Chapter 8

Valuation of Inventories:
A Cost-Basis Approach
1
 INVENTORY ISSUES

Classification
Inventories are asset:
 items held for sale in the ordinary course of business, or
 goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandiser or Manufacturer
INVENTORY ISSUES

Classification
 One inventory
account.
 Purchase
merchandise in
a form ready for
sale.
ILLUSTRATION 8-1
Comparison of Presentation
of Current Assets for
Merchandising and
Manufacturing Companies
INVENTORY ISSUES

Classification
Three accounts
 Raw Materials
 Work in Process
 Finished Goods

ILLUSTRATION 8-1
Comparison of Presentation
of Current Assets for
Merchandising and
Manufacturing Companies
ILLUSTRATION 8-2
Flow of Costs through
Manufacturing and
Merchandising Companies
INVENTORY ISSUES

Inventory Cost Flow ILLUSTRATION 8-3

Inventory Cost Flow

Two types of systems for maintaining inventory records — perpetual

system or periodic system.
 Inventory Cost Flow

Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to
Inventory.
3. Cost of goods sold is debited and Inventory is credited for
each sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.

The perpetual inventory system provides a continuous

record of Inventory and Cost of Goods Sold.
 Inventory Cost Flow

Periodic System
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net + 800,000
Goods available for sale900,000
Ending inventory - 125,000
Cost of goods sold $ 775,000
 Inventory Cost Flow

Comparing Perpetual and Periodic System

Illustration: Fesmire Company had the following transactions
during the current year.

Record these transactions using the Perpetual and Periodic

systems.
Inventory Cost Flow ILLUSTRATION 8-4
Comparative Entries—
Perpetual vs. Periodic
 Inventory Cost Flow

Illustration: Assume that at the end of the reporting period, the

perpetual inventory account reported an inventory balance of
$4,000. However, a physical count indicates inventory of $3,800 is
actually on hand. The entry to record the necessary write-down is
as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies
sometimes report Inventory Over and Short in the “Other revenues and gains” or
“Other expenses and losses” section of the income statement.
 INVENTORY ISSUES

Inventory Control
All companies need periodic verification of the inventory records
 by actual count, weight, or measurement,
 with counts compared with detailed inventory records.

Companies should take the physical inventory

 near the end of their fiscal year,
 to properly report inventory quantities in their annual
accounting reports.
 INVENTORY ISSUES

Determining Cost of Goods Sold

Companies must allocate the cost of all the goods available for
sale (or use) between the goods that were sold or used and
those that are still on hand.

ILLUSTRATION 8-5
Computation of Cost of Goods Sold
 GOODS AND COSTS INCLUDED IN INVENTORY

Goods Included in Inventory

A company recognizes inventory and accounts payable at
the time it controls the asset.
Passage of title is often used to determine control because
the rights and obligations are established legally.
 Goods Included in Inventory

Goods in Transit

Ownership of the goods passes Ownership of the goods remains

to the buyer when the public with the seller until the goods
carrier accepts the goods from reach the buyer.
the seller.
Goods Included in Inventory

Consigned Goods
 Goods out on consignment remain the property of the
consignor.
 The consignee makes no entry to the inventory account for
goods received.
Goods Included in Inventory

Special Sales Agreements

Sales with Repurchase Agreement.
 Often referred to as a repurchase (or product financing)
agreement, usually involves a transfer (sale) with either an
implicit or explicit repurchase agreement.
 These arrangements are often described in practice as
“parking transactions.”

UNDERLYING CONCEPTS
Recognizing revenue at the time the inventory is “parked” violates the
revenue recognition principle. That is, a performance obligation is not
met because control has not been transferred to the buyer.
Goods Included in Inventory

Special Sales Agreements

Sales with High Rates of Return.
Seller
1. Record sales revenue at the amount it expects to receive
from the transaction.
2. Establishes an estimated inventory return account at the
date of sale to recognize that some of its inventory will be
returned.
 Costs Included in Inventory

Product Costs
Costs directly connected with bringing the goods to the buyer’s
place of business and converting such goods to a salable
condition.

Period Costs
Generally selling, general, and administrative expenses.

Treatment of Purchase Discounts

Gross vs. Net Method
 Costs Included in Inventory
ILLUSTRATION 8-6
Treatment of Purchase Discounts Entries under Gross
and Net Methods

**

* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

 WHICH COST FLOW ASSUMPTIONS TO ADOPT?

Specific Identification
vs.
FIFO --- LIFO --- Average Cost

Cost
Cost Flow
FlowAssumption
AssumptionAdopted
Adopted
does
doesNOT
NOTneed
needto
tobe
beconsistent
consistent with
with
Physical
PhysicalMovement
Movement of
of Goods
Goods

Method adopted should be one that most clearly reflects periodic income.
 Which Cost Flow Assumptions to Adopt?

