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Inventories: Measurement. Objectives of this Chapter. Discuss the importance of inventory valuation. Study perpetual and periodic inventory systems and the ending period adjustments for inventory. Study and compare the inventory cost flow assumptions. Explain the effect of LIFO liquidations.

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Objectives of this chapter
Objectives of this Chapter

  • Discuss the importance of inventory valuation.

  • Study perpetual and periodic inventory systems and the ending period adjustments for inventory.

  • Study and compare the inventory cost flow assumptions.

  • Explain the effect of LIFO liquidations.

Inventories: Measurement


Objectives of this chapter contd
Objectives of this Chapter (contd.)

  • Identify the items that should be included in the inventory count.

  • Discuss the lower of cost or market (LCM) rule.

  • Study the accounting treatment of changing to LIFO cost flow assumption and the use of LIFO reserve account.

  • LIFO Inventory Pools

  • Dollar-value LIFO technique.

Inventories: Measurement


1 inventories the importance of inventory valuation
1. Inventories: the Importance of Inventory Valuation

  • How would the valuation and cost flow assumptions of inventory affect the income measurement?

    • Valuation Methods: Historical Cost, Current Exist Value, Current Entry Value, Present Value, LCM.

    • Cost Flow Assumptions: LIFO, FIFO, Average, Specific Identification.

    • CGS = Beginning Inventory + Net

      Purchase - Ending Inventory

Inventories: Measurement


Inventories the importance of inventory valuation contd
Inventories: the Importance of Inventory Valuation (contd.)

  • Different valuation methods and different cost flow assumptions will result in different cost of ending inventories and therefore different cost of goods sold.

Inventories: Measurement


The impact of valuation of ending inventory on the cgs income
The Impact of Valuation of Ending Inventory on The CGS & Income

Year 1

IncomeCGS = Beg. Inv. + Net Pur. - End. Inv.

under over under a

over under over b

Year 2

over under under

under over over

a. either understating the units or the value

b. either overstating the units or the value

Inventories: Measurement


Impact on omitting goods from purchases
Impact on Omitting Goods from Purchases Income

CGS = Beg. Inventory + N.P. - End. Inventory

B/S I/S

Ending Inv. understated Purchase understated

R/E no effect CGS no effect

A/P under N/I no effect

Working Capital no effect Inventory (End.) understated

Current Ratio overstatinga

a. When CA > CL

Inventories: Measurement


Defining inventory
Defining Inventory Income

1. Assets held for resale purpose in a normal course of business

2. Assets used to produce products for resale purpose

  • Merchandising Firms: Merchandise

  • Manufacturing Firms: Raw materials

    Work-in-process

    Finished Goods

Inventories: Measurement


How to determine inventory value presented on the balance sheet
How to Determine Inventory Value Presented on the Balance Sheet?

  • Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories.

  • Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory account.

Inventories: Measurement


2 inventory systems and ending period adjustments
2. Inventory Systems and Sheet?Ending Period Adjustments

  • Types of Inventory Systems

    • A. Perpetual Inventory System

    • B. Periodic Inventory System

Inventories: Measurement


A perpetual inventory system
A. Perpetual Inventory System Sheet?

  • Purchase:

    Inventory xxx

    A/P xxx

  • Sale:

    CGS xxx

    Inventory xxx

    A/R xxx

    Sales xxx

Inventories: Measurement


Perpetual inventory system contd
Perpetual Inventory System Sheet?(contd.)

  • Inventory account is used for the purchase and sale transactions.

  • CGS account is used to record the CGS of a sale. Therefore, the CGS is also known at all time.

  • CGS is determined by selecting a cost flow assumption.

Inventories: Measurement


Perpetual inventory system example
Perpetual Inventory System Sheet?Example

a. Sales price is $10 per unit.

b. Sales price is $11 per unit.

