Inventories: Measurement

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InventoriesMeasurement

• Chapter 8

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Inventory

• Those assets that a company

1. Intends to sell in the normal course of
business.
2. Has in production (work in process) for
future sale.
3. Uses currently in the production of goods to
be sold (raw materials).
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Types of Inventories
Types of Inventory
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Inventory Cost Flows
RawMaterials
Work inProcess
FinishedGoods
XX (7)
(1) XX
XX (4)
XX
XX
XX (8)
DirectLabor
Cost of GoodSold
(2) XX
XX (5)
ManufacturingOverhead
XX
(3) XX
XX (6)

• Raw materials purchased
• Direct labor incurred
• Manufacturing overhead incurred
• Raw materials used
• Direct labor applied
• Manufacturing overhead applied
• Work in process transferred to finished goods
• Finished goods sold

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Inventory Methods
Two accounting systems are used to record
transactions involving inventory
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Perpetual Inventory System
Matrix, Inc. purchases on account 600,000 of
merchandise for resale to customers.
Returns of inventory are credited to the
inventory account. Discounts on inventory
purchases can be recorded using the gross or net
method.
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Perpetual Inventory System
Matrix, Inc. sold, on account, inventory with
a retail price of 820,000 and a cost basisof
540,000, to a customer.
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Periodic Cost of Goods Sold Equation
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Periodic Inventory System
Matrix, Inc. purchases on account 600,000 of
merchandise for resale to customers.
Returns of inventory are credited to the Purchase
Returns and Allowances account. Discounts on
inventory purchases can be recorded using the
gross or net method.
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Periodic Inventory System
Matrix, Inc. sold on account, inventory with
a retail price of 820,000 and a cost basisof
540,000, to a customer.
No entry is made to record Cost of Good Sold.
Assuming BeginningInventory of 120,000. A
physical count of Ending Inventory showsa
balance of 180,000. Lets calculate Cost of
Goods Sold atthe end of the accounting period.
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Periodic Inventory System
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Comparison of Inventory Systems
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What is Included in Inventory?

• General Rule
• All goods owned by the company on the inventory
  date, regardless of their location.

Goods in Transit
Goods on Consignment
Depends on FOB shipping terms.
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Expenditures Included in Inventory
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Purchase Discounts
Discount terms are 2/10, n/30.
14,000x 0.02 280
Partial payment not made within the discount
period
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Net Method Using Perpetual and Periodic
Matrix, Inc. purchased on account 6,000 of
merchandise for resale to customers. The
merchandise was purchased subject to a cash
discount of 2/10, n/30. The company incurred 160
in freight-in on the merchandise. Upon
inspection, the company found that 200 of
merchandise was damaged and the seller agreed to
accept the merchandise return and credit the
account of the company. The inventory was sold
for 8,300 on account. Lets look at the journal
entries under both the perpetual and periodic
accounting system assuming Matrix uses the net
method to record merchandise purchases.
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Net Method Using Perpetual and Periodic
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Inventory Cost Flow Methods

• Specific cost identification
• Average cost
• First-in, first-out (FIFO)
• Last-in, first-out (LIFO)

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Specific Cost Identification

• The specific cost of each inventory item must be
  known.
• By selecting specific items from inventory at the
  time of sale, income can be manipulated.

• Items are added to inventory at cost when they
  are purchased.
• COGS for each sale is based on the specific cost
  of the item sold.

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Average Cost Method
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First-In, First-Out

• 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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First-In, First-Out
Even though the periodic and the perpetual
approaches differ in the timing of adjustments to
inventory . . . . . . COGS and Ending Inventory
Cost are the same under both approaches.
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Last-In, First-Out

• 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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Last-In, First-Out

• Unlike FIFO, using the LIFO method may result in
  COGS and Ending Inventory Cost that differ under
  the periodic and perpetual approaches.

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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.
• Is not officially endorsed by the IASC.

• 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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Comparison of Cost Flow Methods
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Comparison of Cost Flow Methods
Inventory Method Used by Major Companies
2003
1973
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Decision Makers Perspective
What factors motivate companies to select one
inventory method over another?
How accurate is the timing of reported income and
income taxes?
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LIFO Liquidation
When prices rise . . .
LIFO inventory costs on the balance sheet are
out of date because they reflect old purchase
transactions.
If inventory declines, these out of date costs
may be charged to current earnings.
This LIFO liquidation results in paper profits.
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LIFO Reserves
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 to LIFO
takes place at the end of the period. The
conversion may look like this
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Gross Profit Ratio
This measure indicates how much of each sales
dollar is left after deducting the cost of goods
sold to cover expenses and provide a profit.
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Inventory Turnover Ratio
Cost of goods sold Average inventory
Inventory turnover ratio

• This ratio measures how many times a companys
  inventory has been sold and replaced during the
  year.

If a companys inventory turnover Is less than
its industry average, it either has excessive
inventory or the wrong sorts of inventory.
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Earnings Quality
Many believe that manipulating income reduces
earnings quality because it can mask permanent
earnings. Inventory write-downs and changes in
inventory method are two additional
inventory-related techniques a company could use
to manipulate earnings.
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End of Chapter 8