Valuation of Inventories

Chapter 7: Valuation of Inventories: A Cost-Basis Approach

Overview

• Topics Covered:

  • Perpetual and Periodic Inventory Systems

  • Costs Included in Inventory

  • Effects of Inventory Errors

  • Cost Flow Assumptions

  • LIFO – Special Issues

Two Inventory Systems

• Perpetual Inventory System:

  • Inventory account is continuously updated as purchases and sales are made.

  • Cost of Goods Sold (COGS) is recorded for each sale.

  • Does not use a separate Purchases account.

  • Freight-in, purchase returns and allowances, and discounts are recorded directly in Inventory, not in separate accounts.

• Periodic Inventory System:

  • Inventory account is adjusted only at the end of the accounting period.

  • No entries to COGS until the end of the period.

  • Uses Purchases account.

  • Freight-in, purchase returns and allowances, and discounts are recorded in separate accounts.

Inventory Systems - Journal Entries

• Perpetual:

  • Purchases:

  • Debit Inventory

  • Credit Accounts Payable (A/P)

  • Sales:

  • Debit Accounts Receivable (A/R)

  • Credit Sales

  • Debit COGS

  • Credit Inventory

  • Closing (at end of period):

  • Physically count inventory to adjust for errors.

  • Close COGS and Sales accounts.

• Periodic:

  • Purchases:

  • Debit Purchases

  • Credit Accounts Payable (A/P)

  • Sales:

  • Debit Accounts Receivable (A/R)

  • Credit Sales

  • Closing (at end of period):

  • Physically count inventory to determine ending balance.

  • Compute COGS:

    • ext{COGS} = ext{Inventory (beginning balance)} + ext{Net Purchases} – ext{Inventory (ending balance)}

  • COGS is affected by:

  • Ending balance of Inventory

  • Beginning balance of Inventory

  • Purchases

  • Freight-in

  • Close COGS and Sales accounts.

Costs Included in Inventory

• Product Costs:

  • Include Raw Materials, Labor, and other costs directly related to acquisition or production of inventory.

  • Shipping (freight-in) is a product cost and included in inventory value.

• Period Costs:

  • Selling, General, and Administrative costs that are not directly related to acquisition or production of inventory.

  • Typically not included in inventory value.

  • In some cases, interest expense may be included (see Chapter 9).

Manufacturing Inventory Costs Example

• Harley Inc. manufactures and sells mopeds:

  • No mopeds at the start of the fiscal period.

  • Costs incurred during the period:

  • Raw materials used: $10,000

  • Wages for production staff: $5,000

  • Wages for sales staff: $4,000

  • Depreciation for Production Property, Plant, and Equipment (PPE): $2,500

  • Depreciation for Delivery PPE: $1,000

  • All raw materials purchased in prior periods; wages are yet to be paid.

  • Finished 20 mopeds with a total cost of $14,000 ($700 each), with 15 mopeds sold during the period.

Cost Allocation in Manufacturing

• Costs that should be capitalized:

  • Raw Materials: $10,000

  • Work in Process: $5,000

  • Finished Goods: $14,000

• Total Costs:

  • Accumulated Depreciation: $2,500 + $1,000 = $3,500

  • Total Selling Expenses: $4,000

What is Included in Inventory?

• General Rule:

  • All goods owned by the company on the inventory date, regardless of their location.

• Goods in Transit:

  • f.o.b. shipping point: Included in inventory of the buyer.

  • f.o.b. destination: Included in inventory of the seller.

Freight-in on Purchases

• Perpetual System:

  • Freight costs included directly in the Inventory account.

• Periodic System:

  • Freight costs are included in a separate temporary account called Freight-in.

Purchase Discounts: Two Methods

• Gross Method:

  • Purchase discounts reported as a deduction from purchases.

• Net Method:

  • Purchase discounts lost considered a financial expense reported in the "other expense and loss" section of the income statement.

Example of Treatment of Purchase Discounts

• Gross Method:

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

  • Purchases: $20,000

  • Accounts Payable: $20,000

  • Payment of invoices within the discount period:

  • Accounts Payable: $15,000

  • Purchase Discounts: $300

  • Payment of invoices after the discount period:

  • Accounts Payable: $5,000

  • Purchase Discount Lost: $100

Effect of Inventory Errors

• Ending Inventory Understated:

  • An error on net income in one year (e.g. 2006) offsets in the following year (e.g. 2007) but misstates the income statement for both years.

Example 1 of Inventory Errors

• Beginning inventory is correctly stated; ending inventory understated by $100.

  • COGS will be overstated by $100.

