Chapter 10
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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Inventories: Additional
Valuations Issues
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1. Lower of Cost or Market

Required by GAAP
◦ Inventory must be reported at LCM

Theory
◦ should not report inventory at a value higher
than benefits to be received from selling it
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1a. Lower of Cost or Market

Definition of market
◦ cost to replace the item (replacement cost)
◦ really “lower of cost or constrained market”

Ceiling
◦ market can’t exceed NRV
◦ NRV = selling price – selling costs

Floor
◦ market can’t be lower than NRV less normal profit
◦ floor = NRV – normal profit margin
Can apply to individual items, groups of items, or whole
inventory
 Does not apply to damaged or deteriorated goods

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1b. Lower of Cost or Market

Example
Selling price
Additional selling costs
Normal profit margin
Cost
Current replacement cost
Case A
$58
Case B
$37
Case C
$21
ACCT-3030
$60
$10
40% (of selling price)
$36
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3. Inventory Estimation Methods

Gross profit method
◦ based on relationship between sales and gross
profit
◦ not acceptable for financial reporting or taxes

Retail method
◦ used by large volume retailers
◦ dollar based method – not unit based method
◦ acceptable for financial reporting and taxes
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4. Gross Profit Method

Based on assumptions that
◦ gross profit is constant from period-to-period
◦ sales mix of products is constant

Used to estimate inventory value
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4a. Gross Profit Method

Example
Sales
Cost of goods sold
Gross profit




$200
$120
$ 80
GP % = 80/200 = 40%
CGS% = 120/200 = 60%
GP% on sales = 80/200 = 40%
GP% on cost = 80/120 = 66⅔%
ACCT-3030
GP on Sales =
GP on Costs
1 + GP on Costs
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4a. Gross Profit Method

Example
A hurricane destroyed the entire inventory stored in a
warehouse. The following information is available from
the company’s records.
Beginning inventory
$220,000
Purchases
$400,000
Sales
$600,000
Historical gross profit rate
30%
Required: Estimate the cost of the destroyed inventory.
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4a. Gross Profit Method

Example — Solution
Beginning inventory (from records)
Plus: Net purchases (from records)
Cost of goods available for sale
Less: Cost of goods sold:
Net sales
Less: Estimated gross profit of 30%
Estimated cost of goods sold
Estimated cost of inventory destroyed
ACCT-3030
$220,000
400,000
620,000
$600,000
(180,000)
(420,000)
$200,000
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5. Retail Method
Method is based on the pattern between
the cost and retail value of the goods
 Method requires:

1. total costs of goods purchased
2. total retail value of goods available for sale
3. total sales

Companies always keep 1 & 3
◦ with this method also must keep 2
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5a. Retail Method

Basic method
Cost
Beginning Inventory
Retail
600
1,000
Net Purchases
5,000
8,000
Goods Available for Sale
5,600
9,000
Cost Ratio: 5,600/9,000 = .62222
Sales
7,500
Ending Inventory at Retail
1,500
End Inv at Cost (1,500 x .62222)
933
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5c. Retail Method

Retail terminology
Term

Meaning
Initial markup
Original markup reflected in sales price
Additional markup
Additional increase in selling price after
original markup
Markup cancellation
Elimination of additional markup
Markdown
Reduction in selling price below original
selling price
Markdown cancellation
Elimination of markdown
Net markups and netACCT-3030
markdowns
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5b. Retail Method

Ratios – computed as:
cost of goods available for sale
retail value of goods available for sale

Based on how ratio computed, can be used
to approximate following methods:
◦
◦
◦
◦
average – include everything
LCM – exclude markdowns (conventional retail method)
FIFO – exclude beginning inventory
LIFO – compute separate ratio for each layer
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5d. Retail Method
Cost
Retail
Beginning Inventory
+
+
Purchases
+
+
Purchases Returns
-
-
Purchases Discounts
-
Freight-In
+
Net Markups
+
Net Markdowns
-
Available for Sale
X
X
Sales
-
Sales Returns and Allow.
+
Sales Discounts
+
Ending Inventory at Retail
X
Ending Inventory at Cost
X
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5e. Retail Method
Avg.
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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+
X
+
+
X
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5f. Retail Method
LCM
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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+
X
+
+
X
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5g. Retail Method
FIFO
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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+
X
+
+
X
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5h. Retail Method
•Example
Cost
Retail
Beginning Inventory
195,000
400,000
Net Purchases
300,000
450,000
Net Markups
50,000
Net Markdowns
<20,000>
Available for Sale
495,000
880,000
Net Sales
407,000
Ending Inventory at Retail
473,000
Ending Inventory at Cost
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