Inventories: Cost Measurement and Flow Assumptions

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Inventories Cost Measurement and Flow
Assumptions
An electronic presentation by Douglas Cloud
Pepperdine University
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Objectives

• 1. Describe how inventory accounts are
  classified.
• 2. Explain the uses of perpetual and periodic
  inventory systems.
• 3. Identify how inventory quantities are
  determined.
• 4. Determine the cost of inventory.
• 5. Compute ending inventory and cost of goods
  sold under specific identification, FIFO, average
  cost, and LIFO.

Continued
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Objectives
6. Explain the conceptual issues regarding
alternative inventory cost flow assumptions.
7. Understand dollar-value LIFO. 8. Explain
additional LIFO issues. 9. Understand inventory
disclosures. 10. Record foreign currency
transactions involving inventory (Appendix).
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Flow of Inventory Costs
Merchandising Company
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Flow of Inventory Costs
Manufacturing Company
Continued
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Flow of Inventory Costs
Manufacturing Company
Continued
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Flow of Inventory Costs
Manufacturing Company
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Alternative Inventory Systems
A company using a perpetual system maintains a
continuous record of the physical quantities in
its inventory.
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Alternative Inventory Systems
A company using a periodic system does not
maintains a continuous record of the physical
quantities on hand.
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Computation of Net Purchases

• Purchases
• Freight-in
• - Purchases Returns and Allowances
• - Purchases Discounts Taken
• Net Purchases

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Comparison of Systems
Perpetual Inventory System
Periodic Inventory System
Beginning inventory Purchases (net) - Goods
Sold Ending Inventory
Beginning inventory Purchases (net) - Ending
Inventory Goods Sold
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FOB Shipping Point
Goods being shipped included in inventory of
buyer.
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FOB Destination
Goods being shipped included in inventory of
seller.
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Determination of Inventory Costs

• Price paid or consideration given
• Freight-in
• Receiving
• Unpacking
• Inspecting
• Storage
• Insurance
• Sales and other applicable taxes

