chapter 10--learning objectives 1.explain the importance of inventory for asset valuation and income...

Chapter 10--Learning Objectives

1. Explain the importance of inventory for asset valuation and income measurement

Inventories are a significant asset for many businesses

Inventories affect income

Sales XXX

Beginning inventory XXX

Purchases XXX

Goods available for sale XXX

Ending inventory XXX

Cost of goods sold XXX

Gross profit XXX

Operating expenses XXX

Net income XXX


2. Understand the nature of inventory and what is included in it

Types of inventory

1. Assets held for sale (or resale) in the ordinary course of business

2. Assets used or consumed in the production of goods to be sold in the ordinary course of business

A retail store(Sears, Wal-Mart, Safeway)

Has inventory for resale to customers

A manufacturer(Ford, IBM, Exxon)

Has inventories used or consumed in the production of goods for sale

A manufacturer’s inventorieswill usually include

Raw materials inventory

Items used in producing the productWork in process inventory

Products started but not yet completedFinished goods inventory

Products completed but not yet sold

What about this F.O.B. stuff ?

“F.O.B.” means “free on board” and refers to the time and place at which the goods were turned over to the transportation carrier

If you are in Los Angelesand your supplier is in New York City

You

Them


Somebody has to pay for moving the goods across the country

You

Them


And somebody owns the goods while they are moving across the country

You

Them

The F.O.B. designation determines who that “somebody” is

You

Them

If the goods are shipped F.O.B. New York(or F.O.B. origin)

You will pay the transportation cost

and you will own the merchandise

once it is turned over to the carrier in NYC

You

Them

If the goods are shipped F.O.B. Los Angeles(or F.O.B. destination)

The supplier will pay the transportation cost

and they will own the merchandise

until in reaches you in Los Angeles

You

Them

The owner of the goods

Is usually the entity that should include

those goods in inventory

This applies to goods in transit

and to consignment situations

But there are exceptions for some

special sales agreements

An interesting situation arisesin purchase commitmentsThese are noncancellable, long-term contracts to

purchase goods at a set price

You might enter into such an agreement to buy a product if you thought its price was about to go up

If the price does go up, everything is cool and you will make lots of money

But if the price goes down, you have an economic problem and an accounting problem

The Oliver Peck Oil Company(O. Peck for short)

Thinking that the price of gas is about to increase

Peck signs a contract during 19X1 to purchase 100,000 gallons of gas during 19X2 at $1.00 per gallon

On December 31, 19X1,gas is selling for $.94

Since Peck has agreed to pay $1.00 per gallon, accounting conservatism mandates:

December 31, 19X1

Est. Loss on Purch. Commit. 6,000

Est. Liab. on Contract 6,000

This reduces Peck’s income and increases his liabilities

Assume that on the April 1, 19X2, delivery date, gas is selling for $.90

Since Peck has agreed to pay $1.00 per gallon, there is an additional loss:

April 1, 19X2

Purchases 90,000


Loss on Purchase Contract 4,000

Cash 100,000

Now assume that on the April 1, 19X2, delivery date, gas is selling for $.98

Peck must still pay $1.00, but the situation has improved since December 31:

April 1, 19X2

Purchases 98,000


Recovery on Contract 4,000

Cash 100,000

Now assume that on the April 1, 19X2, delivery date, gas is selling for $1.05

This is what Peck was planning on, but the purchase is recorded at $1.00 and lower cost of goods sold will give Peck higher profits when the gas is sold

April 1, 19X2

Purchases 100,000


Recovery on Contract 6,000

Cash 100,000


3. Differentiate between perpetual and periodic inventory measurement systems

In a periodic inventory system

Purchases of goods for resale are recorded in a “Purchases” account:

Purchases XXX

Cash or Accts. Payable XXX


Recording sales of merchandise is simple:

Cash or Accts. Receivable XXX

Sales XXX


An adjusting entry closes out the beginning inventory and purchases accounts and records the cost of goods sold and ending inventory

Inventory (ending) XXX

Cost of Goods Sold XXX

Inventory (beginning) XXX

Purchases XXX

In a perpetual inventory system

Purchases of merchandise for resale are recorded in the “Inventory” account

Inventory XXX

Cash or Accts. Payable XXX


Recording sales is more complicated:


Sales XXX


Inventory XXX

The first entry records the sale at the selling price, just like in a periodic system


Recording sales is more complicated:


Sales XXX


Inventory XXX

The second entry removes the cost of the merchandise sold from the “Inventory” account and transfers it to “Cost of Goods Sold”


