Chapter 8
Inventories:
Measurement
Copyright © 2015 McGraw-Hill Education. All rights reserved.
Inventory
Refers to assets a company:
• Intends to sell in the normal course of business
• Has in production for future sale or
• Uses currently in the production of goods to be
sold
Types of Inventory
Inventory
Merchandising
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 the goods in condition
and location for sale
Manufacturing
Inventory
• Goods that are produced by
a manufacturing company
to be sold to wholesalers,
retailers, or other
manufacturers
• Consists of:
 Raw materials
 Work-in-process
 Finished goods
Inventory for a manufacturer consists of:
• Represent the cost of components purchased
from other manufacturers that will become part
Raw
of the finished product
materials • Example: Computer chips and memory modules
that will go into computers produced by Dell, Inc.
• Refers to the products that are not yet complete
• The cost of work in process includes:
Work-inprocess
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 Dell’s Texas facility
Finished
goods
• Consists of costs that have accumulated in work
in process after the manufacturing process is
completed
• Example: Computers produced by Dell, Inc., that
are intended for sale to customers
Illustration: Inventories Disclosure—The
Hillshire Brands Company
Illustration: 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
LO8-1
Perpetual Inventory System
• Continually adjusted for each change in inventory
– Caused by:
• A purchase
• A sale, or
• A return of merchandise by the company to its
supplier
• Cost of goods sold account is adjusted each time
goods are sold or are returned by a customer
• Designed to track inventory quantities from their
acquisition to their sale
• Allows management to:
– Determine goods on hand on any date
– Determine the number of items sold during a period
LO8-1
Illustration: Perpetual Inventory System
The Lothridge Wholesale Beverage Company purchases soft drinks
from producers and then sells them to retailers. The company begins
2016 with merchandise inventory of $120,000 on hand. During 2016
additional merchandise is purchased on account at a cost of $600,000.
Sales for the year, all on account, totaled $820,000. The cost of the soft
drinks 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.
Journal Entry-2016
Inventory
Accounts payable
Debit
Credit
600,000
600,000
LO8-1
Illustration: Perpetual Inventory System (continued)
The Lothridge Wholesale Beverage Company purchases soft drinks
from producers and then sells them to retailers. The company begins
2016 with merchandise inventory of $120,000 on hand. During 2016
additional merchandise is purchased on account at a cost of $600,000.
Sales for the year, all on account, totaled $820,000. The cost of the soft
drinks 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.
Journal Entry-2016
Debit
Accounts receivable
Sales revenue
820,000
Cost of goods sold
Inventory
540,000
Credit
820,000
540,000
LO8-1
Periodic Inventory System
• Adjusts inventory 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
+
purchases
Ending
–
inventory
LO8-1
Illustration: Periodic Inventory System
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2016 with merchandise inventory of $120,000
on hand. During 2016, additional merchandise was purchased
on account at a cost of $600,000. Sales for the year, all on
account, totaled $820,000. Lothridge uses a periodic inventory
system. A physical count determined the cost of inventory at
the end of the year to be $180,000.
Journal Entry-2016
Purchases
Accounts payable
Debit
Credit
600,000
600,000
LO8-1
Illustration: Periodic Inventory System (continued)
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2016 with merchandise inventory of $120,000
on hand. During 2016, additional merchandise was purchased
on account at a cost of $600,000. Sales for the year, all on
account, totaled $820,000. Lothridge uses a periodic inventory
system. A physical count determined the cost of inventory at
the end of the year to be $180,000.
Journal Entry-2016
Accounts receivable
Sales revenue
Debit
Credit
820,000
No entry is recorded for the cost of inventory sold.
820,000
LO8-1
Illustration: Cost of Goods Sold
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2016 with merchandise inventory of $120,000
on hand. During 2016, additional merchandise was purchased
on account at a cost of $600,000. Sales for the year, all on
account, totaled $820,000. Lothridge uses a periodic inventory
system. A physical count determined the cost of inventory at
the end of the year to be $180,000.
