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Intermediate Accounting, Ninth Edition. Kieso and Weygandt. Prepared by Catherine Katagiri, CPA The College of Saint Rose Albany, New York. John Wiley & Sons, Inc. 1. 1. 1. 1. Chapter 8: Valuation of Inventories: A Cost Basis Approach. After studying this chapter you should be able to:

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intermediate accounting ninth edition
Intermediate Accounting, Ninth Edition

Kieso and Weygandt

Prepared by

Catherine Katagiri, CPA

The College of Saint Rose

Albany, New York

John Wiley & Sons, Inc.

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chapter 8 valuation of inventories a cost basis approach
Chapter 8: Valuation of Inventories:A Cost Basis Approach

After studying this chapter you should be able to:

  • Identify major classifications of inventory
  • Distinguish between perpetual and periodic inventory systems.
  • Identify the effects of inventory errors on the financial statements.
  • Identify the items that should be included as inventory cost.
  • Describe and compare the flow assumptions used in accounting for inventories.
  • Explain the significance and use of a LIFO reserve.
  • Explain the effect of LIFO liquidations.
  • Explain the dollar-value LIFO method.
  • Identify the major advantages and disadvantages of LIFO.
  • Identify the reasons why a given inventory method is selected.
inventory classification
Inventory Classification

Inventories: Goods Held for Resale

  • Retailer
    • One inventory of finished goods (FG)
  • Manufacturer
    • 3 inventories
      • Raw materials (RM),
      • Work in process (WIP)
      • Finished goods (FG)
  • Inventories can be of high dollar value.
  • A Just-in-Time inventory system may be in place. Inventories kept to a minimum.

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inventory classification1
Inventory Classification
    • Level and condition of inventory important.
    • Inventory may be subject to obsolescence.
    • Inventory is held in anticipation of a sale, an uncertain event.
  • Review of Periodic and Perpetual Inventory Systems

Periodic: Inventory is not up to date. When goods are bought you use the purchases account to record them. When inventory is sold you record the event only once at retail. You must count the inventory and update it periodically. You must calculate the cost of goods sold as you have not kept track of it.

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inventory systems
Inventory Systems
  • Journal entries:
  • To buy:
  • Purchases XX
  • A/P XX
  • ** Assumes the gross approach is taken
  • To return:
  • A/P XX
  • Purc Returns and Allowances XX

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inventory systems1
Inventory Systems

To sell:

A/R XX

Sales XX

** At end of period the inventory must be counted and adjusted, CGS calculated.

  • To adjust:
  • CGS (or Income Summary) XX
  • Beginning inventory XX
  • Ending inventory XX
  • CGS (or Income Summary) XX

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inventory systems2
Inventory Systems
  • Perpetual system: Inventory account is increased and decreased as goods are bought and sold. Inventory is counted at the end of the period to confirm the accounting number. CGS is not a calculated figure as you keep track of it as goods are sold.
  • Journal entries:
  • To buy: (assume gross method)
  • Inventory XX
  • A/P XX

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inventory systems3
Inventory Systems

To return:

A/P XX

Inventory (returns) XX

  • To sell:
  • A/R XX
  • Sales XX
  • CGS XX
  • Inventory XX
  • There is a modified perpetual inventory in use by many firms. Records are kept in quantities only, not dollars. Memo system, outside the journal entry system.

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inventory systems4
Inventory Systems
  • There is a system called a “base or base stock” inventory system. It means that a certain level ($ value) of inventory is assumed to be on hand at all times.
    • If the inventory increases then

the increase is carried at the

acquistion (recent) cost.

    • If the inventory declines then

it is first replaced at the base

price before any layers are added.

    • Not GAAP.

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goods included in inventory
Goods Included in Inventory
  • What belongs in inventory? Anything that the company owns, i.e., it has title to. Physical possession (or the lack of) is not the final indicator.
    • Consignment sales.
    • FOB destination means goods belong to the seller in transit.
    • FOB shipping means goods belong to the buyer in transit.
    • Cutoff tests (done at end of period):
      • Purchases: To avoid understatement of inventory and A/P.
      • Sales: To avoid overstatement of inventory and A/R, sales.

