PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Inventories:Measurement

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Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Merchandise

Goods acquired for resale

Manufacturing (see page 397)

•Raw Materials•Work-in-Process•Finished Goods

Types of Inventory

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Inventory SystemsInventory Systems

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 The inventory account is adjusted account is adjusted

at the end of a at the end of a reporting cycle.reporting cycle.

The inventory The inventory account is adjusted account is adjusted

at the end of a at the end of a reporting cycle.reporting cycle.

Two accounting recording systems

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Inventory Journal Entries(pages 397-400)

• We will use:• Exercise 8-1 (page 427) – perpetual system

• Exercise 8-2 (page 428) – periodic system

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Exercise 8-1 (page 427)

• 1 of 3 To record the purchase of inventory on account and the payment of freight charges.

•  • Inventory 5,000• Accounts payable 5,000•  • Inventory 300• Cash 300•  

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Exercise 8-1 (page 427)

• 2 of 3 To record purchase returns.•  • Accounts payable 600• Inventory 600

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Exercise 8-1 (page 427)

• 3 of 3 To record cash sales and cost of goods sold.

•  • Cash 5,200• Sales revenue 5,200• and • Cost of goods sold 2,800• Inventory 2,800

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Exercise 8-2 (page 428)

• 1 of 3: To record the purchase of inventory on account and the payment of freight charges.

•  • Purchases 5,000• Accounts payable 5,000•  • Freight-in 300• Cash 300

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Exercise 8-2 (page 428)

• 2 of 3: To record purchase returns.•  • Accounts payable 600• Purchase returns 600

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Exercise 8-2 (page 428)

• 3 of 3: To record cash sales.•  • Cash 5,200• Sales revenue 5,200•  • NOTE:

NO ENTRY IS MADE FOR THE COST OF GOODS SOLD AT THE POINT OF SALE

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If the Periodic Inventory System Is Used ….

Beginning Inventory+ Net Purchases

Cost of Goods Available for Sale

- Ending Inventory= Cost of Goods Sold

Cost of goods sold must be calculated after the physical inventory count at the end of the period.

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Comparison of Inventory Systems(students to use as study aid)

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What is Included in Inventory?

General RuleAll goods owned by the company on the inventory

date, regardless of their location.

Goods in TransitGoods in Transit Goods on Consignment

Goods on Consignment

Depends on FOB shipping terms.

Depends on FOB shipping terms.

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Expenditures Included in InventoryExpenditures Included in Inventory

Invoice PriceInvoice Price

Freight-in on Purchases

Freight-in on Purchases

+

Purchase Returns and Allowances

Purchase Returns and Allowances

Purchase Discounts

Purchase Discounts

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Purchase Discount Journal Entries(Ilustr # 8-3 and 8-4, pp. 402-403)

• We will use

• Exercise 8-9 (page 428) – gross method

• Exercise 8-10 (page 428) – net method

• Notice: the similarity of these approaches to the sales discount entries in chapter 7

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Gross Method: Exercise 8-9 p.429Purchase price =1,000 units x $50 = 50,000

• Requirement : 1 of 3•  July 15, 2011 • Purchases 50,000• Accounts payable 50,000• July 23, 2011 (in time for discount)• Accounts payable 50,000• Cash (98% x $50,000) 49,000• Purch. Disc. (2% x $50,000) 1,000

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Gross Method: Exercise 8-9 (page 429)

• Requirement : 2 of 3 • If payment is on 8/15 (too late to get the

discount)

• August 15, 2011• Accounts payable 50,000• Cash 50,000

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Gross Method: Exercise 8-9 (page 429)

• Requirement: 3 of 3• The July 15 entry would include a debit to the

inventory account instead of to purchases• the July 23 entry would include a credit to the

inventory account instead of to purchase discounts.

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Net Method: Exercise 8-10 (p.429)

• Requirement : 1 of 3 • July 15, 2011• Purchases (98% x $50,000) 49,000• Accounts payable 49,000•  •  July 23, 2011• Accounts payable 49,000• Cash 49,000

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Net Method: Exercise 8-10 (p.429)

• Requirement: 2 of 3•  if payment is on 8/15 – it is too late to take the

discount• August 15, 2011• Accounts payable 49,000• Interest expense 1,000• Cash 50,000

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Net Method: Exercise 8-10 (p.429)

• Requirement : 3 of 3

• The July 15 entry would include a debit to the inventory account instead of to purchases.

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Cost Flow Methods:Let’s look @ Illustr: # 8-5 (page 404)

• Demonstrates what the “problem” is that causes accountants to choose between:– FIFO– LIFO– Weighted-Average– Specific Identification

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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.