Beginning
inventory
+
Net
purchases
–
Ending
inventory
Beginning inventory
Plus: Purchases
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
=
Cost of
goods sold
$120,000
600,000
720,000
(180,000)
$540,000
LO8-1
Illustration: Cost of Goods Sold (continued)
Beginning inventory
Plus: Purchases
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
Journal Entry-December 31, 2016
Cost of goods sold
Inventory (ending)
Inventory (beginning)
Purchases
$120,000
600,000
720,000
(180,000)
$540,000
Debit
Credit
540,000
180,000
120,000
600,000
Concept Check √
The Golson Company uses the periodic inventory system. Information for
2016 is as follows:
Sales
$1,325,000
Beginning inventory
340,000
Purchases
600,000
Purchase returns
6,000
Ending inventory
370,000
Golson's cost of goods sold for 2016 is:
a.
$761,000.
b.
$594,000.
c.
$570,000.
d.
$564,000. $340,000 (beginning inventory) + $600,000 (purchases) -
$6,000 (purchase returns) - $370,000 (ending inventory) =
$564,000
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
• Facilitate 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
• Constantly monitor only
inventory quantities
LO8-2
Physical Quantities Included in Inventory
Items in the
possession of the
company
Goods that are in
transit
Physical Quantities
Included in
Inventory
Goods on
consignment
Anticipated sales
returns
LO8-2
Goods in Transit
Refers to situations:
• Where the goods are on the way to their destination
• Between the suppliers and a company and between
the company and its customers
Accounting for
goods in transit
Depends on
Ownership of
goods
LO8-2
Goods in Transit
In December 2016, the Lothridge Wholesale Beverage
Company sold goods to the Jabbar Company. The
goods were shipped on December 29, 2016, and
arrived at Jabbar’s warehouse on January 3, 2017. The
fiscal year-end for both companies is December 31.
If goods are shipped f.o.b. shipping point:
• Lothridge records the sale and inventory reduction in
2016
• Jabbar Company records a 2016 purchase and
includes the goods in 2016 ending inventory
LO8-2
Goods in Transit (continued)
In December 2016, the Lothridge Wholesale Beverage
Company sold goods to the Jabbar Company. The
goods were shipped on December 29, 2016, and
arrived at Jabbar’s warehouse on January 3, 2017. The
fiscal year-end for both companies is December 31.
If goods are shipped f.o.b. destination:
• Lothridge includes the merchandise in its 2016
ending inventory and the sale is recorded in 2017
• Jabbar records the purchase in 2017
Concept Check √
Barrington Corporation uses the periodic inventory system. At December
31, 2016, 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 1/5/17)
$3,000
Merchandise shipped to a customer on 12/29 f.o.b. shipping point
(merchandise arrived at customer's location on 1/2/17)
1,500
Merchandise purchased from a supplier, shipped f.o.b. destination
on 12/26, arrived on January 4, 2017
6,000
Barrington's 2016 ending inventory should be:
a.
$80,000.
b.
$89,000.
c.
$83,000.
d.
$87,750. $80,000 (ending inventory count) + $3,000 (f.o.b.
destination shipment made 12/28) = $83,000
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
LO8-2
Sales Returns
Sales Returns:
• When merchandise is returned:
• Adjusting entry for estimated sales returns reduces sales
revenue and accounts receivable
• Cost of goods sold is reduced and inventory is increased
Accounting treatment:
•
Company includes in inventory the cost of merchandise
it anticipates will be returned
LO8-3
Expenditures Included in Inventory
Cost of
inventory
All necessary expenditures:
(1) To acquire the
inventory, and
(2) To bring it to its desired
condition and location
(1) For sale, or
(2) For use in manufacturing process
Cost of acquiring inventory
(1) Freight
charges on
incoming goods
(2) Insurance
costs during
transit
Purchase price
(3) Costs of unloading,
unpacking, and preparing
merchandise inventory
LO8-3
Expenditures Included in Inventory (continued)
Freight-in on Purchases
• Costs incurred 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
LO8-3
Expenditures Included in Inventory (continued)
Shipping charges on outgoing goods
• Shipping charges on outgoing goods are not included
in the cost of inventory. They are:
•
Treated as a part of cost of goods sold or as an
operating expense
• If not included in the cost of goods sold:
•
The amounts incurred during the period as well as the
income statement classification of the expense must
be disclosed
LO8-3
Expenditures Included in Inventory (continued)
Purchase Returns
• A buyer views a return as a reduction of net
purchases
• In a perpetual inventory system:
•
Reduction in both inventory and accounts payable
• In a periodic system:
•
Purchase returns account temporarily accumulates
these amounts and are later deducted from purchases
LO8-3
Expenditures Included in Inventory (continued)
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
LO8-3
Illustration: Purchase Discounts
On October 5, 2016, the Lothridge Wholesale Beverage Company
purchased merchandise at a price of $20,000. The repayment
terms are stated as 2/10, n/30. Lothridge paid $13,720 ($14,000
less the 2% cash discount) on October 14 and the remaining
balance of $6,000 on November 4. Lothridge employs a periodic
inventory system.