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goods included in inventory1
Goods Included in Inventory
  • Special Arrangement: Sales with buyback.
    • These arrangements are not usually, in substance, a sale.
    • Should not be reported as a sale but as a financing transaction.
    • Briefly the sequence of events:

#1. Goods are delivered to buyer and used by the buyer to collateralize a loan, etc.

#2. Buyer uses part (or all) of the loan proceeds to pay for the inventory.

#3. Seller receives the payment and turns around and uses it to repurchase the inventory previously sold.

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goods included in inventory2
Goods Included in Inventory
  • Sales with high rates of return Two approaches are available:
    • You provide for the high amount of returns and reduce sales and A/R. To provide:
  • Contra sales (R & A) XX
  • Provision for Returns (contra A/R) XX
  • (Perpetual--increase inventory and decrease A/R)

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goods included in inventory3
Goods Included in Inventory
    • A second possiblity for sales with high rates of returns is to not record any sale until circumstances indicate the amount of inventory the buyer will return. When the amount of returns can be reasonable estimated , the goods should be considered sold. If returns are unpredictable, removal of these goods from the inventory of the seller is inappropriate.
  • Installment sales:
    • Allowable under financial accounting only when significant uncertainty surrounds the collectibility of the sale.
    • Goods should be excluded from seller’s inventory if the percentage of bad debts can be reasonable estimated.
    • This topic will be extensively covered in Chapter 19.

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inventory errors
Inventory Errors
  • Inventory errors
    • Let’s take a look at four separate cases.
    • Inventory errors are self-correcting. We’ll follow up Case #2.

Case #1 Ending inventory, Purchases, A/P are understated.

Arises from the failure to record and count a purchase.

Error on B/S only.

Ending inventory is too low, A/P too low.

You did not: (assume $100 amount)

Inventory (or purchases) 100

A/P 100

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inventory errors1
Inventory Errors

Case #1

Value Was Should’ve been

Beg. Inven. $100 $100 (OK)

+ Purchases 300 400 (under)

Goods Avail.$400 $500 (under)

-End Inven. 200 300 (under)

CGS $200 $200 (OK)

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inventory errors2
Inventory Errors

Case #2

Ending inventory overstated; Purchases, A/P OK.

Failure to record a sale

  • CGS 100
  • Inventory 100
  • B/S assets too high
  • I/S income too high causing RE to be too high
  • Balance sheet would still balance.

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inventory errors3
Inventory Errors

Case #2

Was Should’ve Been

Beg. Inven. $100 $100 OK

+Purchases 500500 OK

Goods Avail. $600 600 OK

-End Inven. 500* 400 *(overstated)

CGS 100** 200 **(understated)

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inventory errors4
Inventory Errors

Case #3

Ending Inventory OK, Purchases and A/P overstated.

Goods coming FOB destination are recorded prior to their receipt (they were not included in the physical count).

Should not have:

  • Purchases 100
  • A/P 100

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inventory errors5
Inventory Errors

Case #3

Was Should’ve Been

Beg. Inven $100 $100 OK

+Purc 600* 500 *Over

GA 700* 600 *Over

-EI 400*400 *OK

CGS 300* 200 *Over

B/S liability too high

I/S, RE too low

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inventory errors6
Inventory Errors

Case #4

Ending inventory OK, Purchases, A/P understated.

Goods counted prior to invoice received and recorded.

Did not record:

  • Purchases 100
  • A/P 100

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inventory errors7
Inventory Errors

Case #4

Was Should’ve Been

Beg. Inven. $100 $100

+Purchases 400* 500 *Under

GA 500* 600 *Under

-End Inven. 400 400 OK

CGS 100* 200 *Under

B/S liability understated

I/S income overstated

B/S RE overstated

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inventory errors8
Inventory Errors

Case #2: Effect of inventory errors will reverse

End of first year the Ending Inventory was overstated, Purchases and A/P were OK.

