ACCT303 Chapter 9 Teaching Pp

8/12/2019 ACCT303 Chapter 9 Teaching Pp

1/115

Chaptger 9: InventoriesLearning objectives

1. The relationship between inventory valuation

and cost of goods sold.

2. The two methods used to allocate the total

inventory cost between the COGS and theending inventoriesperpetual and periodic.

3. What kinds of costs are included in inventory.

4. What absorption costing is and how it

complicates financial analysis.5. The difference between inventory cost flow

assumptionsweighted average, FIFO and

LIFO.

9-1


2/115

Learning objectivesconcluded

6. How LIFO reserve disclosures can be used

to estimate inventory holding gains and

to transform LIFO firms to a FIFO basis.

7. How LIFO affects firms income taxes.

8. How to eliminate realized holding gains

from FIFO income.

9. Economic incentives guiding the choice

of inventory methods.

9-2


3/115

Learning objectivesconcluded

10.How to apply the lower of cost or market

method.

11.The key differences between GAAP andIFRS requirements for inventory

accounting.

9-3


4/115

4

Main Types of Businesses

Service Companies: Travel agency, Entertainment, Internet,

etc.

Merchandising Companies: Wholesalers and retailer: to buy and sell

ready-to-sell merchandise.

Manufacturing CompaniesAcquire and process raw materials into

finished goods.


5/115

5

Main Types of Businesses

For both merchandising andmanufacturing companies,

inventories are important assets. Therefore, inventory accounting is

crucial to financial reporting.


6/115

6

Inventory types

Wholesaler or retailer: Manufacturer:

Manufacturer

Merchandiseinventory

Customer

Raw materials

Work-in-process

Finished goods

Supplier

Customer

Includes other

manufacturingcosts ( Directlabor costs,directmaterials,manufacturing

overhead,etc.)

Firm

Firm

Gross Profit: SalesCost of Goods Sold


7/115

Overview of accounting issues

What kind of costs areincluded in inventory?

How is the cost ofgoods available for

sale split between thebalance sheet and theincome statement?

Old unit New unit

Issue:

Issue:

9-7


8/115

Overview of accounting issues:Summary

Weighted average

FIFO

LIFO

GAAP does not require the costflow assumptionto correspond tothe actual physical flowofinventory.

If the cost of inventory neverchanges, all three cost flowassumptions would yield the samefinancial statement result.

No matter what assumption isused, the total dollar amountassigned to the balance sheet andthe income statement is the same($640 in this example).

Three methods for allocating thecost of goods available for sale:

9-8


9/115

Overview of accounting issues:

Allocating the cost of goods available for sale

Weighted average approach:

Uses the average cost of the twounits.

Oldest unit cost flows to income.

First-in, first-out (FIFO) approach:

Uses the average cost of the twounits.

FIFOproducesa smallerexpense

Newest unit cost flows to income.

Last-in, last-out (LIFO) approach: LIFOproducesa largerexpense

9-9


10/115

Overview of accounting issues:

How to allocate total inventory between theCOGS and the ending inventory?

What items should be included in ending

inventory? What costs should be included in inventory

purchases (and eventually in endinginventory)?

What different cost flow assumptions canbe used in determine the COGS under eachinventory method (i.e., perpetual vs.

periodic)? 9-10


11/115

11

Learning Objective:

How to allocate total inventory between theCOGS and the ending inventory?


12/115

12

Perpetual inventory system

This approach keeps a running (or perpetual) recordof the amount of inventory on hand.

The inventory T-account under a perpetual inventory

system looks like this:

Entries are made asunits are purchased

Entries are made asunits are sold


13/115

13

Determining inventory quantities:Periodic inventory system

This approach does NOTkeep a running (or perpetual)record of the amount of inventory on hand.

Ending inventoryand cost of goods sold must be determined byphy sica lly count ing the goods on h and at the end of the per iod.

Entries are made as units are purchased


14/115

14

Determining inventory quantities:

Journal entries illustrated

Beginning Inv.(1,400) + Purchases (9,100)Ending Inv. (3,500)=COGS (7,000)


15/115

15

Periodic and perpetual compared

Less recordkeeping meanslower cost to maintain.

Less management controlover inventory.

COGS is a plug figure andthere is no way to determinethe extent of inventory losses(shrinkage).

Typically used when inventoryvolumes are high and per-unitcosts are low.

More complicated and usuallymore expensive.

Does NOT eliminate the needto take a physical inventory.

Better management controlover inventories includingstock outs.

Typically used for low volume,high unit cost items or whencontinuous monitoring ofinventory levels is essential.