Journal Entry-October 5, 2016
Gross Method
Purchases
Accounts payable
Net Method
Purchases
Accounts payable
Debit
Credit
20,000
20,000
19,600
19,600
$20,000 – ($20,000 × 2%)
LO8-3
Illustration: Purchase Discounts (continued)
On October 5, 2016, the Lothridge Wholesale Beverage Company
purchased merchandise at a price of $20,000. The repayment
terms are stated as 2/10, n/30. Lothridge paid $13,720 ($14,000
less the 2% cash discount) on October 14 and the remaining
balance of $6,000 on November 4. Lothridge employs a periodic
inventory system.
$14,000 × 2%
Journal Entry-October 14, 2016
Gross Method
Accounts payable
Purchase discounts
Cash
Net Method
Accounts payable
Cash
Debit
Credit
14,000
280
13,720
13,720
13,720
LO8-3
Illustration: Purchase Discounts (continued)
On October 5, 2016, the Lothridge Wholesale Beverage Company
purchased merchandise at a price of $20,000. The repayment
terms are stated as 2/10, n/30. Lothridge paid $13,720 ($14,000
less the 2% cash discount) on October 14 and the remaining
balance of $6,000 on November 4. Lothridge employs a periodic
inventory system.
$6,000 × 2%
Journal Entry-November 4, 2016
Gross Method
Accounts payable
Cash
Net Method
Accounts payable
Interest expense
Cash
Debit
Credit
6,000
6,000
5,880
120
6,000
Concept Check √
Covington Mattress buys mattresses from Simpson Manufacturing.
Covington purchased mattresses from Simpson on August 16 and received
an invoice for $12,000 with payment terms of 2/10, n/30. Covington uses
the net method to record purchases. Covington should record the purchase
at:
a.
$11,880.
b.
$11,760.
c.
$12,000.
d.
$12,240.
$12,000 x 98% = $11,760
Concept Check √
Covington Mattress buys mattresses from Simpson Manufacturing.
Covington purchased mattresses from Simpson on August 16 and received
an invoice for $12,000 with payment terms of 2/10, n/30. Covington uses
the gross method to record purchases. Covington should record the
purchase at:
a.
$11,880.
b.
$11,760.
c.
$12,000.
d.
$12,240.
Invoice price = $12,000
LO8-3
Illustration: 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 2016
with merchandise inventory of $120,000 on hand. During 2016,
additional merchandise is purchased on account at a cost of $600,000.
Lothridge’s suppliers offer credit terms of 2/10, n/30. All discounts were
taken. Lothridge uses the net method to record purchase discounts. All
purchases are made f.o.b. shipping point. Freight charges paid by
Lothridge totaled $16,000. Merchandise with a net of discount cost of
$20,000 was returned to suppliers for credit. Sales for the year, all on
account, totaled $830,000. The cost of the soft drinks sold is $550,000.
$154,000 of inventory remained on hand at the end of 2016.
