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Chapter 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Sommers – Intermediate I. Discussion Question. Q8-6 Goods out on approval to customers Goods in transit that were recently purchased f.o.b. destination Land held by a realty firm for sale R aw Materials

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chapter 8 valuation of inventories a cost basis approach sommers intermediate i
Chapter 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACHSommers – Intermediate I
discussion question
Discussion Question

Q8-6

  • Goods out on approval to customers
  • Goods in transit that were recently purchased f.o.b. destination
  • Land held by a realty firm for sale
  • Raw Materials
  • Goods received on consignment
  • Manufacturing supplies
transfer of ownership
Transfer of ownership

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

discussion question1
Discussion Question

Q8-3 What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

periodic inventory system
Periodic Inventory System

We need the following adjusting entry to record cost of good sold.

December 31, 2011

Cost of goods sold 540,000

Inventory (ending) 180,000

Inventory (beginning) 120,000

Purchases 600,000

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

inventory notation
Inventory Notation

Beginning

Balance

Purchases

Cost of Goods Available for Sale

Ending

Balance

Cost of Goods Sold

?

?

slide8

Choosing a Cost Flow Assumption

Specific Identification --- Average Cost

LIFO --- FIFO

Cost Flow Assumption Adopted

does not need to equal

Physical Movement of Goods

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

example 1 fifo periodic
Example 1: FIFO Periodic

Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows:

8,000 units were on hand at the end of the month.

Calculate January’s ending inventory and cost of goods sold for the month using FIFO, periodic system.

example 1 fifo periodic1
Example 1: FIFO Periodic

Cost of Goods Sold:

Ending Inventory:

example 1 lifo periodic
Example 1: LIFO Periodic

Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows:

8,000 units were on hand at the end of the month.

Calculate January’s ending inventory and cost of goods sold for the month using LIFO, periodic system.

example1 lifo periodic
Example1: LIFO Periodic

Cost of Goods Sold:

Ending Inventory:

example 1 lifo perpetual
Example 1: LIFO Perpetual

Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows:

8,000 units were on hand at the end of the month.

Calculate January’s ending inventory and cost of goods sold for the month using LIFO, perpetual system.

ex 1 lifo perpetual january 5 th sale
Ex 1: LIFO Perpetual (January 5th Sale)

Available:

Cost of Goods Sold:

Ending Inventory:

ex 1 lifo perpetual january 12 th sale
Ex 1: LIFO Perpetual (January 12th Sale)

Available:

Beg 3,000 units @ $8 = $24,000

Cost of Goods Sold:

Ending Inventory:

p8 5 lifo perpetual january 20 th sale
P8-5 LIFO Perpetual (January 20th Sale)

Available:

Beg 3,000 units @ $ 8 = $ 24,000

Jan 10 3,000 units @ $ 9 = 27,000

Cost of Goods Sold:

Ending Inventory:

example 1 lifo perpetual summary
Example 1: LIFO Perpetual (Summary)

Cost of Goods Sold:

Jan 5 3,000 units = $24,000

Jan 12 2,000 units = 18,000

Jan 20 4,000 units = 40,000

Total 9,000 units = $82,000

Ending Inventory:

Beg 3,000 units @ $ 8 = $24,000

Jan 10 3,000 units @ $ 9 = 27,000

Jan 18 2,000 units @ $10 = 20,000

8,000 units $71,000

example 1 average cost periodic
Example 1: Average Cost, Periodic

Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows:

8,000 units were on hand at the end of the month.

Calculate January’s ending inventory and cost of goods sold for the month using Average Cost, Periodic.

example 1 average cost periodic1
Example 1: Average Cost Periodic

Cost of Goods Sold:

Ending Inventory:

example 1 average cost perpetual
Example 1: Average Cost, Perpetual

Ferris Company began 2011 with 6,000 units of its principal product. The cost of each unit is $8. Merchandise transactions for the month of January 2011 are as follows:

8,000 units were on hand at the end of the month.

