class #3 inventory measurement. inventory those assets that a company: 2. has in production (work in...
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Class #3
Inventory Measurement
InventoryThose assets that a company:
2. Has in production (work in process) for future sale.
2. Has in production (work in process) for future sale.
1. Intends to sell in the normalcourse of business.
1. Intends to sell in the normalcourse of business.
3. Uses currently in the productionof goods to be sold (raw materials).3. Uses currently in the productionof goods to be sold (raw materials).
Types of Inventories
Merchandise Inventory
Merchandise Inventory
Goods acquired for resale
Goods acquired for resale
Manufacturing Inventory
Manufacturing Inventory
• Raw Materials• Work-in-Process• Finished Goods
• Raw Materials• Work-in-Process• Finished Goods
Types of Inventory
Inventory Cost FlowsRaw
Materials
(1) $XX $XX (4)
Work inProcess
FinishedGoods
Cost of GoodSold
DirectLabor
ManufacturingOverhead
$XX $XX (7) $XX $XX (8)
$XX
(2) $XX $XX (5)
(3) $XX $XX (6)
(1) Raw materials purchased(2) Direct labor incurred(3) Manufacturing overhead incurred(4) Raw materials used(5) Direct labor applied(6) Manufacturing overhead applied(7) Work in process transferred to finished goods(8) Finished goods sold
(1) Raw materials purchased(2) Direct labor incurred(3) Manufacturing overhead incurred(4) Raw materials used(5) Direct labor applied(6) Manufacturing overhead applied(7) Work in process transferred to finished goods(8) Finished goods sold
Inventory Methods
Perpetual Inventory System
Perpetual Inventory System
The inventory account is continuously
updated as purchases and sales are made.
The inventory account is continuously
updated as purchases and sales are made.
Periodic Inventory System
Periodic Inventory System
The inventory account is adjusted at the end of a reporting cycle.
The inventory account is adjusted at the end of a reporting cycle.
Two accounting systems are used to record transactions involving inventory:
Perpetual Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale
to customers.
Returns of inventory are credited to the inventory account.
Discounts on inventory purchases can be recorded using the gross or net method.
2013Inventory 600,000
Accounts payable 600,000To record the purchase of merchandise inventory.
Perpetual Inventory SystemDuring 2013, LWBC sold, on account, inventory with a retail
price of $820,000 and a cost basis of $540,000, to customers.
2013Inventory 600,000
Accounts payable 600,000To record the purchase of merchandise inventory.
2013Accounts receivable 820,000
Sales revenue 820,000To record sales on account.
Cost of goods sold 540,000Inventory 540,000
To record cost of goods sold.
Periodic Inventory System
Beginning Inventory+ Net Purchases
Cost of Goods Available for Sale
- Ending Inventory= Cost of Goods Sold
The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated, using the schedule below, after
the physical inventory count at the end of the period.
Periodic Inventory SystemLothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period itpurchases on account $600,000 of merchandise for resale
to customers.
2013Purchases 600,000
Accounts payable 600,000To record the purchase of merchandise inventory.
Periodic Inventory System
No entry is made to record cost of goods sold. A physical countof ending inventory shows a balance of $180,000. Let’s
calculate cost of goods sold at the end of 2013.
During 2013, LWBC sold, on account, inventory with a retail price of $820,000 to customers, and a cost basis of $540,000.
2013Accounts receivable 820,000
Sales revenue 820,000To record sales on account.
Periodic Inventory System
Beginning inventory 120,000$ Plus: Purchases 600,000 Cost of goods available for sale 720,000 Less: Ending inventory (180,000) Cost of goods sold 540,000$
Calculation of Cost of Goods Sold
We need the following adjusting entry to record cost of good sold.December 31, 2013Cost of goods sold 540,000Inventory (ending) 180,000
Inventory (beginning) 120,000Purchases 600,000
To adjust inventory, close the purchases account, and record cost of goods sold.
Comparison of Inventory SystemsTransaction or
EventPeriodic
InventoryPerpetual Inventory
Routine purchases of various inventory items
Costs debited to purchases account
Costs debited to inventory account
Sale of inventoryNo accounting entries made
Debit Cost of goods sold and credit
inventory
End-of-period accounting entries and
related activities
Physical count of inventory to
determine cost of good sold
No separate determination of cost
of goods sold necessary
What is Included in Inventory?
General RuleAll goods owned by the company on the inventory date,
regardless of their location.
General RuleAll goods owned by the company on the inventory date,
regardless of their location.
Goods in TransitGoods in Transit Goods on ConsignmentGoods on Consignment
Depends on FOB shipping terms.
Depends on FOB shipping terms.
