Intermediate Accounting, Ninth Edition
Kieso and Weygandt
Prepared by
Catherine Katagiri, CPA
The College of Saint Rose
Albany, New York
John Wiley & Sons, Inc.
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Chapter 8: Valuation of Inventories:
A Cost Basis Approach
After studying this chapter you should be able to:
• Identify major classifications of inventory
• Distinguish between perpetual and periodic inventory
systems.
• Identify the effects of inventory errors on the financial
statements.
• Identify the items that should be included as inventory cost.
• Describe and compare the flow assumptions used in
accounting for inventories.
• Explain the significance and use of a LIFO reserve.
• Explain the effect of LIFO liquidations.
• Explain the dollar-value LIFO method.
• Identify the major advantages and disadvantages of LIFO.
• Identify the reasons why a given inventory method is selected.
Inventory Classification
Inventories: Goods Held for Resale
– Retailer
» One inventory of finished goods (FG)
– Manufacturer
» 3 inventories
• Raw materials (RM),
• Work in process (WIP)
• Finished goods (FG)
– Inventories can be of high dollar value.
– A Just-in-Time inventory system may be in place.
Inventories kept to a minimum.
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Inventory Classification
– Level and condition of inventory important.
– Inventory may be subject to obsolescence.
– Inventory is held in anticipation of a sale, an uncertain
event.
• Review of Periodic and Perpetual Inventory
Systems
Periodic: Inventory is not up to date. When goods are
bought you use the purchases account to record
them. When inventory is sold you record the event
only once at retail. You must count the inventory and
update it periodically. You must calculate the cost of
goods sold as you have not kept track of it.
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Inventory Systems
• Journal entries:
To buy:
Purchases
XX
A/P
XX
** Assumes the gross approach is taken
To return:
A/P
XX
Purc Returns and Allowances XX
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Inventory Systems
To sell:
A/R
XX
Sales
XX
** At end of period the inventory must be counted
and adjusted, CGS calculated.
To adjust:
CGS (or Income Summary)
XX
Beginning inventory
Ending inventory
XX
XX
CGS (or Income Summary)
XX
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Inventory Systems
– Perpetual system: Inventory account is increased and
decreased as goods are bought and sold. Inventory is
counted at the end of the period to confirm the
accounting number. CGS is not a calculated figure as
you keep track of it as goods are sold.
Journal entries:
To buy: (assume gross method)
Inventory
A/P
XX
XX
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Inventory Systems
To return:
A/P
XX
Inventory (returns)
XX
To sell:
A/R
XX
Sales
CGS
XX
XX
Inventory
XX
•There is a modified perpetual inventory in use by
many firms. Records are kept in quantities only, not
dollars. Memo system, outside the journal entry
system.
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Inventory Systems
• There is a system called a “base or base stock”
inventory system. It means that a certain level ($
value) of inventory is assumed to be on hand at all
times.
– If the inventory increases then
the increase is carried at the
acquistion (recent) cost.
– If the inventory declines then
it is first replaced at the base
price before any layers are added.
– Not GAAP.
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Goods Included in Inventory
What belongs in inventory? Anything that the company owns,
i.e., it has title to. Physical possession (or the lack of) is not the
final indicator.
– Consignment sales.
– FOB destination means goods belong to the seller in transit.
– FOB shipping means goods belong to the buyer in transit.
– Cutoff tests (done at end of period):
» Purchases: To avoid understatement of inventory and A/P.
» Sales: To avoid overstatement of inventory and A/R, sales.
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Goods Included in Inventory
• Special Arrangement: Sales with buyback.
– These arrangements are not usually, in
substance, a sale.
– Should not be reported as a sale but as a
financing transaction.
– Briefly the sequence of events:
#1.
Goods are delivered to buyer and used by the buyer to
collateralize a loan, etc.
#2.
Buyer uses part (or all) of the loan proceeds to pay for
the inventory.
#3.
Seller receives the payment and turns around and
uses it to repurchase the inventory previously sold.
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Goods Included in Inventory
• Sales with high rates of return Two
approaches are available:
– You provide for the high amount
of returns and reduce sales and
A/R. To provide:
Contra sales (R & A)
XX
Provision for Returns (contra A/R)
XX
(Perpetual--increase inventory and decrease A/R)
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Goods Included in Inventory
– A second possiblity for sales with high rates of returns is to
not record any sale until circumstances indicate the amount of
inventory the buyer will return. When the amount of returns
can be reasonable estimated , the goods should be
considered sold. If returns are unpredictable, removal of
these goods from the inventory of the seller is inappropriate.
• Installment sales:
– Allowable under financial accounting only when significant
uncertainty surrounds the collectibility of the sale.
– Goods should be excluded from seller’s inventory if the
percentage of bad debts can be reasonable estimated.
– This topic will be extensively covered in Chapter 19.
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Inventory Errors
• Inventory errors
– Let’s take a look at four separate cases.
