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Chapter 8-1
Chapter
8-1
C C H H A A P P T T E E R R 8

CC HH AA PP TT EE RR

88

VVALUATIONALUATION OFOF INVENTORIES:INVENTORIES:

AA COSTCOST--BASISBASIS APPROACHAPPROACH

Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Chapter

8-2

13th Edition Kieso, Weygandt, and Warfield Chapter 8-2 LearningLearning ObjectivesObjectives 1. 1. Identify

LearningLearning ObjectivesObjectives

1.1. IdentifyIdentify majormajor classificationsclassifications ofof inventory.inventory.

2.2. DistinguishDistinguish betweenbetween perpetualperpetual andand periodicperiodic inventoryinventory systems.systems.

3.3. IdentifyIdentify thethe effectseffects ofof inveinventoryntory errorserrors onon thethe financialfinancial statements.statements.

4.4. UnderstandUnderstand thethe itemsitems toto includeinclude asas inventoryinventory cost.cost.

5.5. DescribeDescribe andand comparecompare thethe costcost flflowow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

6.6. ExplainExplain thethe significancesignificance andand useuse ofof aa LIFOLIFO reserve.reserve.

7.7. UnderstandUnderstand thethe effecteffect ofof LIFOLIFO liquidations.liquidations.

8.8. ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

9.9. IdentifyIdentify thethe majormajor advantagesadvantages andand disadvantagesdisadvantages ofof LIFO.LIFO.

10.10. UnderstandUnderstand whywhy companiescompanies selectselect givengiven inventoryinventory methods.methods.

Chapter

8-3

InventoryInventory IssuesIssues InventoryInventory IssuesIssues CostCost--BasisBasis ApproachApproach
InventoryInventory IssuesIssues
InventoryInventory IssuesIssues
CostCost--BasisBasis ApproachApproach
IllustrationIllustration 88--11
Classification
Classification
Inventories are:
PhysicalPhysical
CostsCosts
InventoryInventory
GoodsGoods
CostCost FlowFlow
LIFO:LIFO: SpecialSpecial
BasisBasis forfor
IncludedIncluded
IssuesIssues
IncludedIncluded inin
AssumptionsAssumptions
IssuesIssues
SelectionSelection
items held for sale, or
inin InventoryInventory
InventoryInventory
One inventory
account
goods to be used in the production of goods to be sold.
ClassificationClassification
GoodsGoods inin transittransit
ProductProduct costscosts
SpecificSpecific
LIFOLIFO reservereserve
SummarySummary ofof
identificationidentification
inventoryinventory
CostCost flowflow
ConsignedConsigned
PeriodPeriod costscosts
LIFOLIFO liquidationliquidation
valuationvaluation
goodsgoods
AverageAverage costcost
ControlControl
PurchasePurchase
DollarDollar--valuevalue LIFOLIFO
Purchase goods
ready for sale
methodsmethods
SpecialSpecial salessales
discountsdiscounts
FIFOFIFO
BasicBasic inventoryinventory
ComparisonComparison ofof
Businesses with Inventory:
agreementsagreements
valuationvaluation
LIFOLIFO
LIFOLIFO approachesapproaches
InventoryInventory errorserrors
AdvantagesAdvantages ofof
LIFOLIFO
DisadvantagesDisadvantages ofof
MerchandiserMerchandiser
or
ManufacturerManufacturer
LIFOLIFO
Chapter
Chapter
Chapter
LOLO 11 IdentifyIdentify majormajor claclassificationsssifications ofof inventory.inventory.
LOLO 11 IdentifyIdentify majormajor claclassificationsssifications ofof inventory.inventory.
8-4
8-5
8-6

InventoryInventory IssuesIssues

Classification

Three accounts

Raw materialsIssuesIssues Classification Three accounts Work in process Finished goods Chapter 8-7 Illustration

Work in processIssuesIssues Classification Three accounts Raw materials Finished goods Chapter 8-7 Illustration Illustration 8 8 -

Finished goodsClassification Three accounts Raw materials Work in process Chapter 8-7 Illustration Illustration 8 8 - -

Chapter

8-7

IllustrationIllustration 88--11

goods Chapter 8-7 Illustration Illustration 8 8 - - 1 1 LO LO 1 1 Identify

LOLO 11 IdentifyIdentify majormajor claclassificationsssifications ofof inventory.inventory.

