Chapter 10

Valuation of Inventories: A Cost-Basis Approach

ACCT-3030 1

1. Introduction Definition

◦ Assets held for sale in the ordinary course of business or goods that will be consumed in production

Importance Cost of inventory

◦ all expenditures necessary in acquiring goods and converting them to saleable condition

Cutoff Who owns inventory if “sale” is a(an)

product financing arrangement, installment sale, consignment, sales with high rates of return

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2. Inventory Systems Periodic system

◦no running balance of inventory & CGS

◦purchases account used◦beginning inv balance unchanged

during year◦take physical inventory at year-end

and record ending balance through adjusting entry

◦CGS calculatedCGS format

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2a. Inventory Systems Perpetual system

◦keeps running balance of inventory & CGS

◦no purchases account used◦all changes in inventory cost

recorded in inventory account◦take physical inventory at year-end

& adjust book balance to actual

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2b. Inventory Systems Periodic & perpetual entriesNet and gross methods of

recording1. purchase merchandise, $1,200;

2/10,n/302. return merchandise, $2003. sell remainder for $1,8004. pay above

a. within discount periodb. after discount period

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2c. Inventory Systems Periodic inventory system YE

adjusting entry◦ Account balances

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Account Balance

Inventory, January 1 1,000

Inventory, December 31 1,500

Purchases 4,000

Purchases Returns and Allowances

300

Purchases Discounts 50

2c. Inventory Systems Periodic inventory system YE

adjusting entry

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Account Dr Cr

Inventory, December 31 1,500

Purchases Returns and Allowances

300

Purchases Discounts 50

CGS 3,150

Purchases 4,000

Inventory, January 1 1,000

3. Inventory Cost Flow AssumptionsProblem

◦purchases made at different prices

Flow of costs v. flow of goodsFour GAAP methods

◦specific identification◦FIFO◦LIFO◦average

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3a. Inventory Cost Flow Assumptions

Specific identification◦only used if relatively small number

of high priced goods that can be easily distinguished

◦can manipulate income

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3b. Inventory Cost Flow Assumptions

FIFO◦assume goods used in order

purchased◦ending inventory approximately at

current costs◦CGS at old prices◦periodic and perpetual systems

always give same result

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3c. Inventory Cost Flow Assumptions LIFO

◦ assumes last goods purchased are first sold

◦ advantages matches current costs with revenues

tax benefits

improved cash flow

◦ disadvantages reduction in reported earnings

understatement of ending inventory on bal. sheet

does not reflect underlying physical flow of goods

causes poor buying habits

can manipulate income

◦ LIFO conformity rule must use LIFO for financial reporting if used for tax reporting

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3d. Inventory Cost Flow Assumptions

Average cost◦weighted average or moving average used

◦values goods based on average cost of goods on hand and acquired

Other methods◦base stock

◦standard cost

◦NIFO

◦LIFO/FIFOACCT-3030 12

3e. Inventory Cost Flow Assumptions

Comparison of methods (during periods of rising prices)

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Method Ending Inventory CGS Net Income

FIFO highest lowest highest

LIFO lowest highest lowest

Average in middle in middle in middle

What would be the differences between the methods if all units had the same cost?

3f. Inventory Cost Flow Assumptions

Example of methods

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Date Action Units Unit Price

Total Price

Jan 1 Beg. Inv. 2,000 $ 9.775 $ 19,550

Jan 6 Purchase 1,500 $ 10.300 $ 15,450

Jan 7 Sale 1,800

Jan 26 Purchase 3,400 $ 10.750 $ 36,550

Jan 31 Sale 3,200

Total $ 71,550

Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems.

