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Chapter 8: Chapter 8: Inventory ValuationInventory Valuation

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The Inventory FormulaUsed 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 + COGSPurchases (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).

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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.

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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.

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Goods in TransitSeller Purchaser

Seller Purchaser

FOB Shipping Point

Title Transfers

Belongs to Purchaser

Title Transfers

FOB Destination

Belongs to Seller

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Class ProblemDallas 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.

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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.

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Inventory ErrorsInventory 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.

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Class Problem-Inventory ErrorAssume 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.

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Class Problem

Analysis (O = overstated, U = understated):

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

14: 15:

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Journal Entries - Periodic SystemJournal Entries - Periodic System1. When inventory purchased (gross method):

Purchases xxCash 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

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Journal Entries - Periodic SystemJournal Entries - Periodic SystemNote 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 Soldxx (based on FIFO,LIFO,Avg.)Inventory - Ending xx (based on FIFO,LIFO,Avg.)Purchase Discounts xxPurchase Rt. & Allow. xx

Purchases xxTransportation-in xxInventory - Beginning xx

Purchases – Gross versus NetPurchase $100 on account. Terms 2/10, n/30. Gross Method Net MethodPurchase: Purchases 100 Purchases 98

A/Pay 100 A/Pay 98Payment within 10 days: A/Pay 100 A/Pay 98

Cash 98 Cash 98 Purch. Discounts 2

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.

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Journal Entries - ExampleJournal Entries - ExampleExample - assume the following balance in the

Unadjusted Trial Balance of Raider Co.:DR CR

Merch. Inv. (1/1/14) 2,600Purchases 12,000Freight-in 500

Purchase Discounts 900Purchase R & A 1,400

At the end of 2014, Raider calculated its ending inventory to be $1,900, based on the FIFO technique.

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Journal Entries - Periodic SystemJournal Entries - Periodic SystemPart 1: What is the value of Cost of Goods Sold?

BI + P (net) - EI = COGS

Part 2, AJE:

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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.

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Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS?Methods: 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.

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Class Problem - Cost FlowsGiven the following activity for January: Cost Total

Units per Unit CostBegin Inventory 20 $ 9.00 $180Purchase 1/10 40 10.00 400Purchase 1/22 30 11.00 330Total available 90 units $910

Sales on Jan. 12 30 unitsSales on Jan. 24 25 units

Total units sold: 55Total units in EI 35

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Periodic FIFO(LISH)FIFO for COGS (top down)

LISH for EI (bottom up)

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Periodic LIFO(FISH)LIFO for COGS (bottom up)

FISH for EI (top down)

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Average PeriodicAverage PeriodicFirst calculate average:

Goods available cost = $910

Goods available units = 90 units

Avg. = $10.11 per unitNow COGS:

55 units x $10.11 per unit = $ 556Now EI:

35 units x $10.11 per unit = $354

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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=100Balance 30 10.00Purch. 1/22 30 11.00 Sale 1/24 (25) 25@10=250Balance 5 10.00 = 50

30 11.00= 330____________Totals EI=380 COGS=530

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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 = 300Balance 20 9.00

10 10.00Purch. 1/22 30 11.00 Sale 1/24 (25) 25@11=275Balance 20 9.00 = 180

10 10.00 = 100 5 11.00 = 55____________

Totals EI = 335 COGS =575

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Average Perpetual (not tested)(calculate average before each sale)

Units Per Unit Total EI COGSBegin Inv. 20 $ 9.00 = $180 Purch. 1/10 40 10.00 = 400 Average 60 580Sale 1/12 (30) @ 9.67 = (290) $290

Balance 30 9.67 = 290Purch. 1/22 30 11.00 = 330 Average 60 620 Sale 1/24 (25) 10.33 = (258) 258Balance 35 10.33 = 362 $362 $548

9.67

10.33

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Comparison of FIFO, LIFO, and Comparison of FIFO, LIFO, and AverageAverage

In times of rising prices:highest COGS:

lowest COGS

highest EI

lowest EI

highest Net Income

lowest Net Income

LIFO Advantages/DisadvantagesAdvantages: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 LiquidationIf 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.

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LIFO ReserveFor 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.

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.