– Inventory errors are self-correcting. We’ll follow up Case #2.
Case #1 Ending inventory, Purchases, A/P are understated.
Arises from the failure to record and count a purchase.
Error on B/S only.
Ending inventory is too low, A/P too low.
You did not: (assume $100 amount)
Inventory (or purchases)
A/P
100
100
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Inventory Errors
Case #1
Value Was
Beg. Inven.
$100
Should’ve been
$100
(OK)
+ Purchases 300
400
(under)
Goods Avail.$400
$500
(under)
200
300
(under)
$200
$200
-End Inven.
CGS
(OK)
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Inventory Errors
Case #2
Ending inventory overstated; Purchases, A/P OK.
Failure to record a sale
CGS
100
Inventory
100
B/S assets too high
I/S income too high causing RE to be too high
Balance sheet would still balance.
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Inventory Errors
Case #2
Was
Beg. Inven.
$100
Should’ve Been
$100
OK
+Purchases
500
500
OK
Goods Avail.
$600
600
OK
-End Inven.
500*
400
*(overstated)
100**
200
**(understated)
CGS
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Inventory Errors
Case #3
Ending Inventory OK, Purchases and A/P overstated.
Goods coming FOB destination are recorded prior to their
receipt (they were not included in the physical count).
Should not have:
Purchases
A/P
100
100
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Inventory Errors
Case #3
Was
Should’ve Been
Beg. Inven
$100
$100
OK
+Purc
600*
500
*Over
GA
700*
600
*Over
-EI
400*
400
*OK
CGS
300*
200
*Over
B/S liability too high
I/S, RE too low
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Inventory Errors
Case #4
Ending inventory OK, Purchases, A/P understated.
Goods counted prior to invoice received and
recorded.
Did not record:
Purchases
100
A/P
100
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Inventory Errors
Case #4
Was
Beg. Inven.
$100
Should’ve Been
$100
+Purchases
400*
500
*Under
GA
500*
600
*Under
-End Inven.
400
400
OK
CGS
100*
200
*Under
B/S liability understated
I/S income overstated
B/S RE overstated
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Inventory Errors
Case #2: Effect of inventory errors will reverse
End of first year the Ending Inventory was overstated,
Purchases and A/P were OK.
Now, end of the second year, the firm gets the ending
inventory count correct.
First Year
Beg. Inven.
$100 (OK)
+Purchases
500 (OK)
Goods Avail.
600
-End Inven.
500 (over)
CGS
$100 (under)
Second Year
$500 (prior year)
800
(OK)
$1,300 (over)
600 (now OK)
$700
(over)
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Inventory Errors
Note: In year 1 the net income was overstated by $100; the
retained earnings were then over by $100 as was the ending
inventory.
In year 2 the ending inventory is OK. The
net income is off the same amount as year
1 (when error originated) but in the
opposite direction.
Retained earnings, end year 2, is now
correct.
The error may go undetected, but as long
as it is not repeated it will net out (or self
correct) after the next period.
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Inventory Costs
Costs included in inventory:
– Product costs--Material, labor and overhead
– Period costs--Selling, general, administrative, interest,
taxes
– FASB has ruled that interest is not to be made part of the
cost of the asset unless the asset is self-constructed
(and there are limits then).
• Full or absorption costing of inventory.
– All product costs are inventoried-variable and fixed.
– See footnote bottom page 404 on the potential
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differences capitalized for tax versus book purposes.
Inventory Costs
• Variable or direct costing
– Internal use
– Contribution format for the income statement.
– Only variable manufacturing costs become part
of the cost of the product.
– Fixed manufacturing costs become period
expenses.
• Record purchases at either the gross or the net.
– Please see Illustration 8-9
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Inventory Cost Flow Assumptions
Physical flow of goods for sale assumed to be on a FIFO basis
unless it is obviously otherwise.
Cost flow assumptions: How dollars are assigned to goods as
they are sold. Methods:
– Specific identification
– Weighted average
– First-in, First-out (FIFO)
– Last-in, First-out (LIFO)
–Let’s look at an example of each under
the periodic and perpetual systems.
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Inventory Cost Flow Assumptions
Beginning
Inventory
Purchase #1
Sale #1
Purchase #2
Sale #2
Units
Cost/Unit
100
$6
$600
200
$7
$1,400
$10
$3,000
$11
$550
(150)
300
(250)
Purchase #3
50
Goods Avail.
650
Sales
Totals
$5,550
(400)
Ending inventory is 250 units regardless of the cost flow
assumption.
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Inventory Cost Flow Assumptions
• FIFO Periodic and perpetual systems yield the same results.
Units are valued in chronological order.
