Valuation of Inventories: A Cost-Basis Approach

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Valuation of Inventories: A Cost-Basis ApproachValuation of Inventories: A Cost-Basis Approach

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JOIN KHALID AZIZ• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP

MODULE B, B.COM, BBA, MBA & PIPFA.• COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE

D, BBA, MBA & PIPFA.

• CONTACT:• 0322-3385752• 0312-2302870• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.

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1. Physical Goods included in Inventory

2. Costs Included in Inventory

3. Inventory: Periodic vs. Perpetual

4. Purchase Discounts• Gross versus Net

5. Cost Flow Assumptions1. Specific Identification, Average Cost, FIFO, LIFO

6. Specific Issues Related to LIFO1. LIFO Reserve

2. LIFO Liquidation

3. Dollar-Value LIFO

4. Major advantages/disadvantages

Learning Objectives

Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by the enterprise.

Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for the organization.

Inventories are also significant because of their impact on both the balance sheet and the income statement.

InventoryInventory

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Inventories are:

items held for sale, or

goods to be used in the production of goods to be sold.

Inventory Classification and SystemsInventory Classification and Systems

LO 1 Identify major classifications of inventory.LO 1 Identify major classifications of inventory.

Classification

MerchandiserMerchandiser ManufacturerManufacturer

Businesses with Inventory:

or

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Flow of Costs


Illustration 8-2Illustration 8-2

LO 1 Identify major classifications of inventory.LO 1 Identify major classifications of inventory.

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Two systems for maintaining inventory records:


Control

Perpetual system

Periodic system

• Purchases are debited to Inventory account

• Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in Inventory account.

• Debit COGS and credit Inventory account for each sale.

• Purchases are debited to Purchases account.

• Freight-in, Purchase Returns and Allowances and Purchase Discounts are recorded in their respective accounts.

• COGS is computed only periodically :COGAS – Ending Inventory = COGS

Perpetual Method Periodic Method

Inventory Systems

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1. Beginning inventory (100 units at $7 = 700)|

2. Purchase 900 units at $7: |

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Inventory 6,300 | Purchases 6,300Accounts payable 6,300 | Accounts payable 6,300

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3. Sale of 600 untis at $14: |

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Accounts receivable 8,400 | Accounts receivable 8,400Sales 8,400 | Sales 8,400

Cost of goods sold 4,200 |

Inventory 4,200 |

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4. Adjusting entries (ending inventory = 400 units @ $7 = $2,800)|

No Entry Necessary | Inventory 2,100| Cost of goods sold 4,200| Purchases 6,300

Inventory Classification and SystemsInventory Classification and SystemsPerpetual System Periodic System vs.

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Requires the following:

Basic Issues in Inventory ValuationBasic Issues in Inventory Valuation

Valuation of Inventories

The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements).

The costs to include (product vs. period costs).

The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

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A company should record purchases when it obtains legal title to the goods.

Physical Goods Included in InventoryPhysical Goods Included in Inventory

Physical Goods

The following goods are included in “seller’s” inventory:• Goods in transit (FOB Destination)• Goods on consignment with consignee• Goods, sold under buy back agreements • Goods, sold with high rates of return• Installment sales (if bad debts can not be estimated)

Guidelines for Determining Ownership

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Costs Included in InventoryCosts Included in Inventory

Product Costs

Period Costs

Purchase Discounts – Gross vs. Net Method

• Product costs are those costs that "attach" to the inventory and are recorded in the inventory account. These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale.

• Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs. The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process.

Costs Included in InventoryCosts Included in InventoryCosts Included in InventoryCosts Included in Inventory

If the gross method is used, purchase discounts should be reported as a deduction from purchases (purchase discounts) on the income statement.

If the net method is used, purchase discounts lost should be considered a financial expense and reported in the "other expense and loss" section of the income statement.

Purchase Discounts: Two methodsPurchase Discounts: Two methodsPurchase Discounts: Two methodsPurchase Discounts: Two methods

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Purchase cost $20,000, terms 2/10, net 30:|

Purchases 20,000 | Purchases 19,600Accounts payable 20,000 | Accounts payable 19,600

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Invoices of $15,000 are paid within discount period:|

Accounts payable 15,000 | Accounts payable 14,700Purchase discounts 300 | Cash 14,700Cash 14,700 |

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Invoices of $5,000 are paid after discount period:|

Accounts payable 5,000 | Accounts payable 4,900Cash 5,000 | Purchase discount lost 100

| Cash 5,000

Example: Treatment of Purchase DiscountsExample: Treatment of Purchase Discounts

Gross Method Net Method vs.

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Example: E8-3Example: E8-3

Assuming each of the amounts is material, state whether the merchandise should be included in the client’s inventory at 12/31/2007.(1) A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the shipping room on 12/31/07. The customer was billed on that date and the machine excluded from inventory although it was shipped on 1/4/2008.

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(2) Merchandise costing 2,800 was received on 1/3/2008, and the related purchase invoice recorded 1.5.08. The invoice showed the shipment was made on 12/29/2007 f.o.b. destination.

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KARACHI, PAKISTAN.

