ACC 313 Chapter 7

Knight, Creighton University

what inventory do service-type companies hold?

• supplies inventory

“cost of services”

reported by some service-type companies, but is not required to be reported

what inventory do merchandising companies hold?

• supplies inventory

• merchandise inventory

what inventory do manufacturing companies hold?

• supplies inventory

• inventories relating to manufactured goods:

  • raw materials inventory (or DM inventory, stores inventory)

  • WIP

  • FGI

“stores inventory”

sometimes used by manufacturing companies to replace “raw materials inventory”; includes direct/indirect materials and supplies inventory

what are the ways manufacturing inventories can be valued?

• absorption (full) costing

• variable (direct) costing

absorption (full) costing

a manufacturing inventory valuation method that includes both variable and fixed manufacturing costs; required to be used for external financial reporting

variable (direct) costing

a manufacturing inventory valuation method that only includes variable manufacturing costs (DM, DL, VOH); fixed overhead is treated as a period cost

what are the different inventory systems?

• periodic sustem

• perpetual system

periodic system

at any point in time during a period…

• inventory on hand is not known

• “merchandise inventory” balance is equal to beginning inventory balance

entry to record purchase of merchandise inventory - periodic system

Db. purchases

Cr. cash (or A/P)

entry to record freight-in on inventory - periodic system

Db. freight-in (or transportation-in)

Cr. cash (or payable for freight-in costs)

entry to record returns or allowances of inventory - periodic system

Db. cash (or A/P, advances to suppliers)

Cr. purchase returns & allowances

entry to record cash discounts taken by the purchasing company- periodic system

Db. A/P [gross amount owed for purchase]

Cr. cash [amount paid to supplier - cash discount]

Cr. purchase discounts [amount of cash discount]

entry to record sale of merchandise - periodic system

Db. cash (A/R)

Cr. sales 

closing entries - periodic system

Db. income summary

Db. merchandise inventory [amount obtained from a physical count of inventory]

Db. purchase returns & allowances

Db. purchase discounts

Cr. merchandise inventory [beginning inventory balance amount]

Cr. freight-in [or transportation-in]

Cr. purchases

how is inventory information (COGS) reported on the income statement - periodic system?

COGS is a computation, not an account

COGS computation - periodic system

beg. inventory

(+) net purchases

(+) freight-in

COGAS

(-) end. inventory

COGS

perpetual system

at any point in time…

• dollar amount of inventory is known

• “merchandise inventory” balance should always equal the current balance of merchandise inventory on hand

entry to record purchases of merchandise inventory - perpetual system

Db. merchandise inventory

Cr. cash (A/P)

entry to record freight-in on inventory - perpetual system

Db. merchandise inventory

Cr. cash (or payable for freight-in costs)

entry to record returns or allowances of inventory - perpetual system

Db. cash (or A/P, advances to suppliers)

Cr. merchandise inventory

entry to record cash discounts taken by the purchasing company- perpetual system

Db. A/P [gross amount owed for purchase]

Cr. cash [amount paid to supplier - cash discount]

Cr. merchandise inventory [amount of cash discount]

entry to record sale of merchandise - perpetual system

Db. cash (A/R)

Cr. sales [for “retail” amount of sale]

Db. COGS

Cr. merchandise inventory [for “cost” amount of sale]

closing entries - perpetual system

Db. income summary

Cr. COGS

adjustment of “merchandise inventory” account - perpetual system

made if the physical count of inventory on hand differs from the account balance

if amount of shortage is normal spoilage…

Db. COGS

Cr. merchandise inventory

if amount of shortage is abnormal spoilage…

Db. loss from abnormal spoilage of merchandise inventory

Cr. merchandise inventory

how is inventory information (COGS) reported on the income statement - perpetual system?

COGS is an account, not a computation; consists of a single line item which is the account

product costs

costs that are expensed when a product as sold → as part of “COGS”

“inventoriable costs” are _______ costs

product

period costs

costs that are expensed in the period in which they are incurred 

operating expenses are ______ costs

period

what are the 2 mistakes that can be made regarding possession of merchandise inventory?

1. recording of the sale-purchase transaction

2. physical count of merchandise inventory

merchandise inventory possession mistakes involving the recording of the sale-purchase transaction:

• a company that should record a sale/purchase does not

• a company that should not record a sale/purchase does

merchandise inventory possession mistakes involving physical count of merchandise inventory:

• a company that should include merchandise inventory in its physical count does not

• a company that should not include merchandise inventory in its physical count does

legal title

the key to who owns merchandise inventory and who should include it in their physical count

inventory possession rule

the company that has possession of inventory should include it in their physical count

what are the exceptions to the inventory possession rule?