Inventories: Measurement


Example contd journal entries perpetual vs periodic
Example (contd.) Sheet?- Journal Entries (Perpetual vs. Periodic)

3/5 Inventory 900 3/5 Purchases 900

Cash 900 Cash 900

3/7 Cash 2,000 3/7 Cash 2,000

Sales Rev. 2,000 Sales Rev. 2,000

CGS 1,100

Inventory 1,100

3/14 Inventory 700 3/14 Purchases 700

Cash 700 Cash 700

3/28 Cash 330 Cash 330

Sales Rev. 330 Sales Rev. 330

CGS 180

Inventory 180

Perpetual (FIFO) Periodic

Inventories: Measurement


Perpetual inventory system example contd

Inventory Sheet?

(LIFO)

500 1150

900 210

700

740

Inventory

(WA)

500 1120

900 195.9

700

784.1

Inventory a

(FIFO)

B.B.500 1100

900 180

700

E.B.820

Perpetual Inventory SystemExample (contd.)

a. The balance of inventory is known at all time under the perpetual inventory system.

Inventories: Measurement


Perpetual inventory system example contd1

CGS Sheet?

(FIFO)

3/7...1100

3/28...180

1280

CGS

(LIFO)

1150

210

1360

CGS

(W-A)

1120

195.9

1315.9

Perpetual Inventory SystemExample (contd.)

The balance of cost of goods sold account1:

1.The balance of inventory is known at all time under the perpetual inventory system.

Inventories: Measurement


Ending period adjustments perpetual inventory system
Ending Period Adjustments Sheet?Perpetual Inventory System

a. Adjustments for lost units.

b. Adjustments for LCM valuation.

Inventories: Measurement


A adjustments for lost units perpetual inventory system
a. Adjustments for Lost Units Sheet?(Perpetual Inventory System)

Assuming ending units = 110 units.

On 3/31, the lost units = 10.

Cost of 10 lost units => $6 x 10 = $60 (FIFO)

$7 x 10 = $70 (LIFO)

$6.53 x 10 = 65.3 (W-A)

Adjusting Entry:

3/31 Loss on Inventory Units a 60

Inventory 60

a. or use the account of Inventory over and short

Inventories: Measurement


B adjustments for lcm valuation perpetual inventory system

LCM Sheet?

=$600

b. Adjustments for LCM Valuation(Perpetual Inventory System)

Inventory (FIFO)

B.B 500 1,100

900 180

700

820 60 -- 3/31 (Adj. for lost units)

760

  • Ending Inv. Cost (on 3/31, FIFO) = $760

    • Assuming market price = $600 LCM = $600

Inventories: Measurement


Adjustments for lcm valuation contd
Adjustments for LCM Valuation Sheet? (contd.)

  • Adjusting entry => Given that Allowance for Declining in Market Value of inventory has a beginning balance of zero:

    Allowance 3/31

    0 -- 3/1 Loss Due to Market Value

    160 Decline of Inventory 160

    160 -- 3/31 Allowance to Reduce

    Inventory to Market 160

    B/S (3/31)

    Inventory 760

    Allowance (160)

    Inv. At LCM 600

Inventories: Measurement


An alternative of lcm adjustment
An Alternative of LCM Adjustment Sheet?

  • Many companies (i.e., Cisco Systems, inc. 2001, source: Spiceland, etc.)record the adjustment of LCM follows:

  • Cost of Goods Sold 160

  • Inventory 160

  • Note: Recording the loss as an increase in CGS will have the same impact on earnings as reporting it as a loss from value decline in the holding inventory. However, this treatment will distort the gross profit.

Inventories: Measurement


Adjustments for lcm valuation contd1
Adjustments for LCM Valuation Sheet? (contd.)

  • If the allowance account had a beginning balance of $20, the adjusting entry would be:

    Allowance

    20 -- 3/1 Loss 140

    140 Allowance 140

    160 -- 3/31

Inventories: Measurement


Adjustments for lcm valuation contd2
Adjustments for LCM Valuation Sheet? (contd.)