LO8-3
Illustration: Inventory Transactions—Perpetual
and Periodic Systems (continued)
$ in 000s
Perpetual System
Inventory
Accounts payable
Periodic System
588
Inventory
Cash
16
Accounts payable
Inventory
20
Accounts receivable
Sales revenue
830
Cost of goods sold
Inventory
550
Purchases
Purchases
588
Accounts payable
Freight
Freight-in
16
Cash
Returns
Accounts payable
20
Purchase returns
Sales
Accounts receivable
830
Sales revenue
No entry
550
588
588
16
16
20
20
830
830
LO8-3
Illustration: Inventory Transactions—Perpetual
and Periodic Systems (continued)
$ in 000s
Perpetual System
Periodic System
End of the period
No entry
Cost of goods sold
Inventory (ending)
Purchase returns
Inventory (beginning)
550
154
20
Purchases
Freight-in
Supporting Schedule: Cost of goods sold
Beginning inventory
$120,000
584,000
Plus: Net Purchases ($588–20+16)
704,000
Cost of goods available
(154,000)
Less: Ending inventory
$550,000
Cost of goods sold
120
588
16
LO8-4
Inventory Cost Flow Assumptions
Inventory cost flow assumptions are required:
• If the inventory is not specifically identified and
traced through the system
LO8-4
Illustration: Cost Flow
The Browning Company began 2016 with $22,000 of inventory. The
cost of beginning inventory is composed of 4,000 units purchased
for $5.50 each. Merchandise transactions during 2016 were as
follows:
Purchases
Date of Purchase
Units
Unit Cost
Total Cost
Jan. 17
1,000
$6.00
$ 6,000
Mar. 22
3,000
7.00
21,000
Oct. 15
3,000
7.50
22,500
Totals
7,000
$ 49,500
Sales
Date of Sale
Units
Jan. 10
2,000
Apr. 15
1,500
Cost = ?
Nov. 20
3,000
Total
6,500
LO8-4
Illustration: Allocation of Units Available
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of goods available for sale (11,000 units)
Beginning
inventory
(4,000 units)
+
Purchases
(7,000 units)
Units available
(11,000)
$ 22,000
49,500
$ 71,500
Units on hand
at end of period
4,500
4,000 + 7,000 – 6,500
Units sold during
the period
6,500
Total units = 11,000
LO8-4
Illustration: Allocation of Cost of Goods Available
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of 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
($71,500)
$ 22,000
49,500
$ 71,500
?
?
Cost of inventory
on hand at end of
period ?
Cost of goods
sold during the
period ?
Total ending inventory plus
cost of goods sold = $71,500
LO8-4
Specific Identification
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
LO8-4
Cost Flow Assumptions
• Based on assumptions about how inventory might
flow in and out of a company
Cost flow
assumptions
Average cost
•
•
Periodic
average cost
Perpetual
average cost
First-In, First-Out
(FIFO)
Last-In, First-Out
(LIFO)
• Periodic FIFO
• Periodic LIFO
• Perpetual
FIFO
• Perpetual
LIFO
LO8-4
Cost Flow Methods (continued)
Average Cost Method
• Assumes that items sold and items in ending
inventory come from a mixture of all the goods
available for sale
• The average unit cost applied to goods sold or to
ending inventory is the cost weighted by the number
of units acquired at the various unit costs
LO8-4
Average Cost Method
Periodic Average Cost:
• The average cost is computed only at the end of the
period
• Calculated as:
LO8-4
Illustration: Average Cost—Periodic Inventory
System
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of goods available for sale (11,000 units)
$71,500
Weighted-average unit cost = 11,000
$ 22,000
49,500
$ 71,500
= $6.50
Cost of goods sold (6,500 units @ $6.50) =
$ 42,250
Ending inventory (4,500 units @ $6.50) =
$ 29,250
LO8-4
Average Cost Method
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:
o
o
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
Illustration: 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/units
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
Total cost of goods sold = $40,900
4,500 @ $6.80 = $30,600
LO8-4
First-In, First-Out (FIFO)
FIFO assumes:
• that units sold are the first units acquired
• ending inventory consists of the most recently
acquired units
Units Available
Beginning inventory
Jan. 17
Mar. 22
Mar. 22
Oct. 15
Total
4,000
1,000
1,500
1,500
3,000
11,000
6,500 units sold
4,500 units in
ending inventory
LO8-4
Illustration: FIFO—Periodic Inventory System
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of goods available for sale (11,000 units)
Ending inventory (Determined below)
Cost of goods sold (6,500 units)
Cost of Ending Inventory:
Date of Purchase Units
Mar. 22
1,500
Oct. 15
3,000
Total
4,500
Unit Cost
$7.00
7.50
$ 22,000
49,500
$ 71,500
(
)
$ 38,500
Total Cost
$10,500
22,500
$33,000
33,000
LO8-4
Illustration: FIFO—Periodic Inventory System
Cost of Goods Sold:
Date of Purchase
Beg. inv.
