Intermediate Accounting November 22nd, 2010

1. 2. 3. 4. 5. General Course Questions Return Discussion Question #4 Revenue Recognition Turn in Columbia Sportswear Annual Report Projects Discuss Final Group Project Chapter 8 Inventory (using assigned homework) A. When is it Inventory (Ex 1, 3, 5) B. Inventory Errors (BE 4 and exercise 5) C. Inventory Costing Methods (Specific Identification, FIFO, LIFO, Weighted/Moving Average) ?12,13,16. BE 5,6,7, P 6

D. Other Inventory Topics (? 3 , 5, 10)

E. Dollar Value LIFO, LIFO effect, LIFO reserve (Ex 21)
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What is Included in Inventory?

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

Ex 1, 3 and 5

What is Included in Inventory?

Report inventory units at the lower of cost or market (conservatism). What is included in cost for:
- Retailer: - Manufacturing Company:

What is Included in Inventory?

Report inventory units at the lower of cost or market (conservatism). What is included in cost for:
- Merchandiser: items held for sale (Finished Goods) - Manufacturing Company: items held for sale (Finished Goods) goods to be used in production (Raw Materials) goods in production (Work in Process)

Inventory Cost Flow

Merchandiser vs. Manufacturing Co.

Costs Included in Inventory?

Product Costs - costs directly connected with bringing the goods to the buyers place of business and converting such goods to a salable condition. Period Costs generally selling, general, and administrative expenses. Purchase Discounts Gross vs. Net Method (? 10) Product Financing (Question 5)

Purchase Discounts: Gross or Net

Illustration 8-11

**

* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Question 10

Solution on notes page

Purchase Discounts: Gross or Net

Illustration 8-11

**

* $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Solution on notes page

Inventory Cost Flow Perpetual vs. Periodic System

Perpetual vs. Periodic System

Perpetual Method
Purchases are debited to Inventory account Freight-in, Purchases Returns & Allowances and Purchase Discounts are recorded in the Inventory account. Debit COGS and credit Inventory account for each sale.
The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.

Periodic Method
Purchases are debited to Purchases account. Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts. COGS is computed only periodically: Cost of Goods Available Ending Inventory = Cost of Goods Sold
Ending Inventory is determined only by physical count at the end 10 of the period.

Inventory System - Perpetual

Purchase of Inventory: Dr. Inventory 1,000 Cr. A/P, Cash, etc. 1,000 Purchase Returns, Purchases Discounts Dr. A/P 100 Cr. Inventory 100 Transportation In Dr. Inventory 100 Cr. A/P, Cash, etc. 100 Sale of Inventory: Dr. Cost of Goods Sold 1,000 Cr. Inventory 1,000 Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: no j/e required, unless errors are found in inventory count 11 (physical inventory = perpetual inventory, than adjust to physical

Inventory System - Periodic

Purchase of Inventory: Dr. Purchases 1,000 Cr. A/P, Cash, etc. 1,000 Purchase Returns, Purchases Discounts Dr. A/P 100 Cr. Purchases Returns or Purchases Discounts 100 Transportation In Dr. Transportation In 100 Cr. A/P, Cash, etc. 100 Sale of Inventory: Dr. Cash, A/R, etc. 1,500 Cr. Sales Revenue 1,500 At Year-End: Dr. Ending Inventory (determined by count) 38,000 Dr. Cost of Sales (plug) 283,000 Dr. Purchase Returns and Purchase Discounts (close balance) Cr. Purchases (also close Transportation In) 286,000 Cr. Opening Inventory (carried forward from prior year) 35,000
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Inventory Control Physical Count

All companies need periodic verification of the inventory records by actual count, weight, or measurement, with the counts compared with the detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, to properly report inventory quantities in their annual accounting reports.

Question 3

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Effect of Inventory Errors

Error in Ending Inventory
Understated

Effect on Income Items

COGS (over) Net income (under)

Effect on Balance sheet Items

Inventory (under) Retained Earn (under)

Overstated

COGS (under) Net income (over)

Inventory (over) Retained Earn (over)

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Effect of Inventory Errors (U/S Ending)

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Cost Flow Assumptions

Cost flow assumptions DO NOT Need to be consistent with physical flow of goods. The objective is to most clearly reflect periodic income.
The cost flow assumptions are: 1 Specific identification 2 Average cost 3 First-in, first-out (FIFO) and 4 Last-in, first-out (LIFO) (prohibited under IFRS)

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Cost Flow Assumptions: Example

Spaworld reports the following transactions for 2010 (assume no opening inventory): Date Purchases Cost/Unit Purchase Cost May 12 100 units @ $10/unit = $1,000 Aug 14 200 units @ $11/unit = 2,200 Sep 18 120 units @ $15/unit = 1,800 420 units $5,000 On December 31, the company had 20 units on hand and uses the periodic inventory system. What is the cost of goods sold? What is the cost of ending inventory?
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Average Cost Method