  • If the Allowance account had a beginning balance of 200, the adjusting entry would be:

  • Allowance Allowance 40

    • 40 200 Gain from Recovery

    • 160 of M.V. of Inventory 40

Inventories: Measurement


B periodic inventory system
B. Periodic Inventory System Sheet?

  • At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and cost of goods sold:

    1. Do an inventory count.

    2. Applying a cost flow assumption to determine the cost of ending inventory.

    3. Determine the cost of goods sold using:

    CGS = Beg. Inv. + Net Pur. - Ending Inv.a

    a. No adjusting entries are required.

Inventories: Measurement


Periodic inventory system a example
Periodic Inventory System Sheet?aExample

  • Using the example on Page 10 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption):

    $7  100 + $6  5 = $730

a. For journal entries, see page 14.

Inventories: Measurement


Periodic inventory system example contd

Inventory Data: Sheet?

UnitsCost

3/1 (B.B) 100 $5

3/5 Pur. 150 $6

3/14 Pur. 100 $7

The CGS under FIFO is:

$500 + 1,600 - 730 = $1,370.

If a LIFO assumption is used, the cost of end. Inv. is:

$5 x 100 + $6 x 5 = $530.

The CGS is:

$500 + 1600 - 530 = $1,570.

Periodic Inventory SystemExample (contd.)

Inventories: Measurement


Ending period adjustments periodic inventory system
Ending Period Adjustments Sheet?(Periodic Inventory System)

1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS).

Inventories: Measurement


Ending period adjustments periodic inventory system1
Ending Period Adjustments Sheet?(Periodic Inventory System)

2.Adjustment for the LCM valuation assuming FIFO:

Cost of E.I. = $730 LCM Allowance

Market = $600 = $600 0 -- 3/1(assumed)

130

130 --3/31

  • Adjusting entry:

    • Loss Due to Market Decline of Inv. 130

    • Allowance to Reduce Inv. to Market 130

Inventories: Measurement


3 comparison of fifo vs lifo during an inflation period
3. Comparison of FIFO vs. LIFO Sheet?During an Inflation Period

Inventories: Measurement


Survey source accounting trends techniques a b c
Survey: Sheet?(Source: Accounting Trends & Techniques) a, b,c

Inventories: Measurement


Survey source accounting trends techniques contd
Survey: Sheet?(Source: Accounting Trends & Techniques) (contd.)

  • Sample firms are 600 firms. Most companies adopt more than one inventory method.

  • Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s.

  • IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaries.

  • The number of disclosures.

  • Inventories: Measurement


    Switching to lifo during an inflation period
    Switching to LIFO Sheet?During an Inflation Period

    • Reason of switching to LIFO:

      Tax savings.

    Inventories: Measurement


    Income manipulation when lifo is used assuming price is rising
    Income Manipulation When LIFO Is Used Sheet? (assuming price is rising)

    1. To increase income (by decreasing CGS):

    • Strategy:

      2.To decrease income (by increasing CGS):

    • Strategy:

    Inventories: Measurement


    Advantages of fifo
    Advantages of FIFO Sheet?

    a. Less likely to be subject to management manipulation;

    b. Produce higher income during an inflation period;

    c. Inventory cost reported on the B/S is close to the replacement cost.

    Inventories: Measurement


    Disadvantage of fifo
    Disadvantage of FIFO Sheet?

    a. Bad matches of sales revenue and CGS; match current sales revenue with old costs;

    b. Producing higher income during an inflation period results in paying more income tax.

    Inventories: Measurement


    Advantages of lifo
    Advantages of LIFO Sheet?

    a. Good match of sales revenue with CGS.

    b. Produce lower income during an inflation period; result in tax savings.

    Inventories: Measurement


    Disadvantages of lifo
    Disadvantages of LIFO Sheet?

    a. Inventory cost presented on the B/S is not fair.

    b. Subject to management manipulation.

    Note: International Accounting Standard No. 2 does not allow LIFO.