Jan. 17
Mar. 22
Total
Units
4,000
1,000
1,500
6,500
Unit Cost Total Cost
$5.50
$22,000
6.00
6,000
7.00
10,500
$38,500
Illustration: 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
$17,000
Mar. 22
3,000 @ $7.00
= $21,000
2,000 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$38,000
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
= $19,250 3,000 @ $7.50
$33,000
Apr. 15
Oct. 15
Nov. 20
1,500 @ $5.50 = $ 8,250
3,000 @ $7.50
= $22,500
500 @ $6.80
1,000 @ $6.00
1,500 @ $7.00
Total cost of goods sold = $38,500
LO8-4
Last-In, First-Out (LIFO)
LIFO assumes:
• that the units sold are the most recent units
purchased
• ending inventory consists of the units acquired first
Units Available
Beginning inventory
Jan. 17
Jan. 17
Mar. 22
Oct. 15
Total
4,000
500
500
3,000
3,000
11,000
4,500 units in
ending inventory
6,500 units sold
LO8-4
Illustration: LIFO—Periodic Inventory System
Beginning inventory (4,000 units @ $5.50)
Plus: Purchases (7,000 units @ various prices)
Cost of goods available for sale (11,000 units)
Ending inventory (Determined below)
Cost of goods sold (6,500 units)
Cost of Ending Inventory:
Date of Purchase
Units
Beginning inventory
4,000
Jan. 17
500
Total
4,500
$ 22,000
49,500
$ 71,500
(
)
$ 46,500
Unit Cost Total Cost
$5.50
$22,000
6.00
3,000
$25,000
25,000
Illustration: LIFO—Periodic Inventory System
LO8-4
(continued)
Cost of Goods Sold:
Date of Purchase
Units
Jan. 17
500
Mar. 22
3,000
Oct. 15
3,000
Total
6,500
Unit Cost Total Cost
$6.00
$ 3,000
7.00
21,000
7.50
22,500
$46,500
Illustration: LIFO—Perpetual Inventory System
LO8-4
Date
Purchased
Sold
Balance
Illustration:
LIFO—Perpetual
Inventory
System
Beginning 4,000 @ $5.50
4,000 @ $5.50 = $22,000
Inventory
= $22,000
Jan. 10
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
$17,000
Mar. 22
3,000 @ $7.00
= $21,000
2,000 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$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
Apr. 15
Oct. 15
Nov. 20
1,500 @ $7.00 = $ 10,500
3,000 @ $7.50
= $22,500
3,000 @ $7.50 = $22,500
Total cost of goods sold = $44,000
Concept Check √
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.
$1,300.
b.
$2,000.
c.
$1,414.
d.
$1,200.
40 units x $30 = $1,200
Concept Check √
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.
$1,300.
b.
$2,000.
c.
$1,414.
d.
$1,200.
40 units x $50 = $2,000
LO8-4
Comparison of Cost Flow Methods
Cost of goods sold
Ending inventory
Total
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:
o
FIFO results in a lower cost of goods sold and higher
ending inventory than LIFO
• During declining costs:
o
FIFO will result in a higher cost of goods sold and lower
ending inventory than LIFO
LO8-4
Disclosure note for Inventory
• FIFO, LIFO, and average, are all permissible under
GAAP
• A company need not use the same method for its
entire inventory
• A company must identify in a disclosure note the
method(s) it uses
LO8-4
Illustration: Inventory Cost Flow Methods Used
in Practice
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
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
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
o
o
amount of income reported to external parties
the amount of taxes paid to:
• the Internal Revenue Service (IRS)
• state and local taxing authorities
• When prices rise and inventory quantities are not
decreasing:
o
o
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
LO8-5
Income Taxes and Net Income
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
LO8-9
International Financial Reporting Standards
U.S. GAAP
IFRS
Inventory Cost Flow Assumptions
LIFO is an acceptable
inventory valuation method
Does not permit the use of
LIFO
LO8-6
Illustration: Inventories Disclosure—Rite Aid
Corporation
LO8-6
Inventories Disclosure
Supplemental LIFO Disclosures
•
•
•
•
Supplemental LIFO disclosures can be used to convert LIFO inventory
and cost of goods sold amounts
Rite Aid’s disclosure on the previous slide indicates that ending
inventory would have been higher by $1,018,581 thousand and
$915,241 thousand at the end of the company’s 2014 and 2013 fiscal
year ends, respectively, if the company had used FIFO instead of LIFO
Cost of goods sold for the 2014 fiscal year would have been $103,340
($1,018,581 – 915,241) thousand lower if the company had used FIFO
Some LIFO companies keep their internal records using FIFO or average
cost and then enter the conversion adjustment - the difference
between the internal method and LIFO - directly into the records as a
“contra account” to inventory
• This contra account is called either the LIFO reserve or the LIFO
allowance
LO8-6
LIFO Reserves
LIFO for external
reporting and income
tax purposes
̶
FIFO or average cost
used to maintain their
internal records
Reasons
=
LIFO
Reserves
A “contra account” that
records the difference
between the internal
method and 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
LO8-6
Inventories Disclosure
Doubletree Corporation began 2016 with a balance of
$475,000 in its LIFO reserve account, the difference
between inventory valued internally using FIFO and
inventory valued using LIFO. At the end of 2016,
assume this difference increased to $535,000.