• consigned goods

• custom-made/special-order items

• sales with a buyback agreement

• goods-in-transit

consigned goods

• merchandise inventory is in possession of the consignee (the buyer) who will either…

  • sell the goods and pay the consignor (the seller) the amount of the sale less sales commission

  • return unsold goods to the consignor

• included in the consignor’s inventory even though the consignee has possession

consignee

the buyer of inventory

consignor

the seller of inventory

custom-made/special-order items

• items that are completed and ready for shipment; segregated from a seller’s regular inventory

• included in the buyer’s inventory even though the are in possession of the seller

sales with a buyback agreement

• inventory that is “sold” to a buyer, but must be repurchased by the seller if buyer is unable to sell it

• included in the seller’s inventory even though they are in the possession of the buyer

goods-in-transit

• FOB destination → inventory is owned by seller while in transit

• FOB shipping point → inventory is owned by buyer while in transit

• FOB {Location} → inventory is owned by seller until passing through designated location; then owned by buyer

“purchase discounts lost”

reported when a purchase discount that was offered was not taken; shown as an operating expense on the income statement

inventoriable costs

any cost that is incurred in the acquisition of merchandise inventory that is a “normal cost” of obtaining inventory and getting it ready for use → included in valuation of merchandise inventory

trade discounts

discounts given to buyers “in the trade” (in the same industry as seller); not included in the cost of merchandise inventory and not recorded at all

entry to record a trade discount:

no separate entry, instead…

Db. purchases (or merchandise inventory)

Cr. cash (A/P) [for total amount of purchase price after discount]

computation for the annual interest rate being paid by not taking a cash disount:

[% cash discount / (1 - % cash discount)] x [365 / (day payment is due - day discount period ends)]

ordering, handling, and storage costs - theoretically

any cost incurred to get merchandise inventory “ready for sale/intended use” → included in valuation of merchandise inventory; expensed as a product cost

ordering, handling, and storage costs - in practice

only includes…

1. the cost of merchandise inventory itself

2. the cost to ship merchandise inventory  (“freight-in”)

→ included in valuation merchandise inventory; expensed as a product cost

inventoriable costs are included in…

COGS

how do many companies handle ordering, handling,and storage costs today?

they report a wide range of other costs besides just cost of merchandise inventory and freight-in in COGS

the costs that are included in COGS are disclosed in footnote #1

how is normal spoilage recorded?

as “COGS”

entries made for normal spoilage - periodic vs. perpetual

• periodic system → no entry needed

  • was already expensed during period-end adjusting entries

• perpetual system

Db. COGS

Cr. merchandise inventory [period-end physical count - period-end “merchandise inventory” balance that is attributable to normal spoilage]

how is abnormal spoilage recorded?

as “loss from abnormal spoilage” in “other income-other expense”

entries made for abnormal spoilage - periodic vs. perpetual

• periodic system

      Db. loss from abnormal spoilage of inventory

      Cr. COGS

• perpetual system

Db. loss from abnormal spoilage of inventory

Cr. merchandise inventory [period-end physical count - period-end “merchandise inventory” balance that is attributable to abnormal spoilage]

what are the types of timing errors relating to inventory and expenses?

• counterbalancing errors

• non-counterbalancing errors

counterbalancing errors

errors that will correct themselves in the period immediately following the period of the error

ex. merchandise inventory errors

non-counterbalancing errors

errors that will not correct themselves in the period immediately following the period of the error

ex. errors in recording depreciation

how do timing errors affect the income statement?

• can affect specific I/S accounts → results in under/overstatement of NI

• can affect specific I/S accounts but offset each other → no errors in NI

how do timing errors affect the balance sheet?

if there is one error on the B/S, there is a second error because the balance sheet is always in balance

cost flow assumptions (also called inventory valuation methods)

a method of putting a dollar value on an actual (not estimated) number of inventory units

what is the criteria for selecting an inventory valuation method?

it should provide information:

1. that is useful for making investment/credit decisions

2. that is useful in assessing cash flow prospects

3. about a company’s economic resources, claims to them, and changes in them

are there any rules regarding selection for an inventory valuation method?

no → any can be selected; does not have to be consistent with the physical flow of inventory

any inventory valuation method can be selected as long as it is…

both systematic and rational

what are the different inventory valuation methods?

