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Inventories: Measurement

Inventories: Measurement. Objectives of this Chapter. Discuss the importance of inventory valuation. Study perpetual and periodic inventory systems and the ending period adjustments for inventory. Study and compare the inventory cost flow assumptions. Explain the effect of LIFO liquidations.

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Inventories: Measurement

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  1. Inventories: Measurement

  2. Objectives of this Chapter • Discuss the importance of inventory valuation. • Study perpetual and periodic inventory systems and the ending period adjustments for inventory. • Study and compare the inventory cost flow assumptions. • Explain the effect of LIFO liquidations. Inventories: Measurement

  3. Objectives of this Chapter (contd.) • Identify the items that should be included in the inventory count. • Discuss the lower of cost or market (LCM) rule. • Study the accounting treatment of changing to LIFO cost flow assumption and the use of LIFO reserve account. • LIFO Inventory Pools • Dollar-value LIFO technique. Inventories: Measurement

  4. 1. Inventories: the Importance of Inventory Valuation • How would the valuation and cost flow assumptions of inventory affect the income measurement? • Valuation Methods: Historical Cost, Current Exist Value, Current Entry Value, Present Value, LCM. • Cost Flow Assumptions: LIFO, FIFO, Average, Specific Identification. • CGS = Beginning Inventory + Net Purchase - Ending Inventory Inventories: Measurement

  5. Inventories: the Importance of Inventory Valuation (contd.) • Different valuation methods and different cost flow assumptions will result in different cost of ending inventories and therefore different cost of goods sold. Inventories: Measurement

  6. The Impact of Valuation of Ending Inventory on The CGS & Income Year 1 IncomeCGS = Beg. Inv. + Net Pur. - End. Inv. under over under a over under over b Year 2 over under under under over over a. either understating the units or the value b. either overstating the units or the value Inventories: Measurement

  7. Impact on Omitting Goods from Purchases CGS = Beg. Inventory + N.P. - End. Inventory B/S I/S Ending Inv. understated Purchase understated R/E no effect CGS no effect A/P under N/I no effect Working Capital no effect Inventory (End.) understated Current Ratio overstatinga a. When CA > CL Inventories: Measurement

  8. Defining Inventory 1. Assets held for resale purpose in a normal course of business 2. Assets used to produce products for resale purpose • Merchandising Firms: Inventories • Manufacturing Firms: Raw materials Work-in-process Finished goods Inventories: Measurement

  9. Presentation of Inventory for Merchandising and Manufacturing Companies (Illustration 8-1, KWW, 14th e) Inventories: Measurement

  10. Inventory Cost Flow (Illustration 8-3, KWW, 14th e) Inventories: Measurement

  11. How to Determine Inventory Value Presented on the Balance Sheet? • Applying either the periodic inventory system or the perpetual inventory system and select a cost flow assumption to determine the value of inventories. • Both inventory systems require a physical count of inventory at the end of a period to determine the units which can be included in the inventory account. Inventories: Measurement

  12. 2. Inventory Systems and Ending Period Adjustments • Types of Inventory Systems • A. Perpetual Inventory System • B. Periodic Inventory System Inventories: Measurement

  13. Comparing Perpetual and Periodic Systems (Source: KWW, 14th e, p438) • Assuming that Fesmire Company had the following transactions during the current year: Inventories: Measurement

  14. Comparative Entries- Perpetual vs. Periodic (Illustration 8-4, KWW, 14th e) Inventories: Measurement

  15. Perpetual Systems – Cost of Goods Sold and the Ending Inventory • Since the inventory and the cost of goods sold (CGS) accounts are updated with all purchases and sales transactions, the balances of these two accounts are known at all time. • The CGS is determined by selecting a cost flow assumption. Inventories: Measurement

  16. Perpetual Systems – Cost of Goods Sold and the Ending Inventory (contd.) • Physical inventory count is still needed at the end of a period to determine whether inventory loss occurred. • A write down is required in the case of inventory loss. Inventories: Measurement

  17. Periodic Inventory System – the Ending Inventory and the Cost of Goods Sold • For the periodic system, the inventory balance is only determined at the end of a period after an inventory count and applying a cost flow assumption. • The cost of goods sold (CGS)is derived as: CGS = Beg. Inv. + Net purchases – cost of ending inventory Inventories: Measurement

  18. Inventory Cost Flow Assumptions • Fist-In, First-Out (FIFO) • Last-In, First-Out (LIFO) • Weighted-Average Cost (W-A) • Specific Identification Inventories: Measurement

