Chapter 10--Learning Objectives
1. Explain the importance of inventory
for asset valuation and income
measurement
Inventories are a significant asset for
many businesses
Inventories affect income
Sales
Beginning inventory
Purchases
Goods available for sale
Ending inventory
Cost of goods sold
Gross profit
Operating expenses
Net income
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Chapter 10--Learning Objectives
2.
Understand the nature of inventory
and what is included in it
Types of inventory
1. Assets held for sale (or resale) in the
ordinary course of business
2. Assets used or consumed in the
production of goods to be sold in the
ordinary course of business
A retail store
(Sears, Wal-Mart, Safeway)
Has inventory for resale to customers
A manufacturer
(Ford, IBM, Exxon)
Has inventories used or consumed in the
production of goods for sale
A manufacturer’s inventories
will usually include
Raw materials inventory
Items used in producing the product
Work in process inventory
Products started but not yet completed
Finished goods inventory
Products completed but not yet sold
What about this F.O.B. stuff ?
“F.O.B.” means “free on board” and refers to the
time and place at which the goods were turned over
to the transportation carrier
If you are in Los Angeles
and your supplier is in New York City
Them
You
If you are in Los Angeles
and your supplier is in New York City
Them
You
Somebody has to pay for moving the goods
across the country
If you are in Los Angeles
and your supplier is in New York City
Them
You
And somebody owns the goods while they are
moving across the country
The F.O.B. designation determines who
that “somebody” is
Them
You
If the goods are shipped F.O.B. New York
(or F.O.B. origin)
Them
You
You will pay the transportation cost
and you will own the merchandise
once it is turned over to the carrier in NYC
If the goods are shipped F.O.B. Los Angeles
(or F.O.B. destination)
Them
You
The supplier will pay the transportation cost
and they will own the merchandise
until in reaches you in Los Angeles
The owner of the goods
Is usually the entity that should include
those goods in inventory
This applies to goods in transit
and to consignment situations
But there are exceptions for some
special sales agreements
An interesting situation arises
in purchase commitments
These are noncancellable, long-term contracts to
purchase goods at a set price
You might enter into such an agreement to buy a
product if you thought its price was about to go up
If the price does go up, everything is cool and you
will make lots of money
But if the price goes down, you have an economic
problem and an accounting problem
The Oliver Peck Oil Company
(O. Peck for short)
Thinking that the price of gas is about
to increase
Peck signs a contract during 19X1 to
purchase 100,000 gallons of gas
during 19X2 at $1.00 per gallon
On December 31, 19X1,
gas is selling for $.94
Since Peck has agreed to pay $1.00 per gallon,
accounting conservatism mandates:
December 31, 19X1
Est. Loss on Purch. Commit.
6,000
Est. Liab. on Contract
6,000
This reduces Peck’s income and increases his
liabilities
Assume that on the April 1, 19X2,
delivery date, gas is selling for $.90
Since Peck has agreed to pay $1.00 per gallon, there
is an additional loss:
April 1, 19X2
Purchases
90,000
Est. Liab. on Contract
6,000
Loss on Purchase Contract
4,000
Cash
100,000
Now assume that on the April 1, 19X2,
delivery date, gas is selling for $.98
Peck must still pay $1.00, but the situation has
improved since December 31:
April 1, 19X2
Purchases
98,000
Est. Liab. on Contract
6,000
Recovery on Contract
4,000
Cash
100,000
Now assume that on the April 1, 19X2,
delivery date, gas is selling for $1.05
This is what Peck was planning on, but the purchase
is recorded at $1.00 and lower cost of goods sold
will give Peck higher profits when the gas is sold
April 1, 19X2
Purchases
100,000
Est. Liab. on Contract
6,000
Recovery on Contract
6,000
Cash
100,000
Chapter 10--Learning Objectives
3.
