Inventories: Cost Measurement and Flow Assumptions C hapter 8 COPYRIGHT 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University 2 1.Describe how inventory accounts are classified. 2.Explain the uses of the perpetual and periodic inventory systems. 3.Identify how inventory quantities are determined. 4.Determine the cost of inventory. 5.Compute ending inventory and cost of goods sold under specific identification, FIFO, average cost, and LIFO. Objectives 3 6.Explain the conceptual issues regarding alternative inventory cost flow assumptions. 7.Understand dollar-value LIFO. 8.Explain additional LIFO issues. 9.Understand inventory disclosures. 10.Record foreign currency transactions involving inventory (Appendix). Objectives 4 Flow of Inventory Costs Merchandising Company Manufacturing Company 5 Flow of Inventory Costs Merchandising Company Cost of Goods Sold Accounts Payable (or Cash) Merchandise Inventory Goods Purchased Goods Sold 6 Manufacturing Company Accounts Payable (or Cash) Raw Materials Inventory Materials Purchased Materials Used in Production To Work in Process InventoryContinuedContinued Flow of Inventory Costs 7 Direct Labor Actual Direct Labor Manufacturing (Factory) Overhead Actual Mfg. Over- head Overhead Applied to Production To Work in Process Inventory Labor Charged to Production To Work in Process InventoryContinuedContinued Flow of Inventory Costs Manufacturing Company 8 Work in Process Inventory Materials Used Direct Labor Overhead Applied Finished Goods Inventory Goods Finished (Manufactured) Goods Sold to Cost of Goods Sold Flow of Inventory Costs Manufacturing Company 9 Alternative Inventory Systems A company using a perpetual system maintains a continuous record of the physical quantities in its inventory. 10 A company using a periodic system does not maintain a continuous record of the physical quantities of inventory on hand. Alternative Inventory Systems 11 Computation of Net Purchases Purchases +Freight-in Purchases Returns and Allowances Purchases Discounts Taken =Net Purchases Purchases +Freight-in Purchases Returns and Allowances Purchases Discounts Taken =Net Purchases 12 Beginning Inventory +Purchases (net) Goods Sold =Ending Inventory Beginning Inventory +Purchases (net) Goods Sold =Ending Inventory Perpetual Inventory System Beginning Inventory +Purchases (net) Ending Inventory =Goods Sold Beginning Inventory +Purchases (net) Ending Inventory =Goods Sold Periodic Inventory System Comparison of Systems 13 Who Owns the Inventory? 14 Determination of Inventory Costs Price paid or consideration given Freight-in Receiving Unpacking Inspecting Storage Insurance Applicable taxes Price paid or consideration given Freight-in Receiving Unpacking Inspecting Storage Insurance Applicable taxes 15 Under the gross price method, a company records the purchase at the gross price and records the amount of the discount in the accounting system only if the discount is taken. Under the net price method, a company records the purchase at its net price and records the amount of the discount in the accounting system only if the discount is not taken. Purchases Discounts 16 Purchases Discounts: Gross Price Method To record the purchase: Inventory (or Purchases)1,000 Accounts Payable1,000 A company purchases $1,000 of goods under terms of 1/10, n/30. To record payment within the discount period: Accounts Payable1,000 Purchases Discounts Taken10 Cash990 To record payment outside the discount period: Accounts Payable1,000 Cash1,000 17 To record the purchase: Inventory (or Purchases)990 Accounts Payable990 A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts: Net Price Method To record payment within the discount period: Accounts Payable990 Cash990 To record payment outside the discount period: Accounts Payable990 Purchases Discounts Lost10 Cash1,000 Purchases Discounts Lost are treated as a financing expense in the Other Items section of the income statement. 18 Net Price Method Adjusting entry at end of period if discount has expired and invoice is unpaid: Purchases Discounts Lost10 Accounts Payable10 A company purchases $1,000 of goods under terms of 1/10, n/30. Purchases Discounts: Net Price Method 19 If the company does not pay promptly, it is forfeiting 2% in order to keep the money for an additional 20 days. A company purchases $1,000 of goods under terms of 2/10, n/30. What is the annual discount rate? The company can forfeit this discount 18 times during a year. (360 days/20 additional each time = 18) Annual Rate on Discounts 2% forfeited 18 times equals an annual interest rate of 36% 20 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit On April 27, 90 units were sold from the beginning inventory and 50 units from the April 10 purchase. 