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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.

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FIFO, LIFO, Weighted-Average

• Exercise 8-13 – periodic system (page 430)

• Exercise 8-14 – perpetual system (page 430)

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Exercise 8-13:periodic system, using FIFO

• Cost of goods sold:• Beginning inventory (2,000 x $6.10) $12,200• Purchases:• Aug 8: 10,000 x $5.50 $55,000• Aug 18: 6,000 x $5.00 30,000 85,000• goods available (18,000 units) $97,200• Less: End inventory (3,000 units) (15,000)

Cost of goods sold $82,200• E/I = 8/18 layer of 3,000 @ $5.00 = $15,000

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Exercise 8-13periodic system, using LIFO

• Cost of goods sold:• Beginning inventory (2,000 x $6.10) $12,200• P - Aug 8: 10,000 x $5.50 $55,000• P - Aug 18:6,000 x $5.00 30,000

85,000

• goods available (18,000 units) $97,200• Less: Ending inventory (17,700)

Cost of goods sold $79,500• E/I: B/I layer. 2,000 @ $6.10 $12,200• 8/8 layer 1,000 @ 5.50 5,500

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Exercise 8-13periodic system, using weighted-average

• Cost of goods sold:• Beginning inventory (2,000 x $6.10) $12,200• P - Aug 8: 10,000 x $5.50 $55,000• P - Aug 18:6,000 x $5.00 30,000

85,000• goods available (18,000 units) $97,200• Less: End invent. (3,000 units) (16,200)

Cost of goods sold $81,000• E/I = $97,200 / 18,000 units = $5.40

3,000 units x $5.40 = $16,200

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Exercise 8-14 (page 430)Perpetual, using FIFO, LIFO, Average

• Beg. Inv. 2,000 @ $6.10• Aug 8 Purch 10,000 @ $5.50

12,000• Aug 14 Sale -8,000

4,000• Aug 18 Purch 6,000 @ $5.00

10,000• Aug 25 Sale -7,000• End Inv. 3,000

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Exercise 8-14 (page 430)Perpetual, using FIFO, LIFO, Average

• Refer to solution hand-out

Exercise 8-14: Costing Methods

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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 taxable income.

FIFO• Matches low (older)

costs with current (higher) sales.

• Inventory is valued at approximate replacement cost.

• Results in higher taxable income.

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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.

• IAS No. 2, Inventories, does not permit the use of LIFO.

• Because of this restriction, many U.S. companies use LIFO only for domestic inventories.

LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will

impose a serious impediment to convergence.

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Simplifying LIFO

Why simplify?

“unit LIFO” (what we just worked through in Exercises 8-13 and 8-14) can:

– Involve expensive record-keeping, and

– May risk of liquidation of LIFO inventory layers

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LIFO Liquidation

LIFO inventory costs in the balance sheet are “out of date” because they

reflect old purchase transactions.

LIFO inventory costs in the balance sheet are “out of date” because they

reflect old purchase transactions.

When prices rise . . .

If inventory quantities decline, these “out of date” costs may be charged to current

earnings.

If inventory quantities decline, these “out of date” costs may be charged to current

earnings.

This LIFOliquidation results in

“paper profits.”

This LIFOliquidation results in

“paper profits.”

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Example

The replacement inventory differs from the old inventory on

hand. We just create a new layer.

Dollar-Value LIFO (DVL)pages 421-422

DVL inventory pools are viewed as layers of value, rather than layers of similar units.DVL inventory pools are viewed as layers

of value, rather than layers of similar units.

DVL simplifies LIFO record-keeping.

DVL simplifies LIFO record-keeping.

DVL minimizes the probability of layer

liquidation.

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 to beginning inventory.

At the end of the period, we determine if a new inventory layer

was added by comparing ending

inventory to beginning inventory.

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Examples of DVL

• We will use Exercise 8-23 (page 432)

• You should also review Concept Review Exercise on pages 423-424

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Exercise 8-23: DVL

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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 The conversion from FIFO or average cost to LIFO takes place at the end of the to LIFO takes place at the end of the

period. The conversion may look like this:period. The conversion may look like this:

2011 2010

Total inventories at FIFO 15,429$ 15,387$ Less: LIFO allowance (1,508) (1,525) Inventories, at LIFO cost 13,921$ 13,862$

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Example of Supplemental LIFO Disclosure

• Read pages 412-413, and

• .. review Graphics 8-6 and 8-7 (page 413)

End of Chapter 8