Differentiate between perpetual and
periodic inventory measurement
systems
In a periodic inventory system
Purchases of goods for resale are recorded in a
“Purchases” account:
Purchases
Cash or Accts. Payable
XXX
XXX
In a periodic inventory system
Recording sales of merchandise is simple:
Cash or Accts. Receivable
Sales
XXX
XXX
In a periodic inventory system
An adjusting entry closes out the beginning
inventory and purchases accounts and records the
cost of goods sold and ending inventory
Inventory (ending)
Cost of Goods Sold
Inventory (beginning)
Purchases
XXX
XXX
XXX
XXX
In a perpetual inventory system
Purchases of merchandise for resale are recorded in
the “Inventory” account
Inventory
Cash or Accts. Payable
XXX
XXX
In a perpetual inventory system
Recording sales is more complicated:
Cash or Accts. Receivable
Sales
Cost of Goods Sold
Inventory
XXX
XXX
XXX
XXX
The first entry records the sale at the selling price,
just like in a periodic system
In a perpetual inventory system
Recording sales is more complicated:
Cash or Accts. Receivable
XXX
Sales
XXX
Cost of Goods Sold
XXX
Inventory
XXX
The second entry removes the cost of the
merchandise sold from the “Inventory” account and
transfers it to “Cost of Goods Sold”
In a perpetual inventory system
No end-of-period adjustment is required if the actual
inventory cost matches the balance in the
“Inventory” account:
Inventory
XXX
In a perpetual inventory system
If items are missing, an adjustment is made to
change the “Inventory” balance to reflect reality:
Inventory Shrinkage
Inventory
XXX
XXX
“Inventory Shrinkage” is treated as an expense
account, but is often included in “Cost of Goods
Sold” in practice
Inventory shrinkage
can be a result of
Theft
Spoilage
Accidental breakage
Mistakenly thrown away
and other causes
Occasionally, a business will have
more inventory than the records
indicate
Pete’s
Rabbit
Farm
Occasionally, a business will have
more inventory than the records
indicate
Pete’s
Rabbit
Farm
Chapter 10--Learning Objectives
4.
Record and report inventories for
different valuation systems
Inventory cost flow assumptions
Picture five items
identical except for cost
acquired in the order indicated
1-2-3-4-5
1
2
3
4
5
$11
$12
$13
$14
$15
Inventory cost flow assumptions
The total cost of the five items is $65
($11 + 12 + 13 + 14 + 15 = $65)
Assume that three items are sold for $25 each
(total sales revenue = $75)
and that two are on hand at the end of the
period
1
2
3
4
5
$11
$12
$13
$14
$15
Specific identification
The actual items sold are recorded
These might be items 1, 3 and 5
Leaving items 2 and 4 in inventory
The cost of items 2 and 4 is $26
2
4
$12
$14
Specific identification
Sales revenue
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross profit
$75
$65
26
$39
$36
2
4
$12
$14
First-in, first-out ( FIFO )
The first three items would be the items sold-items 1, 2 and 3
Leaving items 4 and 5
The cost of items 4 and 5 is $29
4
5
$14
$15
First-in, first-out ( FIFO )
Sales revenue
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross profit
$75
$65
29
$36
$39
4
5
$14
$15
Last-in, first-out ( LIFO )
The last three items (3, 4 and 5) would be the
items sold
Leaving items 1 and 2
The cost of items 1 and 2 is $23
1
2
$11
$12
Last-in, first-out ( LIFO )
Sales revenue
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross profit
1
2
$11
$12
$75
$65
23
$42
$33
Average cost
The total cost of the five items is $65
So the average cost per item is $13
It doesn’t matter which items are sold and
which remain
The cost of the ending inventory is $26
?
?
Average cost
Sales revenue
Goods available for sale
Less: Ending inventory
Cost of goods sold
Gross profit
?
?
$75
$65
26
$39
$36
Note that in this period of rising prices
the gross profits were:
FIFO
Average
LIFO
$ 39
36
33
LIFO results in a higher cost of goods sold and a
lower gross profit because the higher cost of the
last items purchased is being matched against
revenues
LIFO will also result in a lower income tax in a
period of rising prices
Lower of cost or market
(LCM)
INVENTORY
IS
PURCHASED
AT
COST
THERE IS
NO PROBLEM
IF THE VALUE
INCREASES
Lower of cost or market
(LCM)
INVENTORY
IS
PURCHASED
AT
COST
THERE ARE
PROBLEMS
IF THE
VALUE
GOES DOWN
A decline in inventory value...
