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Agenda

• Quiz 3 Due Wednesday Feb 18• Midterm 2 Monday 2/23: Chapters 7-9 & 18• Wrap up chapter 7 examples

– Notes Receivable– Transfers of Receivables

• Chapter 8: Inventory– Weighted Average/FIFO/LIFO– Dollar Value LIFO

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Inventory Reporting

Report inventory at the lower of cost or market (conservatism)

“Cost” – the historical cost of the inventory:• Retail – the cost to get items in location and in condition for sale

(i.e. purchase price, purchase discounts, purchase returns, transportation in)

• Manufacturing:– Raw materials – cost of materials on hand but not yet placed in

production.– Work-in-process – cost of goods on which production has been started

but not yet completed (i.e. raw materials used, direct labor, manufacturing overhead).

– Finished good – cost of goods complete but not yet sold.

Merchandising Operations

Cost of goodssold

$$$

Merchandise Inventory

Purchases C/G/Sold

Inventory Cost Flows

Flow of Costs through Manufacturing and

Merchandising Companies

Inventory control is important for:

1. Ensuring availability of inventory items2. Preventing excessive accumulation of

inventory items3. Preventing waste, spoilage, or theft

Inventory Control

• Purchases are debited to Inventory account

• Freight-in, Purch. Returns & Allowances and Purch. Disc. are recorded in Inventory account.

• Debit COGS and credit Inventory account for each sale.

• Purchases are debited to Purchases account.

• Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts.

• COGS is computed only periodically:COGA – EI = COGS

Perpetual Method Periodic Method

Inventory Systems

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• Purchases are debited to Inventory account• Freight-in, Purch. Returns & Allowances and Purch. Disc. are

recorded in Inventory account.• Debit COGS and credit Inventory account for each sale.

J/E, Perpetual System:Purchase of Inventory:Dr. Inventory 1,000Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cost of Goods Sold 1,000Cr. Inventory 1,000

Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End: no j/e required, unless errors are found in inventory count

Inventory System - Perpetual

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• Purchases are debited to Purchases account.• Freight-in, Purchase Returns & Allowances and Purchase Discounts are

recorded in their respective accounts.• COGS is computed only periodically: COGA – EI = COGS

J/E, Periodic System:Purchase of Inventory:Dr. Purchases 1,000Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End:Dr. Ending Inventory (determined by count) 38,000Dr. Cost of Sales (plug) 283,000Cr. Purchases 286,000Cr. Opening Inventory (carried forward from prior year) 35,000

Inventory System - Periodic

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Basic Issues:1. Physical goods to be included

1. Goods in transit (FOB Destination)2. Goods on consignment with consignee3. Goods sold under buy back agreements 4. Goods sold with high rates of return (if unable to estimate

returns)5. Installment sales (if unable to estimate bad debts)

2. Costs to be included in inventory (product (RM) vs. period costs (office supplies)

3. Cost flow assumption used (specific identification, average cost, FIFO, LIFO, etc.)

Inventory Valuation

Error in Effect on Effect onEnding Income Balance sheetInventory Items Items

Under- COGS (over) Inventory (under)stated Net income (under) Retained Earn (under)

Over- COGS (under) Inventory (over)stated Net income (over) Retained Earn (over)

Effect of Inventory Errors

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Effect of Inventory Errors (O/S Ending)

Cost flow assumptions need not be consistent with physical flow of goods. The objective is to most clearly reflect periodic income.

The cost flow assumptions are:1 Specific identification 2 Average cost3 First-in, first-out (FIFO) and 4 Last-in, first-out (LIFO) (prohibited under

IFRS)

Cost Flow Assumptions

Spaworld reports the following transactions for 2004 (assume no opening inventory):

Date Purchases Purchase CostMay 12 100 units $1,000Aug 14 200 units 2,200Sep 18 120 units 1,800

420 units $5,000On December 31, the company had 20 units on hand and uses the periodic inventory system. What are the cost of goods sold and the

cost of ending inventory?

Cost Flow Assumptions: Example

Given Data:Date Purchases CostMay 12 100 units $1,000

Aug 14 200 units $2,200

Sep 18 120 units $1,800420 units $5,000

Steps:

1. Calculate per unit average cost: $5,000/420 = $11.905

2. Apply this per unit average cost to units sold to get COGS: 400 x $11.905 = $4,762

3. Apply the per unit average cost to units remaining in inventory to determine Ending inventory: 20 x $11.91 = $238

Average Cost Method

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Journal Entries:Dr. Cost of Sales 4,762Dr. Ending Inventory 238Cr. Opening Inventory 0Cr. Purchases

5,000

Average Cost Method

Given data: Date Purchases CostMay 12 100 units @ $10$1,000Aug 14 200 units @ $11$2,200Sep 18 120 units @ $15$1,800 420 $5,000

Cost of goods sold $4,700

20 X $15 = $300Ending inventory$5,000

Cost of goodsavailable

Cost of goods sold (FIFO)$1,000 (100 sold)$2,200 (200 sold)$1,500 (100 sold; 20 end inv)$4,700

First-In, First-Out (FIFO) Method

Note: FIFO = LISH (Last In Still Here)

“Count” from one direction and “plug” the other

Cost of goods sold $4,800

20 X $10 = $200Ending inventory$5,000

Cost of goodsavailable

Cost of goods sold (LIFO)$ 800 (80 sold; 20, end inv)$2,200 (200 sold)$1,800 (120 sold)$4,800

Given data: Date Purchases CostMay 12 100 units @ $10$1,000Aug 14 200 units @ $11$2,200Sep 18 120 units @ $15$1,800 420$5,000

Last-In, First-Out (LIFO) Method

LIFO = FISH (First In Still Here)

• The ending inventory in units is the same in all three methods: the cost is different

• The cost of goods available is the same for all methods

• The cost of goods sold and the cost of ending inventory are different

• In periods of rising prices, LIFO would result in the smallest reported net income.

