Chapter 8 inventory valuation
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Chapter 8: Inventory Valuation. Used to calculate Cost of Goods Sold (COGS) for the Income Statement and Ending Inventory (EI) for the balance sheet. BI + Purchases (net) - EI = COGS BI + Purchases (net) = EI + COGS Purchases (net) =

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Chapter 8: Inventory Valuation

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Chapter 8 inventory valuation

Chapter 8: Inventory Valuation

The inventory formula

Used to calculate Cost of Goods Sold (COGS) for the Income Statement and Ending Inventory (EI) for the balance sheet.

BI + Purchases (net) - EI = COGS

BI + Purchases (net) = EI + COGS

Purchases (net) =

Purchases (billed cost of inventory purchased)

+Freight-in (could be accounted for separately)

- Purchase Discounts (cash discounts for early payment on account)

- Purchase Returns and Allowances (returns reduce inventory when given back to seller; allowances are a negotiated reduction in price of inventory purchased).

The Inventory Formula

Inventory systems


Up-to-date record in inventory account.

Cost of goods sold computed for each sale.


Inventory purchases are recorded as incurred.

Separate accounts used for the inventory components.

Inventory and cost of goods sold determined at the end of each period through physical count.

Requires AJE to transfer costs to EI and COGS.

Costs and benefits

Perpetual requires more bookkeeping but provides more useful information.

General application: Periodic used for external reporting; perpetual used for internal tracking of units.

Inventory Systems

Acquiring inventory

What items or units to include?

General rule: record in inventory when received, except:

Consignments: belong to consignor, ownership not based on physical possession.

Goods in transit - FOB Shipping Point: belongs to the purchaser while in transit (once inventory leaves seller’s facilities). Note: FOB Destination indicates seller’s inventory while in transit (until inventory reaches purchaser’s facilities)

Special sales agreements:

Sales with buyback agreement.

Sales with high rates of return.

Sales on installment.

Acquiring Inventory

Goods in transit


Seller Purchaser

Goods in Transit

FOB Shipping Point

Belongs to Purchaser



FOB Destination

Belongs to Seller



Class problem

Dallas Company had the following inventory transactions at the end of 2012. Indicate whether Dallas should show the inventory in its financials as of 12/31/12.

1. On 12/28, purchased inventory, FOB Destination. Shipped 12/28, did not arrive until Jan. 2.

2. On Dec. 29, purchased inventory, FOB Shipping Point. Shipped 12/29, did not arrive until Jan. 2

3. On 12/28, sold inventory to Houston Company, FOB Destination. Shipped 12/28; Houston received on Jan. 2.

Class Problem

Class problem1

4. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Jan. 2.

5. On 12/28, sold inventory to Amarillo Company, FOB Shipping Point. Shipped 12/28; Amarillo received on Dec. 29. This inventory included a buyback agreement available for 60 days.

Class Problem

Inventory errors

Inventory Errors

Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods.

Because of the carryover nature of inventory, some inventory errors reverse out by the end of the second year involved.

Other errors, particularly with purchases, may be more complicated to analyze.

To analyze, use basic inventory formula.


Class problem inventory error

Assume that the ending inventory of 2014 was undervalued by $9,000. If the error goes undetected in 2015, what effect would the error have on the balance sheet and income statement accounts for 2014 and 2015. Analyze using the following relationships:

BI + P - EI = COGS NI A = L + SE

Note that the asset account in inventory error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income.

Class Problem-Inventory Error

Class problem2

Analysis (O = overstated, U = understated):

BI + P - EI = COGS NI A = L + SE

Class Problem



Journal entries periodic system

1. When inventory purchased (gross method):


Cash or A/Pxx

2. Pay transportation on inventory:



3. If purchase discount is taken (gross method):


Purchase discountxx

4. If inventory returned:


Purch. Returns & Allow.xx

Journal Entries - Periodic System

Journal entries periodic system1

Journal Entries - Periodic System

Note that Purchase and Transportation-in are created with Debits.

Purchase Discounts, Returns and Allowances are created with a credit (contra to purchases).

At the end of the period, the balances in all of these accounts (along with Beginning Inventory) are transferred to Ending Inventory and COGS (adjusting journal entry):

Cost of Goods Soldxx (based on FIFO,LIFO,Avg.)

Inventory - Endingxx (based on FIFO,LIFO,Avg.)

Purchase Discountsxx

Purchase Rt. & Allow.xx



Inventory - Beginningxx


Purchases gross versus net

Purchases – Gross versus Net

Purchase $100 on account. Terms 2/10, n/30.

Gross Method Net Method


Purchases100Purchases 98

A/Pay 100 A/Pay98

Payment within 10 days:

A/Pay100A/Pay 98

Cash 98 Cash98

Purch. Discounts 2

Payment after 10 days:

A/Pay100A/Pay 98

Cash 100P. Disc. Lost 2*

Cash 100

*Note: Purch. Discounts Lost is a financing charge and is classified as a period expense in the I/S (like interest expense). It is NOT part of COGS.

Journal entries example

Journal Entries - Example

Example - assume the following balance in the Unadjusted Trial Balance of Raider Co.:


Merch. Inv. (1/1/14) 2,600

Purchases 12,000

Freight-in 500

Purchase Discounts900

Purchase R & A 1,400

At the end of 2014, Raider calculated its ending inventory to be $1,900, based on the FIFO technique.