• FIFO

• LIFO

  • dollar-value LIFO

  • pooled LIFO

• average cost

  • weighted average (periodic)

  • moving average (perpetual)

• specific identification

first-in, first-out (FIFO)

assumes a company sells goods in the order in which it purchases them (first goods purchased → first goods sold); used with either a perpetual or periodic system

FIFO - perpetual system

individual purchase and sale transactions must be examined and a running track of inventory level is maintained

FIFO - periodic system

only total purchase and sale transactions for the period are examined and a single determination of merchandise inventory is made at the end of the period

with FIFO, the ending merchandise inventory value and the COGS value are…

the same

(end. inv. = COGS, always)

last-in, first-out (LIFO)

assumes the cost of the total quantity of goods sold during a period comes from a company’s most recent purchases (last goods purchased → last goods sold); used with either a perpetual or periodic system

LIFO - perpetual system

individual purchase and sale transactions must be examined and a running track of inventory level is maintained

LIFO - periodic system

only total purchase and sale transactions for the period are examined and a single determination of merchandise inventory is made at the end of the period

with LIFO, the ending merchandise inventory value and COGS value are most likely…

not the same

(possible for them to be the same, just not likely)

LIFO conformity rule

if a company uses LIFO for tax purposes, it must use LIFO for financial reporting purposes (no other method requires this)

arguments for use of LIFO

• more closely follows matching principle (true regardless of inflation or deflation)

• results in tax benefits and therefore better cash flows (taxable income is smaller bc COGS is greater)

• a loss on inventory will not be reported, even if the market value drops (bc of lower-of-cost-or-market rule)

arguments against use of LIFO

• financial accounting earnings are less

• inventory can be greatly undervalued

• method does not reflect the physical flow of inventory

• undervalued inventory can cause…

  • inventory profits

  • more frequent inventory purchases at the ends of periods to avoid undervalued inventory hitting COGS

  • artificially higher earnings

what is a nonsensical argument against LIFO?

method results in greater inventory obsolescence 

→ this is not true bc inventory valuation methods are only “on paper” and actual physical inventory approximately follows FIFO

inventory profits

a decline in the physical inventory count over a period → greatly increases financial accounting earnings

weighted average method

only used with a periodic system; a weighted average unit cost is multiplied by units sold to get COGS and end. inventory

weighted average method computation

weighted average unit cost = COGAS / goods available for sale

COGS = weighted average unit cost x units sold

end. inv. = weighted average unit cost x units on hand @ period-end

moving average method

only used with a perpetual system; a unit cost is multiplied by units sold at the current time to make the entry for COGS for a sale → this is done every time goods are sold

moving average method computation

COGAS @ time of sale  / goods available for sale @ time of sale = unit cost

unit cost x units sold = COGS

specific identification method

used with either perpetual or periodic system

• COGS equals the actual cost of the specific units that were sold during a period

• end. inv. equals the actual cost of the specific units that are on hand at the end of a period

dollar-value LIFO

used only with a periodic system; determines and measures any increases/decreases in inventory in terms of total dollar value and not the physical quantity of goods

reasons companies use dollar-value LIFO method:

• physical inventory count can be taken much faster and easier

• inventory valuation is not materially different from unit LIFO

• if inventory increases → only a single cost layer is added onto existing inventory layers

• if inventory decreases → inventory profits are not as significant

to compute dollar-value LIFO, what must be known?

• price index for the current period

• ending inventory → obtained from a physical count

how is a price index for the current period obtained?

by either…

• computing it using a sample of ending merchandise inventory on hand

• determining it by using an industry-specific pice index (cannot use a general price index)

dollar-value LIFO method ending inventory computation

end. inv. for current period / price index for the current period = end. inv. @ base-year prices

what is done if inventory for a period at base-year prices has increased? - dollar-value LIFO

a layer for this year’s purchases is added based on base-year prices

• adjustment: base-year layer x price index for the current period

what is done if inventory for a period at base-year prices has decreased? - dollar-value LIFO

layers must be peeled off beginning with the most recent year’s purchases

adjustment for remaining layers: base-year layer x price index for applicable period

layers that are “peeled off” from using an inventory valuation method, the amount is put into…

COGS

when a layer is peeled off and put into COGS, it is…

lost forever 

pooled LIFO

inventory is pooled into groups where units have similar costs and have a relatively consistent inventory mix; alleviates some problems of unit LIFO but is not as efficient or effective as dollar-value LIFO

pooled LIFO computation

a physical count of entire pool is taken, which is compared to the beg. inv. to see if the count in the pool has increased/decreased

what is done if inventory for a period has increased? - pooled LIFO

a layer for this year’s purchases is added based on the year’s weighted average costs [(inc./dec. in units x tot. cost) / tot. units purchased]

what is done if inventory for a period at base-year prices has decreased? - pooled LIFO

layers must be peeled off, beginning with the most recent year’s purchases

most companies, when using either dollar-value or pooled LIFO, have ________ inventory pools

several

where does a company report the type of LIFO method it is employing?

it does not disclose whether it uses dollar-value, pooled, or unit LIFO

LIFO reserve

the difference between end. inv. amount had FIFO been used and the end. inv. amount reported using LIFO