Now, end of the second year, the firm gets the ending inventory count correct.

First Year Second Year

Beg. Inven. $100 (OK) $500 (prior year)

+Purchases 500 (OK) 800 (OK)

Goods Avail. 600 $1,300 (over)

-End Inven. 500 (over) 600 (now OK)

CGS $100 (under) $700 (over)

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inventory errors9
Inventory Errors

Note: In year 1 the net income was overstated by $100; the retained earnings were then over by $100 as was the ending inventory.

In year 2 the ending inventory is OK. The net income is off the same amount as year 1 (when error originated) but in the opposite direction.

Retained earnings, end year 2, is now correct.

The error may go undetected, but as long as it is not repeated it will net out (or self correct) after the next period.

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inventory costs
Inventory Costs

Costs included in inventory:

    • Product costs--Material, labor and overhead
    • Period costs--Selling, general, administrative, interest, taxes
    • FASB has ruled that interest is not to be made part of the cost of the asset unless the asset is self-constructed (and there are limits then).
  • Full or absorption costing of inventory.
    • All product costs are inventoried-variable and fixed.
    • See footnote bottom page 404 on the potential differences capitalized for tax versus book purposes.

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inventory costs1
Inventory Costs
  • Variable or direct costing
    • Internal use
    • Contribution format for the income statement.
    • Only variable manufacturing costs become part of the cost of the product.
    • Fixed manufacturing costs become period expenses.
  • Record purchases at either the gross or the net.
    • Please see Illustration 8-9

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inventory cost flow assumptions
Inventory Cost Flow Assumptions

Physical flow of goods for sale assumed to be on a FIFO basis unless it is obviously otherwise.

Cost flow assumptions: How dollars are assigned to goods as they are sold. Methods:

  • Specific identification
  • Weighted average
  • First-in, First-out (FIFO)
  • Last-in, First-out (LIFO)
  • Let’s look at an example of each under the periodic and perpetual systems.

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inventory cost flow assumptions1
Inventory Cost Flow Assumptions

Units

Cost/Unit

Totals

Ending inventory is 250 units regardless of the cost flow assumption.

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inventory cost flow assumptions2
Inventory Cost Flow Assumptions
  • FIFO Periodic and perpetual systems yield the same results. Units are valued in chronological order.
  • Goods available equals $5,550 or 650 units
  • Ending inventory equals 250 units
  • CGS equals 400 units
  • EI: 50 at $11 = $ 550 CGS: 100 at $6 = $ 600
  • 200 at $10 = $2,000 200 at $7 = $ 1,400
  • Total $2,550 100 at $10 = $1,000 Total $3,000
  • Note: Total EI and CGS = 650 units or $5,550 (must agree)

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inventory cost flow assumptions3
Inventory Cost Flow Assumptions

Simple Weighted Average (periodic)

Goods available in dollars = average cost per unit

Goods available in units

$5,550 = $8.54 per unit rounded (all units at this price)

650 units

Ending inventory = 250 at $8.54 = $2,135

CGS = 400 at $8.54 = $3,416

Note: Again all units and dollars must be accounted for.

Notice the dollar values assigned will vary based on cost flow assumptions. Physical flow of the goods remains the same.

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inventory cost flow assumptions4
Inventory Cost Flow Assumptions
  • Moving average perpetual.
    • Always employ the same formula as before (goods available in dollars/ goods available in units).
    • Apply this formula after each purchase to value each sale until a another purchase is made.
    • The average will change if new units are acquired at other than the previous average.
    • Using our example the valuation of the ending inventory is $2,328 or 250 units at $9.31 (rounded) per unit. The CGS totals $3,223 from the two sales. Please attempt the calculations yourselves to prove these numbers!