4. Special issues related to LIFOInventory Pools

◦Unrealistic to assume only one product◦ If multi product

replace one item with another – loose base layer of LIFO cost

◦Pooled approach group similar items together reduces record keeping costs more difficult to erode old LIFO layers

◦Number of pools?ACCT-3030 15

4. Special issues related to LIFOLIFO reserves

◦maintain internal records using FIFO◦adjust to LIFO at year end

Cost of goods sold xxx Allow to reduce inventory to LIFO xxx

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5. Dollar Value LIFOIntroduction

◦emphasis is on dollar value of inventory not units of inventory

◦greatly reduces problem of changes in mix of inventory

◦more practical method of valuing multi-product inventory than unit LIFO

◦allowed for financial reporting and tax◦LIFO conformity rule

must use LIFO for financial reporting if used for tax

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5a. Dollar Value LIFOBasics of method

1. when first adopt method (base year) value ending inventory at current costs (FIFO)

2. end of each subsequent year, value ending inventory at current costs (FIFO)

3. then restate current year-end cost to price level in base year

4. a new layer formed when EI (in base year $) exceeds base year cost of BI

increase priced at current costs

5. if EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer

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5b. Dollar Value LIFOPrice index

◦company may calculate own double extension method or link-chain

method

◦may use published price indexes e.g., GNP implicit price deflator, CPI, or

industry specific index

◦example using market basket approach

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5c. Dollar Value LIFOExample

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Year End Inv (FIFO) Price Index

2011 $ 300,000 100

2012 $ 363,000 110

2013 $ 420,000 120

2014 $ 430,000 125

Calculate ending inventory using dollar value LIFO for each year.

6. Effect of errorsSelf-correcting errors

◦most errors correct themselves over time e.g., inventory – this year’s ending inventory is next

year’s beginning inventory depreciable assets – over the life of the assets

◦but each year is incorrect over that periodPermanent errors

◦never will correct themselves

◦e.g., expensing land, recording wrong amount

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6a. Inventory Errors Overstatement of ending inventory

◦ Understates cost of goods sold

◦ Overstates income

Understatement of ending inventory◦ Overstates cost of goods sold

◦ Understates income

Overstatement of beginning inventory◦ Overstates cost of goods sold

◦ Understates income

Understatement of beginning inventory◦ Understates cost of goods sold

◦ Overstates incomeACCT-3030 22

6b. Effect of errorsDetermining effect of errors

◦determine effect for all accounts involved

◦examples ending inventory overstated interest expense not accrued on N/P this

year, next year principle and interest paid in full

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Chapter 9

Inventories: Additional Valuations Issues

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1. Lower of Cost or MarketRequired by GAAP*

◦Inventory must be reported at LCMTheory

◦should not report inventory at a value higher than benefits to be received from selling it

Stated reason: “conservative approach”

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1a. Lower of Cost or Market Definition of market

◦ cost to replace the item (replacement cost)◦ really “lower of cost or constrained market”

Ceiling◦ market can’t exceed NRV◦ NRV = selling price – selling costs

Floor◦ market can’t be lower than NRV less normal profit ◦ floor = NRV – normal profit margin

Can apply to individual items, groups of items, or whole inventory

Does not apply to damaged or deteriorated goodsACCT-3030 26

1b. Lower of Cost or MarketExampleSelling price $60

Additional selling costs $10

Normal profit margin 40% (of selling price)

Cost $36

Current replacement cost

Case A $58

Case B $37

Case C $21ACCT-3030 27

1c. Other Valuation BasesValuation at Net Realizable Value

◦e.g., recognizing revenue at completion of production

Valuation using Relative Sales Value◦basket purchase◦meat-packing plant

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2. Purchase CommitmentsGenerally seller retains title to merchandiseBuyer recognizes no asset or liabilityIf material, the buyer should disclose contract

details in footnoteIf contract price > the market price, and

buyer expects that losses will occur when purchase made◦ buyer should recognize liability and corresponding

loss in period when market declinedOmit Hedging

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3. Inventory Estimation Methods

Gross profit method◦based on relationship between sales and

gross profit◦not acceptable for financial reporting or

taxesRetail method

◦used by large volume retailers◦dollar based method – not unit based

method◦acceptable for financial reporting and taxes

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4. Gross Profit MethodBased on assumptions that