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(3) A packing case containing a product costing 3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked “Hold for shipping instructions.” Your investigation revealed that the customer's order was dated 12/18/2007, but that the case was shipped and customer billed on 1/10/2008. The product was a stock item of your client.

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(4) Merchandise received on 1/6/2008, costing Rs680 was entered in the purchase journal on 1/7/2008. The invoice showed shipment was made f.o.b. supplier’s warehouse on 12/31/2007. Because it was not on hand at 12/31, it was not included in inventory.

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(5) Merchandise costing Rs720 was received on 12/28/2007, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was market “on consignment.”

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Cost Flow Assumption Adopted

Physical Movement of Goods

does not need to equal

FIFO

What Cost Flow Assumption to Adopt?What Cost Flow Assumption to Adopt? LIFO

Average Cost

Specific Identification –

High-ticket items: Automobiles, Jewelry, Real estate

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Young & Crazy Company makes the following purchases:

1. One item on 2/2/07 for Rs10



Young & Crazy Company sells one item on 2/28/07 for Rs90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2007, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%.

Example

Cost Flow AssumptionsCost Flow Assumptions

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Purchase on 2/2/07 for Rs10

Purchase on 2/15/07 for

Rs15


Rs20

Inventory Balance = Rs 45

Young & Crazy CompanyIncome Statement

For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 0 Gross profit 90 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 57 Taxes 17 Net Income Rs 40

Cost Flow AssumptionsCost Flow Assumptions“First-In-First-Out

(FIFO)”

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Rs15


Rs20




For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 10 10 Gross profit 80 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 4747 Taxes 14 14 Net Income Rs 33 Rs 33

“First-In-First-Out (FIFO)”

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Rs15


Rs20




Cost Flow AssumptionsCost Flow Assumptions“Last-In-First-Out

(LIFO)”

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Rs15




Rs20


For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 20 20 Gross profit 70 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 37 37 Taxes 11 11 Net Income Rs Rs 26 26

“Last-In-First-Out (LIFO)”

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Rs15


Rs20




Cost Flow AssumptionsCost Flow Assumptions“Average Cost”

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Rs15


Rs20




For the Month of Feb. 2007 Sales Rs 90 Cost of goods sold 15 15 Gross profit 75 Expenses: Administrative 14 Selling 12 Interest 7 Total expenses 33 Income before tax 42 42 Taxes 12 12 Net Income Rs Rs 3030

“Average Cost”

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Rs15


Rs20




Cost Flow AssumptionsCost Flow Assumptions“Specific Identification”

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Rs15


Rs20




Cost Flow AssumptionsCost Flow Assumptions“Specific Identification”

Depends which one is Depends which one is soldsold

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Many companies use

LIFO for tax and external financial reporting purposes

FIFO, average cost, or standard cost system for internal reporting purposes.

Reasons:

Special Issues Related to LIFOSpecial Issues Related to LIFO

LIFO Reserve

1. Pricing decisions2. Record keeping easier3. Profit-sharing or bonus arrangements4. LIFO troublesome for interim periods

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LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO.

Example:FIFO value per booksFIFO value per books Rs160,000Rs160,000

LIFO value LIFO value 145,000145,000

LIFO ReserveLIFO Reserve Rs Rs 15,00015,000

Cost of goods sold 15,000

LIFO reserve 15,000

Journal entry to reduce inventory to LIFO:

Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

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Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.


LIFO Liquidation

Illustration 8-20Illustration 8-20

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Changes in a pool are measured in terms of total dollar value, not physical quantity.

Advantage:

Broader range of goods in pool.

Permits replacement of goods that are similar.

Helps protect LIFO layers from erosion.


Dollar-Value LIFO

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Exercise 8-26 The following information relates to the Jimmy Johnson Company.

Use the dollar-value LIFO method to compute the ending inventory for 2003 through 2005.

Dollar-Value LIFO

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LO 8 Explain the dollar-value LIFO method.LO 8 Explain the dollar-value LIFO method.

I nventory at I nventory at $ Value

End- of- Year Base- Year Base $ Value LI FO LI FO

Year Prices I ndex Prices Layers I ndex LI FO TOTAL Reserve

2003 70,000$ 1.00 70,000$ 70,000$ 1.00 70,000$ 70,000$ -$

2004 90,300 1.05 86,000 70,000 1.00 70,000

16,000 1.05 16,800 86,800 3,500

2005 95,120 1.16 82,000 70,000 1.00 70,000

12,000 1.05 12,600 82,600 12,520

Dec. 31 Dec. 31 Dec. 31Balance Sheet 2003 2004 2005

I nventory 70,000$ 90,300$ 95,120$ LI FO Reserve - (3,500) (12,520)

70,000$ 86,800$ 82,600$ J ournal entry

Cost of goods sold 3,500 9,020 Lifo reserve (3,500) (9,020)

Exercise 8-26 Solution

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Matching

Tax Benefits/Improved Cash Flow

Future Earnings Hedge


Advantages

Reduced earnings

Inventory understated

Physical flow

Involuntary Liquidation / Poor Buying Habits

Disadvantages

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KARACHI, PAKISTAN.

Documents

Valuation of Inventories: A Cost-Basis Approach