CHAPTER 8 INVENTORIES: MEASUREMENT Overview The next two chapters continue our study of assets by investigating the measurement and reporting issues involving inventories and the related expense—cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold. Learning Objectives 1. Explain the difference between a perpetual inventory system and a periodic inventory system. 2. Explain which physical quantities of goods should be included in inventory. 3. Determine the expenditures that should be included in the cost of inventory. 4. Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold. 5. Discuss the factors affecting a company’s choice of inventory method. 6. Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income. 7. Calculate the key ratios used by analysts to monitor a company’s investment in inventories. 8. Determine ending inventory using the dollar-value LIFO inventory method. 9. Discuss the primary difference between U.S. GAAP and IFRS with respect to determining the cost of inventory. TYPES OF INVENTORY Merchandising Companies Merchandise inventory — Goods purchased in finished form for resale. Manufacturing Companies Raw materials — The cost of components purchased from other manufacturers that will become part of the finished product. Work in process — The products that are not yet complete. It includes the cost of raw materials, the cost of labor that can be directly traced to the goods in process, and an allocated portion of other manufacturing costs, called manufacturing overhead. Finished goods — Once the manufacturing process is complete, the costs accumulated in work in process are transferred to finished goods. INVENTORY COST FLOW FOR A MANUFACTURING COMPANY Raw Work in Finished Cost of Materials Process Goods Goods Sold ------------------------- ----------------------- ---------------------- ----------------------- (1) $XX $XX (4) $XX $XX (7) $XX $XX (8) $XX Direct Labor ------------------------- (2) $XX $XX (5) (1) Raw materials purchased (2) Direct labor incurred Manufacturing (3) Manufacturing overhead incurred Overhead (4) Raw materials used ------------------------- (5) Direct labor applied (3) $XX $XX (6) (6) Manufacturing overhead applied (7) Work in process transferred to finished goods (8) Finished goods sold Graphic 8-2 PHYSICAL QUANTITIES INCLUDED IN INVENTORY Generally, physical quantities included in inventory consist of items in the possession of the company. Goods in transit If the goods are shipped f.o.b. (free on board) shipping point, then legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier. If the goods are shipped f.o.b. destination, the seller is responsible for shipping and legal title does not pass until the goods arrive at the customer's location. Goods on consignment Goods on consignment should be included in inventory of the consignor even though not in the company's physical possession. The consignor records a sale only when the consignee sells the goods. Sales Returns A company includes in inventory the cost of merchandise it anticipates will be returned. EXPENDITURES INCLUDED IN INVENTORY The cost of inventory includes all expenditures necessary to bring inventory to its desired condition and location for sale. This includes: The purchase price of goods. Freight charges on incoming goods borne by the purchaser. Insurance costs while the goods are in transit. The costs of unloading, unpacking, and preparing merchandise for sale. Cost is reduced by purchase returns and purchase discounts. COST FLOW ASSUMPTIONS The Browning Company began 2011 with $22,000 of inventory. The cost of beginning inventory (BI) is composed of 4,000 units purchased for $5.50 each. Merchandise transactions during 2011 were as follows: Purchases Date of Purchase Units Unit Cost* Total Cost Jan. 17 1,000 $6.00 $ 6,000 Mar. 22 3,000 7.00 21,000 Oct. 15 3,000 7.50 22,500 Totals 7,000 $49,500 * includes purchase price and cost of freight. Sales Date of Sale Units Jan. 10 2,000 Apr. 15 1,500 Nov. 20 3,000 Total 6,500 Illustration 8-5 Beginning inventory Cost of inventory ($22,000) \ on hand at end of period Cost of goods / ? available + ($71,500) Purchases \ Cost of goods sold ($49,500) / during the period ? Total ending inventory plus cost of goods sold = $71,500 Graphic 8-4 COST FLOW ASSUMPTIONS The average cost method assumes that items sold and items in ending inventory come from a mixture of all the goods available for sale. The first-in, first-out (FIFO) method assumes that items sold are those that were acquired first. Ending inventory consists of the most recently acquired items. The last-in, first-out (LIFO) method assumes that items sold are those that were most recently acquired. Ending inventory consists of the items acquired first. In a periodic system, ending inventory and cost of goods sold are determined using one of the three cost flow assumptions compared on the next slide: COMPARISON OF COST FLOW METHODS The three cost flow methods are compared below assuming a periodic inventory system. AVERAGE FIFO LIFO Cost of goods sold $42,250 $38,500 $46,500 Ending inventory 29,250 33,000 25,000 Total $71,500 $71,500 $71,500 During periods of generally rising costs FIFO cost of goods sold results in a lower cost of goods sold than LIFO. LIFO cost of goods sold will include the more recent higher unit cost purchases. FIFO ending inventory includes the most recent higher cost purchases which results in a higher ending inventory than LIFO. LIFO CONFORMITY RULE If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures that report in a note the effect of using another method on inventory valuation rather than LIFO. Inventories Disclosure — The Great Atlantic & Pacific Tea Company, Inc. Summary of Significant Accounting Policies(in part) Inventories Store inventories are stated principally at the lower of cost or market. As of February 28, 2009, and February 28, 2008, cost of 61.0% and 61.1% of our inventories, respectively, was determined using the