21 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Apr. 20 $12 per unit $10 per unit Apr. 1 $11 per unit Apr. 10 $12 per unit $10 per unit $11 per unit $12 per unit Sold 90 Sold 50 Ending Inventory = $ 100 =330 = 840 $1,270 Cost of Goods Sold. $1,450 =$ 900 =550 = 0 Sold 0 22 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Apr. 20 Apr. 1 Apr. 10 $12 per unit $10 per unit $11 per unit $12 per unit Ending Inventory Goods Available for Sale = $ 1,000 =880 = 840 $2,720 = $ 100 =330 = 840 $1,270 Cost of Goods Sold. $1,480 Cost of Goods Sold.. 23 $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Sold 140 units during April $11 per unit Sold all $10 per unit Sold 40 Sold 0 $12 per unit First-In, First-Out (FIFO) 24 Ending Inventory $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per $11 per unit $10 per unit $12 per unit Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold = $ 0 =440 = 840 $1,280 $1,000 + $1,720 $1,280 = $1,440 First-In, First-Out (FIFO) 25 The ending inventory and the cost of goods sold under perpetual and periodic FIFO are identical. First-In, First-Out (FIFO) 26 = $1,000 =880 = 840 $2,720 Average Cost $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit Sold 140 units during April 250 units Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold $2,720 250 units = $10.88 $10.88 110 units = Ending Inventory of $1,197 $1,000 + $1,720 $1,197 = $1,523 27 $1,780 160 Apr. 18Sales $10.44 (940) Apr. $10.44$ 940 Apr. 20Purchases $ $11.125$1,780 Moving Average Apr. 1Beginning $10$1,000 Apr.10Purchases $ $10.44$1,880 Apr. 27Sales $ (556) Apr. $11.125$1,224 Cost of Goods Sold (140 units) $940 + $556$1,496 Ending Inventory (110 $11.125)$1,224 $1,880 180 28 Last-In, First-Out (LIFO) $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Sold 140 units during April $11 per unit Sold 0 Sold 70 Sold all $12 per unit Periodic Inventory System $12 per unit 29 Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per $11 per unit $12 per unit Periodic Inventory System $12 per unit Ending Inventory = $1,000 =110 = 0 $1,110 Last-In, First-Out (LIFO) $1,000 + $1,720 $1,110 = $1,610 30 $10 per unit $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Purchased 80 $12 per unit Perpetual Inventory System Sold 80 $11 per unit $11 per unit Sold 10 Purchased 70 Sold 50 Last-In, First Out (LIFO) Sold 90 units during April 31 Apr. 1 Apr. 10 Apr. 20 Perpetual Inventory System Ending Inventory Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold = $ 900 =0 = 240 $1,140 $1,000 + $1,720 $1,140 = $1,580 $10 per unit $11 per unit $12 per unit Last-In, First Out (LIFO) 32 Cost of Goods Cost of Available Goods Ending for Sale Sold Inventory Cost Flow Assumption and Method FIFO, periodic$2,720$1,440$1,280 FIFO, perpetual2,7201,4401,280 Weighted average2,7201,5231,197 Moving average2,7201,4961,224 LIFO, periodic2,7201,6101,110 LIFO, perpetual2,7201,5801,140 Comparison of Inventory Assumptions Holding Gains Comparisons FIFO matches the oldest cost with revenue. LIFO matches the most recent cost with revenue. 33 34 $20 per unit $22 per unit $24 per unit $30 per unit =$200,000 =132,000 =192,000 = 120,000 $644,000 Inventory, Jan. 1, 2010.. In 2010 the company purchases 50,000 units at $35 per unit but sells 60,000 units. 2006: 2007: 2008: 2009: Liquidation of LIFO Layers 35 $20 per unit $22 per unit 8,000units at $24 per unit 4,000units at $30 per unit 2006: 2007: 2008: 2009: 2010: =$ 200,000 =132,000 =192,000 = 120,000 =$1,750,000 50,000units at $35 per unit $35 per unit Sold 4,000 Sold 6,000 $30 per unit $24 per unit Liquidation of LIFO Layers In 2010 the company purchases 50,000 units at $35 per unit and sells 60,000 units. Sold 50,000 36 $20 per unit $22 per unit $24 per unit $30 per unit 2006: 2007: 2008: =$ 144,000 =120,000 = 1,750,000 $2,014,000 $35 per unit $24 per unit 2008: 2009: 2010: Cost of Goods Sold.. Liquidation of LIFO Layers 37 1.The LIFO method requires a company to keep numerous detailed records. 2.Fluctuations in the physical quantities of similar inventory items may occur. 3.As technological changes take place, inventory made up with one material is replaced by inventory made with substitute materials, or an outdated design is replaced by a newer design. Difficulties in Applying Simple LIFO 38 Step 1: Value the total ending inventory at current-year costs. 