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Purchases Discounts
Under the gross price method, a company records
the purchase at the gross price, and records the
amount of the discount in the accounting system
only if the discount is taken.
Under the net price method, a company records
the purchase at its net price, and records the
amount of the discount in the accounting system
only if the discount is not taken.
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Gross Price Method
To record the purchase
Inventory (or Purchases) 1,000 Accounts
Payable 1,000
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Gross Price Method
To record payment within the discount period
Accounts Payable 1,000 Purchases Discounts
Taken 10 Cash 990
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Gross Price Method
To record payment after the discount period
Accounts Payable 1,000 Cash 1,000
No adjusting entry is required.
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Net Price Method
To record the purchase
Inventory (or Purchases) 990 Accounts
Payable 990
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Net Price Method
To record payment within the discount period
Accounts Payable 990 Cash 990
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Net Price Method
To record payment after the discount period
Accounts Payable 990 Purchases Discounts
Lost 10 Cash 1,000
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Purchases Discounts
A company purchases 1,000 of goods under terms
of 1/10, n/30.
Net Price Method
Adjusting entry at the end of period if discount
has expired and invoice is unpaid
Purchases Discounts Lost 10 Accounts Payable 10
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Specific Identification
100 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
80 units _at_ 11 per unit
70 units _at_ 12 per unit
On April 27, sold 90 units from the beginning
inventory and 50 units from the April 10 purchase.
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Specific Identification
Ending Inventory
10 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
30 units _at_ 11 per unit
70 units _at_ 12 per unit
On April 27, sold 90 units from the beginning
inventory and 50 units from the April 10 purchase.
Beg. Inv. Purchases - End. Inv. Cost of Goods
Sold
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First-In, First-Out (FIFO)
100 units _at_ 10 per unit
0 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
80 units _at_ 11 per unit
40 units _at_ 11 per unit
70 units _at_ 12 per unit
Sold 140 units on April 27.
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First-In, First-Out (FIFO)
Ending Inventory
0 440 840 1,280
Sold 140 units on April 27.
Beg. Inv. Purchases - End. Inv. Cost of Goods
Sold
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Average Cost
Periodic System
1,000 880 840 2,720
250 units
2,720 ? 250 units 10.88
Sold 140 units during April.
Beg. Inv. Purchases - End. Inv. Cost of Goods
Sold
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Moving Average
Apr. 1 Beginning Inventory 100 units _at_
10 1,000 Apr. 10 Purchases 80 units _at_ 11
880 Apr. 10 Balance 180 units _at_ 10.44 1,880
Apr. 18 Sales -90 units _at_ 10.44 -940 Apr.
18 Balance 90 units _at_ 10.44 940 Apr.
20 Purchases 70 units _at_ 12
840 Apr. 20 Balance 160 units _at_ 11.125 1,780
Apr. 27 Sales -50 units _at_ 11.125 -556 Apr.
30 Balance 110 units _at_ 11.125 1,224
Cost of Goods Sold (140 units) 940
556 1,496 Ending Inventory (110 units _at_
11.125) 1,224
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Last-In, First-Out (LIFO)
Periodic Inventory System
100 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
80 units _at_ 11 per unit
10 units _at_ 11 per unit
0 units _at_ 12 per unit
70 units _at_ 12 per unit
Sold 140 units during April.
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Last-In, First-Out (LIFO)
Periodic Inventory System
100 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
10 units _at_ 11 per unit
0 units _at_ 12 per unit
Ending inventory..
Sold 140 units during April.
Beg. Inv. Purchases - End. Inv. Cost of Goods
Sold
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Last-In, First-Out (LIFO)
Perpetual Inventory System
90 units _at_ 10 per unit
100 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
80 units _at_ 11 per unit
0 units _at_ 11 per unit
80 units _at_ 11 per unit
70 units _at_ 12 per unit
Sold 90
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Last-In, First-Out (LIFO)
Perpetual Inventory System
90 units _at_ 10 per unit
Apr. 1 Apr. 10 Apr. 20
0 units _at_ 11 per unit
20 units _at_ 12 per unit
Ending inventory..
Beg. Inv. Purchases - End. Inv. Cost of Goods
Sold
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Comparison of Inventory Assumptions
Cost of Goods Cost of Available
Goods Ending for Sale
Sold Inventory
Cost Flow Assumption and Method
FIFO, periodic 2,720 1,440 1,280 FIFO,
perpetual 2,720 1,440 1,280 Weighted
average 2,720 1,523 1,197 Moving
average 2,720 1,496 1,224 LIFO,
periodic 2,720 1,610 1,110 LIFO,
perpetual 2,720 1,580 1,140
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Holding Gains Comparisons
Per Unit
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Liquidation of LIFO Layers
10,000 units at 20 per unit
200,00 132,000 192,000
120,000 644,000
2000 2001 2002 2003
6,000 units at 22 per unit
8,000 units at 24 per unit
4,000 units at 30 per unit
Inventory, January 1, 2004.
In 2004 the company purchases 50,000 units at 35
per unit and sells 60,000 units.
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Liquidation of LIFO Layers
10,000 units at 20 per unit
2000 2001 2002 2003 2004
200,00 132,000 192,000 120,000 1,750,00
0
6,000 units at 22 per unit
Sold 6,000
8,000 units at 24 per unit
6,000 units at 24 per unit
Sold 4,000
4,000 units at 30 per unit
4,000 units at 30 per unit
Sold 50,000
50,000 units at 35 per unit
50,000 units at 35 per unit
In 2004 the company purchases 50,000 units at 35
per unit and sells 60,000 units.
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Liquidation of LIFO Layers
10,000 units at 20 per unit
2000 2001 2002
6,000 units at 22 per unit
2,000 units at 24 per unit
144,000 120,000 1,750,000 2,014,000
6,000 units at 24 per unit
2002 2003 2004
4,000 units at 30 per unit
50,000 units at 35 per unit
Cost of goods sold
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Difficulties in Applying Simple LIFO

• 1. The LIFO method requires a company to keep
  numerous detailed records.
• 2. Fluctuations in the physical quantities of
  similar inventory items may occur.
• 3. As technological changes take place, inventory
  made up with one material is replaced by
  inventory made with substitute materials or an
  outdated design is replaced by a newer design.

