had ending inventory at end-of-year prices of $100,000 at December 31,
2005; $123,200 at December 31, 2006; and $134,560 at December 31, 2007. The year-end
price indexes were 100 at 12/31/05, 110 at 12/31/06, and 116 at 12/31/07. Compute the
ending inventory for Easy-E Company for 2005 through 2007 using the dollar-value LIFO
method.
Also, work BE8-9 on your own.
HOMEWORK: You should now be able to work E8-20, E8-22, E8-25, E8-26, P8-8, and P810.
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v) Selecting a Price Index:
(1) Many companies use the general price-level index prepared/published monthly by federal
government.
(2) Most popular general external price-level index is Consumer Price Index for Urban
Consumers (CPI-U).
(3) Companies may compute its own specific internal price index.
(4) Price index provides measure of change in price levels b/t base year and current year.
(5) General Index Formula:
Ending Inventory for the Period at Current Cost
---------------------------------------------------------Ending Inventory for Period at Base-Year Cost
= Price Index for Current Year
This approach is generally referred to as double-extension method. This is time
consuming and difficult where substantial technological change has occurred or where a
large number of items is involved. See illustrations in text on page 391.
d
e
f
Comparison of LIFO Approaches:
Dollar-value LIFO is the method employed by most companies that currently use a LIFO system.
Problem Areas:
What to include in a pool. (Important b/c manipulation of items in pool w/o conceptual
justification can affect net income.
Major Advantages of LIFO:
i) Matching:
ii) Tax Benefits/Improved Cash Flow:
(1) Main reason method is popular.
(2) As long as prices increase and inventory quantities do not decrease, a deferral of income
tax occurs, b/c the items most recently purchased at higher price levels are matched against
revenues.
(3) LIFO conformity rule: Tax law requires that if a company uses LIFO for tax purposes, it
must also use LIFO for financial accounting purposes.
iii) Future Earnings Hedge:
Major Disadvantages of LIFO Approaches:
i) Reduced Earnings:
ii) Inventory Understated:
iii) Physical Flow:
iv) Involuntary Liquidation/Poor Buying Habits:
7) Basis for Selection of Inventory Method:
a General:
i) Concern about reduced income resulting from adoption of LIFO is not as problematic as it
used to be b/c IRS relaxed LIFO conformity rule which required a company that employed
LIFO for tax to use it for financial accounting reporting. IRS relaxed restrictions against
providing non-LIFO income numbers as supplementary info. Thus, profession permits
supplemental non-LIFO disclosure but not on face of income statement. This may be useful
info in comparing operating income and working capital with companies not using LIFO.
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b
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ii) Relaxation of conformity rule has led more companies to select LIFO as their method b/c they
will be able to disclose FIFO income numbers in financial reports.
iii) Variety of inventory methods are allowed to assist in accurate net income computation. They
were not developed to allow manipulation of reported income. Once a method is selected, it
should be used consistently. Serious consideration should be considered before switching
methods. Explanations for change and effect should be disclosed in financial statements.
Inventory Valuation Methods – Summary Analysis:
i) Look at Illustration 8-30 (p 397):
ii) Look at Illustration 8-31 (p 397):