Class #3 Inventory Measurement. Inventory Those assets that a company: 2. Has in production (work in process) for future sale. 1. Intends to sell in the

Class #3

Inventory Measurement

InventoryThose assets that a company:

2. Has in production (work in process) for future sale.

2. Has in production (work in process) for future sale.

1. Intends to sell in the normalcourse of business.

1. Intends to sell in the normalcourse of business.

3. Uses currently in the productionof goods to be sold (raw materials).3. Uses currently in the productionof goods to be sold (raw materials).

Types of Inventories

Merchandise Inventory

Merchandise Inventory

Goods acquired for resale

Goods acquired for resale

Manufacturing Inventory

Manufacturing Inventory

• Raw Materials• Work-in-Process• Finished Goods

• Raw Materials• Work-in-Process• Finished Goods

Types of Inventory

Inventory Cost FlowsRaw

Materials

(1) $XX $XX (4)

Work inProcess

FinishedGoods

Cost of GoodSold

DirectLabor

ManufacturingOverhead

$XX $XX (7) $XX $XX (8)

$XX

(2) $XX $XX (5)

(3) $XX $XX (6)

(1) Raw materials purchased(2) Direct labor incurred(3) Manufacturing overhead incurred(4) Raw materials used(5) Direct labor applied(6) Manufacturing overhead applied(7) Work in process transferred to finished goods(8) Finished goods sold

(1) Raw materials purchased(2) Direct labor incurred(3) Manufacturing overhead incurred(4) Raw materials used(5) Direct labor applied(6) Manufacturing overhead applied(7) Work in process transferred to finished goods(8) Finished goods sold

Inventory Methods

Perpetual Inventory System

Perpetual Inventory System

The inventory account is continuously

updated as purchases and sales are made.

The inventory account is continuously

updated as purchases and sales are made.

Periodic Inventory System


The inventory account is adjusted at the end of a reporting cycle.

The inventory account is adjusted at the end of a reporting cycle.

Two accounting systems are used to record transactions involving inventory:

Perpetual Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins

2013 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale

to customers.

Returns of inventory are credited to the inventory account.

Discounts on inventory purchases can be recorded using the gross or net method.

2013Inventory 600,000

Accounts payable 600,000To record the purchase of merchandise inventory.

Perpetual Inventory SystemDuring 2013, LWBC sold, on account, inventory with a retail

price of $820,000 and a cost basis of $540,000, to customers.

2013Inventory 600,000


2013Accounts receivable 820,000

Sales revenue 820,000To record sales on account.

Cost of goods sold 540,000Inventory 540,000

To record cost of goods sold.


Beginning Inventory+ Net Purchases

Cost of Goods Available for Sale

- Ending Inventory= Cost of Goods Sold

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.

Periodic Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins

2013 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale

to customers.

2013Purchases 600,000



No entry is made to record cost of goods sold. A physical countof ending inventory shows a balance of $180,000. Let’s

calculate cost of goods sold at the end of 2013.

During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000.

2013Accounts receivable 820,000

Sales revenue 820,000To record sales on account.


Beginning inventory 120,000$ Plus: Purchases 600,000 Cost of goods available for sale 720,000 Less: Ending inventory (180,000) Cost of goods sold 540,000$

Calculation of Cost of Goods Sold

We need the following adjusting entry to record cost of good sold.December 31, 2013Cost of goods sold 540,000Inventory (ending) 180,000

Inventory (beginning) 120,000Purchases 600,000

To adjust inventory, close the purchases account, and record cost of goods sold.

Comparison of Inventory SystemsTransaction or

EventPeriodic

InventoryPerpetual Inventory

Routine purchases of various inventory items

Costs debited to purchases account

Costs debited to inventory account

Sale of inventoryNo accounting entries made

Debit Cost of goods sold and credit

inventory

End-of-period accounting entries and

related activities

Physical count of inventory to

determine cost of good sold

No separate determination of cost

of goods sold necessary

What is Included in Inventory?

General RuleAll goods owned by the company on the inventory date,

regardless of their location.

General RuleAll goods owned by the company on the inventory date,

regardless of their location.

Goods in TransitGoods in Transit Goods on ConsignmentGoods on Consignment

Depends on FOB shipping terms.

Depends on FOB shipping terms.

Expenditures Included in Inventory

Invoice PriceInvoice Price

Freight-in on Purchases

Freight-in on Purchases

+

Purchase Returns

Purchase Returns

Purchase DiscountsPurchase Discounts

Real World• …the cost of warehousing and occupancy for our

Wal-Mart segment distribution facilities are included in operating, selling and general and administrative expenses. Because we do not include the cost of our Wal-Mart segment distribution facilities in cost of sales, our gross profit and gross margin may not be comparable to those of other retailers that may include all costs related to their distribution facilities in costs of sales and in the calculation of gross profit and gross margin.

Purchase Returns

November 8, 2013Accounts payable 2,000 Accounts payable 2,000 Purchase returns 2,000 Inventory 2,000

On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000.

Periodic Inventory Method Perpetual Inventory Method

Returns of inventory are credited to the Purchase Returns account when using the periodic inventory method.