Expenditures Included in Inventory
Invoice PriceInvoice Price
Freight-in on Purchases
Freight-in on Purchases
+
Purchase Returns
Purchase Returns
Purchase DiscountsPurchase Discounts
Real World• …the cost of warehousing and occupancy for our
Wal-Mart segment distribution facilities are included in operating, selling and general and administrative expenses. Because we do not include the cost of our Wal-Mart segment distribution facilities in cost of sales, our gross profit and gross margin may not be comparable to those of other retailers that may include all costs related to their distribution facilities in costs of sales and in the calculation of gross profit and gross margin.
Purchase Returns
November 8, 2013Accounts payable 2,000 Accounts payable 2,000 Purchase returns 2,000 Inventory 2,000
On November 8, 2013, LWBC returns merchandise that had a cost to LWBC of $2,000.
Periodic Inventory Method Perpetual Inventory Method
Returns of inventory are credited to the Purchase Returns account when using the periodic inventory method.
The returns are credited to Inventory using the perpetual inventory method.
Purchase Discounts
October 5, 2013Purchases 20,000 Purchases 19,600
Accounts payable 20,000 Accounts payable 19,600
October 14, 2013Accounts payable 14,000 Accounts payable 13,720
Purchase discounts 280 Cash 13,720Cash 13,720
November 4, 2013Accounts payable 6,000 Accounts payable 5,880
Cash 6,000 Interest expense 120Cash 6,000
Discount terms are 2/10, n/30.
$14,000x 0.02$ 280
Partial payment not made within the discount period
Gross Method Net Method
$20,000x 0.02$ 400
@120$ 280
Net Method Using Perpetual and PeriodicDescription Debit Credit
Inventory 5,880 Accounts payable 5,880
Inventory 160 Cash 160
Accounts payable 200 Inventory 200
Accounts receivable 8,300 Sales revenue 8,300
Cost of goods sold 5,840 Inventory 5,840
Purchases 5,880 Accounts payable 5,880
Freight-in 160 Cash 160
Accounts payable 200 Purchase returns 200
Accounts receivable 8,300 Sales revenue 8,300
Periodic Inventory Method
Perpetual Inventory Method
Beginning inventory -$ Purchases 5,880$ Less: Returns (200) Plus: Freight-in 160 Net purchases 5,840 Cost of goods available for sale 5,840 Less: Ending inventory - Cost of goods sold 5,840$
Inventory Cost Flow Methods• Specific cost identification• Average cost• First-in, first-out (FIFO)• Last-in, first-out (LIFO)
• Specific cost identification• Average cost• First-in, first-out (FIFO)• Last-in, first-out (LIFO)
Real World – Wal-Mart
The Company uses the retail last-in, first-out (LIFO) method for general merchandise within the Wal-Mart Stores segment, cost LIFO for the SAM’S CLUB segment and grocery items within the Wal-Mart Stores segment, and other cost methods, including the retail first-in, first-out (FIFO) and average cost methods, for the International segment. Inventories are not recorded in excess of market value.
The specific cost of each inventory item must be known.
Only for items with serial #’s or other identity means.
The specific cost of each inventory item must be known.
Only for items with serial #’s or other identity means.
Specific Cost Identification• Items are added to
inventory at cost when they are purchased.
• COGS for each sale is based on the specific cost of the item sold.
• Items are added to inventory at cost when they are purchased.
• COGS for each sale is based on the specific cost of the item sold.
Perpetual Average Cost
UnitsCost per
Unit Total CostBeg. Inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 2,000
Picture This, LLCInventory of frame number 759
Units sold in September
UnitsCost per
Unit Total CostBeg. Inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000
Sale 9/7 500 10.25 5,125.00$ Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 2,000
Picture This, LLCInventory of frame number 759
Units sold in September
Perpetual Average Cost
($20,000 + 10,750) ÷ (2,000 + 1.000) = $10.25
UnitsCost per
Unit Total CostInventory at 9/21 2,500 10.25$ 25,625.00$ Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 3,500
Sale 9/7 500 10.25 5,125 Sale 9/29 1,500 Units sold in September 2,000 Units in ending inventory 1,500
Picture This, LLCInventory of frame number 759
Units sold in September
Perpetual Average Cost
($25,625 + 10,950) ÷ (2,500 + 1,000) = $10.45
UnitsCost per
Unit Total CostSeptember Inventory and Cost of SalesSale 9/7 500 10.25 5,125.00$ Sale 9/29 1,500 10.45 15,675.00 Cost of goods sold 2,000 20,800.00 Ending inventory 2,000 10.45 20,900.00$
41,700.00$
Picture This, LLCInventory of frame number 759
Perpetual Average Cost
3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.
Weighted-Average Periodic SystemLet’s use the same information to assign costs to ending inventory and cost of goods sold using the
periodic system.