InventoryInventory IssuesIssues

Inventory Cost Flow

IllustrationIllustration 88--22

Inventory Cost Flow Illustration Illustration 8 8 - - 2 2 Chapter 8-8 LO LO 1

Chapter

8-8

LOLO 11 IdentifyIdentify majormajor claclassificationsssifications ofof inventory.inventory.

InventoryInventory IssuesIssues

Inventory Cost Flow

IllustrationIllustration 88--33

Inventory Cost Flow Illustration Illustration 8 8 - - 3 3 Companies use one of two

Companies use one of two types of systems for maintaining inventory records — perpetual system or periodic system.

Chapter

8-9

LOLO 11 IdentifyIdentify majormajor claclassificationsssifications ofof inventory.inventory.

InventoryInventory CostCost FlowFlow

Perpetual System

1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for each sale.

4. Subsidiary records show quantity and cost of each type of inventory on hand.

The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

InventoryInventory CostCost FlowFlow

Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory

$ 100,000

Purchases, net

800,000

Goods available for sale

900,000 125,000 $ 775,000
900,000
125,000
$ 775,000

Ending inventory

Cost of goods sold

InventoryInventory CostCost FlowFlow

Illustration: Fesmire Company had the following transactions during the current year.

had the following transactions during the current year. Record these transactions usin g the Perpetual and

Record these transactions using the Perpetual and Periodic systems.

Chapter

Chapter

Chapter

8-10

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

8-11

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

8-12

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

   

InventoryInventory CostCost FlowFlow

     

InventoryInventory CostCost FlowFlow

       

InventoryInventory IssuesIssues

 

Illustration:

IllustrationIllustration 88--44

 

Inventory Control

    Illustration: Assume that at the end of the reporting period, the perpetual inventory
   

Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows.

 

All companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records.

 

Inventory Over and Short

200

 

Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports.

Inventory

200

 

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the “Other revenues and gains” or “Other expenses and losses” section of the income statement.

   

Chapter

Solution on

Chapter

 

Chapter

 
 

8-13

notes page

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

 

8-14

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

 

8-15

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

 

BasicBasic IssuesIssues inin InventoryInventory ValuationValuation

   

BasicBasic IssuesIssues inin InventoryInventory ValuationValuation

   

PhysicalPhysical GoodsGoods IncludedIncluded inin InventoryInventory

 

Valuation

 

Valuation requires determining

 

A company should record purchases when it obtains legal title to the goods.

IllustrationIllustration 88--66

 

Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand.

IllustrationIllustration 88--55

 

The physical goods (goods on hand, goods in transit, consigned goods, special sales agreements). physical goods (goods on hand, goods in transit, consigned goods, special sales agreements).

The costs to include (product vs. period costs). costs to include (product vs. period costs).

 
The costs to include (product vs. period costs).   The cost flow assumption (FIFO, LIFO, Average
The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

The cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.). cost flow assumption (FIFO, LIFO, Average cost, Specific Identification, Retail, etc.).

Chapter

 

Chapter

 

Chapter

 
 

8-16

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

 

8-17

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

 

8-18

LOLO 22 DistinguishDistinguish betweenbetween perpetperpetualual andand periodicperiodic inventoryinventory systesystems.ms.

EffectEffect ofof InventoryInventory ErrorsErrors

EffectEffect ofof InventoryInventory ErrorsErrors

Ending Inventory Misstated

IllustrationIllustration 88--77

Illustration: Jay Weiseman Corp. understates its ending inventory by $10,000 in 2009; all other items are correctly stated.

by $10,000 in 2009; all other items are correctly stated. The effect of an error on

The effect of an error on net income in one year (2009) will be counterbalanced in the next (2010), however the income statement will be misstated for both years.

Chapter

Chapter

8-19

LOLO 33 IdentifyIdentify thethe effectseffects ofof inventoryinventory errorserrors onon thethe financialfinancial statements.statements.

8-20

IllustrationIllustration 88--88
IllustrationIllustration 88--88

LOLO 33

EffectEffect ofof InventoryInventory ErrorsErrors

Purchases and Inventory Misstated

IllustrationIllustration 88--99
IllustrationIllustration 88--99

The understatement does not affect cost of goods sold and net income because the errors offset one another.