No end-of-period adjustment is required if the actual inventory cost matches the balance in the “Inventory” account:

XXX

Inventory


If items are missing, an adjustment is made to change the “Inventory” balance to reflect reality:

Inventory Shrinkage XXX

Inventory XXX

“Inventory Shrinkage” is treated as an expense account, but is often included in “Cost of Goods Sold” in practice

Inventory shrinkagecan be a result of

Theft

Spoilage

Accidental breakage

Mistakenly thrown away

and other causes

Occasionally, a business will have more inventory than the records indicate

P e t e ’ sP e t e ’ sR a b b i tR a b b i t

F a r mF a r m


4. Record and report inventories for different valuation systems

Inventory cost flow assumptions

Picture five items

identical except for cost

acquired in the order indicated

1 - 2 - 3 - 4 - 5

1$11

2$12

3$13

4$14

5$15

Inventory cost flow assumptions

The total cost of the five items is $65($11 + 12 + 13 + 14 + 15 = $65)

Assume that three items are sold for $25 each (total sales revenue = $75)

and that two are on hand at the end of the period

1$11

2$12

3$13

4$14

5$15

Specific identification

The actual items sold are recorded

These might be items 1, 3 and 5

Leaving items 2 and 4 in inventory

The cost of items 2 and 4 is $26

2$12

4$14

Specific identification

Sales revenue $75

Goods available for sale $65

Less: Ending inventory 26

Cost of goods sold $39

Gross profit $36

2$12

4$14

First-in, first-out ( FIFO )

The first three items would be the items sold--items 1, 2 and 3

Leaving items 4 and 5


4$14

5$15

First-in, first-out ( FIFO )

Sales revenue $75




Gross profit $39

4$14

5$15

Last-in, first-out ( LIFO )

The last three items (3, 4 and 5) would be the items sold

Leaving items 1 and 2


1$11

2$12

Last-in, first-out ( LIFO )

Sales revenue $75




Gross profit $33

1$11

2$12

Average cost

The total cost of the five items is $65

So the average cost per item is $13

It doesn’t matter which items are sold and which remain

The cost of the ending inventory is $26

? ?

Average cost

Sales revenue $75




Gross profit $36

? ?

Note that in this period of rising pricesthe gross profits were:

FIFO $ 39

Average 36

LIFO 33LIFO results in a higher cost of goods sold and a

lower gross profit because the higher cost of the last items purchased is being matched against revenues

LIFO will also result in a lower income tax in a period of rising prices

Lower of cost or market(LCM)

INVENTORYIS

PURCHASEDAT

COST

THERE ISNO PROBLEMIF THE VALUEINCREASES

Lower of cost or market(LCM)

INVENTORYIS

PURCHASEDAT

COST

THERE AREPROBLEMS

IF THEVALUE

GOES DOWN

A decline in inventory value...

Creates an accounting problem

Means that you will lose your shirt

Our job is to solve the

accounting problem

Any adjustment of inventory value

Must be below the ceiling

And above the floor

The Ceiling isNet Realizable Value (NRV)

What we expect to get less costs ofcompletion and disposal

The Floor isNRV less normal profit margin

Net realizable value lesswhat we would expect tomake on a similar item

We must remain betweenthe ceiling and the floor

In the real world

We know what cost was

We can usually get a replacement cost figure

We have to estimate net realizable value

You never know for sure until it’s actually sold

Lower of cost or market

Can be applied three ways:

1. To each inventory item separately

2. To each category of items in the

inventory

3. To the inventory as a whole

Probably the best way to apply lower of cost or marketIs the allowance method. The initial application entry would be:

Holding Loss XXX

Allowance to reduce

inventory to market XXX

The “Allowance” account appears on the balance sheet as a contra account to inventory


5. Estimate inventories using various methods

The gross profit method

Good news

Simple

Quick

Cheap

Bad news

Depends on old data relationships

May not be any good in a changing situation

Recall that...

Amount

Sales $100

Less: Cost of goods sold 70

Equals: Gross profit $ 30

These numbers can be expressed as percentages of sales

In this case, the percentages are:

Amount Pct.