Specific Identification
 Includes in cost of goods sold the costs of the specific
items sold.

 Used when handling a relatively small number of costly,

easily distinguishable items.

 Matches actual costs against actual revenue.

 Cost flow matches the physical flow of the goods.

 May allow a company to manipulate net income.

 Which Cost Flow Assumptions to Adopt?

Average-Cost
 Prices items in the inventory on the basis of the average
cost of all similar goods available during the period.

 Not as subject to income manipulation.

 Measuring a specific physical flow of inventory is often

impossible.
 Which Cost Flow Assumptions to Adopt?

First-In, First-Out (FIFO)

 Assumes goods are used in the order in which they are
purchased.

 Approximates the physical flow of goods.

 Ending inventory is close to current cost.

 Fails to match current costs against current revenues.

SPECIAL ISSUES RELATED TO LIFO

LIFO Reserve
Many companies use
 LIFO for tax and external financial reporting purposes.
 FIFO or average cost for internal reporting purposes.
Reasons:

1. Pricing decisions.
2. Recordkeeping easier.
3. Profit-sharing or bonus arrangements.
4. LIFO troublesome for interim periods.
SPECIAL ISSUES RELATED TO LIFO

LIFO Reserve is the difference between the inventory method

used for internal reporting purposes and LIFO.

Illustration: Acme Boot Company uses the FIFO method for internal
reporting purposes and LIFO for external reporting purposes. At
January 1, 2017, the Allowance to Reduce Inventory to LIFO balance is
$20,000. At December 31, 2017, the balance should be $50,000. As a
result, Acme Boot realizes a LIFO effect and makes the following entry
at year-end.

Journal entry to reduce inventory to LIFO:

Cost of Goods Sold 30,000

Allowance to Reduce Inventory to LIFO 30,000
SPECIAL ISSUES RELATED TO LIFO

LIFO Reserve
Companies should disclose either the LIFO reserve or the
replacement cost of the inventory
ILLUSTRATION 8-14
Note DisclosureIllustration
of LIFO Reserve
8-19
SPECIAL ISSUES RELATED TO LIFO

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

The specific-goods approach to costing LIFO inventories is often

unrealistic for two reasons:
1. Accounting cost of tracking each inventory item is expensive.

2. Erosion of the LIFO inventory can easily occur (LIFO liquidation)

which often distorts net income and leads to substantial tax
payments.
SPECIAL ISSUES RELATED TO LIFO

Dollar-Value LIFO
Increases and decreases in a pool are measured in terms of
total dollar value, not physical quantity of goods.

Advantage:

 Broader range of goods in pool.

 Permits replacement of goods that are similar.

 Helps protect LIFO layers from erosion.

SPECIAL ISSUES RELATED TO LIFO

Comparison of LIFO Approaches

 Specific-goods LIFO - costing goods on a unit basis is
expensive and time consuming.

 Specific-goods pooled LIFO approach.

► Reduces record keeping and clerical costs.
► More difficult to erode the layers.
► Using quantities as measurement basis can lead to
untimely LIFO liquidations.

 Dollar-value LIFO is used by most companies.

SPECIAL ISSUES RELATED TO LIFO

Advantages Disadvantages
 Matching  Reduced Earnings
 Tax Benefits/Improved  Inventory Understated
Cash Flow
 Physical Flow
 Future Earnings Hedge
 Involuntary Liquidation /
Poor Buying Habits
Basis for Selection of Inventory Method

LIFO is generally preferred:

1. If selling prices and revenues are increasing faster than
costs and
2. If a company has a fairly constant “base stock.”

LIFO is not appropriate:

1. Where prices tend to lag behind costs,
2. If specific identification traditionally used, and
3. Where unit costs tend to decrease as production
increases.
Basis for Selection of Inventory Method

Tax consequences are another consideration.

 Switching from FIFO to LIFO usually results in an immediate
tax benefit.
 Concern about reduced income resulting from adoption of
LIFO has even less substance now because the IRS has also
relaxed the LIFO conformity rule.
 Companies are able to disclose
FIFO income numbers in the
financial reports if they so desire.
 EFFECT OF INVENTORY ERRORS

Ending Inventory Misstated ILLUSTRATION 8-28

Financial Statement Effects of
Misstated Ending Inventory

The effect of an error on net income in one year will be counterbalanced in the next,
however the income statement will be misstated for both years.
 Effect of Inventory Errors
ILLUSTRATION 8-30
Purchases and Inventory Misstated Financial Statement
Effects of Misstated
Purchases and Inventory

The understatement does not affect cost of goods sold and net income because the
errors offset one another.
 Purchases and Inventory Misstated

Illustration: Assume that Bishop understated accounts payable and

ending inventory by $40,000. Illustration 8-31 shows the understated
and correct data.

ILLUSTRATION 8-31
Effects of Purchases and
Ending Inventory Errors