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InventoryInventoryBasic Valuation MethodsBasic Valuation Methods

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IMPORTANCE OF INVENTORIES

Largest current asset of most manufacturing and retail firms.

Significant portion of total assets as well.

Inventory accounting methods and management practices can become profit-enhancing tools.

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INVENTORY CATEGORIES

Merchandise inventory -- Goods acquired for resale

Manufacturing inventory -- Raw materials -- Work-in-process -- Finished goods -- Manufacturing supplies

Miscellaneous inventories

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COMPONENTS OF INVENTORY COST

Invoice price

Freight-in

Purchase discounts

Other costs to get the inventory ready forsale

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PERIODIC METHOD

vs.

PERPETUAL METHOD

INVENTORY RECORDINGMETHODS

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INVENTORY RECORDING METHODS

Perpetual inventory system

-- The ongoing physical flow of inventory is monitored, and the cost of the inventory items is maintained on a continual basis.

-- Purchases recorded directly in “Inventory” account

-- May be recorded “gross” or “net”

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Sales revenue recorded in normal fashion

Cost of goods sold recorded immediately upon sale

No adjusting entry necessary for Cost of goods sold

Cost of goods sold account closed along with other expenses

PERPETUAL INVENTORY SYSTEM

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INVENTORY RECORDING METHODS

Periodic inventory system

-- Inventory value is determined only at particular times, such as end of the accounting period.

-- Purchases recorded in “Purchases” account

-- Purchases discount and purchase returns and allowances are recorded in their respective accounts.

• These accounts are contra-purchases accountscontra-purchases accounts, i.e., they have a credit balance.

-- May be recorded “gross” or “net”

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PERIODIC INVENTORY SYSTEM

Sales revenue recorded in normal fashion

No entry for Cost of goods sold at time of sale

Adjusting entry for Cost of goods sold at end of the fiscal period

Cost of goods sold then closed with other expense accounts at year end

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COST OF GOODS SOLD (COGS)

Beginning InventoryBeginning Inventory+ Purchases (net)+ Purchases (net)= Cost of Goods Available for Sale= Cost of Goods Available for Sale- Ending Inventory - Ending Inventory = Cost of Goods Sold = Cost of Goods Sold

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PERIODIC SYSTEM

• At the end of the accounting period, the adjusting entry results in:

• Elimination of: • Beginning inventory• Purchases account and any related accounts ( Purchase discounts, Purchase returns and allowances, etc.)

• Records the ending inventory • Records COGS.

• COGS is then closed to Income Summary alongwith other expenses.

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PERIODIC SYSTEMEXAMPLE

The following is a partial adjusted trial balance:

Account Debit Credit

Inventory 1/1/X6 $175,000Purchases 350,000Purchases Discount $ 22,000Purchase Returns & Allowances 6,000Sales 1,250,000Advertising Expense 7,500Salaries Expense 80,000Utilities Expense 20,000

The physical inventory count at 12/31/X6 was $125,000.

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PERIODIC SYSTEMSOLUTION

GENERAL JOURNAL

Page 1

Date Description PR Debit Credit

Cost of Goods Sold 372,000

Inventory, 12/31/X6 125,000

Purchases Discount 22,000

Purchase Returns & Allowances 6,000

Purchases 350,000

Inventory, 1/1/X6 175,000

To close accounts to COGS

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PERIODIC SYSTEMSOLUTION

GENERAL JOURNAL

Page 1

Date Description PR Debit Credit

Sales 1,250,000

Income Summary 1,250,000

To close account

Income Summary 479,500

Cost of Goods Sold 372,000

Advertising Expense 7,500

Salaries Expense 80,000

Utilities Expense 20,000

To close accounts

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COST FLOW METHODS

An allocation of total cost of goods available for sale:

Ending inventory

Cost of goods sold

Cost of goodsavailable

The cost flowcost flow assumption used for accounting purposescan be different from the physical flowphysical flow of goods throughthe company.

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INVENTORY VALUESCOST FLOW ASSUMPTIONS

Specific costidentification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

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Specific cost of each inventory item must be known

Opportunity to manipulate income by selection of items at time of sale

Allows perpetual inventory

SPECIFIC COST IDENTIFICATION

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WEIGHTED-AVERAGEPERIODIC METHOD

Compute weighted-average cost (WAC) per unit

Beginning inventory cost + Current purchase costBeginning inventory units + Current purchase units

Compute ending inventory

Ending Inv. = Units in Ending Inv. x WAC per Unit

Compute COGS

COGS = Units Sold x WAC per Unit

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MOVING-AVERAGEPERPETUAL METHOD

A new weighted-average unit cost must be

calculated after each purchase.