Journal entries periodic system2

Journal Entries - Periodic System

Part 1: What is the value of Cost of Goods Sold?

BI + P (net) - EI = COGS

Part 2, AJE:


Journal entries perpetual system

For perpetual system, all entries are directly to and against the inventory account, rather than the detail components. Instead of debiting Purchases, the company debits inventory. Instead of crediting Purchase Discounts, the company credits Inventory.

Additionally, when inventory is sold, the transaction is recorded immediately with a debit to COGS and a credit to Inventory.

Thus, no AJE is needed at the end of the period; all accounts are already updated.

Journal Entries – Perpetual System

Cost flow assumptions

Given: BI + P (net) = EI + COGS

How to assign costs of inflows

[BI + P(net)] to EI and COGS?


Specific identification

Averagefor both COGS and EI

FIFO- (first-in, first-out) for COGS

and LISH (last-in, still here) for EI

LIFO - (last-in, first-out) for COGS

and FISH (first-in, still here) for EI

Note that these techniques may be used for either periodic or perpetual systems; calculations for perpetual are more cumbersome.

Cost Flow Assumptions

Class problem cost flows

Given the following activity for January:

Cost Total

Units per Unit Cost

Begin Inventory 20 $ 9.00 $180

Purchase 1/10 40 10.00 400

Purchase 1/22 30 11.00 330

Total available 90 units $910

Sales on Jan. 12 30 units

Sales on Jan. 24 25 units

Total units sold: 55

Total units in EI 35

Class Problem - Cost Flows

Periodic fifo lish

FIFO for COGS (top down)

LISH for EI (bottom up)

Periodic FIFO(LISH)

Periodic lifo fish

LIFO for COGS (bottom up)

FISH for EI (top down)

Periodic LIFO(FISH)

Average periodic

First calculate average:

Goods available cost = $910

Goods available units = 90 units

Avg. = $10.11 per unit


55 units x $10.11 per unit = $ 556

Now EI:

35 units x $10.11 per unit = $354

Average Periodic

Perpetual fifo not tested

Units Per Unit EI COGS

Begin Inv. 20 $ 9.00

Purch. 1/10 40 10.00

Sale 1/12 (30) [email protected] = 180

[email protected]=100

Balance 30 10.00

Purch. 1/22 3011.00

Sale 1/24 (25) [email protected]=250

Balance 510.00 = 50

30 11.00= 330____________

Totals EI=380 COGS=530

Perpetual FIFO (not tested)

Perpetual lifo not tested

Units Per Unit EI COGS

Begin Inv. 20 $ 9.00

Purch. 1/10 40 10.00

Sale 1/12 (30) [email protected] = 300

Balance 20 9.00

10 10.00

Purch. 1/22 30 11.00

Sale 1/24 (25) [email protected]=275

Balance 20 9.00 = 180

10 10.00 = 100

5 11.00 = 55____________

Totals EI = 335 COGS =575

Perpetual LIFO (not tested)

Average perpetual not tested calculate average before each sale

Units Per Unit Total EI COGS

Begin Inv. 20 $ 9.00 = $180

Purch. 1/10 40 10.00 = 400

Average 60 580

Sale 1/12 (30) @ 9.67 = (290) $290

Balance 30 9.67 = 290

Purch. 1/22 30 11.00 = 330

Average 60 620

Sale 1/24 (25) 10.33 = (258)258

Balance 35 10.33 = 362 $362 $548

Average Perpetual (not tested)(calculate average before each sale)



Comparison of fifo lifo and average

In times of rising prices:

highest COGS:

lowest COGS

highest EI

lowest EI

highest Net Income

lowest Net Income

Comparison of FIFO, LIFO, and Average

Lifo advantages disadvantages

LIFO Advantages/Disadvantages


Tax benefits - cash flow savings in times of rising prices.

Matching on the income statement – current revenues and current costs.

Minimize write downs of inventory (already at a low cost).


Inventory may be significantly undervalued.

LIFO liquidation may cause significant increases in income (and in taxes).

Difficulty in comparing LIFO firms to FIFO firms.

Lifo layer liquidation

LIFO Layer Liquidation

If an old, low LIFO layer is liquidated (usually when an product line or large segment is eliminated), then current income may increase significantly, as COGS absorbs much lower costs.

This effect, in the past, had been another technique that managers might use to manipulate income (with a corresponding net decrease in cash).

The SEC now requires that any income increases from LIFO layer liquidation now be disclosed separately in the financials.

Lifo reserve

For companies that use LIFO for tax and external financial reporting, a financial statement disclosure is required that indicates the calculated inventory(ies) at FIFO. The difference between the FIFO and LIFO inventories is called the LIFO Reserve.

This number may be used to convert LIFO Inventory and COGS and Net Income to a FIFO basis, to allow for comparison to other companies.

It also facilitates the calculation of the cash flow savings from reduced taxes.

LIFO Reserve

Dollar value lifo

Dollar Value LIFO

Unit LIFO (from previous section) is cumbersome and very difficult to implement for any company with even a modest amount of inventory.

Most companies that use LIFO choose to use Dollar Value LIFO. In this technique, the different groups of inventories are turned into annual dollar layers.

First the units of EI are turned into dollars by extending all the units at end of the year prices. Then the dollars are added to create a single layer of inventory costs, in dollars.

Each year the new layers are compared to old layers (in common dollars), and inventory change is calculated. See Handout for example.

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