Chapter 8: Inventory Valuation

1

The Inventory Formula

Used to calculate Cost of Goods Sold (COGS) for the Income Statement and Ending Inventory (EI) for the balance sheet.

BI + Purchases (net) - EI = COGS BI + Purchases (net) = EI + COGS

Purchases (net)

=

Purchases

(billed cost of inventory purchased)

+Freight-in

(could be accounted for separately)

- Purchase Discounts

(cash discounts for early payment on account)

- Purchase Returns and Allowances

(returns reduce inventory when given back to seller; allowances are a negotiated reduction in price of inventory purchased).

2

Inventory Systems

   Perpetual – Up-to-date record in inventory account.

– Cost of goods sold computed for each sale.

Periodic – Inventory purchases are recorded as incurred.

– – Separate accounts used for the inventory components.

Inventory and cost of goods sold determined at the end of each period through physical count.

– Requires AJE to transfer costs to EI and COGS.

Costs and benefits – Perpetual requires more bookkeeping but provides more useful information.

– General application: Periodic used for external reporting; perpetual used for internal tracking of units.

3



Acquiring Inventory

What items or units to include?

– General rule: record in inventory when received, except: – Consignments: belong to consignor, ownership not based on physical possession.

– Goods in transit - FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). Note: FOB Destination indicates seller’s inventory while in transit (until inventory reaches purchaser’s facilities) – Special sales agreements:    Sales with buyback agreement.

Sales with high rates of return.

Sales on installment.

4

Seller

Title Transfers

Goods in Transit

FOB Shipping Point Belongs to Purchaser Purchaser FOB Destination Seller Belongs to Seller Purchaser

Title Transfers 5

Class Problem

Dallas Company had the following inventory transactions at the end of 2012. Indicate whether Dallas should show the inventory in its financials

as of 12/31/12

. 1. On 12/28, purchased inventory, FOB Destination. Shipped 12/28, did not arrive until Jan. 2.

2. On Dec. 29, purchased inventory, FOB Shipping Point. Shipped 12/29, did not arrive until Jan. 2 3. On 12/28, sold inventory to Houston Company, FOB Destination. Shipped 12/28; Houston received on Jan. 2.

6

Class Problem

4. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Jan. 2.

5. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Dec. 29. This inventory included a buyback agreement available for 60 days.

7

Inventory Errors

 Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods.

 Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved.

 Other errors, particularly with purchases, may be more complicated to analyze.

 To analyze, use basic inventory formula.

8

Class Problem-Inventory Error

Assume that the ending inventory of 2014 was undervalued by $9,000. If the error goes undetected in 2015, what effect would the error have on the balance sheet and income statement accounts for 2014 and 2015. Analyze using the following relationships:

BI + P - EI = COGS NI A = L + SE

Note that the

asset

account in inventory error analysis is

ending inventory

, and the

equity

effect is

retained earnings

, specifically the effect on net income.

9

Class Problem

Analysis (O = overstated, U = understated):

BI + P - EI = COGS NI A = L + SE

14: 15:

10

Journal Entries - Periodic System

1. When inventory purchased (gross method):

Purchases xx

Cash or A/P xx 2. Pay transportation on inventory: Freight-in xx Cash xx 3. If purchase discount is taken (gross method): A/P xx Purchase discount xx 4. If inventory returned: A/P xx Purch. Returns & Allow.

xx 11

Journal Entries - Periodic System

Note that Purchase and Transportation-in are created with Debits.

Purchase Discounts, Returns and Allowances are created with a credit (contra to purchases).

At the end of the period, the balances in all of these accounts (along with Beginning Inventory) are transferred to Ending Inventory and COGS (adjusting journal entry): Cost of Goods Sold Inventory - Ending xx ( based on FIFO,LIFO,Avg.

) xx ( based on FIFO,LIFO,Avg.

) Purchase Discounts Purchase Rt. & Allow. xx Purchases xx xx Transportation-in xx Inventory - Beginning xx

12

Purchases – Gross versus Net

Purchase $100 on account. Terms 2/10, n/30.

Gross Method

Purchase:

Purchases A/Pay 100 100

Payment within 10 days:

A/Pay 100 Cash 98 Purch. Discounts 2

Net Method

Purchases A/Pay A/Pay Cash 98 98 98 98

Payment after 10 days:

A/Pay 100 A/Pay 98 Cash 100 P. Disc. Lost 2* Cash 100

*Note: Purch. Discounts Lost is a financing charge and is classified as a period expense in the I/S (like interest expense). It is NOT part of COGS.

13

Journal Entries - Example

Example - assume the following balance in the Unadjusted Trial Balance of Raider Co.: DR CR Merch. Inv. (1/1/14) 2,600 Purchases 12,000 Freight-in Purchase Discounts Purchase R & A 500 900 1,400 At the end of 2014, Raider calculated its ending inventory to be $1,900, based on the FIFO technique.

14

Journal Entries - Periodic System

Part 1: What is the value of Cost of Goods Sold?

