8 Inventories: Measurement PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Recording and Measuring Inventory Types of Inventory Merchandise Inventory Goods acquired for resale 8-2 Manufacturing Inventory •Raw Materials •Work-in-Process •Finished Goods Manufacturing Inventories Raw Materials Work in Process $XX Finished Goods $XX Direct Labor Cost of Goods Sold $XX Manufacturing Overhead 8-3 Raw materials purchased Direct labor incurred Manufacturing overhead incurred Raw materials used Direct labor applied Manufacturing overhead applied Work in process transferred to finished goods Finished goods sold Inventory Systems Two accounting systems are used to record transactions involving inventory: 8-4 Perpetual Inventory System Periodic Inventory System The inventory account is continuously updated as purchases and sales are made. The inventory account is adjusted at the end of a reporting cycle. Perpetual Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2011 Inventory Accounts payable 600,000 600,000 Purchase of merchandise inventory on account Returns of inventory are credited to the inventory account. Discounts on inventory purchases can be recorded using the gross or net method. 8-5 Perpetual Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 and a cost basis of $540,000, to customers. 2011 Inventory Accounts payable 600,000 600,000 Purchase of merchandise inventory on account. 2011 Accounts receivable Sales revenue 820,000 820,000 Record sales on account. Cost of goods sold Inventory Record cost of goods sold. 8-6 540,000 540,000 Periodic Inventory System The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after the physical inventory count at the end of the period. Beginning Inventory + Net Purchases Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold 8-7 Periodic Inventory System Lothridge Wholesale Beverage Company (LWBC) begins 2011 with $120,000 in inventory. During the period it purchases on account $600,000 of merchandise for resale to customers. 2011 Purchases Accounts payable Purchase of merchandise inventory on account 8-8 600,000 600,000 Periodic Inventory System During 2011, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000. 2011 Accounts receivable Sales revenue 820,000 820,000 Record sales on account. No entry is made to record Cost of Goods Sold. A physical count of Ending Inventory shows a balance of $180,000. Let’s calculate Cost of Goods Sold at the end of 2011. 8-9 Periodic Inventory System Calculation of Cost of Goods Sold Beginning inventory Plus: Purchases Cost of goods available for sale Less: Ending inventory Cost of goods sold $ 120,000 600,000 720,000 (180,000) $ 540,000 We need the following adjusting entry to record cost of good sold. December 31, 2011 Cost of goods sold Inventory (ending) Inventory (beginning) Purchases 540,000 180,000 120,000 600,000 To adjust inventory, close purchases, and record cost of goods sold. 8 - 10 Comparison of Inventory Systems Transaction or Event Routine purchases of various inventory items Costs debited to purchases account Costs debited to inventory account Sale of inventory No accounting entries made to inventory Debit Cost of goods sold and credit inventory End-of-period accounting entries and related activities 8 - 11 Periodic Inventory Perpetual Inventory Physical count to No separate determine ending determination of cost of inventory and cost of goods sold necessary goods sold What is Included in Inventory? General Rule All goods owned by the company on the inventory date, regardless of their location. Goods in Transit Depends on FOB shipping terms. 8 - 12 Goods on Consignment Expenditures Included in Inventory Invoice Price Purchase Returns and Allowances + Freight-in on Purchases 8 - 13 Purchase Discounts Purchase Returns On November 8, 2011, LWBC returns merchandise that had a cost to LWBC of $2,000, and a cost basis to the seller of 1,600. Periodic Inventory Method November 8, 2011 Accounts payable 2,000 Purchase returns and allowances 2,000 Perpetual Inventory Method Accounts payable Inventory 2,000 Returns of inventory are credited to the Purchase Returns and Allowances account when using the periodic inventory method. The returns are credited to Inventory using the perpetual inventory method. 