3 inventory -part1

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C H A P T E R C H A P T E R 88

VALUATION OF INVENTORIES: VALUATION OF INVENTORIES: A COST-BASIS APPROACHA COST-BASIS APPROACH

Intermediate AccountingIFRS Edition

Kieso, Weygandt, and Warfield

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1. Identify major classifications of inventory.

2. Distinguish between perpetual and periodic inventory

systems.

3. Identify the effects of inventory errors on the financial

statements.

4. Understand the items to include as inventory cost.

5. Describe and compare the methods used to price

inventories.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

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Goods in transit

Consigned goods

Special sales agreements

Inventory errors

Inventory IssuesInventory IssuesPhysical Goods Physical Goods

Included in Included in InventoryInventory

Cost Included in Cost Included in InventoryInventory

Cost Flow Cost Flow AssumptionsAssumptions

Classification

Cost flow

Control

Basic inventory valuation

Product costs

Period costs

Purchase discounts

Specific identification

Average cost

FIFO

Summary analysis

Valuation of Inventories:Valuation of Inventories:Cost-Basis ApproachCost-Basis Approach

Valuation of Inventories:Valuation of Inventories:Cost-Basis ApproachCost-Basis Approach

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Inventories are:

items held for sale, or

goods to be used in the production of goods to be sold.

Inventory IssuesInventory IssuesInventory IssuesInventory Issues

LO 1 Identify major classifications of inventory.LO 1 Identify major classifications of inventory.

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory

or

Classification

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One inventory

account.

Purchase goods

in form ready for

sale.

Classification



Illustration 8-1

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Three accounts

• Raw materials

• Work in process

• Finished goods

Classification


LO 1LO 1

Illustration 8-1

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Inventory Cost Flow


Illustration 8-2


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Inventory Cost Flow


Illustration 8-3


Companies use one of two types of systems for maintaining inventory records — perpetual system or periodic system.

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Inventory Cost FlowInventory Cost FlowInventory Cost FlowInventory Cost Flow

LO 2 Distinguish between perpetual and periodic inventory systems.LO 2 Distinguish between perpetual and periodic inventory systems.

Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and

allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each

sale.

4. Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

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Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory

$ 100,000

Purchases, net

800,000

Goods available for sale

900,000

Ending inventory

125,000

Cost of goods sold

$ 775,000

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Illustration: Fesmire Company had the following transactions during the current year.

Record these transactions using the Perpetual and Periodic systems.

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Illustration 8-4Illustration:

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Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the “Other income and expense” section of the income statement.

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Inventory Control



All companies need periodic verification of the inventory

records by actual count, weight, or measurement, with the

counts compared with the detailed inventory records.

Companies should take the physical inventory near the

end of their fiscal year, to properly report inventory

quantities in their annual accounting reports.

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Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand.

Illustration 8-5

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Basic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory ValuationBasic Issues in Inventory Valuation


The physical goods (goods on hand, goods in transit,

consigned goods, special sales agreements).

The costs to include (product vs. period costs).

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

Valuation requires determining

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A company should record purchases when it obtains legal title to the goods.

Physical Goods Included in InventoryPhysical Goods Included in InventoryPhysical Goods Included in InventoryPhysical Goods Included in Inventory


Illustration 8-6

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LO 3 Identify the effects of inventory errors on the financial statements.LO 3 Identify the effects of inventory errors on the financial statements.

Effect of Inventory Errors

The effect of an error on net income in one year (2010) will be counterbalanced in the next (2011), however the income statement will be misstated for both years.

Illustration 8-7

Ending Inventory Misstated

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Effect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory ErrorsEffect of Inventory Errors

Illustration: Yei Chen Corp. understates its ending inventory by HK$10,000 in 2010; all other items are correctly stated.

Illustration 8-8

LO 3LO 3

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LO 3 Identify the effects of inventory errors on the financial statements.LO 3 Identify the effects of inventory errors on the financial statements.