BI + P (net) EI = COGS Part 2, AJE: 15

Journal Entries – Perpetual System

For perpetual system, all entries are directly to and against the inventory account, rather than the detail components. Instead of debiting Purchases, the company debits inventory. Instead of crediting Purchase Discounts, the company credits Inventory.

Additionally, when inventory is sold, the transaction is recorded immediately with a debit to COGS and a credit to Inventory.

Thus, no AJE is needed at the end of the period; all accounts are already updated.

16

Cost Flow Assumptions

  [BI + P(net)] to EI and COGS?

Methods:   Given:

BI + P (net) = EI + COGS

How to assign costs of inflows

Specific identification Average

for both COGS and EI   

FIFO

– - (first-in, first-out) for COGS and LISH (last-in, still here) for EI

LIFO

- (last-in, first-out) for COGS – and FISH (first-in, still here) for EI Note that these techniques may be used for either periodic or perpetual systems; calculations for perpetual are more cumbersome.

17

Class Problem - Cost Flows

Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00

$180 Purchase 1/10 40 10.00 400 Purchase 1/22 Total available 30 90 units 11.00 330 $910 Sales on Jan. 12 30 units Sales on Jan. 24 25 units Total units sold: 55 Total units in EI 35

18

Periodic FIFO(LISH)

 FIFO for COGS (top down)  LISH for EI (bottom up)

19

Periodic LIFO(FISH)

 LIFO for COGS (bottom up)  FISH for EI (top down)

20

Average Periodic

 First calculate average: Goods available cost =

$910

Goods available units =

90 units Avg. = $10.11 per unit

 Now COGS:

55 units x $10.11 per unit = $ 556

 Now EI:

35 units x $10.11 per unit = $354

21

Perpetual FIFO (not tested)

Units Per Unit EI COGS Begin Inv. 20 $ 9.00

Purch. 1/10 40 10.00 Sale 1/12 (30) 20@9 = 180 10@10=100 Balance 30 10.00

Purch. 1/22 30 11.00 Sale 1/24 (25) Balance 5 10.00 = 50 25@10=250 30 11.00= 330____________ Totals EI=380 COGS=530

22

Perpetual LIFO (not tested)

Units Per Unit EI COGS Begin Inv. 20 $ 9.00

Purch. 1/10 40 10.00 Sale 1/12 (30) 30@10 = 300 Balance 20 9.00

10 10.00

Purch. 1/22 30 11.00 Sale 1/24 (25) Balance 20 9.00 = 180 10 10.00 = 100 25@11=275 5 11.00 = 55____________ Totals EI = 335 COGS =575

23

Average Perpetual (not tested)

(calculate average before each sale) Units Per Unit Total EI COGS Begin Inv. 20 $ 9.00 = $180 Purch. 1/10 40 10.00 = 400 Average 60 9.67

580 Sale 1/12 (30) @ 9.67 = (290) Balance 30 9.67 = 290 Purch. 1/22 30 11.00 = 330 Average 60 10.33

620 Sale 1/24 (25) 10.33 = (258) Balance 35 10.33 = 362 $290 258 $362 $548

24

Comparison of FIFO, LIFO, and Average

 In times of rising prices: highest COGS: lowest COGS highest EI lowest EI highest Net Income lowest Net Income

25

LIFO Advantages/Disadvantages

Advantages:

Tax benefits - cash flow savings in times of rising prices.

Matching on the income statement – current revenues and current costs.

Minimize write downs of inventory (already at a low cost).

Disadvantages:

Inventory may be significantly undervalued.

LIFO liquidation may cause significant increases in income (and in taxes).

Difficulty in comparing LIFO firms to FIFO firms.

LIFO Layer Liquidation

If an old, low LIFO layer is liquidated (usually when an product line or large segment is eliminated), then current income may increase significantly, as COGS absorbs much lower costs.

This effect, in the past, had been another technique that managers might use to manipulate income (with a corresponding net decrease in cash).

The SEC now requires that any income increases from LIFO layer liquidation now be disclosed separately in the financials.

  

LIFO Reserve

For companies that use LIFO for tax and external financial reporting, a financial statement disclosure is required that indicates the calculated inventory(ies) at FIFO. The difference between the FIFO and LIFO inventories is called the LIFO Reserve.

This number may be used to convert LIFO Inventory and COGS and Net Income to a FIFO basis, to allow for comparison to other companies. It also facilitates the calculation of the cash flow savings from reduced taxes.

28

   

Dollar Value LIFO

Unit LIFO (from previous section) is cumbersome and very difficult to implement for any company with even a modest amount of inventory.

Most companies that use LIFO choose to use Dollar Value LIFO. In this technique, the different groups of inventories are turned into annual dollar layers.

First the units of EI are turned into dollars by extending all the units at end of the year prices. Then the dollars are added to create a single layer of inventory costs, in dollars.

Each year the new layers are compared to old layers (in common dollars), and inventory change is calculated. See Handout for example.