Beginning Inventory (2,000 units)
Purchases (2,000 units)
Available for Sale
(4,000 units)
Ending Inventory(2,000 units)
Goods Sold(2,000)
$41,700 ÷ 4,000 = $10.425 weighted-average per unit cost
Weighted-Average Periodic System
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.25 5,125.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Units sold in September
First-In, First-Out (FIFO)
The cost of the oldest inventory items are charged to COGS when goods are sold.
The cost of the newest inventory items remain in ending inventory.
The cost of the oldest inventory items are charged to COGS when goods are sold.
The cost of the newest inventory items remain in ending inventory.
The FIFO method
assumes that items are sold
in the chronological order of their acquisition.
First-In, First-Out (FIFO)
Even though the periodic and the perpetual
approaches differ in the timing of adjustments to
inventory . . .
. . . COGS and Ending Inventory Cost are the
same under both approaches.
Even though the periodic and the perpetual
approaches differ in the timing of adjustments to
inventory . . .
. . . COGS and Ending Inventory Cost are the
same under both approaches.
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00
Cost of goods sold 2,000 10.425$ 20,850.00 Ending Inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Ending Inventory and Cost of Goods Sold
First-In, First-Out (FIFO)Periodic Inventory System
These 2,000 units come from the
beginning inventory (first-in,
first-out).
These 2,000 units come from the
beginning inventory (first-in,
first-out).
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00
Cost of goods sold 2,000 10.425$ 20,000.00 Ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Ending Inventory and Cost of Goods Sold
First-In, First-Out (FIFO)Periodic Inventory System
First-In, First-Out (FIFO)Periodic Inventory System
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00
Cost of goods sold 2,000 10.425$ 20,000.00 Ending inventory 2,000 10.425$ 21,700.00$
Picture This, LLCInventory of frame number 759
Ending Inventory and Cost of Goods Sold
Last-In, First-Out (LIFO)
The cost of the newest inventory items are charged to COGS when goods are sold.
The cost of the oldest inventory items remain in inventory.
The cost of the newest inventory items are charged to COGS when goods are sold.
The cost of the oldest inventory items remain in inventory.
The LIFO method
assumes that the newest
items are sold first, leaving the
older units in inventory.
Last-In, First-Out (LIFO)Unlike FIFO, using the
LIFO method may result in COGS and
Ending Inventory Cost that differ under the
periodic and perpetual approaches.
Unlike FIFO, using the LIFO method may result in COGS and
Ending Inventory Cost that differ under the
periodic and perpetual approaches.
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.25 5,125.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Units sold in September
Last-In, First-OutPerpetual Inventory System
These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.
These are the oldest units in inventory and are most likely to remain in inventory when using LIFO.
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.75 5,375.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Units sold in September
Last-In, First-OutPerpetual Inventory System
The Cost of Goods Sold for the September 7 sale come from the purchase of September 3, so we record the
cost of goods sold at $5,375 (500 units times $10.75).
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.75 5,375.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Units sold in September
Last-In, First-OutPerpetual Inventory System
The Cost of Goods Sold for the September 29 sale come from the purchase of September 3 (500 remaining units) plus 1,000 units from
the purchase of September 21, for a total of 1,500 units,
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.75 5,375.00 Sale 9/29 1,500 10.45 16,325.00 Cost of goods sold 2,000 10.425$ 21,700.00 Ending inventory 2,000 10.00$ 20,000.00$
Picture This, LLCInventory of frame number 759
Units sold in September
Last-In, First-OutPerpetual Inventory System
9/21 purchase 1,000 10.95$ 10,950.00$ 9/3 purchase 500 10.75 5,375.00 Cost of goods sold 1,500 16,325.00$
Last-In, First-OutPeriodic Inventory System
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Sale 9/7 500 10.25 5,125.00 Sale 9/29 1,500 10.45 15,675.00 Units sold in September 2,000 10.425$ 20,850.00 Units in ending inventory 2,000 10.425$ 20,850.00$
Picture This, LLCInventory of frame number 759
Units sold in September
UnitsCost per
Unit Total CostBeginning inventory 2,000 10.00$ 20,000.00$ Purchase 9/3 1,000 10.75 10,750.00 Purchase 9/21 1,000 10.95 10,950.00 Units available for sale 4,000 41,700.00$
Cost of goods sold 2,000 10.425$ 21,700.00 Ending inventory 2,000 10.425$ 20,000.00$
Picture This, LLCInventory of frame number 759
Units sold in September
Last-In, First-OutPeriodic Inventory System
When Prices Are Rising . . .
LIFO Matches high (newer)
costs with current (higher) sales.
Inventory is valued based on low (older) cost basis.
Results in lower pre-tax income.
FIFO• Matches low (older)
costs with current (higher) sales.
• Inventory is valued at approximate replacement cost.
• Results in higher pre-tax income.
U. S. GAAP vs. IFRS
• LIFO is permitted and used by U.S. Companies.
