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

Inventory Issues

• Inventories are asset items:
  • Held for sale in the ordinary course of business.
  • Goods to be used in the production of goods to be sold.

Classification of Inventory

Merchandising Company

• Uses one inventory account.
• Purchases merchandise in a form ready for sale.

Manufacturing Company

• Uses three inventory accounts:
  • Raw Materials
  • Work in Process
  • Finished Goods

Inventory Cost Flow

• Cost of Goods Available for Sale = Beginning Inventory + Cost of Goods Purchased
• Cost of Goods Sold = Cost of Goods Available for Sale - Ending Inventory
• Beginning\ inventory,\ Jan.\ 1: $100,000
• Cost\ of\ goods\ acquired\ or\ produced\ during\ the\ year: $800,000
• Total\ cost\ of\ goods\ available\ for\ sale: $900,000
• Ending\ inventory,\ Dec.\ 31: ($200,000)
• Cost\ of\ goods\ sold\ during\ the\ year: $700,000

Inventory Systems

Perpetual System

• Purchases of merchandise are debited to Inventory.
• Freight-in is debited to Inventory.
• Purchase returns and allowances and purchase discounts are credited to Inventory.
• Cost of Goods Sold is debited, and Inventory is credited for each sale.
• Subsidiary records show quantity and cost of each type of inventory on hand.

Periodic System

• A company determines the quantity of inventory on hand only periodically.

Trader Joe's Example:

• Beginning inventory: 100 jars at $6 = $600
• Purchases: 900 jars at $6 = $5,400
• Sales: 600 jars at $12 = $7,200
• Ending inventory: 400 jars at $6 = $2,400

Perpetual Inventory System:

• Beginning inventory: Inventory account shows $600.
• Purchase 900 units at $6:
  • Inventory \quad 5,400
  • Accounts\ Payable \quad 5,400
• Sales of 600 units at $12:
  • Accounts\ Receivable \quad 7,200
  • Sales\ Revenue \quad 7,200
  • Cost\ of\ Goods\ Sold\ (600\ at\ $6) \quad 3,600
  • Inventory \quad 3,600
• End-of-period entries for Inventory account. 400 units at $6:
  • Inventory (ending by count) 2,400

Periodic Inventory System:

• Beginning inventory: Inventory account shows $600.
• Purchase 900 units at $6:
  • Purchases \quad 5,400
  • Accounts\ Payable \quad 5,400
• Sales of 600 units at $12:
  • Accounts\ Receivable \quad 7,200
  • Sales\ Revenue \quad 7,200
• No entry for Cost of Goods Sold at the time of sale.
• End-of-period entries for Inventory account. 400 units at $6:
  • No entry necessary until the end of the period
  • Cost\ of\ Goods\ Sold \quad 3,600
  • Purchases \quad 5,400
  • Inventory\ (beginning) \quad 600

Inventory Control

• Importance of an accurate inventory accounting system.
• Risks of not stocking enough inventory: lost sales and customers.
• Risks of stocking too much inventory: high storage costs or obsolescence.
• Risks of not adequately protecting inventory: theft or damage.

Inventory Shortage

• Example:
  • Perpetual inventory account balance: $4,000.
  • Physical count: $3,800.
  • Entry to record write-down:
    • Inventory\ Over\ and\ Short \quad 200
    • Inventory \quad 200
  • Inventory Over and Short is reported on the income statement in the “Other revenue and gains” or “Other expenses and losses” section.

Goods and Costs Included in Inventory

Goods Included in Inventory

• A company recognizes inventory and accounts payable when it controls the asset.
• Passage of title is often used to determine control.

Terms of Sale

• FOB Shipping Point: Buyer pays freight costs; ownership passes to buyer when loaded on the truck.
• FOB Destination: Seller pays freight costs; ownership passes to buyer upon delivery.

Consigned Goods

• Goods out on consignment remain the property of the consignor.
• Consignee makes no entry to the inventory account for goods received.

Sales with Returns

• Transfer of legal title determines whether to include an item in inventory.
• Sales with high rates of return can cause problems.

Special Sales Agreements

• Sales with Repurchase Agreement
  • Involves a transfer (sale) with either an implicit or explicit repurchase agreement.
  • Referred to as “parking transactions.”

Purchase Discounts

• Gross Method: Records purchases and accounts payable at the invoice price.
• Net Method: Recognizes the purchase and related accounts payable at the invoice price less the cash discount.

BCycle Example:

• Purchased bicycle inventory with cost $10,000, terms 2/10, net 30.
• Invoices of $4,000 are paid within discount period.
• Invoices of $6,000 are paid after discount period.