Calculate January’s ending inventory and cost of goods sold for the month using Average Cost, Perpetual.

ex 1 average cost perpetual jan 5 th sale
Ex 1: Average Cost Perpetual (Jan 5th Sale)

Cost of Goods Sold:

Ending Inventory:

ex 1 average cost perpetual jan 12 th sale
Ex 1: Average Cost Perpetual (Jan 12th Sale)

Cost of Goods Sold:

Ending Inventory:

ex 1 average cost perpetual jan 20 th sale
Ex 1: Average Cost Perpetual (Jan 20th Sale)

Cost of Goods Sold:

Ending Inventory:

ex 1 average cost perpetual summary
Ex 1: Average Cost Perpetual (Summary)

Cost of Goods Sold:

Jan 5 3,000 units = $24,000

Jan 12 2,000 units = 17,250

Jan 20 4,000 units = 37,250

Total 9,000 units = $78,500

Ending Inventory:

8,000 units @ $9.3125 = $74,500

supplemental lifo disclosures
Supplemental LIFO Disclosures

Tootsie Roll 2008

Balance Sheet20082007

Finished goods and work-in-process 34,862 37,031

Raw materials and supplies 20,722 20,371

Income Statement

Product cost of goods sold 333,314 327,695

Footnote:

Inventories are stated at cost, not to exceed market. The cost of substantially all of the Company’s inventories ($53,557 and $54,367 at December 31, 2008 and 2007, respectively) has been determined by the last-in, first-out (LIFO) method. The excess of current cost over LIFO cost of inventories approximates $12,432 and $11,284 at December 31, 2008 and 2007, respectively. The cost of certain foreign inventories ($2,027 and $3,036 at December 31, 2008 and 2007, respectively) has been determined by the first-in, first-out (FIFO) method. Rebates, discounts and other cash consideration received from a vendor related to inventory purchases is reflected as a reduction in the cost of the related inventory item, and is therefore reflected in cost of sales when the related inventory item is sold.

supplemental lifo disclosures1
Supplemental LIFO Disclosures

Tootsie Roll 2008

Balance Sheet20082007

Finished goods and work-in-process 34,862 37,031

Raw materials and supplies 20,72220,371

Total LIFO inventory 55,584 57,402

LIFO reserve 12,432 11,284

Total FIFO inventory 68,016 68,686

Income Statement

Product cost of goods sold – LIFO 333,314 327,695

Product cost of goods sold – FIFO ? ?

lifo to fifo conversion tootsie roll
LIFO to FIFO Conversion – Tootsie Roll

LIFO

FIFO

57,402

331,496

388,898

55,584

333,314

Inventory Turnover:

discussion question2
Discussion Question

Explain why proponents of LIFO argue that it provides a better match of revenue and expenses. In what situation would it not provide a better match?

Proponents of LIFO argue that it provides a better match of revenues and expenses because cost of goods sold includes the costs of the most recent purchases. These are matched with sales that reflect a current selling price. On the other hand, inventory costs in the balance sheet generally are out of date because they are derived from old purchase transactions. It is conceivable that a company’s LIFO inventory balance could be based on unit costs actually incurred several years earlier. When inventory quantity declines during a period, then these out-of-date inventory layers will be liquidated and cost of goods sold will match noncurrent costs with current selling prices.

discussion questions
Discussion Questions

Q8–18 Explain the following terms:

(a) LIFO Layer

(b) LIFO Reserve

(c) LIFO Effect

simplifying lifo with lifo inventory pools
Simplifying LIFO with LIFO Inventory Pools
  • 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.
dollar value lifo dvl
Dollar Value LIFO (DVL)
  • DVL extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO record-keeping, it also 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 to beginning inventory. When using DVL we think in terms of inventory layers rather than inventory pools.
  • The goal of DVL is to determine if an increase in ending inventory over beginning inventory is due to a price increase of a real increase in inventory.
dollar value lifo dvl1
Dollar-Value LIFO (DVL)

1a. Compute a Cost Index for the year.

1b. Deflate the ending inventory value using the cost index.

1c. Compare ending inventory (at base year cost) to beginning inventory.

dollar value lifo dvl2
Dollar-Value LIFO (DVL)
  • Next, identify the layers in ending inventory and the years they were created.
  • Convert each layer’s base year cost to layer year cost by multiplying times the cost index.
  • Sum all the layers to arrive at Ending Inventory at DVL cost.

