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Chapter 7: Inventory. Acquisition of inventory: What costs to capitalize? Recording inventory activity: Which method? Selling inventory: Which cost flow assumption? Ending inventory: Lower-of-cost-or market valuation. Chapter 7: Inventory. What items or units to include?

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chapter 7 inventory2
Acquisition of inventory: What costs to capitalize?

Recording inventory activity: Which method?

Selling inventory: Which cost flow assumption?

Ending inventory: Lower-of-cost-or market valuation.

Chapter 7: Inventory
1 acquiring inventory
What items or units to include?

General rule: (1) held for sale and (2) complete and unrestricted ownership.

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).

FOB Destination: belongs to seller while in transit (until inventory reaches purchaser’s facilities).

1. Acquiring Inventory
class exercise e7 1
Error if Dallas includes in ending inventory at 12/31?

1. FOB Shipping Point (purchase):

No error

2. FOB Shipping Point (sale):

Yes - inventory overstated.

3. FOB Destination (sale):

No error

4. FOB Destination (purchase):

No error

5. FOB Destination (purchase):

Yes - inventory overstated

Class Exercise E7-1
inventory errors
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.

To analyze, use basic inventory formula.

Inventory Errors
class problem
Assume that the ending inventory of 2004 was undervalued by $9,000. If the error goes undetected in 2005, what effect would the error have on the balance sheet and income statement accounts for 2004 and 2005. 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.

Class Problem
class problem7
Analysis:

BI + P - EI = COGS NI A = L + SE

Class Problem

04:

9u

9o

9u

9u

9u

05:

9u

9u

9o

X

X

Why no effect on 2005 ending SE?

NI 2004 understated by $9,000

NI 2005 overstated by $9,000

Both closed to RE, so no net effect at end.

acquiring inventory contd
What costs to attach? General rule: all costs associated with purchase or manufacture, including shipping to facility.

Freight-in (transportation-in) adds to the cost of inventory.

Purchase returns reduce the cost of purchases (contra) for returned inventory.

Purchase allowances reduce the cost of purchases (contra) for reduced prices due to damage or errors.

Purchase discounts from early cash payments (contra) reduce the cost of purchases.

Acquiring inventory - contd.
2 perpetual or periodic method
Perpetual

Up-to-date record in inventory account.

Cost of goods sold computed for each sale.

Periodic

Inventory purchases are recorded as incurred.

Inventory and cost of goods sold determined at the end of each period through physical count.

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.

2. Perpetual or Periodic Method
figure 7 3 perpetual system
December 10 Purchase of 100 units @ $20:

Inventory 2,000

Accts. Pay. 2,000

December 20 Sale of 50 units @ $30:

Cash 1,500

Sales 1,500

COGS 1,000

Inventory 1,000

December 30 AJE to recognize loss of 5 units @$20 each (170 on hand, books show 175)

Loss 100

Inventory 100

Figure 7.3, Perpetual System
figure 7 3 periodic system
December 10 Purchase of 100 units @ $20:

Purchases 2,000

Accts. Pay. 2,000

December 20 Sale of 50 units @ $30:

Cash 1,500

Sales 1,500

(no COGS entry until the end of the period)

December 31 AJE/CJE to recognize EI and COGS:

(Note: BI given at $2,500 and EI of 175 units (125 BI + 100 Purchase -50 Sold) valued at $20 per unit, or $3,500)

Inventory (end) 3,500

COGS 1,000

Purchases 2,000

Inventory (begin) 2,500

Figure 7.3, Periodic System
this aje under periodic system follows the formula for cogs
BI + Purchases (net) - EI = COGS

2,500 + 2,000 - 3,500 = 1,000

Note that Purchases (net) =

Purchases

+ Freight-in

- Purchase Discounts (see next slide)

- Purchase Returns

- Purchase Allowances

This AJE under periodic system follows the formula for COGS:

(Alternative: BI + P(net) = EI + COGS)

purchase discounts gross method
Assume purchase of $100 on account on 6/1/05, terms 2/15 (2% discount if paid within15 days), n/30.

GJE to record purchase on 6/1/05:

Purchases 100

Accounts Payable 100

GJE to record payment, if on or before 6/16/05:

Accounts Payable 100

Purchase Discounts 2

Cash 98

GJE to record payment, if after 6/16/05:

Accounts Payable 100

Cash 100

(Purch Disc. is contra to Purchases; part of COGS calc.)