Sales $100 100

Less: Cost of goods sold 70 70

Equals: Gross profit $ 30 30

Knowing the cost of goods sold percentage and some other facts allows us to estimate inventory

Assume that the following are known:

Beginning inventory $ 40,000

Purchases 480,000

Sales revenue 700,000

Cost of goods sold percentage 70%

These items would be available from the accounting records and prior year statements

Using the known data

Beginning inventory $ 40,000

Plus: Purchases 480,000

Equals: Goods avail. for sale $520,000

Sales x CGS %

($700,000 x .70) = 490,000

Estimated ending inventory $ 30,000

The retail method

Overcomes the problems of the gross profit method, but is more trouble

Some more trouble in the classroom

Considerably more trouble in the real world

Requires keeping two sets of sales records

One at cost (which would be done anyway)

Another at retail

Based on the relationship between goods available for sale at cost and at retail

Retail method example

Cost Retail

Beginning inventory $ 6,000 $10,000

Purchases 48,000 80,000

Goods available for sale $54,000 $90,000

Cost / Retail ratio for

Goods available for sale

( $54,000 / $90,000 ) = .60

Retail method example

Cost Retail

Goods available for sale $54,000 $90,000

Less: Sales 70,000

Ending inventory at retail $20,000

Cost / retail ratio .60

Ending inventory at cost $12,000

Retail method terminology

Markup--Amount by which original sales price exceeds cost--also called normal profit

Additional markup--Amount added to original sales price

Markup cancellation--Cancellation of all or part of the additional markup

Net markup--Additional markup less the markup cancellation

More retail method terminology

Markdown--Amount subtracted from the original sales price

Markdown cancellation--Cancellation of all or part of the markdown. Markdown cancellation cannot exceed the amount of the markdown

Net markdown--The difference between the total markdowns and the markdown cancellations

As previously demonstrated, the retail method approximates average cost

With modifications, it can be used to approximate:

Average cost on a lower of cost or market (LCM ) basis (very widely used and known as the “conventional method”

FIFO (with or without LCM )

LIFO

Summary of modifications

To approximate lower of cost or market ( LCM ) exclude net markdowns from the cost / retail ratio calculation

To approximate FIFO and LIFO, exclude beginning inventory from the cost / retail ratio calculation

Comprehensive retail methodassumptions (Sales = $125,000)

Cost Retail

Beginning inventory $ 5,000 $ 8,000

Purchases 85,000 160,000

Purchase discounts 4,000

Purchase returns 1,000 2,000

Freight-in 5,000

Net markups 14,000

Net markdowns 15,000

Ending inventory at retail $ 40,000

For FIFO, cost retail ratio is:

Cost RetailPurchases 85,000 160,000Purchase discounts - 4,000Purchase returns - 1,000 - 2,000Freight-in + 5,000Net markups + 14,000Net markdowns - 15,000Ratio basis 85,000 157,000

Ratio = .541EI Retail = $40,000, Est. EI = $21,656

For FIFO LCM, cost retail ratio is:

Cost Retail

Purchases 85,000 160,000

Purchase discounts - 4,000

Purchase returns - 1,000 - 2,000

Freight-in + 5,000

Net markups + 14,000

Ratio basis 85,000 172,000

Ratio = .494

EI Retail = $40,000, Est. EI = $19,767

For average cost, cost retail ratio is:

Cost RetailBeginning inventory 5,000 8,000Purchases + 85,000+160,000Purchase discounts - 4,000Purchase returns - 1,000 - 2,000Freight-in + 5,000Net markups + 14,000Net markdowns - 15,000Ratio basis 90,000 165,000

Ratio = .545EI Retail = $40,000, Est. EI = $21,818

For average LCM, cost retail ratio is:

Cost Retail

Beginning inventory 5,000 8,000

Purchases + 85,000+160,000

Purchase discounts - 4,000


Freight-in + 5,000


Ratio basis 90,000 180,000

Ratio = .500

EI Retail = $40,000, Est. EI = $20,000

LIFO advantages and disadvantages

Advantages

Matches current costs with revenues

Results in lower income taxes in periods of rising prices

Disadvantages

Distorts asset values on balance sheet

Becomes cumbersome to deal with

Can distort income if early, low-cost layers are liquidated

Lifo pools

A way of avoiding LIFO layer liquidation

Similar items are put together in groups or pools

Pooled items are treated as if purchased at same time

Less likely to liquidate layers in practice

Dollar value LIFO

A way of approximating LIFO

Think in terms of layers

In LIFO, if inventory quantity were constant, beginning and ending inventory would be exactly the same

Additional inventory adds a layer

Decreases reduce layers in LIFO order

Dollar value LIFO examplewith no price-level change

2000 ending inventory $20,000

2001 ending inventory 23,100

2001 inventory consists of:

2000 base layer $20,000

plus additional layer of 3,100

Total $23,100

Dollar value LIFO examplewith no price-level change

2000 ending inventory $20,0002001 ending inventory 23,1002002 ending inventory 27,250