01/01/09$10,000 12/31/09$12,100 12/31/10$13,125 12/31/11$16,800 12/31/12$12,360 Dollar-Value LIFO 39 Step 2: Convert the ending inventory cost to base-year costs. 12/31/09$12,100 12/31/10$13,125 12/31/11$16,800 12/31/12$12,360 Ending Inventory at Current Costs Base-Year Cost Index Current Cost Index 100/110 = $11,000 12/31/09 Dollar-Value LIFO 40 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 $11,000 $10,000 $1,000 1/1/09 12/31/09 Dollar-Value LIFO 41 Step 4a:If there is an increase in the inventory levels at base-year costs, convert this increase to current-year costs. Base year, $10,000 $1,000$1,000 12/31/09 110/100 =$ 1,100 100/100 = 10,000 $11,100 Ending inventory, 12/31/09 Dollar-Value LIFO 42 Step 2: Convert the ending inventory cost to base-year costs. 12/31/09$12,100 12/31/10$13,125 12/31/11$16,800 12/31/12$12,360 Ending Inventory at Current Costs Base-Year Cost Index Current Cost Index 100/110 = $11,000 100/125 = $10,500 12/31/10 Dollar-Value LIFO 43 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/10 $1,000 $11,000 $10,500 Dollar-Value LIFO 44 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/10 $500 Dollar-Value LIFO 45 Step 4b: If there is a decrease in the inventory levels at base-year costs, this decrease reduces the inventory. Base year, $10,000 $500 12/31/10 110/100 =$ 550 100/100 = 10,000 $10,550 Ending inventory, 12/31/10 Dollar-Value LIFO 46 Step 2: Convert the ending inventory cost to base-year costs. 12/31/09$12,100 12/31/10$13,125 12/31/11$16,800 12/31/12$12,360 110/100 = $11,000 100/125 = $10,500 100/140 = $12,000 12/31/11 Dollar-Value LIFO Ending Inventory at Current Costs Base-Year Cost Index Current Cost Index 47 Step 3: Compute the change in the inventory level for the year at base-year costs. $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/11 $500 $12,000 $10,500 = $1,500 Dollar-Value LIFO 48$500 $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/11 $1,500 Step 3: Compute the change in the inventory level for the year at base-year costs. Dollar-Value LIFO 49 Step 4a:If there is an increase in inventory levels at base-year costs, convert this increase to current-year costs. Base year, $10,000 12/31/11 140/100 =$ 2,100 110/100 = 550 100/100 = 10,000 $12,650 Ending inventory, 12/31/11 $500 $1,500 Dollar-Value LIFO 50 Step 2: Convert the ending inventory cost to base-year costs. 12/31/09$12,100 12/31/10$13,125 12/31/11$16,800 12/31/12$12,360 110/100 = $11,000 100/125 = $10,500 100/140 = $12,000 100/120 = $10,300 12/31/12 Dollar-Value LIFO Ending Inventory at Current Costs Base-Year Cost Index Current Cost Index 51$500 $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/12 $1,500 Dollar-Value LIFO 52$500 $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/12 Dollar-Value LIFO 53$300 $11,000 $10,500 $12,000 $10,300 12/31/09 12/31/10 12/31/11 12/31/12 Base year, $10,000 12/31/12 Dollar-Value LIFO 54 Step 4a:If there is an increase in the inventory levels at base-year costs, convert this increase to current-year costs. Base year, $10,000 12/31/12 110/100 = $ 330 100/100 = 10,000 $10,330 Ending inventory, 12/31/12 $300 Dollar-Value LIFO 55ContinuedContinued Alternate 8-12 Current Cost Current at Base-Year Historical Costs Prices Cost $11,100 $10,550 12/31/09 $12,100 = $11, /31/10 $13,125 = $10, $10,000 =$10, ,000 = 1, $10,000 =$10, = 56 Alternate 8-12 Current Cost Current at Base-Year Historical Costs Prices Cost $12,650 $10,330 12/31/11 $16,800 = $12, /31/12 $12,360 = $10, $10,000 =$10, = $10,000 =$10, = ,500 = 2, 57 Cost Index = Sample of Ending Inventory at Current-Year Costs Sample of Ending Inventory at Base-Year Costs 100 Double-Extension Method Determination of Cost Index 58 Cost Index = Sample of Ending Inventory at Current -Year Costs Sample of Ending Inventory at Previous-Year Costs Link-Chain Method Previous- Year Cost Index Determination of Cost Index 59 A company may use inventory pools in conjunction with dollar-value LIFO. The purpose of the pools is to maintain the benefits from using LIFO when fluctuations in the physical quantities or similar inventory items occur and when technological change takes place. Inventory Pools 60 To illustrate the concept of an inventory pool, consider Hermanns Soup Company, which adopts dollar-value LIFO on January 1, 2010, using a single pool. The pool includes three types of soup that the company