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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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).
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.
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.
FOB Shipping Point
Belongs to Purchaser
Belongs to Seller
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.
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.
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.
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.
Analysis (O = overstated, U = understated):
BI + P - EI = COGS NI A = L + SE
1. When inventory purchased (gross method):
Cash or A/Pxx
2. Pay transportation on inventory:
3. If purchase discount is taken (gross method):
4. If inventory returned:
Purch. Returns & Allow.xx
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 Rt. & Allow.xx
Inventory - Beginningxx
Purchase $100 on account. Terms 2/10, n/30.
Gross Method Net Method
A/Pay 100 A/Pay98
Payment within 10 days:
Cash 98 Cash98
Purch. Discounts 2
Payment after 10 days:
Cash 100P. Disc. Lost 2*
*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.
Example - assume the following balance in the Unadjusted Trial Balance of Raider Co.:
Merch. Inv. (1/1/14) 2,600
Purchase R & A 1,400
At the end of 2014, Raider calculated its ending inventory to be $1,900, based on the FIFO technique.
Part 1: What is the value of Cost of Goods Sold?
BI + P (net) - EI = COGS
Part 2, AJE:
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.
Given: BI + P (net) = EI + COGS
How to assign costs of inflows
[BI + P(net)] to EI and COGS?
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.
Given the following activity for January:
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
FIFO for COGS (top down)
LISH for EI (bottom up)
LIFO for COGS (bottom up)
FISH for EI (top down)
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
35 units x $10.11 per unit = $354
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
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
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
In times of rising prices:
highest Net Income
lowest Net Income
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.
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.
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.
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.