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Agenda. Quiz 3 Due Wednesday Feb 18 Midterm 2 Monday 2/23: Chapters 7-9 & 18 Wrap up chapter 7 examples Notes Receivable Transfers of Receivables Chapter 8: Inventory Weighted Average/FIFO/LIFO Dollar Value LIFO. Inventory Reporting.

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Agenda
Agenda

  • Quiz 3 Due Wednesday Feb 18

  • Midterm 2 Monday 2/23: Chapters 7-9 & 18

  • Wrap up chapter 7 examples

    • Notes Receivable

    • Transfers of Receivables

  • Chapter 8: Inventory

    • Weighted Average/FIFO/LIFO

    • Dollar Value LIFO


Inventory reporting
Inventory Reporting

Report inventory at the lower of cost or market (conservatism)

“Cost” – the historical cost of the inventory:

  • Retail – the cost to get items in location and in condition for sale (i.e. purchase price, purchase discounts, purchase returns, transportation in)

  • Manufacturing:

    • Raw materials – cost of materials on hand but not yet placed in production.

    • Work-in-process – cost of goods on which production has been started but not yet completed (i.e. raw materials used, direct labor, manufacturing overhead).

    • Finished good – cost of goods complete but not yet sold.


Merchandise

Inventory

Purchases

C/G/Sold

Cost of goods

sold

$$$

Inventory Cost Flows

Merchandising Operations



Inventory Control Companies

Inventory control is important for:

  • Ensuring availability of inventory items

  • Preventing excessive accumulation of inventory items

  • Preventing waste, spoilage, or theft


Purchases are debited to Inventory account Companies

Freight-in, Purch. Returns & Allowances and Purch. Disc. are recorded in Inventory account.

Debit COGS and credit Inventory account for each sale.

Purchases are debited to Purchases account.

Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts.

COGS is computed only periodically:

COGA – EI = COGS

Inventory Systems

Perpetual Method

Periodic Method


Inventory system perpetual
Inventory System - Perpetual Companies

  • Purchases are debited to Inventory account

  • Freight-in, Purch. Returns & Allowances and Purch. Disc. are recorded in Inventory account.

  • Debit COGS and credit Inventory account for each sale.

    J/E, Perpetual System:

    Purchase of Inventory:

    Dr. Inventory 1,000

    Cr. A/P, Cash, etc. 1,000

    Sale of Inventory:

    Dr. Cost of Goods Sold 1,000

    Cr. Inventory 1,000

    Dr. Cash, A/R, etc. 1,500

    Cr. Sales Revenue 1,500

    At Year-End: no j/e required, unless errors are found in inventory count


Inventory system periodic
Inventory System - Periodic Companies

  • Purchases are debited to Purchases account.

  • Freight-in, Purchase Returns & Allowances and Purchase Discounts are recorded in their respective accounts.

  • COGS is computed only periodically: COGA – EI = COGS

    J/E, Periodic System:

    Purchase of Inventory:

    Dr. Purchases 1,000

    Cr. A/P, Cash, etc. 1,000

    Sale of Inventory:

    Dr. Cash, A/R, etc. 1,500

    Cr. Sales Revenue 1,500

    At Year-End:

    Dr. Ending Inventory (determined by count) 38,000

    Dr. Cost of Sales (plug) 283,000

    Cr. Purchases 286,000

    Cr. Opening Inventory (carried forward from prior year) 35,000


Inventory Valuation Companies

Basic Issues:

  • Physical goods to be included

    • Goods in transit (FOB Destination)

    • Goods on consignment with consignee

    • Goods sold under buy back agreements

    • Goods sold with high rates of return (if unable to estimate returns)

    • Installment sales (if unable to estimate bad debts)

  • Costs to be included in inventory (product (RM) vs. period costs (office supplies)

  • Cost flow assumption used (specific identification, average cost, FIFO, LIFO, etc.)


Effect of Inventory Errors Companies

Error in Effect on Effect on

Ending Income Balance sheet

Inventory Items Items

Under- COGS (over) Inventory (under)

stated Net income (under) Retained Earn (under)

Over- COGS (under) Inventory (over)

stated Net income (over) Retained Earn (over)



Cost Flow Assumptions Companies

Cost flow assumptions need not be consistent with physical flow of goods. The objective is to most clearly reflect periodic income.

The cost flow assumptions are:

  • Specific identification

  • Average cost

  • First-in, first-out (FIFO) and

  • Last-in, first-out (LIFO) (prohibited under IFRS)


Cost Flow Assumptions: Example Companies

Spaworld reports the following transactions for 2004 (assume no opening inventory):

Date Purchases Purchase Cost

May 12 100 units $1,000

Aug 14 200 units 2,200

Sep 18 120 units1,800

420 units $5,000

On December 31, the company had 20 units on hand and uses the periodic inventory system.

What are the cost of goods sold and the cost of ending inventory?