• If used for income tax reporting, the company must use LIFO for financial reporting.
• Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter.
LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, an inability to use LIFO under IFRS will
impose a serious impediment to convergence.
IAS No. 2, Inventories, does not permit the use of LIFO.
Because of this restriction, many U.S. multinational companies use LIFO only for domestic inventories.
Decision Makers’ Perspective
Factors Influencing Method Choice
How are income taxes affected by inventory method
choice?
How closely do reported
costs reflect actualflow of inventory?
How well are costs matched against
related revenues?
Supplemental LIFO Disclosures
Many companies use LIFO for external reporting and income tax purposes but maintain internal records using
FIFO or average cost.
The conversion from FIFO or average cost to LIFO takes place at the end of the
period. The conversion may look like this:
2014 2013
Total inventories at FIFO 15,429$ 15,387$ Less: LIFO allowance (1,508) (1,525) Inventories, at LIFO cost 13,921$ 13,862$
LIFO Liquidation
LIFO inventory costs in the balance sheet are “out of date” because they
reflect old purchase transactions.
When prices rise . . .
If inventory declines, these “out of date” costs
may be charged to current earnings.
This LIFOliquidation results in
“paper profits.”
Inventory Management
Gross profit ratio =Gross profitNet sales
Inventory turnover ratio = Cost of goods soldAverage inventory
The higher the ratio, the higher the markup a company is able to achieve on its products.
(Beginning inventory + Ending inventory2
Designed to evaluate a company’seffectiveness in managing its
investment in inventory
Quality of EarningsChanges in the ratios we discussed above often provide information
about the quality of a company’s current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete
inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).
Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and
changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
Methods of Simplifying LIFO
The objectives of using LIFO inventory pools are to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce
the risk of LIFO layer liquidation. For example, a glass company might group its various grades of window glass into
a single window pool. Other pools might be auto glass and sliding door glass. A lumber company might pool its inventory
into hardwood, framing lumber, paneling, and so on. LIFO pools allow companies to account for a few inventory pools
rather than every specific type of inventory separately.
LIFO Inventory Pools
Example
The replacement inventory differs from the old inventory on
hand. We just create a new layer.
Methods of Simplifying LIFODollar-Value LIFO (DVL)
DVL inventory pools are viewed as layers of value, rather than layers of similar units.
DVL simplifies LIFO recordkeeping.
DVL minimizes the probability of layer
liquidation.
At the end of the period, we determine if a new inventory layer was added by comparing
ending inventory dollar amount to beginning
inventory dollar amount.
Methods of Simplifying LIFODollar-Value LIFO (DVL)
We need to determine if the increase in ending inventory over beginning inventory was due to a cost increase or an increase
in inventory quantity.
1a. Compute a Cost Index for the
year.
Cost index in layer
year =
Cost in layer year
÷Cost in base year
Methods of Simplifying LIFODollar-Value LIFO (DVL)
1b. Deflate the ending
inventory value using
the cost index.
Ending inventory at base
year cost
=
Ending inventory at year-end cost
÷Cost index
1c. Compare ending
inventory at base year cost to beginning inventory at base year
cost.
Change in inventory
=Ending Inv.
at base year cost
–
Beg. Inventory at base
year cost
Methods of Simplifying LIFODollar-Value LIFO (DVL)
Next, identify the layers in ending inventory and the years they were created.
Sum all the layers to arrive at ending inventory at DVL
cost.
Convert each layer’s base year cost to layer
year cost by multiplying times the
cost index.
Methods of Simplifying LIFODollar-Value LIFO (DVL)
Masterwear reports the following inventoryand cost index information. Let’s look at the
solution to this example.
12/31Ending
inventoryCost index
Inventory as base-year
prices2013 150,000$ 100% 150,000$
2014 168,000 105% 160,000
Methods of Simplifying LIFODollar-Value LIFO (DVL)
12/31Ending
inventoryCost index
Inventory at base-year
cost2013 150,000$ 100% 150,000$
2014 168,000 105% 160,000 168,000 ÷ 1.05 = 160,000
Masterwear reports the following inventoryand general price information.
Methods of Simplifying LIFODollar-Value LIFO (DVL)
December 31,
Inventory at base-year
costsPrice index
Ending I\inventory
2013 150,000$ 150,000$
2014 160,000
2014 LIFO Layer 10,000$ 105% 10,500
Inventory 160,500$
First, determine the LIFO layer for the current year:
Methods of Simplifying LIFODollar-Value LIFO (DVL)
December 31,
Inventory at base-year
costsCost index
Ending inventory
2013 150,000$ 100% 150,000$
2014 160,000
2014 LIFO Layer 10,000$ 105% 10,500
Inventory 160,500$
10,000 1.05 = 10,500
At the LIFO layer at end of period prices to theending LIFO inventory from last period.