Periodic inventory Perpetual inventory


16/115

16

Learning Objective:

What items should be included in endinginventory?

.


17/115

Items included in inventory In day-to-day operations, most firms record

inventory when they physically receive it. When it comes to preparing financial

statements, the firm must determinewhether all inventory items are legallyowned. Goods in transit may be owned by the buyer or

the seller.

The party that has legal title during transit willrecord the items as inventory.

Consignment goodsshould not be countedas inventory for the consignee.

9-17


18/115

18

What is Included in Ending

Inventory?General Rule

All goods legally owned by the company onthe inventory date, regardless of their

location.

Goods in Transit Goods on

Consignment

Depends on FOBshipping terms.


19/115

19

Goods in transit

The party with the legal title during

transit will record the items asinventory.

FOB Shipping Point: the title transfers

to the buyer at the shipping point (i.e.,the sellers facility). Thus, the buyer hasthe title during the transit.

FOB Destination: the title transfers tothe buyer at the destination (i.e., buyersfacility. Thus, the seller has the titleduring the transit.


20/115

20

Houston Corporation had the following inventorytransactions in transi ton 12/31/08. Indicatewhether the inventory would be included inHoustons ending inventory on 12/31/2010.

1. Purchased inventory FOB Shipping Point;

shipped on 12/31/10.

2. Sold inventory FOB Shipping Point; shipped on12/31/10.

3. Purchased inventory FOB Destination; shippedon 12/31/10.

4. Sold inventory FOB Destination; shipped on12/31/10.

In Class Exercise :


21/115

21

Learning Objective:

What costs should be included in inventorypurchases?


22/115

22

Costs included in inventory

All costs necessary to obtain the

inventory and to make it saleable shouldbe accounted for.

These costs include:

Purchase cost or production costs Sales taxes and transportation costs (if

paid by the buyer). In-transit insurance costs (if paid by the

buyer). Storage costs.


23/115

23

Costs included in inventory

In theory, costs such as the costs of thepurchasing department and othergeneral and administrative costsassociated with the acquisition and

distribution of inventory should also beincluded in the inventory costs(referredto as the indirect costs).

However, most firms exclude these items.


24/115

24

Costs included in inventory :

Non-manu factur ing f irms consider the

following items in the cost of inventories: Purchase costs ( invoice price)

+ Freight-in(transportation-in)

- Purchase returns - Purchase allowances(reduce the

purchase price due to damages ongoods).

- Purchase discounts (from early cashpayments for the purchase) .


25/115

25

Costs included in inventory:

Manufacturing firmsThe inventory costs (i.e., product costs)of amanufacturer include:

Raw Material (variable)

Direct Labor (variable)

Overhead items:

Variableoverhead:indirect labor,indirect material, electricity used for

production, etc. Fixed overhead: depreciation expense

of machine, property taxes of factories,rent expense for the factories, etc.


26/115

26

Costs included in inventory:

Manufacturing firms (contd.)

The inventory costs are treated as assets(in work-in-processaccount for any rawmaterial, labor and overhead in production

process and in finished goods accountwhen the production process is complete)until finished goods are sold.

When finished goods are sold, thecarrying value of these finished goods ischarged to cost of goods sold.


27/115

27

Costs included in inventory:Manufacturing industry ( FYI )

Two views on treatment ofmanufacturing overhead costs:Absorption and variable costing


28/115

28

Manufacturing Overhead:

Variablecosting versusAbsorptioncosting

Variableproduction

costs

Fixedproduction

costs

Variableproduction

costs

Variable costingof inventory (not

allowed by GAAP)

Absorption costingof inventory (required

by GAAP)

Fixed overhead:

Manufacturing rentalsand depreciation

Property taxes

Raw materials

Direct labor

Variable overhead, likeelectricity

Variable costswill change inproportion tothe level ofproduction.

Costs are considered to beIncludable in inventory if theyprovide future benefits to the firm.

The rationale for absorption costing is thatboth variable and fixed production costs areassets since both are needed to producea saleable product.


29/115

29

Manufacturing Overhead: Summary

These are neverincluded in inventory.

This approach is notallowed by GAAP.


30/115

Costs included in inventory:How absorption costing can distort profitability

As we shall see, the GAAP gross margin increases from $110,000 in2011 to $130,000 in 2012 even though variable production costs andselling price are constant, and sales revenue has fallen.

9-30


31/115

Costs included in inventory:Absorption costing distortion

9-31


32/115

Costs included in inventory:Variable costing illustration

Under variable costing the gross marginfalls

9-32


33/115

33

Absorption Costing and Earnings

Management (source: RCJM Textbook)

A research study found that firms indanger of producing zero earnings resort tooverproducing inventory to reduce sort of

goods sold and thereby boost profits.The evidence suggests that absorptioncosting provides opportunities for firms to

manipulate earnings.