Chapter

8-21

LOLO 33 IdentifyIdentify thethe effectseffects ofof inventoryinventory errorserrors onon thethe financialfinancial statements.statements.

CostsCosts IncludedIncluded inin InventoryInventory CostsCosts IncludedIncluded inin InventoryInventory WhichWhich
CostsCosts IncludedIncluded inin InventoryInventory
CostsCosts IncludedIncluded inin InventoryInventory
WhichWhich CostCost FlowFlow AssumptionAssumption toto Adopt?Adopt?
Treatment of Purchase Discounts
FIFO
LIFO
Product Costs - costs directly connected with
bringing the goods to the buyer’s place of
business and converting such goods to a salable
condition.
IllustrationIllustration 88--1111
**
Period Costs – generally selling, general, and
administrative expenses.
Physical Movement of Goods
*
Average Cost
Specific Identification
Purchase Discounts – Gross vs. Net Method
* $4,000 x 2% = $80
** $10,000 x 98% = $9,800
Answer: Method adopted should be one
that most clearly reflects periodic income.
Solution on
notes page
Chapter
Chapter
Chapter
LOLO 44 UnderstandUnderstand thethe itemsitems toto includeinclude asas inventoryinventory cost.cost.
LOLO 44 UnderstandUnderstand thethe itemsitems toto includeinclude asas inventoryinventory cost.cost.
8-22
8-23
8-24
LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions
usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

Example

Young & Crazy Company makes the following purchases:

1. One item on 2/2/11 for $10

2. One item on 2/15/11 for $15

3. One item on 2/25/11 for $20

Young & Crazy Company sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2011, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%.

Chapter

8-25

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

“First-In-First-Out (FIFO)”

Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10

Chapter

8-26

Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
0
90
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
14
12
7
33
57
17
$ 40

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

“First-In-First-Out (FIFO)”

Inventory Balance = $ 35 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15
Inventory
Balance = $ 35
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10

Chapter

8-27

Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
1010
80
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
14
12
7
33
4747
1414
$$ 3333

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

“Last-In-First-Out (LIFO)”

Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10

Chapter

8-28

Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
0
90
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
14
12
7
33
57
17
$ 40

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

“Last-In-First-Out (LIFO)”

Inventory Balance = $ 25 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15
Inventory
Balance = $ 25
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10

Chapter

8-29

Young & Crazy Company Income Statement For the Month of Feb. 2007

Sales Cost of goods sold Gross profit Expenses:

Administrative Selling Interest Total expenses Income before tax Taxes Net Income

$ 90

2020

70

14

12

7

33

3737

1111

$$ 2626

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions

“Average Cost”

Inventory Balance = $ 45 Purchase on 2/25/07 for $20 Purchase on 2/15/07 for $15
Inventory
Balance = $ 45
Purchase on
2/25/07 for $20
Purchase on
2/15/07 for $15
Purchase on
2/2/07 for $10

Chapter

8-30

Young & Crazy Company Income Statement For the Month of Feb. 2007 Sales Cost of
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
0
90
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
14
12
7
33
57
17
$ 40