    Inventories: Measurement


    IRS Sheet?

    1. Does not allow firms to use LCM if firms are using LIFO.

    2.LIFO conformity rule.

    The non-LIFO income numbers are allowed on the supplementary reports since 1981.

    Inventories: Measurement


    Irs contd
    IRS (contd.) Sheet?

    3. LIFO is not acceptable by the IRS till 1939.

    Inventories: Measurement


    4 lifo liquidations
    4. LIFO Liquidations Sheet?

    • A LIFO Liquidation profit can occur when units purchased are less than units sold in the period.

    Inventories: Measurement


    An example of lifo liquidation profit
    An Example of LIFO Liquidation Profit Sheet?

    20x5 Beg. Inv. 400 $5

    Pur. 300 $6

    Pur. 500 $7

    Pur. 600 $8

    During 20x5, 1,700 units were sold.

    What is the LIFO liquidation profit?

    Total purchases of 20x5 are 1,400 units.

    The LIFO liquidationprofit is:

    (1,700-1,400) x ($8-$5) = $900

    Inventories: Measurement


    Choice of inventory cost flow assumptions and conversion of fifo to lifo for comparison purposes
    Choice of Inventory Cost-Flow Assumptions and Conversion of FIFO to LIFO for Comparison Purposes

    • Choice of inventory cost-flow assumptions.

    • Inventory Management (JIT system, Inventory turnover rate, etc.): the example of Dell Inc.

    • Adjustment of inventory cost-flow assumption on the same basis before making comparison of financial statements.

    Inventories: Measurement


    Adjustment of inventory cost flow assumption an example
    Adjustment of Inventory Cost-Flow Assumption – An Example FIFO to LIFO for Comparison Purposes

    Information: ABC is currently adopting FIFO assumption. IF LIFO were adopted, cost of ending inventory would be $1,000 and $3,000 lower for x1 and x2, respectively.

    Question: How much would the CGS and income be different when LIFO is adopted rather than FIFO?

    Inventories: Measurement


    Adjustment of inventory cost flow assumption an example contd
    Adjustment of Inventory Cost-Flow Assumption- An Example (contd.)

    CGS = Beg. Inv. + Net Pur. – End. Inv.

    Impact => -1000 -3000

    of LIFO

    (LIFO Reserve)

    Thus, CGS should be increased by $2,000 and income before tax would be decreased by $2,000.

    Inventories: Measurement


    Lifo reserve an account used to adjust ending inventory value from fifo to lifo
    LIFO Reserve: An Account Used to Adjust Ending Inventory Value from FIFO to LIFO

    • The difference in the value of inventory between the inventory method used for internal reporting purposes (i.e., FIFO) and LIFO is referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO .

    • The change in the balance of LIFO Reserve from one period to another is referred as the LIFO Effect (i.e.,impact on income).

    Inventories: Measurement


    Lifo reserve example
    LIFO Reserve - Example Value from FIFO to LIFO

    • Assume Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. On 12/31/x5, the LIFO Reserve balance was $20,000. However, the value of ending inventory on 12/31/x6 under LIFO is $50,000 less than that of FIFO.

    • Inventory on 12/31/x5 at FIFO = $320,000

    • Inventory on 12/31/x6 at FIFO =$360,000

    Inventories: Measurement


    Lifo reserve example contd
    LIFO Reserve – Example (contd.) Value from FIFO to LIFO

    (Inventory Disclosure, note D)12/31/x6 12/31/x5

    • Inventory at FIFO $360,000 $320,000

    • LIFO Reserve(50,000) (20,000)

    • Inventory at LIFO $310,000 $300,000

    • Thus, $30,000 should be added to the LIFO Reserve account. The LIFO effect (impact on income) for 20x6 is $30,000.