8 - 14 2,000 Purchase Discounts Gross Method October 5, 2011 Purchases Accounts payable 20,000 20,000 October 14, 2011 Accounts payable 14,000 Purchase discounts Cash November 4, 2011 Accounts payable Cash Discount terms are 2/10, n/30. $14,000 x 0.02 $ 280 8 - 15 Net Method 280 13,720 6,000 6,000 Partial payment not made within the discount period Purchases Accounts payable 19,600 Accounts payable Cash 13,720 Accounts payable Interest expense Cash 5,880 120 19,600 13,720 6,000 $20,000 x 0.02 $ 400 -120 $ 280 Inventory Cost Flow Assumptions • Specific identification • Average cost • First-in, first-out (FIFO) • Last-in, first-out (LIFO) 8 - 16 Perpetual Average Cost Picture This, LLC, uses a standard frame size for all pictures to hold down product costs. The following schedule shows the frame inventory for Picture This, LLC, for September. The physical inventory count at September 30 shows 1,400 frames in ending inventory. Use the perpetual average cost method to determine: (1) Ending inventory cost (2) Cost of goods sold 8 - 17 Perpetual Average Cost Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 18 Units 1,200 900 550 600 800 4,050 (1,400) 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 Date Sales Units 9/15 9/22 9/30 1,000 700 950 2,650 Perpetual Average Cost Date Purchased Beg. Inv. 1,200 x $ 22.00 = 9/3 900 x 24.00 = 9/15 550 x 25.00 = 9/15 Average Cost 26,400 $ 22.00 21,600 22.86 13,750 23.30 Sold 1000 x 23.30 = $61,750 ÷ (1,200 + 900 + 550) = $23.30 rounded 8 - 19 23,300.00 Balance $ 26,400.00 48,000.00 61,750.00 38,450.00 Perpetual Average Cost Date Purchased Beg. Inv. 1,200 x $ 22.00 = 9/3 900 x 24.00 = 9/15 550 x 25.00 = 9/15 2,650 9/21 600 27.00 9/22 Average Cost 26,400 $ 22.00 21,600 22.86 13,750 23.30 Sold 1000 x 23.30 = 16,200 23,300.00 24.29 700 24.29 17,003.00 Balance $ 26,400.00 48,000.00 61,750.00 38,450.00 54,650.00 37,647.00 [(1,650 × $23.30) + (600 × $27)] ÷ 2,250 = $24.29 rounded 8 - 20 Perpetual Average Cost Date Purchased Beg. Inv. 1,200 x $ 22.00 = 9/3 900 x 24.00 = 9/15 550 x 25.00 = 9/15 2,650 9/21 600 x 27.00 = 9/22 9/29 800 x 28.00 = 9/30 Average Cost 26,400 $ 22.00 21,600 22.86 13,750 23.30 16,200 22,400 1,550 × $ 24.29 = $ 800 × 28.00 = 2,350 $ Weighted Average Cost $ Sold 1000 x 23.30 = 23,300.00 700 x 24.29 = 17,003.00 950 x 25.55 = 24,272.50 24.29 25.55 37,650 22,400 60,050 25.55 Ending inventory = 1,400 units × $25.55 = $35,770 Rounding error 8 - 21 Balance $ 26,400.00 48,000.00 61,750.00 38,450.00 54,650.00 37,647.00 60,047.00 35,774.50 Last-In, First-Out Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 22 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 35,774.50 $ 64,575.50 Weighted-Average Periodic System Let’s use the same information to assign costs to ending inventory and cost of goods sold using the periodic system. Ending Inventory (1,400 units) Beginning Inventory (1,200 units) Available for Sale (4,050 units) Goods Sold (2,650) $100,350 ÷ 4,050 = $24.7778 weightedaverage per unit cost 8 - 23 Weighted-Average Periodic System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 24 Units 1,200 900 550 600 800 4,050 (1,400) 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 $ 24.7778 $ 24.7778 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 (34,688.92) $ 65,661.08 First-In, First-Out (FIFO) The FIFO • The cost of the oldest method inventory items are assumes that charged to COGS items are sold when goods are sold. in the • The cost of the chronological newest inventory order of their items remain in acquisition. ending inventory. 8 - 25 First-In, First-Out (FIFO) Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . . . . . COGS and Ending Inventory Cost are the same under both approaches. 