◦gross profit is constant from period-to-period

◦sales mix of products is constantUsed to estimate inventory value

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4a. Gross Profit MethodExampleSales $200

Cost of goods sold $120

Gross profit $ 80

GP % = 80/200 = 40%CGS% = 120/200 = 60%

GP% on sales = 80/200 = 40%GP% on cost = 80/120 = 66⅔%

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GP on Sales =

GP on Costs1 + GP on Costs

4a. Gross Profit MethodExample

A hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000Purchases $400,000Sales $600,000Historical gross profit rate 30%

Required: Estimate the cost of the destroyed inventory. ACCT-3030 33

4a. Gross Profit MethodExample — Solution

   

Beginning inventory (from records) $220,000

Plus: Net purchases (from records) 400,000

Cost of goods available for sale 620,000

Less: Cost of goods sold:

Net sales $600,000Less: Estimated gross profit of 30% (180,000)

Estimated cost of goods sold (420,000)

Estimated cost of inventory destroyed $200,000

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5. Retail MethodMethod is based on the pattern between

the cost and retail value of the goodsMethod requires:

1. total costs of goods purchased2. total retail value of goods available for sale3. total sales

Companies always keep 1 & 3◦with this method also must keep 2

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5a. Retail MethodBasic method

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Cost Retail

Beginning Inventory 600 1,000

Net Purchases 5,000 8,000

Goods Available for Sale 5,600 9,000

Cost Ratio: 5,600/9,000 = .62222

Sales 7,500

Ending Inventory at Retail 1,500

End Inv at Cost (1,500 x .62222) 933

5c. Retail MethodRetail terminology

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Term Meaning

Initial markup Original markup reflected in sales price

Additional markup Additional increase in selling price after original markup

Markup cancellation Elimination of additional markup

Markdown Reduction in selling price below original selling price

Markdown cancellation Elimination of markdown

Net markups and net markdowns

5b. Retail MethodRatios – computed as:

cost of goods available for sale retail value of goods available for sale

Based on how ratio computed, can be used to approximate following methods:◦average – include everything◦LCM – exclude markdowns (conventional retail

method)

◦FIFO – exclude beginning inventory◦LIFO – compute separate ratio for each layer

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5d. Retail Method

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Cost Retail

Beginning Inventory + +

Purchases + +

Purchases Returns - -

Purchases Discounts -

Freight-In +

Net Markups +

Net Markdowns -

Available for Sale X X

Sales -

Sales Returns and Allow. +

Sales Discounts +

Ending Inventory at Retail X

Ending Inventory at Cost X

5e. Retail Method

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Cost Retail

Beginning Inventory + +

Purchases + +

Purchases Returns and Allow. - -

Purchases Discounts -

Freight-In +

Net Markups +

Net Markdowns -

Available for Sale X X

Sales -

Sales Returns and Allow. +

Sales Discounts +

Ending Inventory at Retail X

Ending Inventory at Cost X

Avg. method

5f. Retail Method

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Cost Retail

Beginning Inventory + +

Purchases + +

Purchases Returns and Allow. - -

Purchases Discounts -

Freight-In +

Net Markups +

Net Markdowns -

Available for Sale X X

Sales -

Sales Returns and Allow. +

Sales Discounts +

Ending Inventory at Retail X

Ending Inventory at Cost X

LCM method

5g. Retail Method

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Cost Retail

Beginning Inventory + +

Purchases + +

Purchases Returns and Allow. - -

Purchases Discounts -

Freight-In +

Net Markups +

Net Markdowns -

Available for Sale X X

Sales -

Sales Returns and Allow. +

Sales Discounts +

Ending Inventory at Retail X

Ending Inventory at Cost X

FIFO method

5h. Retail Method

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Cost Retail

Beginning Inventory 195,000 400,000

Net Purchases 300,000 450,000

Net Markups 50,000

Net Markdowns <20,000>

Available for Sale 495,000 880,000

Net Sales 407,000

Ending Inventory at Retail 473,000

Ending Inventory at Cost

•Example