    Inventories: Measurement


    Lifo reserve example contd1
    LIFO Reserve - Example (contd.) Value from FIFO to LIFO

    J.E. to adjust inventory from FIFO to LIFO:

    Cost of Goods Sold 30,000

    LIFO Reserve a 30,000

    (or Allowance to Reduce

    Inventory to LIFO)

    a.reported as a contra account to inventory or a deduction from inventory

    Inventories: Measurement


    Inventory presentation and footnote disclosure
    Inventory Presentation and Footnote Disclosure Value from FIFO to LIFO

    Inventories, net of adjustment to

    LIFO Reserve

    (Note D) $310,000

    Note D (contd.):Inventories. Inventories are valued at the lower of cost or market determined principally by the LIFO method. If the FIFO cost method had been used, inventories would have been $50,000 higher.

    Inventories: Measurement


    5 items to be included in inventory
    5. Items to Be Included in Inventory Value from FIFO to LIFO

    • Any goods with the legal title transferred to the buyer should be included in the inventory of the buyer (including goods in transit with a F.O.B. shipping point term).

    Inventories: Measurement


    Special cases
    Special Cases Value from FIFO to LIFO

    a. Consigned Goods: Legal title remained with the consignor (manufacturers).

    b. Sales with High Sales Returns (conditional sale):

    c. Sales on Approval:

    Inventories: Measurement


    Special cases contd
    Special Cases (contd.) Value from FIFO to LIFO

    d. Product Financing Arrangements: (Parking Transactions; SFAS No. 49)

    e. Sales on Installment (revenue recognition on accrual basis):

    Inventories: Measurement


    What should be included in the product costs
    What Should Be Included in The Product Costs Value from FIFO to LIFO

     Purchase price

     Freight-In cost

    x Handling charge

    x Storage cost related to purchase

    x Buying cost of the purchasing department

    x Insurance, taxes

     Interest cost: only in some cases.

     --> Yes

    x --> No

     --> may be

    Inventories: Measurement


    What should be included in the product costs contd
    What Should Be Included in the Product Costs (contd.) Value from FIFO to LIFO

    • Purchase Discount account should be treated as a contra account to purchases.

    Inventories: Measurement


    6 inventory valuation the lcm rule
    6. Inventory Valuation - the LCM Rule Value from FIFO to LIFO

    Departure from Historical Cost Assumption

    LCM: Lower of Cost or Market.

    Reasons: Conservatism.

    Market ==> Replacement Cost constrained by:

    Ceiling => Net Realizable Value

    = Selling price - estimated cost to

    complete and sell

    Floor => NRV - normal profits

    Inventories: Measurement


    Inventory valuation example
    Inventory Valuation - Example Value from FIFO to LIFO

     Selling price = 12

     Package cost = $1

     Transportation cost = $3

     Normal profits = $3

     NRV = Selling price - Package - Transportation = $12 - $1- $3 = $8

     NRV - Normal profit = $5

    Inventories: Measurement


    Inventory valuation example contd
    Inventory Valuation Value from FIFO to LIFO - Example (contd.)

    a. Example of the ceiling can prevent future unexpected loss.

    b.Example of preventing the recognition of abnormal loss in the current period.

    Inventories: Measurement


    Inventory valuation lcm
    Inventory Valuation - LCM Value from FIFO to LIFO

    • For financial reporting, LCM can be performed at the individual item level, at the category level or at the total inventory level.

    • Common practice: at the individual item level.

    • LCM performed at the individual item level is most conservative and is most commonly used because it is complied with the IRS rule.

    Inventories: Measurement


    Lcm application at individual level versus at group level
    LCM Application - Value from FIFO to LIFOat Individual Level versus at Group Level

    ItemCost Market LCM (at individual level)

    A $50 $60 $50

    B* $140 $100 $100

    C $300 $360 $300

    Total $490 $520 $450

    _____ _____ _____

    _____ _____ _____

    LCM at group level ==> $490

    The difference of $40 is resulting from item B: $140 - 100 = $40

    Inventories: Measurement


    Lcm and igaap
    LCM and iGAAP Value from FIFO to LIFO

    • IAS No. 2 requires inventory to be valued at LCM.