Effect of Inventory Errors

The understatement does not affect cost of goods sold and net income because the errors offset one another.

Illustration 8-9

Purchases and Inventory

Misstated

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Costs Included in InventoryCosts Included in InventoryCosts Included in InventoryCosts Included in Inventory

LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

Product Costs - costs directly connected with

bringing the goods to the buyer’s place of business

and converting such goods to a salable condition.

Period Costs – generally selling, general, and

administrative expenses.

Treatment of Purchase Discounts – Gross vs.

Net Method

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Costs Included in InventoryCosts Included in InventoryCosts Included in InventoryCosts Included in Inventory

LO 4 Understand the items to include as inventory cost.LO 4 Understand the items to include as inventory cost.

Treatment of Purchase DiscountsIllustration 8-11

* $4,000 x 2% = $80

*

** $10,000 x 98% = $9,800

**

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Method adopted should be one that most clearly reflects periodic income.

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?Which Cost Flow Assumption to Adopt?

Specific Identification --- Average Cost --- LIFO

LO 5 Describe and compare the methods used to price inventories.LO 5 Describe and compare the methods used to price inventories.

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Young & Crazy Company makes the following purchases:

1. One item on 2/2/11 for $10



Young & Crazy Company sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended February 2011, assuming the company used the FIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%.

Example

Cost Flow AssumptionsCost Flow AssumptionsCost Flow AssumptionsCost Flow Assumptions


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Purchase on 2/2/11 for $10



Inventory Balance = $ 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income $ 40


“First-In-First-Out (FIFO)”

LO 5LO 5

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For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income $ 33 $ 33

“First-In-First-Out (FIFO)”

LO 5LO 5

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“Average Cost”

LO 5LO 5

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For the Month of Feb. 2011 Sales $ 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 12 12 Net Income $ $ 3030

“Average Cost”

LO 5LO 5

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“Specific Identification”

LO 5LO 5

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Depends which one is soldDepends which one is sold






“Specific Identification”

LO 5LO 5

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Financial Statement Summary

FIFO AverageSales 90$ 90$ Cost of goods sold 10 15

Gross profit 80 75 Operating expenses:

Administrative 14 14 Selling 12 12 Interest 7 7

Total expenses 33 33 Income before taxes 47 42 Income tax expense 14 12 Net income 33$ 30$

Inventory Balance 3035


LO 5LO 5

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LO 5LO 5

Illustration: Call-Mart Inc. had the following transactions in its first month of operations.

Beginning inventory (2,000 x $4)

$ 8,000

Purchases:

6,000 x $4.40

26,400

2,000 x 4.75

9,500

Goods available for sale

$43,900

Calculate Goods Available for Sale

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Specific IdentificationSpecific IdentificationSpecific IdentificationSpecific Identification

Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the amount of ending inventory and cost of goods sold.

Illustration 8-12

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Average CostAverage CostAverage CostAverage Cost

Illustration 8-13Weighted-Average


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Average CostAverage CostAverage CostAverage Cost

Illustration 8-14

In this method, Call-Mart computes a new average unit cost each time it makes a purchase.

Moving-Average


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First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)

Illustration 8-15Periodic Method

Determine cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory.


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First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)First-In, First-Out (FIFO)

Illustration 8-16

Perpetual Method

In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used.


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Inventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - Summary

Illustration 8-17


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Inventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - SummaryInventory Valuation Methods - Summary

Illustration 8-18Balances of Selected Items under Alternative Inventory Valuation Methods


8-41 LO 6 Describe the LIFO cost flow assumption.LO 6 Describe the LIFO cost flow assumption.

Under IFRS, LIFO is not permitted for financial reporting

purposes.

Nonetheless, LIFO is permitted for financial reporting

purposes in the United States, it is permitted for tax purposes

in some countries, and its use can result in significant tax

savings.

Education

3 inventory -part1