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

CostCost FlowFlow AssumptionsAssumptions CostCost FlowFlow AssumptionsAssumptions CostCost FlowFlow
CostCost FlowFlow AssumptionsAssumptions
CostCost FlowFlow AssumptionsAssumptions
CostCost FlowFlow AssumptionsAssumptions
“Average Cost”
“Specific Identification”
“Specific Identification”
Inventory
Balance = $ 30
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Inventory
Balance = $ 45
Young & Crazy Company
Income Statement
For the Month of Feb. 2007
Inventory
Balance = $ 45
Young & Crazy Company
Income Statement
DependsDepends whichwhich oneone isis soldsold
For the Month of Feb. 2007
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
Sales
Cost of goods sold
Gross profit
Expenses:
$ 90
Purchase on
2/25/07 for $20
1515
75
Purchase on
2/25/07 for $20
Purchase on
0
0
90
2/25/07 for $20
90
Purchase on
2/15/07 for $15
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
14
14
14
Purchase on
12
12
12
7
2/15/07 for $15
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
7
Purchase on
2/15/07 for $15
7
33
33
33
4242
57
57
Purchase on
2/2/07 for $10
1212
Purchase on
2/2/07 for $10
17
Purchase on
2/2/07 for $10
Administrative
Selling
Interest
Total expenses
Income before tax
Taxes
Net Income
17
$$ 3030
$ 40
$ 40
Chapter
Chapter
Chapter
8-31
LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions
usedused toto accountaccount forfor inventories.inventories.
8-32
LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions
usedused toto accountaccount forfor inventories.inventories.
8-33
LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions
usedused toto accountaccount forfor inventories.inventories.
CostCost FlowFlow AssumptionsAssumptions
CostCost FlowFlow AssumptionsAssumptions
SpecificSpecific IdentificationIdentification
FinancialFinancial StatementStatement SummarySummary
Illustration: Call-Mart Inc. had the following transactions
in its first month of operations.
FIFO
LIFO
Average
Sales
Cost of goods sold
Gross profit
Operating expenses:
$
90
$
90
$
90
Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from the
March 15 purchase, and 2,000 from the March 30 purchase.
Compute the amount of ending inventory and cost of goods sold.
10
20
15
IllustrationIllustration 88--1212
80
70
75
Administrative
Selling
Interest
Total expenses
Income before taxes
Income tax expense
Net income
14
14
14
12
12
12
7
7
7
Calculate Goods Available for Sale
33
33
33
Beginning inventory (2,000 x $4)
$ 8,000
47
37
42
Purchases:
14
11
12
6,000 x $4.40
26,400
$
33
$
26
$
30
2,000 x 4.75
9,500
Inventory Balance
35
25
30
Goods available for sale
$43,900
Solution on
Chapter
Chapter
Chapter notes page
8-34
LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions
usedused toto accountaccount forfor inventories.inventories.
8-35
LOLO 55
8-36

AverageAverage CostCost

Weighted-Average

IllustrationIllustration 88--1313

Weighted-Average Illustration Illustration 8 8 - - 13 13 AverageAverage CostCost Moving-Average Illustration

AverageAverage CostCost

Moving-Average

IllustrationIllustration 88--1414

Moving-Average Illustration Illustration 8 8 - - 14 14 In this method, Call-Mart computes a new

In this method, Call-Mart computes a new average unit cost each time it makes a purchase.

FirstFirst--In,In, FirstFirst--OutOut (FIFO)(FIFO)

Periodic Method

IllustrationIllustration 88--1515

Periodic Method Illustration Illustration 8 8 - - 15 15 Determine cost of ending inventory by

Determine 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.

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

 

8-37

notes page

 

8-38

notes page

 

8-39

notes page

 

FirstFirst--In,In, FirstFirst--OutOut (FIFO)(FIFO)

   

LastLast--In,In, FirstFirst--OutOut (LIFO)(LIFO)

   

LastLast--In,In, FirstFirst--OutOut (LIFO)(LIFO)

 

Perpetual Method

IllustrationIllustration 88--1616

Periodic Method

IllustrationIllustration 88--1717

Perpetual Method

IllustrationIllustration 88--1818

The cost of the total quantity sold or issued during the month comes from the
The cost of the total quantity sold or issued during the month comes from the

The cost of the total quantity sold or issued during the month comes from the most recent purchases.

The cost of the total quantity sold or issued during the month comes from the most
 

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.

   

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

 

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

Chapter

Solution on

LOLO 55 DescribeDescribe andand comparecompare thethe costcost flowflow assumptionsassumptions usedused toto accountaccount forfor inventories.inventories.

 

8-40

notes page

 

8-41

notes page

 

8-42

notes page

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

LIFO Reserve

Many companies use

LIFO for tax and external financial reporting purposesRelatedRelated toto LIFOLIFO LIFO Reserve Many companies use FIFO, average cost, or standard cost system for

FIFO, average cost, or standard cost system for internal reporting purposes. internal reporting purposes.

Reasons:

1.

Pricing decisions

2. Record keeping easier

3. Profit-sharing or bonus arrangements

4. LIFO troublesome for interim periods

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO.

