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Chapter 8 Valuation of Inventories: A Cost-Basis Approach
1. Introduction • Definition • Assets held for sale in the ordinary course of business or goods that will be consumed in production • Importance • Cost of inventory • all expenditures necessary in acquiring goods and converting them to saleable condition • Cutoff • Who owns inventory if “sale” is a(an) • product financing arrangement, installment sale, consignment, sales with high rates of return
2. Inventory Systems • Periodic system • no running balance of inventory & CGS • purchases account used • beginning inv balance unchanged during year • take physical inventory at year-end and record ending balance through adjusting entry • CGS calculated • CGS format
2a. Inventory Systems • Perpetual system • keeps running balance of inventory & CGS • no purchases account used • all changes in inventory cost recorded in inventory account • take physical inventory at year-end & adjust book balance to actual
2b. Inventory Systems • Periodic & perpetual entries • Net and gross methods of recording • purchase merchandise, $1,200; 2/10,n/30 • return merchandise, $200 • sell remainder for $1,800 • pay above • within discount period • after discount period
2c. Inventory Systems • Periodic inventory system YE adjusting entry • Account balances
2c. Inventory Systems • Periodic inventory system YE adjusting entry
3. Inventory Cost Flow Assumptions • Problem • purchases made at different prices • Flow of costs v. flow of goods • Four GAAP methods • specific identification • FIFO • LIFO • average
3a. Inventory Cost Flow Assumptions • Specific identification • only used if relatively small number of high priced goods that can be easily distinguished • can manipulate income
3b. Inventory Cost Flow Assumptions • FIFO • assume goods used in order purchased • ending inventory approximately at current costs • CGS at old prices • periodic and perpetual systems always give same result
3c. Inventory Cost Flow Assumptions • LIFO • assumes last goods purchased are first sold • advantages • matches current costs with revenues • tax benefits • improved cash flow • disadvantages • reduction in reported earnings • understatement of ending inventory on bal. sheet • does not reflect underlying physical flow of goods • causes poor buying habits • can manipulate income • LIFO conformity rule • must use LIFO for financial reporting if used for tax reporting
3d. Inventory Cost Flow Assumptions • Average cost • weighted average or moving average used • values goods based on average cost of goods on hand and acquired • Other methods • base stock • standard cost • NIFO • LIFO/FIFO
3e. Inventory Cost Flow Assumptions • Comparison of methods (during periods of rising prices) What would be the differences between the methods if all units had the same cost?
3f. Inventory Cost Flow Assumptions • Example of methods Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems.
4. Special issues related to LIFO • Inventory Pools • Unrealistic to assume only one product • If multi product • replace one item with another – loose base layer of LIFO cost • Pooled approach • group similar items together • reduces record keeping costs • more difficult to erode old LIFO layers • Number of pools?
4. Special issues related to LIFO • LIFO reserves • maintain internal records using FIFO • adjust to LIFO at year end Cost of goods sold xxx Allow to reduce inventory to LIFO xxx
5. Dollar Value LIFO • Introduction • emphasis is on dollar value of inventory • not units of inventory • greatly reduces problem of changes in mix of inventory • more practical method of valuing multi-product inventory than unit LIFO • allowed for financial reporting and tax • LIFO conformity rule • must use LIFO for financial reporting if used for tax
5a. Dollar Value LIFO • Basics of method • when first adopt method (base year) value ending inventory at current costs (FIFO) • end of each subsequent year, value ending inventory at current costs (FIFO) • then restate current year-end cost to price level in base year • a new layer formed when EI (in base year $) exceeds base year cost of BI • increase priced at current costs • if EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer
5b. Dollar Value LIFO • Price index • company may calculate own • double extension method or link-chain method • may use published price indexes • e.g., GNP implicit price deflator, CPI, or industry specific index • example using market basket approach
5c. Dollar Value LIFO • Example Calculate ending inventory using dollar value LIFO for each year.
6. Effect of errors • Self-correcting errors • most errors correct themselves over time • e.g., inventory – this year’s ending inventory is next year’s beginning inventory • depreciable assets – over the life of the assets • but each year is incorrect over that period • Permanent errors • never will correct themselves • e.g., expensing land, recording wrong amount
6a. Inventory Errors • Overstatement of ending inventory • Understates cost of goods sold • Overstates income • Understatement of ending inventory • Overstates cost of goods sold • Understates income • Overstatement of beginning inventory • Overstates cost of goods sold • Understates income • Understatement of beginning inventory • Understates cost of goods sold • Overstates income
6b. Effect of errors • Determining effect of errors • determine effect for all accounts involved • examples • ending inventory overstated • interest expense not accrued on N/P this year, next year principle and interest paid in full