2002 inventory consists of:2000 base layer $20,000plus 2001 layer of 3,100plus 2002 layer of 4,150

Total $27,250

Dollar value LIFOWhen price levels change

1. Convert current inventory value to base dollars

2. Analyze change in inventory in terms of base dollars

3. If inventory increases, add a layer, use current index

4. If inventory decreases, reduce layers in LIFO order

Dollar value LIFO examplewith price-level changes

Price

Amount index

2000 ending inventory $20,000 1.00

2001 ending inventory 23,100 1.05

2001 converted to base $

( 23,100 / 1.05 ) = $22,000

Change from 2000 (increase) 2,000


Base Current

Layer Index dollars dollars

Base 1.00 $20,000 $20,000

2001 addl. layer 1.05 2,000 2,100

Totals $22,000 $22,100

The 2001 ending inventory will be reported as $22,100


PriceAmount index

2000 ending inventory $20,000 1.002001 ending inventory 23,100 1.052002 ending inventory 27,250 1.09

2001 conv. to base $22,0002002 conv. to base $25,0002002 increase in base $ $ 3,000


Base CurrentLayer Index dollars dollarsBase 1.00 $20,000 $20,0002001 addl. layer 1.05 2,000 2,1002002 addl. layer 1.09 3,000 3,270

Totals $25,000 $25,370

The 2002 ending inventory will be reported as $25,370

Retail dollar value LIFO

Combines the retail method and dollar value LIFO

Calculate cost / retail ratio as was done for FIFO

Convert retail ending inventory to base dollars

Follow dollar value LIFO layer procedures

1999 retail dollar value LIFO ratio(data from Exhibit 10-15)

Cost Retail

Purchases 80,000 150,000


Freight-in + 2,000


Net markdowns - 4,760

Ratio basis 79,800 164,240

Ratio = .486

1999 ending inventory at retail

Retail

Beginning inventory 25,000

Purchases 150,000

Purchase returns - 4,000



Sales -160,000

Net sales returns + 1,000

Ending inventory at retail 30,240

1999 retail dollar value LIFO layers

Price

Amount index

1998 ending inventory $25,000 1.00

1999 ending inventory 30,240 1.08

1999 converted to base $

( 30,240 / 1.08 ) = $28,000

Change from 1998 (increase) 3,000

Retail dollar value LIFO-1999

Layer Base $ Index C/R DVL

Base 25,000 1.00 .480 12,000

1999 3,000 1.08 .486 1,575

Totals 28,000 13,575

2000 retail dollar value LIFO ratio

Cost Retail

Purchases 95,000 180,000

Purchase returns -0- -0-

Freight-in + 4,000



Ratio basis 99,000 200,000

Ratio = .495


Retail


Purchases 180,000

Purchase returns -0-



Sales -191,000

Net sales + 1,010



PriceAmount index

1995 ending inventory $25,000 1.001996 ending inventory 30,240 1.082000 ending inventory 40,250 1.15

1996 conv. to base 28,0002000 conv. to base 35,0002000 increase in base $ 7,000



Base 25,000 1.00 .480 12,000

1996 3,000 1.08 .486 1,575

2000 7,000 1.15 .495 3,985

Totals 35,000 17,560

2001 retail dollar value LIFO ratio

Cost Retail

Purchases 110,000 198,000


Freight-in + 5,000



Ratio basis 113,400 224,000

Ratio = .506


Retail


Purchases 198,000

Purchase returns - 3,000



Sales -235,000

Sales returns + 7,350



Amount index1995 ending inventory $25,000 1.001996 ending inventory 30,240 1.082000 ending inventory 40,250 1.152001 ending inventory 36,600 1.22

2000 conv. to base 35,0002001 conv. to base 30,0002001 decrease in base $ 5,000



Base 25,000 1.00 .480 12,000

1996 3,000 1.08 .486 1,575

2000 2,000 1.15 .495 1,138

Totals 30,000 14,713

Note reduction of 2000 layer from $7,000 to $2,000


6. Analyze the impact of inventory valuation on liquidity and profitability analysis

Inventory turnover

Cost of goods sold

Average inventory

Average inventory usually calculated

( Beginning inv. + Ending inv. ) / 2

Days sales in inventory

365 days

Inventory turnover

chapter 10--learning objectives 1.explain the importance of inventory for asset valuation and income...

Documents

production of goods

includethose goods

los angelesand

price of gas

los angelesor

new york cityyouthemif

new york cityand

new york citysomebody