    • The market value of IAS is the NRV, not the replacement cost as in US GAAP.

    • IAS allows the reversal of inventory write-down when the conditions for write-down do not exist.

    • US GAAP does not allow the reversal of inventory write-down.

    Inventories: Measurement


    7 initial adoption of lifo
    7. Initial Adoption of LIFO Value from FIFO to LIFO

    • The accounting treatments for accounting method changes are:

    • a. Current Period Approach: cumulative effect from the change reported in the I/S. (Note: eliminated by SFAS 154)

    • b. Retrospective Approach

    Inventories: Measurement


    Initial adoption of lifo
    Initial Adoption of LIFO Value from FIFO to LIFO

    • When change from other method toLIFO, neither a cumulative effect nor a retrospective adjustment can be made.

    • The base year inventory for all following years is the beginning inventory of the year In which LIFO is adopted.

    Inventories: Measurement


    Initial adoption of lifo1
    Initial Adoption of LIFO Value from FIFO to LIFO

    • This value of the beginning inventory needs to be adjusted to the cost.

    • The effect of the change on the current year’s income and on the value of the ending inventory must be disclosed.

    Inventories: Measurement


    Journal entry to restate the beginning inventory to cost
    Journal Entry to Restate Value from FIFO to LIFOthe Beginning Inventory to Cost

    • Assume that Rooms, Inc. decided to switch from FIFO to LIFO in 20x9. The beginning inventory of 20x9 has a cost basis of $100,000 but is reported at $90,000 on the balance sheet because market is lower than cost. The following entry is made to restate the inventory to a cost basis (ignoring tax effects):

    Inventories: Measurement


    Journal entry to restate the beginning inventory to cost contd
    Journal Entry to Restate the Beginning Inventory to Cost (contd.)

    • Alternative 1:

      Allowance to Reduce

      Inventory to Market 10,000

      Adjustment to Record

      Inventory at cost 10,000

      (If an allowance method is used in LCM application.)

    Inventories: Measurement


    Journal entry to restate the beginning inventory to cost contd1
    Journal Entry to Restate the Beginning Inventory to Cost (contd.)

    • Alternative 2:

      Inventory 10,000

      Adjustment to

      Record Inv. at Cost 10,000

      (only If a direct write-off method is used in LCM application)

    Inventories: Measurement


    Footnote disclosure of changing from fifo to lifo
    Footnote Disclosure of Changing (contd.)from FIFO to LIFO

    Note: Inventory Pricing. In the fourth quarter, the company expanded its use of the LIFO method of inventory to additional portion of its inventories in order to more closely match current costs with current revenues. The effect of this change was to reduce net income for the current year by $2,804,000 or $0.49 per share. As of December 31, inventories valued on a LIFO basis amounted to $74,166,000. If valued on a FIFO basis, such inventories would be increased to $90,551,000.

    Inventories: Measurement


    8 lifo inventory pools specific goods pooled lifo source spiceland etc
    8. LIFO Inventory Pools (Specific Goods Pooled LIFO) (contd.)(source: Spiceland, etc.)*

    • Problems associated with the Unit LIFO (i.e., the LIFO concept applies to units of inventory as described in previous sections; also called specific goods LIFO):

      • Costly to implement: It requires the records of each unit of inventory.

      • LIFO liquidations: When units of a specific inventory purchased are less than units sold during the period, the beginning layers are eroded.

    Inventories: Measurement


    Lifo inventory pools contd
    LIFO Inventory Pools (contd.) (contd.)*

    • LIFO inventory pools technique can:

    • 1) simplify recordkeeping by grouping inventory into pools, and

    • 2)reduce the probability of LIFO layer liquidation/erosion.

    Inventories: Measurement


    Lifo inventory pools contd1
    LIFO Inventory Pools (contd.) (contd.)