  19. Perpetual Inventory System - AnExample a. Sales price is $10 per unit. b. Sales price is $11 per unit. c.LIFO is not permiitted under IFRS Inventories: Measurement

  20. Example (contd.) - Journal Entries (Perpetual vs. Periodic) 3/5 Inventory 900 3/5 Purchases 900 Cash 900 Cash 900 3/7 Cash 2,000 3/7 Cash 2,000 Sales Rev. 2,000 Sales Rev. 2,000 CGS 1,100 Inventory 1,100 3/14 Inventory 700 3/14 Purchases 700 Cash 700 Cash 700 3/28 Cash 330 Cash 330 Sales Rev. 330 Sales Rev. 330 CGS 180 Inventory 180 Perpetual (FIFO) Periodic Inventories: Measurement

  21. Inventory (LIFO) 500 1150 900 210 700 740 Inventory (WA) 500 1120 900 195.9 700 784.1 Inventory a (FIFO) B.B.500 1100 900 180 700 E.B.820 Perpetual Inventory SystemExample (contd.) a. The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement

  22. CGS (FIFO) 3/7...1100 3/28...180 1280 CGS (LIFO) 1150 210 1360 CGS (W-A) 1120 195.9 1315.9 Perpetual Inventory SystemExample (contd.) The balance of cost of goods sold account1: 1.The balance of inventory is known at all time under the perpetual inventory system. Inventories: Measurement

  23. Ending Period AdjustmentsPerpetual Inventory System a. Adjustments for lost units. b. Adjustments for LCM valuation. Inventories: Measurement

  24. a. Adjustments for Lost Units(Perpetual Inventory System) Assuming ending units = 110 units. On 3/31, the lost units = 10. Cost of 10 lost units => $6 x 10 = $60 (FIFO) $7 x 10 = $70 (LIFO) $6.53 x 10 = 65.3 (W-A) Adjusting Entry: 3/31 Loss on Inventory Units a 60 Inventory 60 a. or use the account of Inventory over and short Inventories: Measurement

  25. LCM =$600 b. Adjustments for LCM Valuation(Perpetual Inventory System) Inventory (FIFO) B.B 500 1,100 900 180 700 820 60 -- 3/31 (Adj. for lost units) 760 • Ending Inv. Cost (on 3/31, FIFO) = $760 • Assuming market price = $600 LCM = $600 Inventories: Measurement

  26. Adjustments for LCM Valuation (contd.) • Adjusting entry => Given that Allowance for Declining in Market Value of inventory has a beginning balance of zero: Allowance 3/31 0 -- 3/1 Loss Due to Market Value 160 Decline of Inventory 160 160 -- 3/31 Allowance to Reduce Inventory to Market 160 B/S (3/31) Inventory 760 Allowance (160) Inv. At LCM 600 Inventories: Measurement

  27. Adjustments for LCM Valuation (contd.) • If the allowance account had a beginning balance of $20, the adjusting entry would be: Allowance 20 -- 3/1 Loss 140 140 Allowance 140 160 -- 3/31 Inventories: Measurement

  28. Adjustments for LCM Valuation (contd.) • If the Allowance account had a beginning balance of 200, the adjusting entry would be: • Allowance Allowance 40 • 40 200 Gain from Recovery • 160 of M.V. of Inventory 40 Inventories: Measurement

  29. Periodic Inventory System • At the end of an accounting period, the following steps must be followed to determine the cost of ending inventory and cost of goods sold: 1. Do an inventory count. 2. Applying a cost flow assumption to determine the cost of ending inventory. 3. Determine the cost of goods sold using: CGS = Beg. Inv. + Net Pur. - Ending Inv.a a. No adjusting entries are required. Inventories: Measurement

  30. Periodic Inventory Systema : An Example • Using the example on Page 10 and assuming the physical count of inventory indicates 105 units on hand on 3/31, the cost of ending inventory (105 units) would be (given a FIFO cost flow assumption): $7  100 + $6  5 = $730 a. For journal entries, see page 20. Inventories: Measurement

  31. Inventory Data: UnitsCost 3/1 (B.B) 100 $5 3/5 Pur. 150 $6 3/14 Pur. 100 $7 The CGS under FIFO is: $500 + 1,600 - 730 = $1,370. If a LIFO assumption is used, the cost of end. Inv. is: $5 x 100 + $6 x 5 = $530. The CGS is: $500 + 1600 - 530 = $1,570. Periodic Inventory SystemExample (contd.) Inventories: Measurement