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FIRST-IN, FIRST-OUT

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

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

The actual physical flow of inventory items may differ from the FIFO cost flow assumptions.

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FIRST-IN, FIRST-OUTRESULTS

Periodic ending inventory cost equalsequals perpetualending inventory cost.

Periodic COGS equalsequals perpetual COGS.

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EVALUATION OF FIFO

Advantages Easy to apply Inventory value

approximates currentcost

Flow of costs tends tobe consistent withusual physical flow ofgoods

Systematic andobjective

Not subject tomanipulation

Disadvantages Does not match current

cost of goods sold withcurrent revenues

Inventory (or phantom)profits

In periods of risingprices, pay higherincome taxes

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LAST-IN, FIRST-OUTUNIT COST APPROACH

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

The cost of the oldest oldest inventory items remain inending inventory.

The actual physical flow of inventory items maydiffer from the LIFO cost flow assumptions.

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LAST-IN, FIRST-OUTRESULTS

Periodic ending inventory cost is differentdifferent fromperpetual ending inventory cost.

Periodic COGS is differentdifferent from perpetual COGS.

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EVALUATION OF LIFO

Advantages

In periods of risingprices, pay lesstaxes

Matches latestinventory costswith currentrevenues

Disadvantages

LIFO conformityrule for tax andbook purposes

Cost of recordkeeping higher

Inventory valuationis at older costs

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IN PERIODS OF RISING PRICES. . .

LIFOLIFO

Matches high (newer)costs with current(higher) sales

Values inventory onlow (older) cost basis

Results in lowertaxable income

FIFOFIFO

Matches low (older)costs with current(higher) sales

Values inventoryapproximating highercurrent costs

Results in highertaxable income

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POOLED LIFO

Groups items that are used or sold in relatively constant proportions

Each pool represents a group of different, but related, inventory items that are considered as a single entity for inventory accounting purposes

Uses the average cost for the entire pool to determine COGS and cost of ending inventory

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DOLLAR VALUE (DV) LIFO

Uses price indexesprice indexes related to the inventory instead of units and unit costs

Is applied to inventory poolsinventory pools rather than individual items

Approximates LIFO results used for income tax and external reporting purposes

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DOLLAR VALUE (DV) LIFOANNUAL PRICE INDEX

Calculate internal index:internal index:

FIFO ending inv. at current yr. unit cost FIFO ending inv. at base yr. unit cost

If an internal index cannot be determined,use an external indexexternal index provided by theBureau of Labor Statistics.

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DOLLAR VALUE (DV) LIFOINVENTORY POOLS

Single pool—Used when overall operations

constitute a so-called natural businessunit.

Multiple pools

—Separate inventory pools are formed foreach natural business unit.

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– Convert ending inventory in end-of-year

dollars to “base year dollars”base year dollars” (divide by appropriate price index)(divide by appropriate price index)

– Determine annual layers in base year dollarsbase year dollars

– Convert to DV LIFO cost using appropriate price index

DOLLAR VALUE LIFOSteps in Application

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DOLLAR VALUE (DV) LIFOEVALUATION

Advantages

Reduces probability of liquidating LIFO layers.

Reduces accounting costs of using LIFO.– Pooled approach– Fewer layers– Annual index

FIFO or average cost used for internal reporting.

Disadvantages

Establishing appropriate price index.

Subjective makeup of inventory pools.

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Inventory errors may have dramatic impacts on reported financial results Categories of errors

INVENTORY ERRORS

– Mistakes in physical counts– Errors in computing cost of inventory– Inappropriate recording of purchases– Inappropriate recording of sales

Evaluate impact of each errorDO NOT MEMORIZE PATTERNS!!

Make correcting entries as necessary

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Average Costing

CGSBI 1 2 3

4 5 6 7 8

Ending InventoryBI 1 2 3

4 5 67 8

Purchases1 2 34 5 6

7 8

BI

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FIFO COSTING

Purchases

1 2 34 5 6

7 8

BICGS

BI 1 2 34 5 6

EndingInventory

7 8

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LIFO COSTING

Purchases

1

2 34 5 6

7 8

BI

CGS2 3

4 5 6 7 8

EndingInventory

BI 1

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THE END