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					                                 CHAPTER 8
                          INVENTORIES: MEASUREMENT

   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.
 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.

     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

   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.
   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
        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.
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:

         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.

       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              /
             +                   ($71,500)

                                                                      Cost of goods sold
         ($49,500)                                         /          during the period
                                                                   Total ending inventory plus
                                                                  cost of goods sold = $71,500

                                                                                        Graphic 8-4
   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:
 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
     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)
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
    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

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.
   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.
   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

   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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