  32. Ending Period Adjustments (Periodic Inventory System) 1. No adjustment is needed for lost units (because the cost of lost units is embedded in the CGS). Inventories: Measurement

  33. Ending Period Adjustments (Periodic Inventory System) 2.Adjustment for the LCM valuation assuming FIFO: Cost of E.I. = $730 LCM Allowance Market = $600 = $600 0 -- 3/1(assumed) 130 130 --3/31 • Adjusting entry: • Loss Due to Market Decline of Inv. 130 • Allowance to Reduce Inv. to Market 130 Inventories: Measurement

  34. An Alternative of LCM Adjustment • Many companies (i.e., Cisco Systems, inc. 2001, source: Spiceland, etc.)record the adjustment of LCM as follows: Cost of Goods Sold 160 Inventory 160 • Note: Recording the loss as an increase in CGS will have the same impact on earnings as reporting it as a loss from value decline in the holding inventory. However, this treatment will distort the cost of goods sold and therefore, the gross profit.. Inventories: Measurement

  35. Examples of Earnings Boosted by Selling Inventory Which Had Been Written Down previously (Source: P500 of KWW, 14th e) Inventories: Measurement

  36. 3. Comparison of FIFO vs. LIFODuring an Inflation Period Inventories: Measurement

  37. Survey: (Source: Accounting Trends & Techniques and footnote 16 of Chapter 8 , KWW 14th e) a, b,c Inventories: Measurement

  38. Survey: (Source: Accounting Trends & Techniques) (contd.) a. Sample firms are 600 firms. Most companies adopt more than one inventory method. b. Due to low inflation, the number of firms adopting LIFO has declined since mid-1980s. c. IAS No. 2 does not permit LIFO, and therefore, multinational companies use LIFO for all or most of their domestic inventories while use FIFO or average cost for their foreign subsidiaies. Inventories: Measurement

  39. Switching to LIFODuring an Inflation Period • Reason of switching to LIFO: Tax savings. Inventories: Measurement

  40. Income Manipulation When LIFO Is Used (assuming price is rising) 1. To increase income (by decreasing CGS): • Strategy: 2.To decrease income (by increasing CGS): • Strategy: Inventories: Measurement

  41. Advantages of FIFO a. Less likely to be subject to management manipulation; b. Produce higher income during an inflation period; c. Inventory cost reported on the B/S is close to the replacement cost. Inventories: Measurement

  42. Disadvantage of FIFO a. Bad matches of sales revenue and CGS; match current sales revenue with old costs; b. Producing higher income during an inflation period results in paying more income tax. Inventories: Measurement

  43. Advantages of LIFO a. Good match of sales revenue with CGS. b. Produce lower income during an inflation period; result in tax savings. Inventories: Measurement

  44. Disadvantages of LIFO a. Inventory cost presented on the B/S is not fair. b. Subject to management manipulation. Note: International Accounting Standard No. 2 does not allow LIFO. Inventories: Measurement

  45. IRS 1. Does not allow firms to use LCM if firms are using LIFO. 2.LIFO conformity rule. The non-LIFO income numbers are allowed on the supplementary reports since 1981. Inventories: Measurement

  46. IRS (contd.) 3. LIFO is not acceptable by the IRS till 1939. Inventories: Measurement

  47. 4. LIFO Liquidations • A LIFO Liquidation profit can occur when units purchased are less than units sold in the period. Inventories: Measurement

  48. An Example of LIFO Liquidation Profit 20x5 Beg. Inv. 400 $5 Pur. 300 $6 Pur. 500 $7 Pur. 600 $8 During 20x5, 1,700 units were sold. What is the LIFO liquidation profit? Total purchases of 20x5 are 1,400 units. The LIFO liquidationprofit is: (1,700-1,400) x ($8-$5) = $900 Inventories: Measurement

  49. Choice of Inventory Cost-Flow Assumptions and Conversion of FIFO to LIFO for Comparison Purposes* • Choice of inventory cost-flow assumptions. • Inventory Management (JIT system, Inventory turnover rate, etc.): the example of Dell Inc. • Adjustment of inventory cost-flow assumption on the same basis before making comparison of financial statements. Inventories: Measurement

  50. Adjustment of Inventory Cost-Flow Assumption – An Example Information: ABC is currently adopting FIFO assumption. IF LIFO were adopted, thecost of ending inventory would be $1,000 and $3,000 lower for x1 and x2, respectively. Question: How much would the CGS and income be different when LIFO is adopted rather than FIFO for x2? Inventories: Measurement

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