Example:

FIFOFIFO valuevalue perper booksbooks LIFOLIFO valuevalue LIFOLIFO ReserveReserve

$160,000$160,000

145,000145,000

$$ 15,00015,000
$$ 15,00015,000

Journal entry to reduce inventory to LIFO:

Cost of goods sold

15,000

Allowance to reduce inventory to LIFO

15,000

Companies should disclose either the LIFO reserve or the replacement cost of the inventory.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

LIFO Liquidation

Older, low cost inventory is sold resulting in a lower cost of goods sold, higher net income, and higher taxes.

Illustration: Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2010, with cost determined on a specific goods LIFO approach.

with cost determined on a specific goods LIFO approach. Chapter Chapter Chapter 8-43 LO LO 6

Chapter

Chapter

Chapter

8-43

LOLO 66 ExplainExplain thethe significancesignificance andand useuse ofof aa LIFOLIFO reserve.reserve.

8-44

LOLO 66 ExplainExplain thethe significancesignificance andand useuse ofof aa LIFOLIFO reserve.reserve.

8-45

LOLO 77 UnderstandUnderstand thethe effecteffect ofof LIFOLIFO liquidations.liquidations.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

LIFO Liquidation

Illustration: At the end of 2011, only 6,000 pounds of steel remained in inventory.

Chapter

8-46

IllustrationIllustration 88--2121
IllustrationIllustration 88--2121

LOLO 77 UnderstandUnderstand thethe effeeffectct ofof LIFOLIFO liquidations.liquidations.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Dollar-Value LIFO

IssuesIssues RelatedRelated toto LIFOLIFO Dollar-Value LIFO Changes in a pool are measured in terms of total

Changes in a pool are measured in terms of total dollar value, not physical quantity.

Advantage:

Broader range of goods in pool.of total dollar value, not physical quantity. Advantage: Permits replacement of goods that are similar. Helps

Permits replacement of goods that are similar.quantity. Advantage: Broader range of goods in pool. Helps protect LIFO layers from erosion. SpecialSpecial

Helps protect LIFO layers from erosion.in pool. Permits replacement of goods that are similar. SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Dollar-Value LIFO

Exercise 8-26 (partial): The following information relates to the Choctaw Company.

The following information relates to the Choctaw Company. Use the dollar-value LIFO method to compute the

Use the dollar-value LIFO method to compute the ending inventory for 2007 through 2009.

Chapter

Chapter

8-47

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

8-48

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Exercise 8-26 Solution

 

Inventory at

 

Inventory at

     

$ Value

 
 

End-of-Year

 

Base-Year

 

Base

   

$ Value

LIFO

LIFO

Year

Prices

Index

 

Prices

 

Layers

Index

 

LIFO

TOTAL

Reserve

2007

$

70,000

1.00

$ 70,000

$ 70,000

1.00

$ 70,000

$ 70,000

$

-

2008

 

88,200

1.05

 

84,000

 

70,000

1.00

 

70,000

   
         

14,000

1.05

 

14,700

84,700

3,500

2009

 

95,120

1.16

 

82,000

 

70,000

1.00

 

70,000

 
         

12,000

1.05

 

12,600

82,600

12,520

       

Dec. 31

 

Dec. 31

   

Dec. 31

   

Balance Sheet

     

2007

 

2008

   

2009

   
 

Inventory

 

$

70,000

$

88,200

 

$

95,120

   
 

LIFO Reserve

   

-

 

(3,500)

   

(12,520)

   

Journal entry

   

$

70,000

$

84,700

 

$

82,600

   
 

Cost of goods sold

   

3,500

   

9,020

   
   

Lifo reserve

   

(3,500)

   

(9,020)

   

Chapter

               

8-49

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Exercise 8-26 Solution

 

Inventory at

 

Inventory at

     

$ Value

 
 

End-of-Year

 

Base-Year

Base

   

$ Value

LIFO

LIFO

Year

Prices

Index

 

Prices

Layers

Index

 

LIFO

TOTAL

Reserve

2007

$

70,000

1.00

$ 70,000

$ 70,000

1.00

$ 70,000

$ 70,000

$

-

2008

 

88,200

1.05

 

84,000

70,000

1.00

 

70,000

   
       

14,000

1.05

 

14,700

84,700

3,500

2009

 

95,120

1.16

 

82,000

70,000

1.00

 

70,000

 
       

12,000

1.05

 

12,600

82,600

12,520

       