Purchase Discounts - Gross Method
class problem e7 3 periodic
March 3 purchase:

Purchases 50,000

A/P 50,000

March 10 purchase:

Purchases 140,000

A/P 140,000

Class Problem: E7-3 (Periodic)
class problem e7 3 periodic15
March 20 payment (3% discount taken):

A/P 140,000

Purchase discounts 4,200

Cash 135,800

April 25 payment (no discount taken):

A/P 50,000

Cash 50,000

Class Problem: E7-3 (Periodic)
class exercise exercise 7 4 part a
Note:

Cost of goods available for sale = GAS, and

GAS = Beginning inventory + Purchases (net)

GAS = EI + COGS

Class Exercise: Exercise 7-4, Part (a)
class exercise exercise 7 4 part a for 2003
Find Beginning inventory (2003):

BI 2003 = EI 2002 = 1,931

Find GAS (2003):

BI + P(n) = GAS

1,931 + 9,170 = GAS

11,101 = GAS

Find EI (2003):

GAS = EI + COGS

11,101 = EI + 9,285

1,816 = EI

Class Exercise: Exercise 7-4, Part (a) for 2003
class exercise exercise 7 4 part a for 2002
Find Beginning inventory (2002):

BI 2002 = EI 2001 = GAS 2001 - COGS 2001

= 10,840 - 8,749 = 2,091

Find GAS (2002):

GAS = EI + COGS

GAS = 1,931 + 8,496

GAS = 10,427

Find Purchases:

BI + P = GAS

2,091 + P = 10,427

P = 8,336

Class Exercise: Exercise 7-4, Part (a) for 2002
3 cost flow assumptions
Given: BI + P (net) = EI + COGS

How to assign costs of inflows [BI + P(net)] to EI and COGS?

Methods:

Specific identification

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

3. Cost Flow Assumptions
class problem cost flows
Given the following activity for January:

Cost Total

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 -55 units

Ending inventory

Class Problem - Cost Flows

35 units

class problem cost flows21
Note that, for illustrative purposes, only the periodic system is shown here.

The perpetual system give similar results, but is more cumbersome to illustrate.

In fact, using the FIFO method, the perpetual and periodic systems yield exactly the same results.

Class Problem - Cost Flows
fifo lish
FIFO for COGS (top down)

55 units

20 @ $9 = $180

35 @ $10 = $350

Total = $530

LISH for EI (bottom up)

35 units

30 @ $11 = $330

5 @ $10 = $ 50

Total $380

FIFO(LISH)
lifo fish
LIFO for COGS (bottom up)

55 units

30 @ $11 = $330

25 @ $10 = $250

Total = $580

FISH for EI (top down)

35 units

20 @ $ 9 = $180

15 @ $10 = $150

Total = $330

LIFO(FISH)
average
First calculate average:

Goods available cost = $910

Goods available units = 90 units

Avg. = $10.11 per unit

Now COGS:

55 units x $10.11 per unit = $ 556

Now EI:

35 units x $10.11 per unit = $354

Average
comparison of fifo lifo and average
In times of rising prices:

highest COGS:

lowest COGS

highest EI

lowest EI

highest Net Income

lowest Net Income

Comparison of FIFO, LIFO, and Average

LIFO

FIFO

FIFO

LIFO

FIFO

LIFO

additional lifo issues
LIFO and taxes

Why use LIFO for taxes?

Why use LIFO for financial statements?

LIFO and market valuation

Should market value a company higher or lower if they use LIFO?

LIFO liquidation

What happens to net income with liquidation of an old LIFO layer?

LIFO reserve

what information is contained in this disclosure?

Additional LIFO issues:
4 ending inventory applying the lower of cost or market rule
Based on conservatism, ending inventory is valued at cost or market value, whichever is lower.

Problem: can create hidden reserves

Recognizes price decreases immediately

Defers price increase recognition until sold

4. Ending Inventory:Applying the Lower-of-Cost-or-Market Rule
class issues for discussion id7 4
a. AJE (in millions)- reduce EI and recognize loss:

Loss on Inventory 12

Inventory 12

b. Sale next year (new basis = 40):

Cash (or A/R) 48

Sales 48

COGS 40

Inventory 40

c. Loss of $12 in first year; gain of $8 in second year:

- overestimate?

- or creating hidden reserve?

Class Issues for Discussion: ID7-4