You are totally lost so let’s do this!

example 2 dollar value lifo method
Example 2: Dollar Value LIFO Method

On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2013 are as follows:

Calculate Taylor’s ending inventory for 2011, 2012, and 2013.

example 2 continued
Example 2: Continued

On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 is as follows:

Calculate Taylor’s ending inventory for 2011.

example 2 continued1
Example 2: Continued

Adjust 2011 inventory to 2010 base-year prices:

$441,000 / 1.05 = $420,000

Calculate current year LIFO layer:

$420,000 – $400,000 = $20,000

Add the new LIFO layer at end of period prices to prior year LIFO inventory:

$400,000 * 1.00 = $400,000

20,000 * 1.05 = 21,000

$421,000

example 2 continued2
Example 2: Continued

On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2012 are as follows:

Calculate Taylor’s ending inventory for 2012.

example 2 continued3
Example 2: Continued

Adjust 2012 inventory to 2010 base-year prices:

$487,200 / 1.12 = $435,000

Calculate current year LIFO layer:

$435,000 – $420,000 = $15,000

Add the new LIFO layer at end of period prices to prior year LIFO inventory:

$400,000 * 1.00 = $400,000

20,000 * 1.05 = 21,000

15,000 * 1.12 = 16,800

$437,800

example 2 continued4
Example 2: Continued

On January 1, 2011, the Taylor Company adopted the dollar-value LIFO method. The inventory value for its one inventory pool on this date was $400,000. Inventory data for 2011 through 2013 are as follows:

Calculate Taylor’s ending inventory for 2013.

example 2 continued5
Example 2: Continued

Adjust 2013 inventory to 2010 base-year prices:

$510,000 / 1.20 = $425,000

Calculate current year LIFO layer:

$425,000 – $435,000 = ($10,000) Layer liquidation

Calculate LIFO layers at end of period prices:

$400,000 * 1.00 = $400,000

20,000 * 1.05 = 21,000

5,000 * 1.12 = 5,600

$426,600

lifo liquidation
LIFO Liquidation

Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.

  • Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2012, with cost determined on a specific-goods LIFO approach.
lifo liquidation example continued
LIFO Liquidation Example Continued

At the end of 2013, only 6,000 pounds of steel remained in inventory.

lifo liquidation1
LIFO Liquidation

When prices rise ...

  • LIFO inventory costs in the balance sheet are “out of date” because they reflect old purchase transactions.
  • If inventory declines, these “out of date” costs may be charged to current earnings.
  • This LIFO liquidation results in “paper profits.”

Could this be a source of abuse?

example 3 lifo liquidation
Example 3: LIFO Liquidation

The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 55,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 11,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011.

Cost of goods sold:

  • 54,000 units x $8.50 = $459,000
example 3 lifo liquidation continued
Example 3: LIFO Liquidation Continued

The Reuschel Company began 2011 with inventory of 10,000 units at a cost of $7 per unit. During 2011, 50,000 units were purchased for $8.50 each. Sales for the year totaled 54,000 units leaving 6,000 units on hand at the end of 2011. Reuschel uses a periodic inventory system and the LIFO inventory cost method. Calculate cost of goods sold for 2011.

Cost of goods sold:

  • 50,000 units x $8.50 = $425,0004,000 units x $7.00 = 28,000

$453,000

COGS is $6,000 lower because we did not buy inventory!

example 3 lifo liquidation continued1
Example 3: LIFO Liquidation Continued

From a financial reporting perspective, what problem is created by the use of LIFO in this situation? Describe the disclosure required to report the effects of this problem.

When inventory quantity declines during a period, liquidation of LIFO inventory layers carried at lower costs prevailing in prior years results in noncurrent costs being matched with current selling prices. If the resulting effect on income is material, it must be disclosed. In this case, the effect of the LIFO layer liquidation is to increase income (ignoring taxes) by $6,000 [4,000 units liquidated x $1.50 ($8.50 current year cost per unit - $7 LIFO layer cost per unit)].

decision makers perspective
Decision Makers’ Perspective

Factors Influencing Method Choice

  • How closely do reported costs reflect actual flow of inventory?
  • How well are costs matched against related revenues?
  • How are income taxes affected by inventory method choice?
slide49
LIFO

Disadvantages

Advantages

  • Matching
  • Tax Benefits/Improved Cash Flow
  • Future Earnings Hedge
  • Reduced Earnings
  • Inventory Understated
  • Physical Flow
  • Involuntary Liquidation / Poor Buying Habits
basis for selection of inventory method
Basis for Selection of Inventory Method
  • LIFO is generally preferred:
    • if selling prices are increasing faster than costs and
    • if a company has a fairly constant “base stock.”
  • LIFO is not appropriate:
    • if prices tend to lag behind costs,
    • if specific identification traditionally used, and
    • when unit costs tend to decrease as production increases.
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 taxable income.

FIFO

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

Inventory is valued at approximate replacement cost.

Results in higher taxable income.

When Prices Are Rising . . .
example 1 summary of results1
Example 1: Summary of Results

Costs were rising.

If costs are falling, ordering is opposite.

quality of earnings
Quality of Earnings

Changes in the ratios we have discussed 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.

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