Example of Inventory Reporting

• Inventory as reported vs. actual:

  • Beginning Balance:

  • Reported: $1,100

  • Actual: $1,100

  • Purchases: $10,000

  • Ending Balance:

  • Reported: $1,700

  • Actual: $1,800

  • COGS:

  • Reported: $9,400

  • Actual: $9,300

Example 2 of Inventory Errors

• Beginning inventory understated by $100; ending inventory overstated by $300.

  • COGS will be understated by $200.

Inventory Error Reporting Example

• Inventory Values:

  • Beginning Balance:

  • Reported: $700

  • Actual: $800

  • Ending Balance:

  • Reported: $1,200

  • Actual: $900

  • COGS:

  • Reported: $500

  • Actual: $900

Cost Flow Assumptions

• Specific Identification:

  • Each inventory item is identified specifically for each sale, not an assumption.

• Average Cost:

  • All items are assumed to have the same cost via weighted averaging of different purchases.

• First-in, First-out (FIFO):

  • Assumes items are sold in the chronological order of acquisition; oldest costs assigned to COGS; most recent costs remain in ending inventory.

• Last-in, First-out (LIFO):

  • Assumes items are sold in reverse chronological order; most recent costs assigned to COGS; oldest costs remain in ending inventory.

Inventory Issues

• Choice of cost flow assumption does not have to reflect the physical flow of goods.

• Goods Available for Sale (G.A.S.):

  • The same under all cost flow assumptions.

• Only COGS and ending inventory change when using different assumptions.

• In rising price scenarios:

  • LIFO results in higher COGS, lower net income, and lower ending inventory compared to FIFO or Average Cost.

• The Average Cost method will always yield a figure between LIFO and FIFO in fluctuating price conditions.

LIFO Issues

• Provides best matching of expenses with revenues by using the most recent prices for COGS.

• Higher COGS due to rising prices results in lower net income; this can decrease income tax expense.

• Oldest costs remain in inventory on the balance sheet, misrepresenting the cost of replacement.

• Risk of LIFO liquidation may distort net income.

Special Issues Related to LIFO

• LIFO Reserve:

  • The difference between the inventory method used for internal reporting and LIFO. Example:

  • FIFO value per books: $160,000

  • LIFO value: $145,000

  • LIFO Reserve: $15,000

  • COGS impact from LIFO Reserve: $15,000

• Companies must disclose either the LIFO reserve or the replacement cost of inventory in their financial statements.

LIFO Liquidation

• Occurs when a business lowers its inventory quantity, utilizing older layers that may have outdated costs, matching them against current sales, leading to distorted income and misrepresentations.

LIFO Liquidation Example

• Alfa Distributors, Inc.:

  • Beginning 2007 inventory: 4,000 units at $10/unit.

  • 5,000 units purchased for $15/unit.

  • 7,000 units sold during the year.

  • LIFO COGS calculated:

  • 5,000 units @ $15 (2006) = $75,000

  • 2,000 units @ $10 (beg. Inv.) = $20,000

  • Total LIFO COGS: $95,000.

Methods to Alleviate LIFO Liquidation Problems

• Use specific goods pooled LIFO, which combines similar items and allows reductions in one item compensated by increases in others.

• Dollar-Value LIFO:

  • Changes are determined in terms of dollars rather than quantities, simplifying LIFO record-keeping by viewing inventory pools as layers of value.

Dollar-Value LIFO (DVL) Implementation Steps

1. Compute a Cost Index for the year:

   • Cost index in layer year = Cost in layer year ÷ Cost in base year.

2. Divide the ending inventory by the cost index.

3. Compare the adjusted ending inventory (at base year cost) to the beginning inventory:

   • Ending Inventory at base year cost = Ending Inventory Cost ÷ Cost Index.

   • Change in Inventory = Ending Inv. at Base Year Cost - Beg. Inventory.

4. Identify ending inventory layers and their creation years.

5. Sum all layers to determine ending inventory at DVL cost.

6. Convert each layer’s base year cost to layer year cost by multiplying by the corresponding cost index.

Example of DVL Calculation

• Udon Inc.:

  • Adopted dollar-value LIFO on January 1, 2006:

  • Beginning inventory: $700,000

  • Year-end inventory: $777,000 at year-end prices.

  • Cost index: 1.05.

What was DVL inventory on December 31, 2006?

• Answer: C) $742,000.

DVL Calculation Steps:

• Step 1: Layers

• Step 2: Ending Inventory

• Step 3: Ending at Base Year Cost

• Conversion:

  • Acquisition Year Cost:

    • For Beginning Inventory: $700,000 (cost index = 1.00).

  • Ending Inventory Calculation:

    • End of Year:

    • $777,000 (Year End) = $740,000 (Base Year)

    • Conversion of new layer results in: $40,000 x 1.05 = $42,000.

Resulting Inventory Amounts:

• Total DVL inventory = $742,000.