Dec. 31

Dec. 31

   

Dec. 31

   

Balance Sheet

     

2007

2008

   

2009

   
 

Inventory

 

$

70,000

$

88,200

 

$

95,120

   
 

LIFO Reserve

   

-

 

(3,500)

   

(12,520)

   
     

$

70,000

$

84,700

 

$

82,600

   

Journal entry

               
 

Cost of goods sold

   

3,500

   

9,020

   
   

Lifo reserve

   

(3,500)

   

(9,020)

   

Chapter

               

8-50

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Exercise 8-26 Solution

 

Inventory at

 

Inventory at

     

$ Value

 
 

End-of-Year

 

Base-Year

Base

   

$ Value

LIFO

LIFO

Year

Prices

Index

 

Prices

Layers

Index

 

LIFO

TOTAL

Reserve

2007

$

70,000

1.00

$ 70,000

$ 70,000

1.00

$ 70,000

$ 70,000

$

-

2008

 

88,200

1.05

 

84,000

70,000

1.00

 

70,000

   
       

14,000

1.05

 

14,700

84,700

3,500

2009

 

95,120

1.16

 

82,000

70,000

1.00

 

70,000

 
       

12,000

1.05

 

12,600

82,600

12,520

       

Dec. 31

Dec. 31

   

Dec. 31

   

Balance Sheet

     

2007

2008

   

2009

   
 

Inventory

 

$

70,000

$

88,200

 

$

95,120

   
 

LIFO Reserve

   

-

 

(3,500)

   

(12,520)

   
     

$

70,000

$

84,700

 

$

82,600

   

Journal entry

               
 

Cost of goods sold

   

3,500

   

9,020

   
   

Lifo reserve

   

(3,500)

   

(9,020)

   

Chapter

               

8-51

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Comparison of LIFO Approaches

Specific-goods LIFO - costing goods on a unit basis is expensive and time consuming.

Specific-goods Pooled LIFO approach

and time consuming. Specific-goods Pooled LIFO approach reduces record keeping and clerical costs. more difficult

reduces record keeping and clerical costs. more difficult to erode the layers. using quantities as measurement basis can lead to untimely LIFO liquidations.

Dollar-value LIFO is used by most companies.

SpecialSpecial IssuesIssues RelatedRelated toto LIFOLIFO

Advantages

MatchingIssuesIssues RelatedRelated toto LIFOLIFO Advantages Tax Benefits/Improved Cash Flow Future Earnings Hedge

Tax Benefits/ImprovedRelatedRelated toto LIFOLIFO Advantages Matching Cash Flow Future Earnings Hedge Disadvantages Reduced

Cash Flow

Future Earnings HedgeLIFOLIFO Advantages Matching Tax Benefits/Improved Cash Flow Disadvantages Reduced earnings Inventory understated

Disadvantages

Reduced earningsCash Flow Future Earnings Hedge Disadvantages Inventory understated Physical flow Involuntary Liquidation

Inventory understatedFlow Future Earnings Hedge Disadvantages Reduced earnings Physical flow Involuntary Liquidation / Poor Buying Habits

Physical flowHedge Disadvantages Reduced earnings Inventory understated Involuntary Liquidation / Poor Buying Habits BasisBasis

Involuntary Liquidation / Poor Buying Habits Poor Buying Habits

BasisBasis forfor SelectionSelection ofof InventoryInventory MethodMethod

LIFO is generally preferred:

1. if selling prices are increasing faster than costs and

2. if a company has a fairly constant “base stock.”

LIFO is not appropriate:

1. if prices tend to lag behind costs,

2. if specific identification traditionally used, and

3. when unit costs tend to decrease as production increases.

when unit costs tend to decrease as production increases. Chapter Chapter Chapter 8-52 LO LO 8

Chapter

Chapter

Chapter

8-52

LOLO 88 ExplainExplain thethe dollardollar--valuevalue LIFOLIFO method.method.

8-53

LOLO 99 IdentifyIdentify thethe majormajor advantagesadvantages andand disadvantagesdisadvantages ofof LIFO.LIFO.

8-54

LOLO 1010 UnderstandUnderstand whywhy companiescompanies selectselect givengiven inventoryinventory methods.methods.

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Chapter

8-55