Date May 12 Aug 14 Sep 18 Purchases 100 units 200 units 120 units 420 units Dec. 31 Ending inventory 20 units
Steps: 1. Calculate per unit average cost: use four places to right of decimal 2. Apply this per unit average cost to units sold to get COGS:
round to nearest dollar

Cost $1,000 $2,200 $1,800 $5,000

3. Apply the per unit average cost to units remaining in inventory to determine Ending inventory: round to nearest dollar
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Average Cost Method

Date May 12 Aug 14 Sep 18 Purchases 100 units 200 units 120 units 420 units Dec. 31 Ending inventory 20 units Cost $1,000 $2,200 $1,800 $5,000

1. Calculate per unit average cost: use four places to right of decimal

Cost per unit: $5000/420 = 11.9047 per unit

2. Apply this per unit average cost to units sold to get COGS:
round to nearest dollar

11.9047 x 400 = $4,762 COGS

3. Apply the per unit average cost to units remaining in inventory to determine Ending inventory: round to nearest dollar
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11.9047 x 20 = $238 ending inventory

Year End Entry Average Cost

Journal Entry (Periodic Inventory):

20 20

Year End Entry Average Cost

Journal Entry:
Dr. Dr. Cr. Cr. Ending Inventory 238 Cost of Sales 4,762 Purchases Opening Inventory

5,000 0

21 21

First-In, First-Out (FIFO) Method

Given data: Date Purchases May 12 100 units @ $10 Aug 14 200 units @ $11 Sep 18 120 units @ $15 420 Ending Inventory 20 units Cost $1,000 $2,200 $1,800 $5,000 Ending Inventory (FIFO)

Cost of goods sold (FIFO)

Count from one direction and plug the other GAFS

COGS
EI
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$5,000

First-In, First-Out (FIFO) Method

Given data: Date Purchases May 12 100 units @ $10 Aug 14 200 units @ $11 Sep 18 120 units @ $15 420 Ending Inventory 20 units Cost $1,000 $2,200 $1,800 $5,000

Ending Inventory (FIFO) 20 x $15 = $300

Cost of goods sold (FIFO) 100 units @ $10 $1,000 200 units @ $11 $2,200 100 units @ $15 $1,500

Count from one direction and plug the other GAFS

COGS
EI

$4,700
$300
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$5,000

Last-In, First-Out (LIFO) Method

Given data: Date Purchases May 12 100 units @ $10 Aug 14 200 units @ $11 Sep 18 120 units @ $15 420 Ending Inventory 20 units Cost $1,000 $2,200 $1,800 $5,000 Ending Inventory (FIFO)

Cost of goods sold (FIFO)

Count from one direction and plug the other GAFS

COGS
EI
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$5,000

Last-In, First-Out (LIFO) Method

Given data: Date Purchases May 12 100 units @ $10 Aug 14 200 units @ $11 Sep 18 120 units @ $15 420 Ending Inventory 20 units Cost $1,000 $2,200 $1,800 $5,000 Ending Inventory (FIFO) 20 x $10 = $200

Cost of goods sold (FIFO) 80 units @ $10 $ 800 200 units @ $11 $2,200 120 units @ $15 $1,800

Count from one direction and plug the other GAFS

COGS
EI

$4,800 $200
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$5,000

Cost Flow Assumptions: Notes

The ending inventory in units is the same in all three methods: the cost is different The cost of goods available is the same for all methods The cost of goods sold and the cost of ending inventory are different In periods of rising prices, LIFO would result in the smallest reported net income.
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Periodic vs. Perpetual

FIFO: COGS and EI numbers are exactly the same under either periodic or perpetual systems BUT LIFO, Weighted Average will give you different numbers
Under perpetual LIFO, with each sale, you cut into only existing layers (so you must stop and calculate the cost of goods sold at each sale) Under perpetual Weighted Average (more accurately, Moving Average), you stop and calculate a new average cost for every sale
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Same Example - Perpetual Basis

Purchased Unit Total Units Cost Cost 12-May 100 10 1000 1-Jun 14-Aug 200 11 2200 1-Sep 18-Sep 120 15 1800 20-Sep 420 5000 Unit Extended Cost Value 10 850 10 150 11 935 11 1265 15 1500 4700 Units Sold 85 100 215 400 Unit Extended Cost Value 10 850 11 1100 15 1800 11 1045 4795 10 11 150 55 205
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FIFO: Units 1-Jun 85 1-Sep 15 85 20-Sep 115 100 COGS 400 EI

LIFO: Units 1-Jun 85 1-Sep 100 20-Sep 120 95 COGS EI 400 15 5

20 15 300 Same as Periodic

Different from Periodic

Same Example - Perpetual Basis

Purchased Unit Extended Units Cost Cost 12-May 100 10 1000 1-Jun 14-Aug 200 11 2200 1-Sep 18-Sep 120 15 1800 20-Sep 420 5000 Sold Units 85 100 215 400