8 - 26 First-In, First-Out (FIFO) Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 27 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 These are the 1,400 38,600.00 most recently $ 31,050.00 acquired units. First-In, First-Out (FIFO) Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 28 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 38,600.00 $ 61,750.00 First-In, First-Out (FIFO) Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 29 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 These are the first 38,600.00 2,650 units $ 61,750.00 acquired. First-In, First-Out (FIFO) Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 30 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 38,600.00 $ 61,750.00 Last-In, First-Out (LIFO) The LIFO • The cost of the method newest inventory assumes that items are charged to the newest COGS when goods items are sold are sold. first, leaving the • The cost of the oldest older units in inventory items inventory. remain in inventory. 8 - 31 Last-In, First-Out (LIFO) Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches. 8 - 32 Last-In, First-Out Date 9/15 9/22 9/30 Sales Units 1,000 700 950 2,650 Perpetual Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 33 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit Total $ 22.00 $ 26,400.00 24.00 21,600.00 25.00 13,750.00 27.00 16,200.00 28.00 22,400.00 These are the 100,350.00 oldest$units in inventory and are most likely to remain in inventory when using LIFO. Last-In, First-Out Perpetual Inventory System Date Beg. Inv. Purchased 1,200 x 22.00 = 9/3 900 x 24.00 = 9/15 550 x 25.00 = 2,650 Sold Balance $ 26,400.00 48,000.00 61,750.00 26,400 21,600 13,750 550 x 450 x 1,000 25.00 = 24.00 = 13,750.00 10,800.00 24,550.00 The Cost of Goods Sold for the September 15 sale is $24,550. After this sale, there are 1,650 units in inventory at various costs per unit. 8 - 34 37,200.00 Last-In, First-Out Perpetual Inventory System Date Purchased Beg. Inv. 1200 x 22.00 = 26,400 9/3 450 x 24.00 = 10,800 9/21 600 x 27.00 = 16,200 9/22 Sold 600 x 100 x 700 27.00 = 24.00 = Balance $ 26,400.00 37,200.00 53,400.00 16,200.00 2,400.00 18,600.00 The Cost of Goods Sold for the September 15 sale is $18,600. After this sale, there are 1,550 units in inventory at various per unit cost. 8 - 35 34,800.00 Last-In, First-Out Perpetual Inventory System Date Beg. Inv 9/3 9/29 9/30 Purchased 1,200 x 22.00 = 350 x 24.00 = 800 x 28.00 = Sold Balance $ 26,400.00 34,800.00 57,200.00 26,400 8,400 22,400 800 x 150 x 950 28.00 = 24.00 = 22,400.00 3,600.00 26,000.00 31,200.00 The Cost of Goods Sold for the September 30 sale is $26,000. After this sale, there are 1,400 units in inventory (1,200 × $22.00) per unit and (200 × $24.00) for a total cost of ending inventory of $31,200. 8 - 36 Last-In, First-Out Periodic Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 37 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 Last-In, First-Out Periodic Inventory System Beginning inventory Purchase of September 3 Cost of goods available for sale Units Unit Cost Total Cost 1,200 $ 22.00 $ 26,400 200 24.00 4,800 1,400 31,200 Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 38 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 31,200.00 $ 69,150.00 Last-In, First-Out Perpetual Inventory System Picture This, LLC Frame Inventory Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold 8 - 39 Units 1,200 900 550 600 800 4,050 1,400 2,650 $/Unit $ 22.00 24.00 25.00 27.00 28.00 Total $ 26,400.00 21,600.00 13,750.00 16,200.00 22,400.00 $ 100,350.00 31,200.00 $ 69,150.00 When Prices Are Rising . . . FIFO • Matches low (older) costs with current (higher) sales. • Inventory is valued at approximate replacement cost. • Results in higher taxable income. 8 - 40 LIFO • Matches high (newer) costs with current (higher) sales. • Inventory is valued based on low (older) cost basis. • Results in lower taxable income. U. S. GAAP vs. IFRS LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence. • LIFO is permitted and used by U.S. Companies. • If used for income tax reporting, the company must use LIFO for financial reporting. • Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. 