Creates an accounting problem
Means that you will lose your shirt
Our job is to solve the
accounting problem
Any adjustment of inventory value
Must be below the ceiling
And above the floor
The Ceiling is
Net Realizable Value (NRV)
What we expect to get less costs of
completion and disposal
The Floor is
NRV less normal profit margin
Net realizable value less
what we would expect to
make on a similar item
We must remain between
the ceiling and the floor
In the real world
We know what cost was
We can usually get a replacement cost
figure
We have to estimate net realizable value
You never know for sure until it’s
actually sold
Lower of cost or market
Can be applied three ways:
1.
2.
3.
To each inventory item separately
To each category of items in the
inventory
To the inventory as a whole
Probably the best way to apply
lower of cost or market
Is the allowance method. The initial
application entry would be:
Holding Loss
Allowance to reduce
inventory to market
XXX
XXX
The “Allowance” account appears on the balance
sheet as a contra account to inventory
Chapter 10--Learning Objectives
5.
Estimate inventories using various
methods
The gross profit method
Good news
Simple
Quick
Cheap
Bad news
Depends on old data relationships
May not be any good in a changing situation
Recall that...
Amount
Sales $100
Less: Cost of goods sold
Equals: Gross profit
70
$ 30
These numbers can be expressed as
percentages of sales
In this case, the percentages are:
Amount
Sales $100
100
Less: Cost of goods sold
70
Equals: Gross profit
$ 30
Pct.
70
30
Knowing the cost of goods sold percentage
and some other facts allows us to estimate
inventory
Assume that the following are known:
Beginning inventory
Purchases
Sales revenue
Cost of goods sold percentage
$ 40,000
480,000
700,000
70%
These items would be available from the
accounting records and prior year
statements
Using the known data
Beginning inventory
Plus: Purchases
Equals: Goods avail. for sale
Sales x CGS %
($700,000 x .70) =
Estimated ending inventory
$ 40,000
480,000
$520,000
490,000
$ 30,000
The retail method
Overcomes the problems of the gross profit method,
but is more trouble
Some more trouble in the classroom
Considerably more trouble in the real world
Requires keeping two sets of sales records
One at cost (which would be done anyway)
Another at retail
Based on the relationship between goods available
for sale at cost and at retail
Retail method example
Cost Retail
Beginning inventory
$ 6,000 $10,000
Purchases
48,000 80,000
Goods available for sale
$54,000 $90,000
Cost / Retail ratio for
Goods available for sale
( $54,000 / $90,000 ) = .60
Retail method example
Goods available for sale
Less: Sales
Ending inventory at retail
Cost / retail ratio
Ending inventory at cost
Cost Retail
$54,000 $90,000
70,000
$20,000
.60
$12,000
Retail method terminology
Markup--Amount by which original sales price
exceeds cost--also called normal profit
Additional markup--Amount added to original sales
price
Markup cancellation--Cancellation of all or part of
the additional markup
Net markup--Additional markup less the markup
cancellation
More retail method terminology
Markdown--Amount subtracted from the original
sales price
Markdown cancellation--Cancellation of all or part
of the markdown. Markdown cancellation cannot
exceed the amount of the markdown
Net markdown--The difference between the total
markdowns and the markdown cancellations
As previously demonstrated, the retail
method approximates average cost
With modifications, it can be used to
approximate:
Average cost on a lower of cost or market
(LCM ) basis (very widely used and known