Journal Entry-2016
Cost of goods sold
LIFO reserve
Debit
Credit
60,000
60,000
Concept Check √
Doyle Corp. uses the LIFO inventory method. Doyle disclosed that if FIFO
had been used, inventory at the end of 2016 would have been $36 million
higher than the difference between LIFO and FIFO at the end of 2015.
Assuming Doyle’s income tax rate is 40%:
a.
Its reported cost of goods sold for 2016 would have been $21.6
million higher if it had used FIFO rather than LIFO for its financial
statements.
b.
Its reported net income for 2016 would have been $21.6 million
higher if it had used FIFO rather than LIFO for its financial statements.
c.
Its reported net income for 2016 would have been $36 million
higher if it had used FIFO rather than LIFO for its financial statements.
d.
Its reported cost of goods sold for 2016 would have been $36
million higher if it had used FIFO rather than LIFO for its financial
statements.
$36 million x (1 – .40) = $21.6 million
LO8-6
Illustration: Inventories Disclosure—Books-AMillion
LO8-6
LIFO Liquidations
• Out-of-date inventory cost layers are liquidated and
cost of goods sold will partially match noncurrent
costs with current selling prices
• If costs have been increasing (decreasing), LIFO
liquidations produce higher (lower) net income
Illustration: LIFO Liquidation
LO8-6
National Distributors, Inc. uses the LIFO inventory method.
The company began 2016 with inventory of 10,000 units that
cost $20 per unit. During 2016, 30,000 units were purchased
for $25 each and 35,000 units were sold.
Cost of goods sold for 2016
30,000 units @ $25 per unit = $750,000
5,000 units @ $20 per unit = $100,000
35,000
$850,000
10,000 – 5,000 = 5,000 units liquidated
Illustration: LIFO Liquidation (continued)
LO8-6
National Distributors, Inc. uses the LIFO inventory method.
The company began 2016 with inventory of 10,000 units that
cost $20 per unit. During 2016, 30,000 units were purchased
for $25 each and 35,000 units were sold.
Cost of goods sold for 2016
30,000 units @ $25 per unit = $750,000
5,000 units @ $20 per unit = $100,000
35,000
$850,000
If 35,000 units were purchased:
35,000 units @ $25 per unit = $875,000
Before-tax income effect
= $25,000
of the LIFO liquidation =
Alternative method
= 5,000 units × [$25 – $20]= $25,000
LO8-7
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
LO8-7
Just-in-time (JIT) system
Coordinates
Manufacturer
Supplier
production
Raw
materials
Production
process
• Advantages:
– Relatively low inventory balances are maintained
– Customer demand is quickly met
Example:
• Dell Inc.
– A personal computer is not manufactured by Dell until
an order is placed
– Many of the components used in the production are
acquired by Dell until an order is placed
LO8-7
Key Ratios Used to Monitor Investment in
Inventories
• Gross profit (gross margin) ratio:
•
Percentage of each sales dollar available to cover
expenses other than cost of goods sold and to provide
a profit
• Higher the ratio, higher the markup achieved
• Declining ratio might indicate that:
• The company is unable to offset rising costs with
corresponding increases in selling price, or
• Sales prices are declining without a commensurate
reduction in costs
Concept Check √
For its 2016 fiscal year, the Hendricks Chemical Company reported sales of
$3,500,000, cost of goods sold of $1,400,000, and net income of $140,000.