The returns are credited to Inventory using the perpetual inventory method.

Purchase Discounts

October 5, 2013Purchases 20,000 Purchases 19,600

Accounts payable 20,000 Accounts payable 19,600

October 14, 2013Accounts payable 14,000 Accounts payable 13,720

Purchase discounts 280 Cash 13,720Cash 13,720

November 4, 2013Accounts payable 6,000 Accounts payable 5,880

Cash 6,000 Interest expense 120Cash 6,000

Discount terms are 2/10, n/30.

$14,000x 0.02$ 280

Partial payment not made within the discount period

Gross Method Net Method

$20,000x 0.02$ 400

@120$ 280

Net Method Using Perpetual and PeriodicDescription Debit Credit

Inventory 5,880 Accounts payable 5,880

Inventory 160 Cash 160

Accounts payable 200 Inventory 200

Accounts receivable 8,300 Sales revenue 8,300

Cost of goods sold 5,840 Inventory 5,840

Purchases 5,880 Accounts payable 5,880

Freight-in 160 Cash 160

Accounts payable 200 Purchase returns 200

Accounts receivable 8,300 Sales revenue 8,300

Periodic Inventory Method

Perpetual Inventory Method

Beginning inventory -$ Purchases 5,880$ Less: Returns (200) Plus: Freight-in 160 Net purchases 5,840 Cost of goods available for sale 5,840 Less: Ending inventory - Cost of goods sold 5,840$

Inventory Cost Flow Methods• Specific cost identification• Average cost• First-in, first-out (FIFO)• Last-in, first-out (LIFO)

• Specific cost identification• Average cost• First-in, first-out (FIFO)• Last-in, first-out (LIFO)

Real World – Wal-Mart

The Company uses the retail last-in, first-out (LIFO) method for general merchandise within the Wal-Mart Stores segment, cost LIFO for the SAM’S CLUB segment and grocery items within the Wal-Mart Stores segment, and other cost methods, including the retail first-in, first-out (FIFO) and average cost methods, for the International segment. Inventories are not recorded in excess of market value.

The specific cost of each inventory item must be known.

Only for items with serial #’s or other identity means.

The specific cost of each inventory item must be known.

Only for items with serial #’s or other identity means.

Specific Cost Identification• Items are added to

inventory at cost when they are purchased.

• COGS for each sale is based on the specific cost of the item sold.

• Items are added to inventory at cost when they are purchased.

• COGS for each sale is based on the specific cost of the item sold.

Perpetual Average Cost

UnitsCost per

Unit Total CostBeg. Inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$

Sale 9/7 500 Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 2,000

Picture This, LLCInventory of frame number 759

Units sold in September

UnitsCost per

Unit Total CostBeg. Inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000

Sale 9/7 500 10.25 5,125.00$ Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 2,000




($20,000 + 10,750) ÷ (2,000 + 1.000) = $10.25

UnitsCost per

Unit Total CostInventory at 9/21 2,500 10.25$ 25,625.00$ Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 3,500

Sale 9/7 500 10.25 5,125 Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 1,500




($25,625 + 10,950) ÷ (2,500 + 1,000) = $10.45

UnitsCost per

Unit Total CostSeptember Inventory and Cost of SalesSale 9/7 500 10.25 5,125.00$ Sale 9/29 1,500 10.45 15,675.00 Cost of goods sold 2,000 20,800.00 Ending inventory 2,000 10.45 20,900.00$

41,700.00$



3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.

Weighted-Average Periodic SystemLet’s use the same information to assign costs to ending inventory and cost of goods sold using the

periodic system.

Beginning Inventory (2,000 units)

Purchases (2,000 units)

Available for Sale

(4,000 units)

Ending Inventory(2,000 units)

Goods Sold(2,000)

$41,700 ÷ 4,000 = $10.425 weighted-average per unit cost

Weighted-Average Periodic System

UnitsCost per

Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$

Sale 9/7 500 10.25 5,125.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$



First-In, First-Out (FIFO)

The cost of the oldest inventory items are charged to COGS when goods are sold.

The cost of the newest inventory items remain in ending inventory.

The cost of the oldest inventory items are charged to COGS when goods are sold.

The cost of the newest inventory items remain in ending inventory.

The FIFO method

assumes that items are sold

in the chronological order of their acquisition.

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.

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.

UnitsCost per

Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00

Cost of goods sold 2,000 10.425$ 20,850.00 Ending Inventory 2,000 10.425$ 20,850.00$


Ending Inventory and Cost of Goods Sold

First-In, First-Out (FIFO)Periodic Inventory System

These 2,000 units come from the

beginning inventory (first-in,

first-out).

These 2,000 units come from the

beginning inventory (first-in,

first-out).

UnitsCost per


Cost of goods sold 2,000 10.425$ 20,000.00 Ending inventory 2,000 10.425$ 20,850.00$





UnitsCost per





Last-In, First-Out (LIFO)

The cost of the newest inventory items are charged to COGS when goods are sold.

The cost of the oldest inventory items remain in inventory.

The cost of the newest inventory items are charged to COGS when goods are sold.

The cost of the oldest inventory items remain in inventory.