    • Within pools, all purchases of goods in the pool are considered to be made at the same time during the period and at the average cost.

    • When the quantity of ending inventory in the pool increases (i.e., the quantity of ending inv. is greater than that of the beg. Inv.), the ending inventory of the pool will consist of the beg. Inv. and the layer of the period.

    Inventories: Measurement


    Lifo inventory pools an example contd
    LIFO Inventory Pools: An Example (contd.) (contd.)

    • The 2008 beg. inventory (BI)of Cole Glass Inc. LIFO inventory pool consisted of the following:

    Inventories: Measurement


    Lifo inventory pools an example
    LIFO Inventory Pools: An Example (contd.)

    • During 20x8, Cole sold 48,000 squared feet of window glass and purchased 51,000 squared feet as follows:

    Inventories: Measurement


    Lifo inventory pools an example contd1
    LIFO Inventory Pools: An Example (contd.) (contd.)

    • The average cost of 2008 beg. inventory and 2008 window glass inventory pool is $2.55 and $2.75, respectively.

    • The ending inventory quantity for the pool is:

      35,000+51,000-48,000=38,000 units

    Inventories: Measurement


    Lifo inventory pools an example contd2
    LIFO Inventory Pools: An Example (contd.) (contd.)

    • Since the ending inventory of 2008 exceeds its beg. Inventory, the ending inventory will include the beginning inventory (i.e., 35,000 units ) and a LIFO layer of 3,000 units from 2008 .

    • Thus, the cost of 2008 ending inventory equals:

      $2.55 x 35,000+ $2.75x 3,000 = $97,500

    Inventories: Measurement


    Problems associated with lifo inventory pools
    Problems Associated with LIFO Inventory Pools (contd.)

    • When a product in an inventory pool is discontinued, the old costs of the discontinued item will become the cost of goods sold and therefore, result in LIFO liquidation.

    • Even if the product is replaced, it may not be similar to the old item and cannot be included in the same pool.

    • Therefore, LIFO inventory pool requires redefine pools periodically when there are changes in the product mix of the pool.

    Inventories: Measurement


    9 dollar value lifo dv lifo technique
    9. Dollar-Value LIFO (DV LIFO) Technique (contd.)*

    • DV LIFO technique simplifies the recordkeeping procedures (due to no need to keep unit flows).

    • DV LIFO technique helps to protect LIFO layers from erosion (i.e., reduce the probability of LIFO liquidations; more than the LIFO inventory pool technique).

    • This technique is frequently used in practice

    Inventories: Measurement


    Dv lifo technique contd
    DV LIFO Technique (contd.) (contd.)*

    • DV LIFO defines a layer as the dollar value, not units, of ending inventory for a specific year.

    • One layer is formed for each year.

    • Dollar Value of Inventories: Current cost (the most recent purchase price) of the ending Inventory.

    Inventories: Measurement


    Dv lifo technique contd1
    DV LIFO Technique (contd.) (contd.)*

    • To determine whether a new LIFO layer is added under DV LIFO, the DV of ending inventory (EI) is compared with that of the beg. Inventory (BI).

    • If the DV of EI exceeds that of the BI, the EI layers will consist of the DV of the BI layer plus a new DV layer created for the current year (i.e., the DV of EI – the DV of BI).

    Inventories: Measurement


    The cost index
    The Cost Index (contd.)

    • When the price level of the EI differs from that of BI, a cost index should be used to adjust the DV of EI at the price level of the BI before forming the layers for the EI.

    • Cost index of a layer year =

      Cost in layer year/Cost in base year

    • Base year is the year in which DV LIFO is adopted and a layer year is any subsequent year in which an inv. Layer is created..

    Inventories: Measurement


    Dollar value lifo an example
    Dollar Value LIFO – An Example (contd.)