The company's gross profit ratio for the year is:
a.
60%.
b.
40%.
c.
4%.
d.
None of these answers is correct.
($3,500,000 - $1,400,000)  $3,500,000 = 60%
Key Ratios Used to Monitor Investment in
Inventories (continued)
LO8-7
• Inventory turnover ratio:
• Shows the number of times the average inventory
balance is sold during a reporting period
• The higher the ratio, the more profitable a company
will be
• Declining ratio is unfavorable for companies
– Caused by:
• Presence of obsolete or slow-moving products
• Poor marketing and sales efforts
Concept Check √
Granger Clothing reported the following in its 2016 financial statements:
Sales
$1,050,000
Cost of goods sold:
Inventory, January 1
$ 205,000
Net purchases
640,000
Cost of goods available for sale 845,000
Inventory, December 31
215,000
Cost of goods sold
Gross profit
630,000
$ 420,000
Granger's 2016 inventory turnover ratio is:
a.
2.93.
b.
5.00.
c.
3.00.
d.
2.00.
$630,000  [($205,000 + 215,000)  2] = 3.00
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
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
LO8-8
LIFO Inventory Pools (continued)
Diamond Lumber Company has a rough-cut lumber inventory
pool that includes three types: oak, pine, and maple. The
beginning inventory consisted of the following:
Oak
Pine
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 =
board feet
the pool
= 2.47 per board feet
LIFO Inventory Pools (continued)
LO8-8
During the next reporting period Diamond purchased
50,000 board feet of lumber. Diamond sold 46,000 board
feet during this period.
Oak
Pine
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 =
Beginning inventory
LIFO layer added
Ending inventory
= 2.54
Quantity
(Board Feet)
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
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
LO8-8
Dollar-Value LIFO (continued)
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
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
LO8-8
The DVL Inventory Estimation Technique
Three steps process
Step 1: Convert ending inventory valued at yearend costs to base year costs.
Step 2: Identify the layers of ending inventory
and the years they were created.
Step 3: Convert each layer’s base year cost to
layer year cost using the cost index for the year it
was acquired.
LO8-8
The DVL Inventory Estimation Technique
Hanes Company adopted the dollar-value LIFO method on
January 1, 2016, when the inventory value was $400,000.
The 2016 ending inventory valued at year-end costs is
$441,000, and the cost index for the year is 1.05 (105%).
Step 1: Convert ending inventory valued at year-end cost to
base year cost.
Ending inventory at base year cost
=
$441,000
1.05
=
$420,000
LO8-8
Illustration: The DVL Inventory Estimation
Technique (continued)
Hanes Company adopted the dollar-value LIFO method on
January 1, 2016, when the inventory value was $400,000.
The 2016 ending inventory valued at year-end costs is
$441,000, and the cost index for the year is 1.05 (105%).
Step 2: Identify the layers of ending inventory and the years
they were created.
Ending Inventory
Date
at Base Year Cost
1/1/16
$400,000
2016 layer
20,000
$420,000
LO8-8
The DVL Inventory Estimation Technique
(continued)
Hanes Company adopted the dollar-value LIFO method on
January 1, 2016, when the inventory value was $400,000.
The 2016 ending inventory valued at year-end costs is
$441,000, and the cost index for the year is 1.05 (105%).
Step 3: Convert each layer’s base year cost to layer year cost
using the cost index for the year it was acquired.
Date
1/1/16
2016 layer
Ending Inventory at
×
Base Year Cost
$400,000
20,000
$420,000
×
×
Cost Index =
1.00
1.05
=
=
Ending Inventory
at DVL Cost
$400,000
21,000
$421,000
Concept Check √
On December 31, 2016, the Burroughs Company adopted the dollar-value
LIFO inventory method. Inventory at the end of 2016 for its only inventory
pool was $600,000. At the end of 2017 inventory at year-end cost is
$806,400 and the cost index is 1.05. Inventory at the end of 2017 at dollarvalue LIFO cost is:
a.
$750,000.
b.
$768,000.
c.
$806,400.
d.
$776,400.
End-of-2017 inventory at end-of-2016 year cost = $768,000
($806,400  1.05). The increase in the end-of-2016
inventory at end-of-2016 dollars is $168,000. $168,000 x
1.05 = $176,400 + 600,000 = $776,400
End of Chapter 8