The LIFO method

assumes that the newest

items are sold first, leaving the

older units in inventory.

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.

Unlike FIFO, using the LIFO method may result in COGS and

Ending Inventory Cost that differ under the

periodic and perpetual approaches.

UnitsCost per





Last-In, First-OutPerpetual Inventory System

These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.

These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.

UnitsCost per






The Cost of Goods Sold for the September 7 sale come from the purchase of September 3, so we record the

cost of goods sold at $5,375 (500 units times $10.75).

UnitsCost per






The Cost of Goods Sold for the September 29 sale come from the purchase of September 3 (500 remaining units) plus 1,000 units from

the purchase of September 21, for a total of 1,500 units,

UnitsCost per


Sale 9/7 500 10.75 5,375.00 Sale 9/29 1,500 10.45 16,325.00 Cost of goods sold 2,000 10.425$ 21,700.00 Ending inventory 2,000 10.00$ 20,000.00$




9/21 purchase 1,000 10.95$ 10,950.00$ 9/3 purchase 500 10.75 5,375.00 Cost of goods sold 1,500 16,325.00$

Last-In, First-OutPeriodic Inventory System

UnitsCost per





UnitsCost per





Last-In, First-OutPeriodic Inventory System

When Prices Are Rising . . .

LIFO Matches high (newer)

costs with current (higher) sales.

Inventory is valued based on low (older) cost basis.

Results in lower pre-tax income.

FIFO• Matches low (older)

costs with current (higher) sales.

• Inventory is valued at approximate replacement cost.

• Results in higher pre-tax income.

U. S. GAAP vs. IFRS

• 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.

LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will

impose a serious impediment to convergence.

IAS No. 2, Inventories, does not permit the use of LIFO.

Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories.

Decision Makers’ Perspective

Factors Influencing Method Choice

How are income taxes affected by inventory method

choice?

How closely do reported

costs reflect actualflow of inventory?

How well are costs matched against

related revenues?

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:

2014 2013

Total inventories at FIFO 15,429$ 15,387$ Less: LIFO allowance (1,508) (1,525) Inventories, at LIFO cost 13,921$ 13,862$

LIFO Liquidation

LIFO inventory costs in the balance sheet are “out of date” because they

reflect old purchase transactions.

When prices rise . . .

If inventory declines, these “out of date” costs

may be charged to current earnings.

This LIFOliquidation results in

“paper profits.”

Inventory Management

Gross profit ratio =Gross profitNet sales

Inventory turnover ratio = Cost of goods soldAverage inventory

The higher the ratio, the higher the markup a company is able to achieve on its products.

(Beginning inventory + Ending inventory2

Designed to evaluate a company’seffectiveness in managing its

investment in inventory

Quality of EarningsChanges 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.

Methods of Simplifying LIFO

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.

LIFO Inventory Pools

Example

The replacement inventory differs from the old inventory on

hand. We just create a new layer.

Methods of Simplifying LIFODollar-Value LIFO (DVL)

DVL inventory pools are viewed as layers of value, rather than layers of similar units.

DVL simplifies LIFO recordkeeping.

DVL minimizes the probability of layer

liquidation.

At the end of the period, we determine if a new inventory layer was added by comparing

ending inventory dollar amount to beginning

inventory dollar amount.


We need to determine if the increase in ending inventory over beginning inventory was due to a cost increase or an increase

in inventory quantity.

1a. Compute a Cost Index for the

year.

Cost index in layer

year =

Cost in layer year

÷Cost in base year


1b. Deflate the ending

inventory value using

the cost index.

Ending inventory at base

year cost

=

Ending inventory at year-end cost

÷Cost index

1c. Compare ending

inventory at base year cost to beginning inventory at base year

cost.

Change in inventory

=Ending Inv.

at base year cost

–

Beg. Inventory at base

year cost


Next, identify the layers in ending inventory and the years they were created.

Sum all the layers to arrive at ending inventory at DVL

cost.

Convert each layer’s base year cost to layer

year cost by multiplying times the

cost index.


Masterwear reports the following inventoryand cost index information. Let’s look at the

solution to this example.

12/31Ending

inventoryCost index

Inventory as base-year

prices2013 150,000$ 100% 150,000$

2014 168,000 105% 160,000


12/31Ending

inventoryCost index

Inventory at base-year

cost2013 150,000$ 100% 150,000$

2014 168,000 105% 160,000 168,000 ÷ 1.05 = 160,000

Masterwear reports the following inventoryand general price information.


December 31,


costsPrice index

Ending I\inventory

2013 150,000$ 150,000$

2014 160,000

2014 LIFO Layer 10,000$ 105% 10,500

Inventory 160,500$

First, determine the LIFO layer for the current year:


December 31,


costsCost index

Ending inventory

2013 150,000$ 100% 150,000$

2014 160,000

2014 LIFO Layer 10,000$ 105% 10,500

Inventory 160,500$

10,000 1.05 = 10,500

At the LIFO layer at end of period prices to theending LIFO inventory from last period.

Documents

Class #3 Inventory Measurement. Inventory Those assets that a company: 2. Has in production (work in process) for future sale. 1. Intends to sell in the