    Layer Current Cost Cost EI at Value of

    Year of Ending (Price) Base year Inv. At

    Inventory Index Price Levl. D-V LIFO

    20x0 a $20,000 100 $20,000 $20,000

    20x1 $30,000 120 $25,000 $26,000

    20x2 $31,200 130 $24,000 $24,800

    20x3 $39,200 140 $28,000 $30,400

    a. the base year

    Inventories: Measurement


    Example contd
    Example (contd.) (contd.)

    Forming of layers:

    20x0 20x1 20x2 20x3

    20,000 ... L1 20,000...L1 20,000...L1 20,000...L1

    5,000...L2 4,000...L2 4,000...L2

    0...L3 0...L3

    4,000 ..L4

    Converting to the corresponding year’s index level:

    20x0 20x1 20x2 20x3

    20,000x1 20, 000x1+ 20,000x1+ 20,000x1+

    =20,000 5 ,000x1.2 4,000x1.2+ 4,000x1.2+

    =26,000 0x1.3 0x1.3+

    =24,800 4,000x1.4

    =30,400

    Inventories: Measurement


    Comments on dollar value lifo
    Comments on Dollar-Value LIFO (contd.)

    • Items with similar economic, not physical, characteristics (i.e., subject to similar cost change pressure) will be pooled together.

    • The more items are included in an inventory pool, the less likely the erosion of the LIFO layers can occur.

    Inventories: Measurement


    Comments on dollar value lifo contd
    Comments on Dollar-Value LIFO (contd.) (contd.)*

    • Income number can be manipulated by changing the number of inventory pools.

    • On average, retailers form 6 pools for their inventories and non-retailers form 3 pools for their inventories.

    Inventories: Measurement


    An example of manipulating income by changing the number of inventory pools
    An Example of Manipulating Income by Changing the Number of Inventory Pools

    • Stauffer Chemical Company had increased LIFO pools from 8 to 280 , boosting its net income by $16,515,000 (13%) (source: KWW, 13th edition).

    Inventories: Measurement


    Types of indexes
    Types of Indexes Inventory Pools

    • Internal Index: Internal price indexcomputed by the company for its own product.

    • External Index: Computed by an outside party such as the government, commodity exchange, or trade association.

    • General Index: Composed of several commodities, goods or services.

    • Specific Index: For one commodity, good or service.

    Inventories: Measurement


    External price index
    External Price Index Inventory Pools*

    • The Consumer Price Index for urban consumers (CPI-U) is an example of an external general price index.

    • CPI-U is published monthly by the Bureau of Labor Statistics of the federal government.

    • Specific external price indexes (i.e., for gold, silver, corn…) are also available from trade associations.

    Inventories: Measurement


    The internal indexes
    The Internal Indexes Inventory Pools

    • A Double-Extension Method (i.e., the value of inv. units extended at both current and base-year prices):

    • Internal Index for the Current Year =

      End. Inv*. at Current Year’s Cost

      End. Inv. at Base-Year Cost

      • End. Inv. is the ending inventory of the current year.

      • The cost index for the base year equals one.

    Inventories: Measurement


    Example
    Example Inventory Pools

    • To compute specific internal price indexes:

      Year Current Units of Cost

      Cost End. Inv.Index(%)

      20x0 (base year) $19 300 100a

      20x1 $22.8 400 120b

      20x2 $24.7 450 130c

      20x3 $26.6 370 140d

      a. 19*300/19.0*300=100%c.24.7*450/19*450=130%

      b. 22.8*400/19*400=120%d.26.6*370/19*370=140%

    Inventories: Measurement


    Example contd1
    Example (contd.) Inventory Pools

    • General internal price index:

      (for more than one inventory in the pool):

      Inv. A Inv. B

      Current Units of Current Units of

      Cost End. Inv. Cost End. Inv.

      20x0(base year) $19 100 $20 150

      20x1 $22.8 110 $22 120

      General internal price index of 20x0:

      (19x100+20x150) / (19x100+20x150)=100%

      General internal price index of 20x1:

      (22.8x110+22x120) / (19x110+20x120)=114.6%

    Inventories: Measurement


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