Average Cost Method Companies

Given Data:

Date Purchases Cost

May 12 100 units $1,000

Aug 14 200 units $2,200

Sep 18 120 units$1,800

420 units $5,000

  • Steps:

  • Calculate per unit average cost: $5,000/420 = $11.905

  • Apply this per unit average cost to units sold to get COGS: 400 x $11.905 = $4,762

  • Apply the per unit average cost to units remaining in inventory to determine Ending inventory: 20 x $11.91 = $238


Average cost method
Average Cost Method Companies

Journal Entries:

Dr. Cost of Sales 4,762

Dr. Ending Inventory 238

Cr. Opening Inventory 0

Cr. Purchases 5,000


Cost of goods Companies

available

$4,700

$5,000

Cost of goods sold

20 X $15 = $300

Ending inventory

First-In, First-Out (FIFO) Method

Given data:

Date Purchases Cost

May 12 100 units @ $10 $1,000

Aug 14 200 units @ $11 $2,200

Sep 18 120 units @ $15 $1,800

420 $5,000

Cost of goods sold (FIFO)

$1,000 (100 sold)

$2,200 (200 sold)

$1,500 (100 sold; 20 end inv)

$4,700

“Count” from one direction and “plug” the other

Note: FIFO = LISH (Last In Still Here)


Cost of goods Companies

available

$4,800

$5,000

Cost of goods sold

20 X $10 = $200

Ending inventory

Last-In, First-Out (LIFO) Method

Cost of goods sold (LIFO)

$ 800 (80 sold; 20, end inv)

$2,200 (200 sold)

$1,800 (120 sold)

$4,800

Given data:

Date Purchases Cost

May 12 100 units @ $10 $1,000

Aug 14 200 units @ $11 $2,200

Sep 18 120 units @ $15 $1,800

420 $5,000

LIFO = FISH (First In Still Here)


Cost Flow Assumptions: Notes Companies

  • The ending inventory in units is the same in all three methods: the cost is different

  • The cost of goods available is the same for all methods

  • The cost of goods sold and the cost of ending inventory are different

  • In periods of rising prices, LIFO would result in the smallest reported net income.


Advantages of LIFO Method Companies

  • LIFO matches more recent costs with current revenues.

  • With increasing prices:

    • LIFO yields the lowest taxable income (assuming inventory does not decrease).

    • Under LIFO, there is less need to write down inventory down to market


Disadvantages of LIFO Method Companies

  • LIFO yields the lowest net income and therefore reduced earnings (with increasing prices)

  • Under LIFO, the ending inventory is understated relative to current costs

  • LIFO liquidation (reduction of quantities of inventory during a period – results in “costing” items at older prices):

    • May result in income that is detrimental from a tax view

    • May cause poor buying habits (because of the layer liquidation problem)

  • LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also.


Periodic vs perpetual
Periodic vs. Perpetual Companies

  • FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems

  • BUT – LIFO, Weighted Average will give you different numbers

    • Under perpetual LIFO, with each sale, you cut into only existing layers (so you must stop and calculate the cost of goods sold at each sale)

    • Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale




LIFO Reserve Companies

LIFO Reserve (Allowance) account is used, when:

LIFO is used for external reporting and a non-LIFO basis is used for internal reporting.

SEC reporting requirements – disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet


Dr. Cost of goods sold $30,000 Companies

Cr. Allowance to Reduce Inventory

to LIFO $30,000

LIFO Reserve: Example

Jeppo Inc reports the following balances:

Inventory (FIFO basis) on Dec 31, 2004: $50,000

Inventory (LIFO basis) on Dec 31, 2004: $20,000

Adjust the cost of ending inventory to the LIFO basis

Balance Sheet (Assets):

Inventory (FIFO) $50,000

less: Allowance to Reduce Inventory ($30,000)

Inventory (LIFO) basis $20,000


LIFO Layers Companies

  • Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when:

    • Earlier costs are matched against current sales due to a reduction of quantities of inventory during a period (results in “costing” items at older prices)

    • Such matching results in distorted income.


Dollar Value LIFO Companies

  • Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units

  • Used for external purposes (i.e., financial statements and taxes)

  • Advantages over regular LIFO:

    • Reduces record keeping (maximum of one layer per year).

    • Mitigates likelihood of eroding old layers (some decreases in goods in the pool are offset by increases in other goods in the pool).

  • Price index – a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year

    • Internal = Ending inventory quantities X current year costs

      Ending inventory quantities X base year costs

    • External – calculated by the Bureau of Labor Statistics


Dollar Value LIFO Calculation Steps Companies

Compare ending inventory at base year prices to beginning of year inventory, also at base year prices – if there is an increase – we add a new LIFO layer at CY prices:

  • Calculate EI at current year costs - FIFO

  • Calculate current year price index.

  • Calculate EI at base year costs - FIFO

  • Calculate the change in inventory at base year costs – FIFO (this represents the quantity change in base year prices)

  • Calculate the EI at dollar value LIFO:

    • If the change in inventory at base year FIFO is positive, add a layer to BI at current year cost (i.e. price this real dollar quantity increase at current prices)

    • If the change in inventory at base year FIFO is zero, BI equals EI

    • If the change in inventory at base year FIFO is negative, peel off layer(s) from BI


Dollar Value LIFO: Example Companies

Given:

Base layer (Dec 31, 2003): $20,000

Inventory (current prices)

Dec 31, 2004: $26,400

Prices increased 20% during 2004.

Determine dollar value LIFO at Dec 31,2004


At base $: Companies

$22,000

$26,400 / 1.20

At EOY prices:

$26,400

Dollar value

LIFO Inventory

Net increase

at base $:

Restate at

current $:

$2,400

(layer added)

$20,000

plus

$2,400 =

$22,400

$22,000 less

$20,000

$2,000 * 1.20

Dollar Value LIFO: Example

Price increase, 20%

Dec 31, 2003

Dec 31, 2004


Dollar Value LIFO: Notes Companies

When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000):

  • the decrease must be subtracted from the most recently added layer.

  • Once a layer is eliminated (peeled off), it cannot be rebuilt.


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