Chap 7 Inventory Valuation & Measurement Issues

• Costs included in inventory• Cost of Goods Sold for merchandizers• Concepts ( no calculations) on the different inventory

costing methods• Effects of inventory errors on financial statements• Lower of Cost or Market in relation to inventory valuation• Inventory Management & Internal Control• Perpetual vs. Periodic Inventory Systems• Inventory Turnover ratio

7-5

Costs Included in Inventory Purchases

The cost principlecost principle requires that inventory be recorded at the price paid or the

consideration given.

Invoice Price Freight

Inspection Costs

Preparation Costs

7-6

Flow of Inventory Costs

MerchandisePurchases

MerchandiseMerchandisePurchasesPurchases

Cost ofGoods Sold

Cost ofCost ofGoods SoldGoods Sold

MerchandiseInventory

MerchandiseMerchandiseInventoryInventory

Merchandiser

RawMaterials

RawRawMaterialsMaterials

Raw MaterialsInventory

Raw MaterialsRaw MaterialsInventoryInventory

Work in ProcessInventory

Work in ProcessWork in ProcessInventoryInventory

Finished GoodsInventory

Finished GoodsFinished GoodsInventoryInventory

Cost ofGoods Sold

Cost ofCost ofGoods SoldGoods Sold

Manufacturer

DirectLaborDirectDirectLaborLabor

FactoryOverheadFactoryFactory

OverheadOverhead

7-7

Nature of Cost of Goods Sold

BeginningInventoryBeginningBeginningInventoryInventory

Purchasesfor the PeriodPurchasesPurchases

for the Periodfor the Period

Ending Inventory(Balance Sheet)

Ending InventoryEnding Inventory(Balance Sheet)(Balance Sheet)

Goods availablefor Sale

Goods availableGoods availablefor Salefor Sale

Cost of Goods Sold(Income Statement)

Cost of Goods SoldCost of Goods Sold(Income Statement)(Income Statement)

Beginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale – Ending inventory = Cost of goods sold

Beginning inventory + Purchases = Goods Available for SaleBeginning inventory + Purchases = Goods Available for Sale

Goods Available for Sale Goods Available for Sale –– Ending inventory = Cost of goods soldEnding inventory = Cost of goods sold

7-9

Inventory Costing Methods

Specific Identification

Specific Specific IdentificationIdentification FIFOFIFOFIFO

LIFOLIFOLIFO Weighted Average

Weighted Weighted AverageAverage

7-11

Specific Identification

When units are sold, the

specific costof the unit sold

is added to cost of goods

sold.

When units are sold, the

specific costof the unit sold

is added to cost of goods

sold.

7-10

Inventory Costing Methods

Total Dollar Amount of Goods Available for Sale

Total Dollar Amount of Goods Total Dollar Amount of Goods Available for SaleAvailable for Sale

Ending InventoryEnding InventoryEnding Inventory Cost of Goods SoldCost of Goods SoldCost of Goods Sold

Inventory Costing Method

7-13

First-In, First-Out Method

Cost of Goods Sold

Cost of Cost of Goods SoldGoods SoldOldest CostsOldest CostsOldest Costs

Ending InventoryEnding Ending

InventoryInventoryRecent CostsRecent CostsRecent Costs

7-19

Last-In, First-Out Method

Ending InventoryEnding Ending

InventoryInventory

Cost of Goods Sold

Cost of Cost of Goods SoldGoods Sold

Oldest CostsOldest CostsOldest Costs

Recent CostsRecent CostsRecent Costs

7-25

Average Cost Method

When a unit is sold, the average cost of each unit in inventory is assigned to cost

of goods sold.

When a unit is sold, the average cost of each unit in inventory is assigned to cost

of goods sold.

Cost of Goods Available for

Sale

Number of Units

Available for Sale

÷

7-29

Financial Statement Effects of Costing Methods

Advantages of MethodsAdvantages of MethodsAdvantages of Methods

Better matches current costs in cost of goods sold with

revenues.

Better matches Better matches current costs in cost current costs in cost of goods sold with of goods sold with

revenues.revenues.

Ending inventory approximates

current replacement cost.

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

First-In, First-OutFirstFirst--In, In, FirstFirst--OutOut

Last-In, First-OutLastLast--In, In,

FirstFirst--OutOut

Smoothes out price changes.Smoothes out Smoothes out price changes.price changes.

Weighted AverageWeighted Weighted AverageAverage

7-31

Managers Choice of Inventory Methods

Net Income EffectsManagers prefer to report higher earnings for their

companies.

Net Income EffectsNet Income EffectsManagers prefer to report Managers prefer to report higher earnings for their higher earnings for their

companies.companies.