manufactures, and we show the calculation of the total cost of the beginning inventory. The company assigns a cost index of 100 to the beginning inventory and uses it as the base for calculating the cost index in later years. Inventory Pools 61 Inventory Pools 62 During 2010, the company purchased 150,000 cans of soup and sold 139,000 cans, leaving 51,000 cans in ending inventory, including the quantities of each type as shown. Using the double-extension method, the company calculates a cost index of 107 for the ending inventory by dividing the ending inventory at current-year costs by the ending inventory at base-year costs. Completing the remaining steps in the dollar-value LIFO calculations results in an ending inventory at LIFO cost of $10,167. Inventory Pools 63 Inventory Pools 64 Inventory Pools 65 Life Valuation Adjustment - Frequently, a company uses LIFO for external financial reporting and income tax purposes but uses another method for internal management. Additional LIFO Considerations 66 Interim Statements Using LIFO If a company uses LIFO for annual reporting purposes, it must use LIFO for interim reporting purposes. GAAP states that if a company using LIFO has an inventory liquidation at an interim date that it expects to replace by the end of the annual period, it does not include the LIFO liquidation in its inventory, and its cost of sales includes the expected cost of replacement of the liquidated LIFO inventory. Additional LIFO Considerations 67 Change to or from LIFO - A company may occasionally change its inventory cost flow assumption. To Usually, the effect on the results of prior periods is not determinable. Then GAAP requires that the company apply the change prospectively, as of the earliest date practicable. From Retroactively restate the results of prior periods and treat the change as a retrospective adjustment. Additional LIFO Considerations 68 IFRS vs. U.S. GAAP IFRS do not allow the use of LIFO for both financial and tax purposes. While both U.S. GAAP and IFRS allow the use of multiple acceptable cost flow assumptions, IFRS require that the same assumption be used for all inventories that have a similar nature and use. No such requirement exists under U.S. GAAP. 69 Disclosure of Inventory Values and Methods 70 1.An exchange gain occurs when the exchange rate declines between the date a payable is recorded as a result of a purchase of inventory and the date of the cash payment. 2.An exchange gain occurs when the exchange rate increases between the date a receivable is recorded as a result of a sale of inventory and the date of the cash receipt. When exchange rates are stated in terms of $ per unit of foreign currency, exchange gains and losses occur for purchases or sales on account as follows: ContinuedContinued Appendix: Foreign Currency Transactions Involving Inventory 71 Appendix: Foreign Currency Transactions Involving Inventory 3.An exchange loss occurs when the exchange rate increases between the date a payable is recorded as a result of a purchase of inventory and the date of the cash payment. 4.An exchange loss occurs when the exchange rate declines between the date a receivable is recorded as a result of a sale of inventory and the date of the cash receipt. RMB 72 A U.S. company purchases inventory of electronic components from a Japanese company for 50 million yen () when the exchange rate is $ 50,000,000 $0.009 = $450,000 Inventory (or Purchases)450,000 Cash450,000 Appendix: Foreign Currency Transactions Involving Inventory 73 Assume that the exchange rate on the date of payment is $ The U.S. company has to pay only $440,000. 50,000,000 $ = $440,000 Accounts Payable450,000 Cash440,000 Exchange Gain10,000 Appendix: Foreign Currency Transactions Involving Inventory 74 A U.S. company sells computer equipment (cost, $200,000) to a German Company on account and the agreed price is 300,000 euros. On the date of the sale, the exchange rate is $1.40 (1 euro = $1.40). 300,000 $1.40 = $420,000 Accounts Receivable420,000 Sales Revenue420,000 Cost of Goods Sold200,000 Inventory200,000 Appendix: Foreign Currency Transactions Involving Inventory 75 If the exchange rate is $1.38 when the German company pays the amount owed, the U.S. company can convert those euros into only $414,000. 300,000 $1.38 = $414,000 Cash414,000 Exchange Loss6,000 Accounts Receivable420,000 Appendix: Foreign Currency Transactions Involving Inventory 76 C hapter 8 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.