34/115

34

Cost Flow Assumptions:

Differentiate between the specific identification,

FIFO, LIFO, and average cost methods used todetermine the cost of ending inventory and cost

of goods sold.


35/115

9-35

Cost flow assumptions:The concepts

In a few industries, it is possible toidentify which particular units have beensold. Examples include jewelry stores

and automobile dealerships. These firmsuse specific identificationinventorycosting.

For most firms, however, a cost flow

assumptionis required.


36/115

36

Cost Flow Assumptions:

Allocating the cost of goods available for sale

Weighted average

Oldest unit cost flows to income.

First-in, first-out (FIFO)

Uses the average cost of

the two units.FIFO

producesa smallerexpense

Newest unit cost flowsto income.

Last-in, first-out (LIFO)

LIFOproducesa largerexpense

Oldest unit cost flows toincome.

Assumption: the cost of inventory is risingOlder inventory purchase: Unit price:$300Most recent inventory purchase: Unit price ;$340
http://localhost/var/www/apps/conversion/ACCT303%20Spring%202008/Class%20Notes/Chapter%209.ppthttp://localhost/var/www/apps/conversion/ACCT303%20Spring%202008/Class%20Notes/Chapter%209.ppt


37/115

37

Cost Flow Assumptions: Summary

GAAP does not require the cost flow

assumptionto correspond to the actualphysical flowof inventory.

If the cost of inventorynever changes, all

three cost flow assumptions would yieldthe same financial statement result.

No matter what assumption is used, the

total amount assigned to the balancesheet and the income statement is thesame (i.e., the amount of goods availablefor sale).


38/115

38

Cost flow assumptions:

What assumptions do firms use?(Accounting Trends and

Techniques)


39/115

39

Inventory Cost Flow Methods

Specific cost identification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)


40/115

40

The specific cost ofeach inventory item

must be known.

By selecting specificitems from inventory

at the time of sale,income may bemanipulated.

Specific Cost Identification

Items are added toinventory at cost

when they arepurchased.

COGS for each sale

is based on thespecific costof theitem sold.

Companies which can identify specific units sold can adopt the specific

identification method to allocate costs of goods sold and cost of ending

Inventory. Examples include jewelry stores and automobile dealerships.


41/115

41

Weighted Average Cost Method

Weighted-

average

unit cost

=

Cost of

goodsavailable for

sale

Quantity

available for

sale

Periodic average cost uses awei hted-avera e unit cost:

Perpetual average cost uses a movingaverage unit cost that is recomputed

each time a new purchase is made.


42/115

42

Weighted Average MethodPeriodic

system

Begin Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 400Purchase 1/22 30 @ 11.00 330Sales 1/13 : 55 UnitsEnding Inventory on 1/31:20 + 40 + 30 - 55=35 units

Average unit cost:$ of Goods available cost( 180+400+330 )= $10.11per unitUnits of Goods available ( 20+40+30 )

Ending Inventories:35 units x $10.11 = $354

Cost of Goods Sold: $180+ (400+330)354 = $556


43/115

43

Weighted Average MethodPerpetual systemBegin Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 400Purchase 1/22 30 @ 11.00 330Sales 1/13 : 55 UnitsEnding Inventory on 1/31:20 + 40+ 3055 = 35 units

Calculate weighted average unit cost on 1/10:Goods available cost ( 180+400 )= $580 = $9.67 per unitGoods available units ( 20+40) 60

Cost of Goods sold on 1/13:

55units x $9.67 per unit = $ 531.85 Calculate weighted average unit cost on1/22:

Goods available cost ( 5*9.67+30*11)= $378 = $10.81Goods available units ( 20+40-55+30 ) 35

Cost of ending inventory on 1/31:35 units x $10.81 per unit = $378.35


44/115

44

First-In, First-Out

The FIFO method assumes that items are

sold in the chronological order of theiracquisition.

The cost of the oldestinventory items are

charged to COGS when goods are sold. The cost of the newest inventory items

remain in ending inventory.

The COGS and ending inventory cost are the

sameunder periodic and perpetualapproaches regardless their differences inthe timing of adjustments to inventory.