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Dollar-Value LIFO
Step 1 Value the total ending inventory at
current-year costs.
01/1/03 10,000 12/31/03 12,100 12/31/04 13,125
12/31/05 16,800 12/31/06 12,360
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Dollar-Value LIFO
Step 2 Convert (roll back) the ending inventory
cost to base-year cost
12/31/03 12,100 12/31/04 13,125 12/31/05 16,800
12/31/06 12,360
x 100/110 11,000 x 100/125
10,500 x 100/140 12,000 x 100/120 10,300
Base Year Cost Index
Ending Inventory at Current Cost
12/31/03
x
Current Cost Index
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Dollar-Value LIFO
Step 3 Compute the change in the inventory
level for the year at base-year costs.
11,000 - 10,000
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
1,000
Base year, 10,000
12/31/03
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Dollar-Value LIFO
Step 4a If there has been an increase, convert
this increase to current-year costs.
1,000
x 110/100 1,100 x 100/100 10,000
Base year, 10,000
12/31/03
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Dollar-Value LIFO
Step 2 Convert the ending inventory cost to
base-year cost
12/31/03 12,100 12/31/04 13,125 12/31/05 16,800
12/31/06 12,360
x 100/110 11,000 x 100/125
10,500 x 100/140 12,000 x 100/120 10,300
Base Year Cost Index
Ending Inventory at Current Cost
12/31/04
x
Current Cost Index
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Dollar-Value LIFO
Step 3 Compute the change in the inventory
level for the year at base-year costs.
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
11,000 - 10,500
1,000
Base year, 10,000
12/31/04
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Dollar-Value LIFO
Step 3 Compute the change in the inventory
level for the year at base-year costs.
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
500
Base year, 10,000
12/31/04
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Dollar-Value LIFO
Step 4b If there is a decrease, this decrease
reduces the inventory.
500
x 110/100 550 x 100/100 10,000
Base year, 10,000
12/31/04
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Dollar-Value LIFO
Step 2 Convert the ending inventory cost to
base-year cost
12/31/03 12,100 12/31/04 13,125 12/31/05 16,800
12/31/06 12,360
x 110/100 11,000 x 100/125
10,500 x 100/140 12,000 x 100/120 10,300
Base Year Cost Index
Ending Inventory at Current Cost
12/31/05
x
Current Cost Index
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Dollar-Value LIFO
Step 3 Compute the change in the inventory
level for the year at base-year costs.
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
12,000 - 10,500 1,500
500
Base year, 10,000
12/31/05
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Dollar-Value LIFO
Step 3 Compute the change in the inventory
level for the year at base-year costs.
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
1,500
500
Base year, 10,000
12/31/05
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Dollar-Value LIFO
Step 4a Convert increase to current-year costs.
x 140/100 2,100 x 110/100 550 x
100/100 10,000 12,650
1,500
500
Base year, 10,000
12/31/05
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Dollar-Value LIFO
Step 2 Convert the ending inventory cost to
base-year cost
12/31/03 12,100 12/31/04 13,125 12/31/05 16,800
12/31/06 12,360
x 110/100 11,000 x 100/125
10,500 x 100/140 12,000 x 100/120 10,300
Base Year Cost Index
Ending Inventory at Current Cost
12/31/06
x
Current Cost Index
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Dollar-Value LIFO
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
1,500
500
Base year, 10,000
12/31/06
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Dollar-Value LIFO
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
500
Base year, 10,000
12/31/06
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Dollar-Value LIFO
11,000 10,500 12,000 10,300
12/31/03 12/31/04 12/31/05 12/31/06
300
Base year, 10,000
12/31/06
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Dollar-Value LIFO
Step 4a Convert increase to current-year costs.
x 110/100 330 x 100/100
10,000 10,330
300
Base year, 10,000
12/31/06
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Determination of Cost Index
Sample of Ending Inventory at Current -Year Costs
x 100
Cost Index
Sample of Ending Inventory at Base-Year Costs
Double-Extension Method
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Determination of Cost Index
Sample of Ending Inventory at Current -Year Costs
Previous-Year Cost Index
x
Cost Index
Sample of Ending Inventory at Previous-Year Costs
Link-Chain Method
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Disclosure of Inventory Values and Methods

Number of Companies Methods
2000 1997
First-in, first-out (FIFO) 386 415 Last-in,
first-out (LIFO) 283 326 Average
cost 180 188 Other 38 32 887 961
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Disclosure of Inventory Values and Methods

Number of Companies Use of LIFO
2000 1997
All inventories 23 17 50 or more
inventories 148 326 Average cost 180 170 Less
than 50 of inventories 82 99 Not
determinable 30 40
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Foreign Currency Transactions Involving Inventory
A U.S. company purchases inventory of electronic
components from a Japanese company for 50 million
yen () when the exchange rate is 0.008.
50,000,000 x 0.008 400,000
Inventory (or Purchases) 400,000 Cash 400,000
Click button to skip Appendix material.
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Foreign Currency Transactions Involving Inventory

• 1. An exchange gain occurs when the exchange rate
  declines between the date a payable is recorded
  as a result of a purchase of inventory and the
  date of the cash payment.
• 2. An exchange gain occurs when the exchange rate
  increases between the date a receivable is
  recorded as a result of a sale of inventory and
  the date of the cash receipt.

When exchange rates are stated in terms of per
unit of foreign currency, exchange gains and
losses occur for purchases or sales on account as
follows
Continued
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Foreign Currency Transactions Involving Inventory
3. An exchange loss occurs when the exchange rate
increases between the date a payable is recorded
as a result of a purchase of inventory and the
date of the cash payment. 4. An exchange loss
occurs when the exchange rate declines between
the date a receivable is recorded as a result of
a sale of inventory and the date of the cash
receipt.
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Foreign Currency Transactions Involving Inventory
Assume that the exchange rate on the date of
payment is 0.0078. The U.S. company has to pay
only 390,000.
50,000,000 x 0.0078 390,000
Accounts Payable 400,000 Cash 390,000
Exchange Gain 10,000
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Foreign Currency Transactions Involving Inventory
A U.S. company sells computer equipment (cost,
100,000) to Swiss Company on account and the
agreed price is 300,000 francs. On the date of
the sale, the exchange rate is 0.60.
300,000 x 0.60 180,000
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Foreign Currency Transactions Involving Inventory
If the exchange rate is 0.67 when Swiss Company
pays the amount owed, the U.S. company can
convert those francs into only 174,000.
300,000 x 0.58 174,000
Cash 174,000 Exchange Loss 6,000 Accounts
Receivable 180,000
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