Cost Flow Assumptions: Notes

• LIFO matches more recent costs with current revenues.

• With increasing prices:– LIFO yields the lowest taxable income

(assuming inventory does not decrease).

– Under LIFO, there is less need to write down inventory down to market

Advantages of LIFO Method

• LIFO yields the lowest net income and therefore reduced earnings (with increasing prices)

• Under LIFO, the ending inventory is understated relative to current costs

• LIFO liquidation (reduction of quantities of inventory during a period – results in “costing” items at older prices):– May result in income that is detrimental from a tax

view– May cause poor buying habits (because of the layer

liquidation problem)

• LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also.

Disadvantages of LIFO Method

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Periodic vs. Perpetual

• FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems

• BUT – LIFO, Weighted Average will give you different numbers– Under perpetual LIFO, with each sale, you cut into only

existing layers (so you must stop and calculate the cost of goods sold at each sale)

– Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale

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Same Example - Perpetual Basis

Unit Total UnitsUnits Cost Cost Sold

12-May 100 10 10001-Jun 85

14-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Unit Extended Unit ExtendedFIFO: Units Cost Value LIFO: Units Cost Value

1-Jun 85 10 850 1-Jun 85 10 8501-Sep 15 10 150 1-Sep 100 11 1100

85 11 935 20-Sep 120 15 180020-Sep 115 11 1265 95 11 1045

100 15 1500COGS 400 4700 COGS 400 4795

EI 20 15 300 EI 15 10 150Same as Periodic 5 11 55

205Different from Periodic

Purchased

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Same Example - Perpetual BasisSold

Unit ExtendedUnits Cost Cost Units

12-May 100 10 10001-Jun 85

14-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Calculate the average cost at time of each sale

Unit ExtendedWt. Av. Units Cost Value 1-Sep

1-Jun 85 10 850 costs to date 32001-Sep 100 10.9 1093.02 costs expensed 850

20-Sep 215 13 2796.81 0 23500 2150 Av Cost 10.9

COGS 400 4739.83Sept. 20

EI 20 13 260.168 Costs to date 5000Costs expensed 1943Remaining costs 3057Remaining units 235

Different from Periodic Av cost 13

Purchased

LIFO Reserve (Allowance) account is used, when:

LIFO is used for external reporting and a non-LIFO basis is used for internal reporting.

SEC reporting requirements – disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet

LIFO Reserve

Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004:$50,000 Inventory (LIFO basis) on Dec 31, 2004:$20,000

Adjust the cost of ending inventory to the LIFO basis

Dr. Cost of goods sold $30,000Cr. Allowance to Reduce Inventory

to LIFO $30,000

Balance Sheet (Assets):Inventory (FIFO) $50,000less: Allowance to Reduce Inventory ($30,000)Inventory (LIFO) basis $20,000

LIFO Reserve: Example

• Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when:– Earlier costs are matched against current sales

due to a reduction of quantities of inventory during a period (results in “costing” items at older prices)

– Such matching results in distorted income.

LIFO Layers

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• Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units

• Used for external purposes (i.e., financial statements and taxes)

• Advantages over regular LIFO: – Reduces record keeping (maximum of one layer per year).– Mitigates likelihood of eroding old layers (some decreases in goods in the pool

are offset by increases in other goods in the pool).

• Price index – a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year

– Internal = Ending inventory quantities X current year costsEnding inventory quantities X base year costs

– External – calculated by the Bureau of Labor Statistics

Dollar Value LIFO

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Compare ending inventory at base year prices to beginning of year inventory, also at base year prices – if there is an increase – we add a new LIFO layer at CY prices:

1. Calculate EI at current year costs - FIFO2. Calculate current year price index.3. Calculate EI at base year costs - FIFO4. Calculate the change in inventory at base year costs – FIFO (this

represents the quantity change in base year prices)5. Calculate the EI at dollar value LIFO:

• If the change in inventory at base year FIFO is positive, add a layer to BI at current year cost (i.e. price this real dollar quantity increase at current prices)

• If the change in inventory at base year FIFO is zero, BI equals EI• If the change in inventory at base year FIFO is negative, peel off layer(s)

from BI

Dollar Value LIFO Calculation Steps

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Given: Base layer (Dec 31, 2003):$20,000 Inventory (current prices) Dec 31, 2004: $26,400 Prices increased 20% during 2004.

Determine dollar value LIFO at Dec 31, 2004

Dollar Value LIFO: Example

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Dec 31, 2003 Dec 31, 2004

Price increase, 20%

At EOY prices:$26,400

$26,400 / 1.20At base $:$22,000

Net increaseat base $:

$22,000 less$20,000

Restate atcurrent $:

$2,400(layer added)

$2,000 * 1.20

$20,000 plus

$2,400 =$22,400

Dollar valueLIFO Inventory

Dollar Value LIFO: Example

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When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000):– the decrease must be subtracted from the

most recently added layer. – Once a layer is eliminated (peeled off), it

cannot be rebuilt.

Dollar Value LIFO: Notes