8 - 41 • IAS No. 2, Inventories, does not permit the use of LIFO. • Because of this restriction, many U.S. companies use LIFO only for domestic inventories. Decision Makers’ Perspective Factors Influencing Method Choice How closely do reported costs reflect actual flow of inventory? How are income taxes affected by inventory method choice? 8 - 42 How well are costs matched against related revenues? Inventory Management Gross profit ratio = The higher the ratio, the higher is the markup a company is able to achieve on its products. Gross profit Net sales Inventory turnover ratio = Designed to evaluate a company’s effectiveness in managing its investment in inventory 8 - 43 Cost of goods sold Average inventory (Beginning inventory + Ending inventory 2 Quality of Earnings Changes in the ratios we discussed above often provide information about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income). Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. 8 - 44 Methods of Simplifying LIFO LIFO Inventory Pools The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools rather than every specific type of inventory separately. 8 - 45 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) DVL inventory pools are viewed as layers of value, rather than layers of similar units. DVL simplifies LIFO record-keeping. DVL minimizes the probability of layer liquidation. 8 - 46 At the end of the Example period, we determine if The inventory replacement a new layer inventory differs was added byfrom the old inventory on comparing ending hand. We to just create a inventory beginning new layer. inventory. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) We need to determine if the increase in ending inventory over beginning inventory was due to a price increase or an increase in inventory. 1a. Compute a Cost Index for the year. 8 - 47 Cost index in layer = year Cost in layer year ÷ Cost in base year Methods of Simplifying LIFO Dollar-Value LIFO (DVL) 1b. Deflate the ending inventory value using the cost index. 1c. Compare ending inventory (at base year cost) to beginning inventory. 8 - 48 Ending inventory at base year cost Change in inventory Ending = inventory ÷ cost Cost index Ending Inv. Beg. = at base – inventory year cost Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Next, identify the layers in ending inventory and the years they were created. Convert each layer’s base year cost to layer year cost by multiplying times the cost index. 8 - 49 Sum all the layers to arrive at Ending Inventory at DVL cost. Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information. Let’s look at the solution to this example. 8 - 50 12/31 2011 Ending inventory $ 150,000 Price index 100% Inventory as base-year prices $ 150,000 2012 168,000 105% 160,000 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) Masterwear reports the following inventory and general price information. 12/31 2011 2012 Ending inventory $ 150,000 168,000 Price index 100% 105% 168,000 ÷ 1.05 = 160,000 8 - 51 Inventory at base-year prices $ 150,000 160,000 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) First, determine the LIFO layer for the current year . . . Inventory at base-year December 31, prices 2011 $ 150,000 2012 160,000 2012 LIFO Layer $ 10,000 Inventory 8 - 52 Price index Ending I\inventory $ 150,000 105% $ 10,500 160,500 Methods of Simplifying LIFO Dollar-Value LIFO (DVL) At the LIFO layer at end of period prices to the ending LIFO inventory from last period. December 31, 2011 2012 2012 LIFO Layer Inventory Inventory at base-year prices $ 150,000 160,000 $ 10,000 Price index 100% Ending inventory $ 150,000 105% 10,500 160,500 $ 10,000 1.05 = 10,500 8 - 53 Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this: Total inventories at FIFO Less: LIFO allowance Inventories, at LIFO cost 8 - 54 2011 2010 $ 15,429 (1,508) $ 13,921 $ 15,387 (1,525) $ 13,862 LIFO Liquidation When prices rise . . . LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions. If inventory declines, these “out of date” costs may be charged to current earnings. 8 - 55 This LIFO liquidation results in “paper profits.” End of Chapter 8