Chapter 8

Chapter 8: Valuation of Inventories: A Cost-Basis Approach

Learning Objectives

After studying this chapter, you should be able to:

1. Identify inventory classifications and different inventory systems.

2. Determine the goods and costs included in inventory.

3. Describe and compare the cost flow assumptions used to account for inventories.

4. Identify special issues related to LIFO (Last-In, First-Out).

5. Determine the effects of inventory errors on the financial statements.

Preview of Chapter 8

Inventory Issues:

• Classification: Understanding how inventories are categorized is critical for accurate accounting and reporting.

• Cost flow: Recognizing the cost flow assumptions impacts financial reporting significantly.

• Control: Implementing effective inventory control systems ensures optimal stock levels and reduces losses.

• Cost of goods sold (COGS): Accurately calculating COGS is essential for understanding profitability.

Goods and Costs Included in Inventory:

• Goods included: Criteria for recognizing inventory items must be clear to avoid misstatements.

• Costs included: Understanding which costs should be capitalized in inventory helps in accurate financial reporting.

Cost Flow Assumptions:

• Specific identification: Used primarily for items that are distinct and easily tracked.

• Average-cost: Provides a simple method for valuation by averaging costs.

• FIFO (First-In, First-Out): Assumes the oldest inventory items are sold first.

• LIFO (Last-In, First-Out): Assumes the newest inventory items are sold first, raising specific accounting challenges.

Learning Objective 1: Identify Inventory Classifications and Different Inventory Systems

Inventory Issues Classification

Inventories are classified into categories based on their purpose in the supply chain:

• Asset items held for sale: Items that are intended for sale in the ordinary course of business.

• Goods to be used in production: Raw materials and components that are transformed into finished goods.

Merchandising Company Classification

Typically, a merchandising company maintains:

• One inventory account: Comprised of all goods purchased for sale, without significant modification to the products.

Manufacturing Company Classification

Firms engaged in manufacturing will have:

1. Raw Materials: Basic materials that are to be processed into products.

2. Work in Process (WIP): Goods that are partially finished and require further processing.

3. Finished Goods: Completed products ready for sale to customers.

Flow of Costs

For effective financial management:

• For Merchandising Companies: The figure for inventory reflects the cost of acquired goods that are available for sale.

• For Manufacturing Companies: The WIP account reflects costs associated with production, including labor and overhead, in addition to raw materials.

Inventory Cost Flow

Understands how inventory impacts the financial statements:

• COGS and Ending Inventory Calculation: The formula is:Beginning Inventory + Purchases = Goods Available for Sale- Ending Inventory = Cost of Goods Sold

Inventory Cost Flow: Systems

Perpetual System

A detailed tracking mechanism that includes:

• Purchases of merchandise are recorded directly to the Inventory account as they occur.

• Freight-in costs are also debited to Inventory, thus reflecting the total cost of acquiring goods.

• Each sale results in a debit to Cost of Goods Sold and a credit to Inventory, keeping inventory records current.

• Subsidiary records maintain detailed data on quantities and per unit costs of every type of inventory.

Periodic System

This system functions differently:

• Purchases are recorded in a separate Purchases account, with the end inventory established by a physical count at specific intervals.

• COGS is calculated using the formula:Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold.

Comparison of Perpetual and Periodic Systems

Illustrative examples can show the differences in:

• Recording transactions under both systems, detailing how purchases, sales, and inventory adjustments differ in documentation and reporting.

Learning Objective 2: Determine the Goods and Costs Included in Inventory

Goods Included in Inventory

Recognition of inventory is guided by control over the asset:

• Title Passage: The moment ownership transfers under FOB (Free On Board) terms dictates whether goods should be included:

  • FOB Shipping Point: Ownership passes to the buyer when goods are shipped, necessitating careful tracking of shipment dates.

  • FOB Destination: Ownership remains with the seller until goods reach their final destination, affecting when they are recorded as inventory.

Consigned Goods

• Goods that are out on consignment will remain the property of the consignor. The consignee does not record them on their balance sheet, maintaining the integrity of the inventory records.

Special Sales Agreements

• Repurchase Agreement: Involves either explicit or implicit arrangements that may affect inventory levels.

• Sales with High Rates of Return: Companies must anticipate potential returns to avoid overestimating revenue and could create an estimated inventory return account to manage this risk.

Costs Included in Inventory

• Product Costs: Essential to determine costs that contribute to inventory value, encompassing all expenses directly linked to bringing the goods to salable condition.

• Period Costs: Expenditures related to selling, general, and administrative functions are not included in inventory and must be carefully delineated.

• Treatment of Purchase Discounts: Businesses can choose between the Gross and Net methods for recognizing discounts affecting inventory valuation.

Learning Objective 3: Compare Cost Flow Assumptions

A nuanced understanding of costing methods helps in selecting the right approach:

• Specific Identification: Tailored for high-value, easily distinguishable items, ensuring accurate assignment of costs.

• Average-Cost: Smoothens out price fluctuations by averaging costs across all items available for sale during the period.

• FIFO: Asserts that the earliest purchased goods are sold first, often benefiting during times of inflation as older, cheaper costs are recorded as COGS.

• LIFO: Sells the most recently acquired inventory first, which can result in lower taxes during inflation but requires careful reporting of the LIFO reserve.

Learning Objective 4: Identify Special Issues Related to LIFO

LIFO Reserve

This reserve reflects the difference between the inventory method adopted internally versus LIFO for external reporting. It is essential for investors to understand potential earnings impacts.

LIFO Liquidation

When old, lower-cost inventory is sold under LIFO, it can inflate net income temporarily and complicate tax obligations, potentially misleading stakeholders.

Dollar-Value LIFO

A sophisticated approach measuring inventory changes based on dollar values instead of physical quantities, which safeguards LIFO layers against reductions in inventory value.

Learning Objective 5: Determine the Effects of Inventory Errors on Financial Statements

Effects of Inventory Errors

Misstating ending inventory can directly impact net income and working capital, necessitating precise inventory tracking.

• Inventory errors tend to reverse over time, thus affecting financial reports in subsequent periods.

Illustration of Effects

Examples showcasing how incorrect ending inventory can distort net income figures over multiple accounting periods. This highlights the critical importance of sound inventory management practices to maintain financial integrity.