• Goods available equals $5,550 or 650 units
• Ending inventory equals 250 units
• CGS equals 400 units
EI: 50 at $11 = $ 550
200 at $10 = $2,000
Total
$2,550
CGS: 100 at $6 = $
600
200 at $7 = $ 1,400
100 at $10 = $1,000
Total
$3,000
•Note: Total EI and CGS = 650 units or
$5,550 (must agree)
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Inventory Cost Flow Assumptions
Simple Weighted Average (periodic)
Goods available in dollars = average cost per unit
Goods available in units
$5,550 = $8.54 per unit rounded (all units at this price)
650 units
Ending inventory = 250 at $8.54 = $2,135
CGS = 400 at $8.54 = $3,416
Note: Again all units and dollars must be accounted for.
Notice the dollar values assigned will vary based on cost flow
assumptions. Physical flow of the goods remains the same.
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Inventory Cost Flow Assumptions
• Moving average perpetual.
– Always employ the same formula as before (goods
available in dollars/ goods available in units).
– Apply this formula after each purchase to value each sale
until a another purchase is made.
– The average will change if new units are acquired at
other than the previous average.
– Using our example the valuation of the ending inventory
is $2,328 or 250 units at $9.31 (rounded) per unit. The
CGS totals $3,223 from the two sales. Please attempt
the calculations yourselves to prove these
numbers!
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Inventory Cost Flow Assumptions
• LIFO periodic
Basic facts remain the same Ending inventory
250 units, sales of 400 units, goods available of
650 units for a total cost of $5,550.
EI:
CGS:
100 at $6 = $ 600
50 at $11 = $ 550
150 at $7 = $1,050
300 at $10 = $3,000
250
50 at $ 7 = $ 350
$1,650
400
$3,900
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Inventory Cost Flow Assumptions
• LIFO perpetual yields a different result than LIFO periodic.
This is because of the creation of LIFO layers. Units are
not removed all at once; purchases are not exhausted by
each sale, some may be left behind as they are no longer
the last in.
Ending inventory valuation:
after S#1
CGS after S# 1
100 at $6 = $ 600
150 at $7 = $1,050
50 at $7 = $ 350
300 at $10 = $3,000
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Inventory Cost Flow Assumptions
• LIFO perpetual continued:
after P#2
100 at $6 = $ 600
50 at $7 = $ 350
300 at $10 = $3,000
• Inventory valuation:
after S#2
CGS from S#2
100 at $6 = $ 600
250 at $10 = $ 2,500
50 at $7 = $ 350
50 at $10 = $500
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Inventory Cost Flow Assumptions
Inventory valuation:
after P#3
100 at $6 = $ 600
50 at $7 = $ 350
50 at $10 = $ 500
50 at $11 = $ 550
250
$2,000
Total CGS = $3,550
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LIFO
• Please review LIFO reserve on page 409.
• Please review LIFO liquidation
–Review what happens you consume
older, cheaper goods and the effect on
income taxes and cash flows.
–Please see page 410.
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Dollar-Value LIFO
• Dollar Value LIFO: Method to value inventory to ease the liquidation of
LIFO layers.
– Selection of a “base year”.
– The beginning inventory of that year becomes the base year
(BY). We will assume the price index for the base year is 100
(or 100%).
– In words, what you are attempting to do is to create an
inventory as if LIFO had been in place. You may maintain
your books using FIFO but you wish to use LIFO for reporting
and tax purposes.
– The current inventory is
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carried at current prices.
Dollar-Value LIFO
– You need to convert the $ to a common size (as if they
were all base year dollars).
– You then create the layers common to LIFO by using
various price indices (PI). That is, inventory is restated
to various acquisition year prices.
Current year inventory at cost = Current inventory in
BY $
Current year price index
– We will be given the price index as there are several
sources for possible price indices.
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Dollar-Value LIFO
– After the current year’s inventory has been
converted to common size base year (BY)
dollars:
Current year inventory (BY$)
less: Base year inventory (BY$) times 1.0 PI =
$
Additional layer of inventory times current layer’s PI = ($)
Total Dollar Value LIFO inventory
$
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Dollar-Value LIFO
For example:
Year 1 BY inventory $2,000; price index is 100%
Year 2 (current year) inventory $3,000; price index is 120%
For Year 2:
$3,000
=
$2,500 (current inventory BY $)
1.2
less BY layer (2,000) BY$ x 1.00 =
year 2 layer
$500
x 1.20 =
$2,000
600
$2,600 DV LIFO
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LIFO
LIFO advantages
–Reduces taxes
–Reduces inventory profits
–Matching
–Cash flow
–Inventory unlikely to be written down
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LIFO
• LIFO disadvantages:
– Understatement of inventory.
– Reduces reported net income.
– Reduces reported working capital.
– Liquidation of layers
– Unexpected consequences if prices fall dramatically.
– Physical flow of goods does not match the dollar
flow
– Replacement cost not used (Next-in, first out or
NIFO)
– Poor buying habits develop in an effort to avoid
liquidating LIFO layers.
Please review basis for selection of inventory method,
pages 419-422.
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