Income Tax EffectsManagers prefer to pay

the least amount of taxes allowed by law as late as

possible.

Income Tax EffectsIncome Tax EffectsManagers prefer to pay Managers prefer to pay

the least amount of taxes the least amount of taxes allowed by law as late as allowed by law as late as

possible.possible.

7-41

LIFO and International Comparisons

LIFO Permitted?LIFO Permitted?

YesYesNoNo

ChinaSingapore

Canada

Great Britain

Australia

7-32

Choosing Inventory Costing Methods

LIFO for books

LIFO for books

LIFO for taxes

LIFO for taxes

If . . . Then . . .LIFO Conformity

Rule

7-34

Valuation at Lower of Cost or Market

Ending inventory is reported at the lower of cost or market (LCM).

Ending inventory is reported at the Ending inventory is reported at the lower of cost or market (LCM)lower of cost or market (LCM). .

Replacement CostThe current purchase price

for identical goods.

Replacement CostReplacement CostThe current purchase price The current purchase price

for identical goods.for identical goods.

The company will recognize a “holding” loss in the current period rather than the period in which the

item is sold.This practice is conservative.

The company will recognize a “holding” loss in the The company will recognize a “holding” loss in the current period rather than the period in which the current period rather than the period in which the

item is sold.item is sold.This practice is This practice is conservativeconservative..

7-35

Valuation at Lower of Cost or Market

Item Quantity Cost Replacement

Cost LCM Total LCM

Pentium chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

Item Quantity Cost Replacement

Cost LCM Total LCM

Pentium chips 1,000 250$ 200$ 200$ 200,000$ Disk drives 400 100 110 100 40,000

Debit CreditCost of goods sold 50,000

Inventory 50,000

Date Description

GENERAL JOURNAL

7-37

Inventory Turnover

Cost of Goods Sold=

Average Inventory

Inventory Turnover

Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing storage and

obsolescence costs.

This ratio reflects how many times This ratio reflects how many times average inventory was produced and average inventory was produced and sold during the period. A higher ratio sold during the period. A higher ratio indicates that inventory moves more indicates that inventory moves more quickly thus reducing storage and quickly thus reducing storage and

obsolescence costs. obsolescence costs.

7-43

Internal Control of Inventory

Separation of inventory accounting and physical

handling of inventory.

Storage in a manner that protects from theft and

damage.

Limiting access to authorized employees.

Maintaining perpetual inventory records.

Comparing perpetual records to periodic

physical counts.

7-44

Perpetual and Periodic Inventory Systems

Provides up-to-dateinventory records.

Provides Provides upup--toto--datedateinventory records.inventory records.

Provides up-to-date cost of sales records. Provides Provides upup--toto--date date

cost of sales records. cost of sales records.

Perpetual System

Perpetual Perpetual SystemSystem

In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting

period based on a physical count.

7-45

Perpetual and Periodic Inventory Systems

Inventory System

Item Periodic System Perpetual System

Beginning InventoryCarried over

from prior periodCarried over from

prior period

Add: PurchasesAccumulated in the Purchases

account

Accumulated in the Inventory

account

Less: Ending Inventory

Measured at end of period by

physical

inventory count

Perpetual record updated at every

sale

Cost of Goods Sold

Computed as a residual amount at end of period

Measured at every sale based

on perpetual record

7-46

Errors in Measuring Ending Inventory

Errors in Measuring InventoryEnding Inventory Beginning Inventory

Overstated Understated Overstated Understated

Ending Inventory + - N/A N/A

Retained Earnings + - - +

Goods Available for Sale N/A N/A + -Cost of Goods Sold - + + -Gross Profit + - - +Net Income + - - +

Effect on Current Period's Balance Sheet

Effect on n Current Period's Income Statement

7-37

Inventory Turnover

Cost of Goods Sold=

Average Inventory

Inventory Turnover

Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2

Average Inventory is . . .Average Inventory is . . .(Beginning Inventory + Ending Inventory) ÷ 2(Beginning Inventory + Ending Inventory) ÷ 2

This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more

quickly thus reducing storage and obsolescence costs.

This ratio reflects how many times This ratio reflects how many times average inventory was produced and average inventory was produced and sold during the period. A higher ratio sold during the period. A higher ratio indicates that inventory moves more indicates that inventory moves more

quickly thus reducing storage and quickly thus reducing storage and obsolescence costs. obsolescence costs.

Homework Manager Assignment

• E7-3

• E7-5

• E7-7

• E7-12

• E7-13

End of Chapter MC Answers

• 1. c)• 2. d)• 3. a)• 4. b)• 5. d)• 6. c)• 7. a)• 8. c)• 9. c)• 10. a)