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) =
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
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
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
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
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 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.
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
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 Sold xx (based on FIFO,LIFO,Avg.)
Inventory - Ending xx (based on FIFO,LIFO,Avg.)
Purchase Discounts xx
Purchase Rt. & Allow. xx
Inventory - Beginning xx
Purchase $100 on account. Terms 2/10, n/30.
Gross Method Net Method
Purchases 100 Purchases 98
A/Pay 100 A/Pay 98
Payment within 10 days:
A/Pay 100 A/Pay 98
Cash 98 Cash 98
Purch. Discounts 2
Payment after 10 days:
A/Pay 100 A/Pay 98
Cash 100 P. 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 Discounts 900
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:
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
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.Cost Flow Assumptions
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 35Class Problem - Cost Flows
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 $548Average Perpetual (not tested)(calculate average before each sale)
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.
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
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.