first-in, first-out (“FIFO”) method and the cost of 39.0% and 38.9% of our inventories was determined using the last-in, first-out (“LIFO”) method. At February 28, 2009, and February 23, 2008, if valued on a FIFO basis, the LIFO inventory carrying values would have been approximately $10 million and $2 million higher, respectively. Graphic 8-6 LIFO LIQUIDATION PROFIT A decline in inventory quantity results in LIFO liquidation profit in periods of rising costs. National Distributors, Inc., uses the LIFO inventory method. The company began 2011 with inventory of 10,000 units that cost $20 per unit. During 2011 30,000 units were purchased for $25 each and 35,000 units were sold. National’s LIFO cost of goods sold for 2011 consists of: 30,000 units @ $25 per unit = $750,000 5,000 units @ $20 per unit = 100,000 35,000 $850,000 Included in cost of goods sold are 5,000 units from beginning inventory purchased at $20 that have now been liquidated. If the company had purchased at least 35,000 units, no liquidation would have occurred. Then cost of goods sold would have been $875,000 (35,000 units x $25 per unit) instead of $850,000. The difference between these two cost of goods sold figures of $25,000 ($875,000 - 850,000) is the before tax LIFO liquidation profit. Assuming a 40% income tax rate, the net effect of the liquidation is to increase net income by $15,000 [$25,000 x (1 - .40)]. A material effect on net income of LIFO layer liquidation must be disclosed in a note. Illustration 8-6 INTERNATIONAL FINANCIAL REPORTING STANDARDS Inventory Cost Flow Assumptions. IAS NO. 2 does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies employ the use of LIFO only for all or most of their domestic inventories and FIFO or average cost for their foreign subsidiaries. General Mills provides an example with a disclosure note included in a recent annual report: Inventories (in part) All inventories in the United States other than grain are valued at the lower of cost, using the last-in, first-out (LIFO method, or market… Inventories outside of the United States are valued at the lower of cost, using the first-in, first-out (FIFO) method, or market. This difference could prove to be a significant impediment to U.S. convergence to international standards. Unless the U.S. Congress repeals the LIFO conformity rule, convergence would cause many corporations to lose a valuable tax shelter, the use of LIFO for tax purposes. If these companies were immediately taxed on the difference between LIFO inventories and inventories valued using another method, it would cost companies billions of dollars. Some industries would be particularly hard hit. Most oil companies and auto manufacturers, for instance, use LIFO. As an example, it would cost Exxon Mobil over $4 billion. The companies affected most certainly will lobby heavily to retain the use of LIFO for tax purposes. DECISION MAKERS’ PERSPECTIVE — SUPPLEMENTAL LIFO DISCLOSURES Supplemental LIFO disclosures can be used to convert LIFO inventory and cost of goods sold amounts. The Great Atlantic & Pacific Tea Company, Inc For the Year Ended February 28, February 23, ($ in millions) 2009 2008 Balance sheets: Inventories $474 $505 Income statements: Net sales 9,516 6,401 Cost of goods sold 6,613 4,431 The Great Atlantic & Pacific Tea Company (GAPT) uses a combination of LIFO and FIFO cost methods to value its inventory. We can convert GAPT's inventory and cost of goods sold to a 100% FIFO basis before comparing to a competitor by using the information provided in Graphic 8-6 (Slide T8-15). ($ in millions) 2009 2008 Inventories (as reported) $474 $505 Add: Conversion to FIFO 10 2 Inventories (100% FIFO) $484 $507 Cost of goods sold for 2009 would have been $8 million lower had GAPT used FIFO instead of LIFO for its LIFO inventories. While beginning inventory would have been 2 million higher, ending inventory also would have been higher by $10 million. An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. DECISION MAKERS’ PERSPECTIVE — FINANCIAL ANALYSIS The gross profit ratio indicates the percentage of each sales dollar available to cover other expenses and provide a profit. The inventory turnover ratio helps to evaluate a company's effectiveness in managing its investment in inventory. Gross profit ratio = Gross profit Net sales Inventory turnover ratio = Cost of goods sold Average Inventory DOLLAR-VALUE LIFO (DVL) Many LIFO applications are based on this approach. Inventory is viewed as a quantity of value instead of a physical quantity of goods. The DVL inventory pool is viewed as comprising layers of dollar value from different years. An inventory pool is identified in terms of economic similarity rather than physical similarity (subject to the same cost change pressures). DVL simplifies the recordkeeping procedures because no information is needed about unit flows. DVL minimizes the probability of the liquidation of LIFO inventory layers, through the aggregation of many types of inventory into larger pools. COST INDEXES Under unit LIFO we determine whether a new LIFO layer was added by comparing the ending quantity with the beginning quantity. Under DVL we determine whether a new LIFO layer was added by comparing the ending dollar amount with the beginning dollar amount. However, if the cost level has changed, we need a way to determine whether an increase observed is a real increase or one caused by an increase in costs. So before we compare the beginning and ending inventory amounts, we need to deflate the ending inventory amount by any increase in costs so that both the beginning and ending amounts are based on the same level of costs. We accomplish this by using cost indexes. A cost index for a particular layer year is determined as follows: Cost in layer year Cost index in layer year = Cost in base year The cost index for the base year (the year DVL is initially adopted) is set at 100.
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