Calculate the average cost at time of each sale Wt. Av. Units 1-Jun 85 1-Sep 100 20-Sep 215 Unit Extended Cost Value 10 850 10.9 1093.02 13 2796.81 0 0 4739.83 13 260.168 1-Sep costs to date costs expensed 0 Av Cost

3200 850 2350 215 10.9

COGS EI

400 20

Different from Periodic

Sept. 20 Costs to date 5000 Costs expensed 1943 Remaining costs 3057 Remaining units 235 Av cost 13

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Advantages of LIFO Method

LIFO matches more recent costs with current revenues. With increasing prices:
LIFO yields the lowest taxable income (assuming inventory does not decrease). Under LIFO, there is less need to write down inventory down to market

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Special Issues Related to LIFO: Setting up a LIFO Reserve

LIFO Reserve (Allowance) account is used, when:

LIFO is used for tax & external financial reporting purposes

FIFO, average cost, or standard cost system for internal reporting purposes.
Reasons: 1. Pricing decisions 2. Record keeping easier 3. Profit-sharing or bonus arrangements 4. LIFO troublesome for interim periods

SEC reporting requirements disclose the difference between LIFO and current cost of inventory reported on the Balance Sheet which is the LIFO RESERVE

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LIFO Reserve: Example

Jeppo Inc reports the following balances: Inventory (FIFO basis) on Dec 31, 2004: Inventory (LIFO basis) on Dec 31, 2004:

$50,000 $20,000

Adjust the cost of ending inventory to the LIFO basis Dr. Cost of goods sold $30,000 Cr. Allowance to Reduce Inventory to LIFO $30,000 Balance Sheet (Assets): Inventory (FIFO) less: Allowance to Reduce Inventory Inventory (LIFO) basis $50,000 ($30,000) 32 $20,000

LIFO Layers
Under the LIFO approach, a business may build up layers of inventory from prior periods. A layer liquidation occurs, when:
Earlier costs are matched against current sales due to a reduction of quantities of inventory during a period (results in costing items at older prices) Such matching results in distorted income.
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Disadvantages of LIFO Method

LIFO yields the lowest net income and therefore reduced earnings (with increasing prices) Under LIFO, the ending inventory is understated relative to current costs LIFO liquidation (reduction of quantities of inventory during a period results in costing items at older prices):
May result in income that is detrimental from a tax view May cause poor buying habits (because of the layer liquidation problem)

LIFO Conformity Rule: if you use LIFO for tax purposes, you must use it for financial reporting also.
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Dollar Value LIFO

Dollar value LIFO applies LIFO procedures to pools of similar goods based on dollars rather than units Used for external purposes (i.e., financial statements and taxes) Advantages over regular LIFO:
Reduces record keeping (maximum of one layer per year). Mitigates likelihood of eroding old layers (some decreases in goods in the pool are offset by increases in other goods in the pool).

Price index a measure of the change in prices from a base year (the year dollar value LIFO is adopted in this case) to the current year Internal = Ending inventory quantities X current year costs Ending inventory quantities X base year costs External calculated by the Bureau of Labor Statistics
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Dollar Value LIFO Calculation Steps

Compare ending inventory at base year prices to beginning of year inventory, also at base year prices if there is an increase we add a new LIFO layer at Current Year prices:
1. 2. 3. 4. Calculate Ending Inventory at current year costs (FIFO) Calculate or locate the current year price index. Convert the ending inventory at current cost to inventory at base-year cost by dividing the current year cost by the current price index (1 / 2 ) Split the ending inventory at current cost into layers depending on the year the items were acquired by comparing current inventory at base prices to prior inventory at base prices. If there is an increase add an additional layer. If there is a decrease deduct from the most recently purchased layer. Once a layer is eliminated (peeled off), it can not be rebuilt. Multiply each layer by the appropriate price index (price index of the year of acquisition) to obtain the quantity in ending inventory at dollarvalue LIFO cost.

5.

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Dollar Value LIFO: Example

Given: Base layer (Dec 31, 2009): $20,000 Inventory (current prices) Dec 31, 2010: $26,400 Prices increased 20% during 2010.
Determine dollar value LIFO at Dec 31,
2010
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Dollar Value LIFO: Example

Price increase, 20%
Dec 31, 2009 Dec 31, 2010

At base $: $22,000

$26,400 / 1.20

At EOY prices: $26,400

Dollar value LIFO Inventory

Net increase at base $: $22,000 less $2,000 * 1.20 $20,000

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Restate at current $: $2,400 (layer added)

$20,000 plus $2,400 = $22,400

Dollar Value LIFO: Notes

When the ending inventory (at base year prices) is less than the beginning inventory (at base year prices) (i.e. in the example above if EI at base year prices was < $20,000):
the decrease must be subtracted from the most recently added layer. Once a layer is eliminated (peeled off), it cannot be rebuilt.
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