Inventory Cost Flow Assumptions

• Companies with large amounts of inventory of similar items do not use the specific identification method.
• Accounting Standards allow companies to make a cost flow assumption.
• The cost flow assumption adopted does not need to be consistent with the physical movement of goods.
• A company’s major objective in selecting a method should be to choose the one that most clearly reflects periodic income.

Key Considerations:

• Specific Identification vs. FIFO vs. LIFO vs. Average Cost
• Method adopted should clearly reflect periodic income.

Zenlife Transactions:

• Beginning inventory: 0 units, $0.00 total cost
• March 2: 2,000 units at $4.00 = $8,000
• March 15: 6,000 units at $4.40 = $26,400
• March 30: 2,000 units at $4.75 = $9,500
• Cost of goods available for sale: 10,000 units, $43,900
• Ending inventory: 6,000 units
• Cost of goods sold: 4,000 units

Specific Identification

• ZenLife Inc.’s 6,000 units of ending inventory consists of:
  • 1,000 units from the March 2 purchase.
  • 3,000 from the March 15 purchase.
  • 2,000 from the March 30 purchase.

Calculation:

• March 2: 1,000 units at $4.00 = $4,000
• March 15: 3,000 units at $4.40 = $13,200
• March 30: 2,000 units at $4.75 = $9,500
• Ending Inventory: 6,000 units, $26,700
• Cost of goods available for sale: $43,900
• Deduct: Ending inventory $26,700
• Cost of goods sold: $17,200
• Includes in cost of goods sold the costs of specific items sold
• Used when handling a relatively small number of costly, easily distinguishable items
• Matches actual costs against actual revenue
• Cost flow matches physical flow of goods
• May allow a company to manipulate net income

Average-Cost

• Prices items in inventory based on the average cost of all similar goods available during the period
• Not subject to income manipulation
• Measuring a specific physical flow of inventory is often impossible

Average-Cost Inventory Cost Flow (Periodic Method)

• ZenLife Inc. uses the periodic method and has 6,000 units of ending inventory.

Calculation:

• Beginning inventory: $0
• March 2: 2,000 units at $4.00 = $8,000
• March 15: 6,000 units at $4.40 = $26,400
• March 30: 2,000 units at $4.75 = $9,500
• Total goods available: 10,000 units, $43,900
• Weighted-average cost per unit: 43,900 / 10,000 = $4.39
• Ending inventory: 6,000 units × $4.39 = $26,340
• Cost of goods available for sale: $43,900
• Deduct: Ending inventory $26,340
• Cost of goods sold: $17,560

Moving – Average Method – Perpetual Inventory

• Computes a new average unit cost each time it makes a purchase.

Example:

• March 2: (2,000 @ $4.00) = $8,000, Balance: (2,000 @ $4.00) = $8,000
• March 15: (6,000 @ $4.40) = $26,400, Balance: (8,000 @ $4.30) = $34,400
• March 19: Sold (4,000 @ $4.30) = $17,200, Balance: (4,000 @ $4.30) = $17,200
• March 30: (2,000 @ $4.75) = $9,500, Balance: (6,000 @ $4.45) = $26,700

First-In, First-Out (FIFO)

• Assumes goods are sold in the order in which they are purchased
• Approximates physical flow of goods
• Ending inventory is close to current cost
• Fails to match current costs against current revenues

FIFO Inventory Cost Flow (Periodic System)

Calculation:

• March 30: 2,000 units at $4.75 = $9,500
• March 15: 4,000 units at $4.40 = $17,600
• Ending inventory: 6,000 units, $27,100
• Cost of goods available for sale: $43,900
• Deduct: Ending inventory $27,100
• Cost of goods sold: $16,800
• Determine the cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory.

FIFO Method – Perpetual Inventory

• In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used.

Last-In, First-Out (LIFO)

• The last-in, first-out (LIFO) method matches the cost of the last goods purchased against revenue.

LIFO Inventory Cost Flow (Periodic System)

Calculation:

• March 2: 2,000 units at $4.00 = $8,000
• March 15: 4,000 units at $4.40 = $17,600
• Ending inventory: 6,000 units, $25,600
• Goods available for sale: $43,900
• Deduct: Ending inventory $25,600
• Cost of goods sold: $18,300
• The cost of the total quantity sold or issued during the month comes from the most recent purchases.

LIFO Method – Perpetual Inventory

• The LIFO method results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method.

Comparative Results of FIFO, Average-Cost, and LIFO for Zenlife

Special Issues Related to LIFO

LIFO Reserve

• Many companies use:
  • LIFO for tax and external financial reporting purposes
  • FIFO, average cost, or standard cost system for internal reporting purposes
• Reasons:
  • Pricing decisions
  • Recordkeeping easier
  • Profit-sharing or bonus arrangements
  • LIFO troublesome for interim periods.