as the “conventional method”
FIFO (with or without LCM )
LIFO
Summary of modifications
To approximate lower of cost or market (
LCM ) exclude net markdowns from the
cost / retail ratio calculation
To approximate FIFO and LIFO, exclude
beginning inventory from the cost / retail
ratio calculation
Comprehensive retail method
assumptions (Sales = $125,000)
Cost Retail
Beginning inventory
$ 5,000 $ 8,000
Purchases
85,000 160,000
Purchase discounts
4,000
Purchase returns
1,000
2,000
Freight-in
5,000
Net markups
14,000
Net markdowns
15,000
Ending inventory at retail
$ 40,000
For FIFO, cost retail ratio is:
Cost Retail
85,000 160,000
- 4,000
- 1,000 - 2,000
+ 5,000
+ 14,000
- 15,000
85,000 157,000
Purchases
Purchase discounts
Purchase returns
Freight-in
Net markups
Net markdowns
Ratio basis
Ratio = .541
EI Retail = $40,000, Est. EI = $21,656
For FIFO LCM, cost retail ratio
is:
Cost Retail
85,000 160,000
- 4,000
- 1,000 - 2,000
+ 5,000
+ 14,000
85,000 172,000
Purchases
Purchase discounts
Purchase returns
Freight-in
Net markups
Ratio basis
Ratio = .494
EI Retail = $40,000, Est. EI = $19,767
For average cost, cost retail ratio
is:
Cost Retail
Beginning inventory
5,000
8,000
Purchases
+ 85,000+160,000
Purchase discounts
- 4,000
Purchase returns
- 1,000 - 2,000
Freight-in
+ 5,000
Net markups
+ 14,000
Net markdowns
- 15,000
Ratio basis
90,000 165,000
Ratio = .545
EI Retail = $40,000, Est. EI = $21,818
For average LCM, cost retail ratio
is:
Cost Retail
Beginning inventory
5,000
8,000
Purchases
+ 85,000+160,000
Purchase discounts
- 4,000
Purchase returns
- 1,000 - 2,000
Freight-in
+ 5,000
Net markups
+ 14,000
Ratio basis
90,000 180,000
Ratio = .500
EI Retail = $40,000, Est. EI = $20,000
LIFO advantages and disadvantages
Advantages
Matches current costs with revenues
Results in lower income taxes in periods of rising
prices
Disadvantages
Distorts asset values on balance sheet
Becomes cumbersome to deal with
Can distort income if early, low-cost layers are
liquidated
Lifo pools
A way of avoiding LIFO layer liquidation
Similar items are put together in groups or pools
Pooled items are treated as if purchased at same time
Less likely to liquidate layers in practice
Dollar value LIFO
A way of approximating LIFO
Think in terms of layers
In LIFO, if inventory quantity were constant,
beginning and ending inventory would be
exactly the same
Additional inventory adds a layer
Decreases reduce layers in LIFO order
Dollar value LIFO example
with no price-level change
2000 ending inventory
2001 ending inventory
$20,000
23,100
2001 inventory consists of:
2000 base layer
plus additional layer of
Total
$20,000
3,100
$23,100
Dollar value LIFO example
with no price-level change
2000 ending inventory
2001 ending inventory
2002 ending inventory
$20,000
23,100
27,250
2002 inventory consists of:
2000 base layer
plus 2001 layer of
plus 2002 layer of
Total
$20,000
3,100
4,150
$27,250
Dollar value LIFO
When price levels change
1. Convert current inventory value to base dollars
2. Analyze change in inventory in terms of base
dollars
3. If inventory increases, add a layer, use current
index
4. If inventory decreases, reduce layers in LIFO
order
Dollar value LIFO example
with price-level changes
2000 ending inventory
2001 ending inventory
Amount
$20,000
23,100
2001 converted to base $
( 23,100 / 1.05 ) =
$22,000
Change from 2000 (increase)
2,000
Price
index
1.00
1.05
Dollar value LIFO example
with price-level changes
Layer
Base
2001 addl. layer
Totals
Base Current
Index dollars dollars
1.00 $20,000 $20,000
1.05
2,000
2,100
$22,000 $22,100