45/115

45

First-in, First-out (FIFO)

Oldestunitsassumedsold

Newest unitsassumed still

on hand


46/115

46

First-in, First-out (FIFO) illustrated

The computations are:


47/115

47

Practice Problem: FIFO - Periodic systemBeginning Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 UnitsEnding Inventory: 20+40+30-55 = 35 units

FIFO of cost of ending units (bottom up) :35 units 30 @ $11 = $330

5 @ $10 = $ 50

Total = $380

FIFO for COGS (top down)55 units 20 @ $ 9 = $180

35 @ $10 = $350

Total = $530

Alternatively(recommended),COGS

= beg. Inv. + net pur.end. Inv.

= $180 + (400+330)380= $530.


48/115

48

Practice Problem: FIFO -Perpetual systemBeginning Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 $400

Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 UnitsEnding Inventory: 20 + 40+ 30 - 55 = 35 units

FIFO COGSfor 1/13 Sale FIFO Inventory on 1/13

55 units 20 @ $ 9 = $180 5 @ $10 = $5035 @ $10 = $350

Total = $530

Inventoryon 1/22 (same as inventory on 1/31 due to

no other transactions after 1/22 in January)35 units 5 @ $10 = $ 50

30 @ $11 = $330

Total = $380


49/115

49

Last-In, First-Out

The LIFO method assumes that the newest

items are sold first, leaving the older units ininventory.

The cost of the newest inventory items arecharged to COGS when goods are sold.

The cost of the oldest inventory items remainin inventory.

Unlike FIFO, using the LIFO method may

result in COGS and ending inventory Costthat differ under the periodic and perpetualapproaches.


50/115

50

Last-in, First-out (LIFO)

Newest unitsassumed sold

Oldest unitsassumed still

on hand


51/115

51

Last-in, First-out (LIFO) illustrated

The computations are:


52/115

52

Practice Problem: LIFO - Periodic systemBeginning Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 UnitsEnding Inventory: 20+40+30-55 = 35 units

LIFO of cost of ending inventory (top down) :35 units 20 @ $9 = $180

15 @ $10 = $150

Total = $330

FIFO for COGS (bottom up)55 units 30 @ $11 = $330

25 @ $10 = $250

Total = $580

Alternatively(recommended),COGS

= beg. Inv. + net pur.end. Inv.

= $180 + (400+330)330 = $580.

P i P bl LIFO P l


53/115

53

Practice Problem: LIFO -Perpetual systemBeginning Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 $400

Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 UnitsEnding Inventory: 20 + 40+ 30 - 55 = 35 units

LIFO COGSfor 1/13 Sale LIFO Inventory on 1/13

55 units 40 @ $10 = $400 5 @ $9 = $4015 @ $9 = $135

Total = $535

Inventoryon 1/22 (same as inventory on 1/31 due to

no other transactions after 1/22 in January)35 units 5 @ $9 = $ 45

30 @ $11 = $330

Total = $375


54/115

54

Learning Objective

LIFO Reserve and LIFO Effect


55/115

5555

LIFO Reserve

Many companies use LIFO for externalreporting and income tax purposes butmaintain internal records using FIFO oraverage cost.

The difference in the value of inventorybetween the inventory method used forinternal reporting purposes (i.e., FIFO) and

LIFOis reported in an account referred to asLIFO Reserveor the Allowance to ReduceInventory to LIFO.


56/115

5656

LIFO Reserve

The change in the balance of LIFOReserve account from one period toanother is referred as the LIFO Effect,

which reflects the impact on incomefrom using LIFO vs. FIFO.

The SEC required the LIFO reservedisclosure since 1974 for firms adoptingLIFO costing.

fl


57/115

Cost flow assumptions:The LIFO reserve disclosure

Amountactually

shown onbalance sheet

Amountshown onbalance sheetif FIFO hadbeen used

9-57


58/115

5858

LIFO Reserve (contd.) The LIFO Reserve decreased by $655,000 in

2005.

This difference is the same as the 2005 COGSdifference between LIFO and FIFO.

A decreased LIFO Reserve indicates a smallerLIFO COGS than FIFO COGS, an indication ofeither deflation or a LIFO liquidation (discussed

later).

When LIFO Reserve increases, it indicates agreater LIFO COGS than FIFO COGS, an

indication of inflation.


59/115

5959

LIFO Reserve (contd.) The proof of LIFO effect equals the COGS impact of FIFO

vs. LIFO: COGS = BI + PurEI (BI=beg. Inv; EI=ending Inv.)

COGS FIFOCOGS LIFO

=(BI FIFOBI LIFO)(EI FIFOEI LIFO)=LIFO Reserve of BILIFO Reserve of EI

Thus, a positive LIFO effect indicates COGS FIFO > COGS LIFO

(see the example in Exhibit 9.6 on p57) Conversely, a negative LIFO effect indicates COGS FIFO

Documents

ACCT303 Chapter 9 Teaching Pp