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inventory cost flow assumptions5
Inventory Cost Flow Assumptions
  • LIFO periodic

Basic facts remain the same Ending inventory 250 units, sales of 400 units, goods available of 650 units for a total cost of $5,550.

EI: CGS:

100 at $6 = $ 600 50 at $11 = $ 550

150 at $7 = $1,050 300 at $10 = $3,000

250 $1,650 50 at $ 7 = $ 350

400 $3,900

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inventory cost flow assumptions6
Inventory Cost Flow Assumptions
  • LIFO perpetualyields a different result than LIFO periodic. This is because of the creation of LIFO layers. Units are not removed all at once; purchases are not exhausted by each sale, some may be left behind as they are no longer the last in.

Ending inventory valuation:

after S#1 CGS after S# 1

100 at $6 = $ 600 150 at $7 = $1,050

50 at $7 = $ 350

300 at $10 = $3,000

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inventory cost flow assumptions7
Inventory Cost Flow Assumptions
  • LIFO perpetual continued:

after P#2

100 at $6 = $ 600

50 at $7 = $ 350

300 at $10 = $3,000

  • Inventory valuation:

after S#2 CGS from S#2

100 at $6 = $ 600 250 at $10 = $ 2,500

50 at $7 = $ 350

50 at $10 = $500

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inventory cost flow assumptions8
Inventory Cost Flow Assumptions

Inventory valuation:

after P#3

100 at $6 = $ 600

50 at $7 = $ 350

50 at $10 = $ 500

50 at $11 = $ 550

250 $2,000 Total CGS = $3,550

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slide35
LIFO
  • Please review LIFO reserve on page 409.
  • Please review LIFO liquidation
    • Review what happens you consume older, cheaper goods and the effect on income taxes and cash flows.
    • Please see page 410.

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dollar value lifo
Dollar-Value LIFO
  • Dollar Value LIFO: Method to value inventory to ease the liquidation of LIFO layers.
    • Selection of a “base year”.
    • The beginning inventory of that year becomes the base year (BY). We will assume the price index for the base year is 100 (or 100%).
    • In words, what you are attempting to do is to create an inventory as if LIFO had been in place. You may maintain your books using FIFO but you wish to use LIFO for reporting and tax purposes.
    • The current inventory is

carried at current prices.

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dollar value lifo1
Dollar-Value LIFO
  • You need to convert the $ to a common size (as if they were all base year dollars).
  • You then create the layers common to LIFO by using various price indices (PI). That is, inventory is restated to various acquisition year prices.

Current year inventory at cost = Current inventory in BY $

Current year price index

  • We will be given the price index as there are several sources for possible price indices.

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dollar value lifo2
Dollar-Value LIFO
  • After the current year’s inventory has been converted to common size base year (BY) dollars:
  • Current year inventory (BY$)
    • less: Base year inventory (BY$) times 1.0 PI = $ Additional layer of inventory times current layer’s PI = ($)
    • Total Dollar Value LIFO inventory $

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dollar value lifo3
Dollar-Value LIFO

For example:

Year 1 BY inventory $2,000; price index is 100%

Year 2 (current year) inventory $3,000; price index is 120%

For Year 2:

  • $3,000 = $2,500 (current inventory BY $)
  • 1.2
  • less BY layer (2,000) BY$ x 1.00 = $2,000
  • year 2 layer $500 x 1.20 = 600
  • $2,600 DV LIFO

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slide40
LIFO

LIFO advantages

  • Reduces taxes
  • Reduces inventory profits
  • Matching
  • Cash flow
  • Inventory unlikely to be written down

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slide41
LIFO
  • LIFO disadvantages:
    • Understatement of inventory.
    • Reduces reported net income.
    • Reduces reported working capital.
    • Liquidation of layers
    • Unexpected consequences if prices fall dramatically.
    • Physical flow of goods does not match the dollar flow
    • Replacement cost not used (Next-in, first out or NIFO)
    • Poor buying habits develop in an effort to avoid liquidating LIFO layers.

Please review basis for selection of inventory method, pages 419-422.

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