The 2001 ending inventory will be reported as
$22,100
Dollar value LIFO example
with price-level changes
2000 ending inventory
2001 ending inventory
2002 ending inventory
Amount
$20,000
23,100
27,250
2001 conv. to base
2002 conv. to base
2002 increase in base $
$22,000
$25,000
$ 3,000
Price
index
1.00
1.05
1.09
Dollar value LIFO example
with price-level changes
Layer
Base
2001 addl. layer
2002 addl. layer
Totals
Index
1.00
1.05
1.09
Base Current
dollars dollars
$20,000 $20,000
2,000
2,100
3,000
3,270
$25,000 $25,370
The 2002 ending inventory will be reported as
$25,370
Retail dollar value LIFO
Combines the retail method and dollar value
LIFO
Calculate cost / retail ratio as was done for
FIFO
Convert retail ending inventory to base dollars
Follow dollar value LIFO layer procedures
1999 retail dollar value LIFO ratio
(data from Exhibit 10-15)
Cost Retail
80,000 150,000
- 2,200 - 4,000
+ 2,000
+ 23,000
- 4,760
79,800 164,240
Purchases
Purchase returns
Freight-in
Net markups
Net markdowns
Ratio basis
Ratio = .486
1999 ending inventory at retail
Beginning inventory
Purchases
Purchase returns
Net markups
Net markdowns
Sales
Net sales returns
Ending inventory at retail
Retail
25,000
150,000
- 4,000
+ 23,000
- 4,760
-160,000
+ 1,000
30,240
1999 retail dollar value LIFO layers
1998 ending inventory
1999 ending inventory
Amount
$25,000
30,240
1999 converted to base $
( 30,240 / 1.08 ) =
$28,000
Change from 1998 (increase)
3,000
Price
index
1.00
1.08
Retail dollar value LIFO-1999
Layer
Base
1999
Totals
Base $
25,000
3,000
28,000
Index
1.00
1.08
C/R
.480
.486
DVL
12,000
1,575
13,575
2000 retail dollar value LIFO
ratio
Cost Retail
95,000 180,000
-0-0+ 4,000
+ 25,000
- 5,000
99,000 200,000
Purchases
Purchase returns
Freight-in
Net markups
Net markdowns
Ratio basis
Ratio = .495
2000 ending inventory at retail
Beginning inventory
Purchases
Purchase returns
Net markups
Net markdowns
Sales
Net sales
Ending inventory at retail
Retail
30,240
180,000
-0+ 25,000
- 5,000
-191,000
+ 1,010
40,250
2000 retail dollar value LIFO layers
1995 ending inventory
1996 ending inventory
2000 ending inventory
Amount
$25,000
30,240
40,250
1996 conv. to base
2000 conv. to base
2000 increase in base $
28,000
35,000
7,000
Price
index
1.00
1.08
1.15
Retail dollar value LIFO-2000
Layer
Base
1996
2000
Totals
Base $
25,000
3,000
7,000
35,000
Index
1.00
1.08
1.15
C/R
.480
.486
.495
DVL
12,000
1,575
3,985
17,560
2001 retail dollar value LIFO
ratio
Cost Retail
Purchases
110,000 198,000
Purchase returns
- 1,600 - 3,000
Freight-in
+ 5,000
Net markups
+ 35,000
Net markdowns
- 6,000
Ratio basis
113,400 224,000
Ratio = .506
2001 ending inventory at retail
Beginning inventory
Purchases
Purchase returns
Net markups
Net markdowns
Sales
Sales returns
Ending inventory at retail
Retail
40,250
198,000
- 3,000
+ 35,000
- 6,000
-235,000
+ 7,350
36,600
2001 retail dollar value LIFO layers
1995 ending inventory
1996 ending inventory
2000 ending inventory
2001 ending inventory
Amount
$25,000
30,240
40,250
36,600
2000 conv. to base
2001 conv. to base
2001 decrease in base $
35,000
30,000
5,000
index
1.00
1.08
1.15
1.22
Retail dollar value LIFO-2001
Layer
Base
1996
2000
Totals
Base $
25,000
3,000
2,000
30,000
Index
1.00
1.08
1.15
C/R
.480
.486
.495
DVL
12,000
1,575
1,138
14,713
Note reduction of 2000 layer from $7,000 to $2,000
Chapter 10--Learning Objectives
6. Analyze the impact of inventory
valuation on liquidity and profitability
analysis
Inventory turnover
Cost of goods sold
Average inventory
Average inventory usually calculated
( Beginning inv. + Ending inv. ) / 2
Days sales in inventory
365
days
Inventory turnover