Chapter 8
Inventories: Cost
Measurement and Flow
Assumptions
Intermediate Accounting 11th edition
Nikolai Bazley Jones
An electronic presentation
By Norman Sunderman
and Kenneth Buchanan
Angelo State University
COPYRIGHT © 2010 South-Western/Cengage Learning
2
Objectives
1. Describe how inventory accounts are
classified.
2. Explain the uses of the 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.
3
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).
4
Merchandising Company
Flow of
Inventory
Costs
Manufacturing Company
5
Flow of Inventory Costs
Merchandising Company
Accounts Payable
(or Cash)
Goods
Purchased
Cost of
Goods Sold
Merchandise
Inventory
Goods
Sold
6
Flow of Inventory Costs
Manufacturing Company
Accounts Payable
(or Cash)
Raw Materials
Inventory
Materials
Purchased
Materials
Used in
Production
Continued
To Work
in Process
Inventory
7
Flow of Inventory Costs
Manufacturing Company
Direct Labor
Actual
Direct
Labor
Manufacturing
(Factory)
Overhead
Actual
Mfg.
Overhead
To Work
in Process
Inventory
Labor Charged
to Production
To Work
in Process
Inventory
Overhead Applied
to Production
Continued
8
Flow of Inventory Costs
Manufacturing Company
Work in Process
Inventory
Materials Used
Direct Labor
Overhead Applied
Finished Goods
Inventory
Goods Finished
(Manufactured)
Goods Sold to
Cost of Goods Sold
9
Alternative Inventory Systems
A company using a perpetual
system maintains a continuous
record of the physical quantities in
its inventory.
10
Alternative Inventory Systems
A company using a periodic
system does not maintain a
continuous record of the physical
quantities of inventory on hand.
11
Computation of Net Purchases
+
–
–
=
Purchases
Freight-in
Purchases Returns and
Allowances
Purchases Discounts Taken
Net Purchases
12
Comparison of Systems
Perpetual
Inventory System
Beginning Inventory
+ Purchases (net)
– Goods Sold
= Ending Inventory
Periodic
Inventory System
Beginning Inventory
+ Purchases (net)
– Ending Inventory
= Goods Sold
13
Who Owns the Inventory?
14
Determination of Inventory Costs
 Price paid or
consideration given
 Freight-in
 Receiving
 Unpacking
 Inspecting
 Storage
 Insurance
 Applicable taxes
15
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.
16
Purchases Discounts: Gross Price Method
A company purchases $1,000 of
goods under terms of 1/10, n/30.
To record the purchase:
Inventory (or Purchases)
Accounts Payable
1,000
1,000
To record payment within the discount period:
Accounts Payable
Purchases Discounts Taken
Cash
1,000
10
990
To record payment outside the discount period:
Accounts Payable
Cash
1,000
1,000
17
Purchases Discounts: Net Price Method
Purchases Discounts Lost are treated as a financing
A company purchases $1,000 of
expense in the Other Items section of the income
goods under terms of 1/10, n/30.
statement.
To record the purchase:
Inventory (or Purchases)
Accounts Payable
990
990
To record payment within the discount period:
Accounts Payable
Cash
990
990
To record payment outside the discount period:
Accounts Payable
Purchases Discounts Lost
Cash
990
10
1,000
18
Purchases Discounts: Net Price Method
A company purchases $1,000 of
goods under terms of 1/10, n/30.
Net Price Method
Adjusting entry at end of period if discount has
expired and invoice is unpaid:
Purchases Discounts Lost
Accounts Payable
10
10
19
Annual Rate on Discounts
A company purchases $1,000 of goods under terms
of 2/10, n/30. What is the annual discount rate?
If the company does not pay promptly, it is forfeiting
2% in order to keep the money for an additional 20
days.
The company can forfeit this discount 18 times
during a year. (360 days/20 additional each time =
18)
2% forfeited 18 times equals an annual interest rate
of 36%
20
Specific Identification
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
80 units @ $11 per unit
70 units @ $12 per unit
On April 27, 90 units were sold from the
beginning inventory and 50 units from the
April 10 purchase.
21
Specific Identification
Apr. 1
Apr. 10
Apr. 20
100
10 units @ $10 per unit
80 units @ $11 per unit
30
70 units @ $12 per unit
=
=
=
Ending Inventory…………
$ Sold
100 90
Sold
330 50
Sold
840 0
$1,270
Apr. 1
90 units @ $10 per unit
=
$ 900
Apr. 10
Apr. 20
50 units @ $11 per unit
=
550
0 units @ $12 per unit
=
0
Cost of Goods Sold……….
$1,450
22
Specific Identification
=
=
=
70 units @ $12 per unit
Goods Available for Sale…
$ 1,000
880
840
$2,720
=
=
Apr. 10
Apr. 20
70 units @ $12 per unit =
Ending Inventory…………
of Goods
Sold………..
CostCost
of Goods
Sold………….
$ 100
330
840
$1,270
$1,480
Apr. 1
Apr. 10
Apr. 20
Apr. 1
100 units @ $10 per unit
80 units @ $11 per unit
10 units @ $10 per unit
30 units @ $11 per unit
23
First-In, First-Out (FIFO)
Apr. 1
Apr. 10
Apr. 20
1000 units @ $10 per unit
40
80 units @ $11 per unit
70 units @ $12 per unit
Sold 140 units during April
Sold all
Sold 40
Sold 0
24
First-In, First-Out (FIFO)
Apr. 1
Apr. 10
Apr. 20
1000 units
units @
@ $10
$10 per
perunit
unit
40 units
80
units @
@ $11
$11 per
perunit
unit
70 units @ $12 per unit
=
=
=
Ending Inventory…………
$
0
440
840
$1,280
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
$1,000
+ $1,720
–
$1,280
=
$1,440
25
First-In, First-Out (FIFO)
The ending inventory and
the cost of goods sold
under perpetual and
periodic FIFO are
identical.
26
Average Cost
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
80 units @ $11 per unit
70 units @ $12 per unit
250 units
=
=
=
$1,000
880
840
$2,720
$2,720  250 units = $10.88
$10.88 × 110 units = Ending Inventory of $1,197
Sold 140 units during April
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
$1,000
+ $1,720 –
$1,197
=
$1,523
27
Moving Average
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
1
10
10
18
18
20
20
27
30
Beginning Inventory 100 units @ $10
Purchases
80 units @ $11
Balance$1,880  180 180 units @ $10.44
Sales
(90) units @ $10.44
Balance
90 units @ $10.44
Purchases
70 units @ $12
Balance
160 units @ $11.125
Sales
(50) units @ $11.125
Balance
110 units @ $11.125
Cost of Goods Sold (140 units) $940 + $556
Ending Inventory (110 units @ $11.125)
$1,000
880
$1,880
(940)
$ 940
840
$1,780
(556)
$1,224
$1,496
$1,224
$1,780  160
28
Last-In, First-Out (LIFO)
Periodic Inventory System
Apr. 1
Apr. 10
Apr. 20
100
10
80
700
units @ $10 per unit
units @ $11 per unit
units @ $12 per unit
Sold 140 units during April
Sold 0
Sold 70
Sold all
29
Last-In, First-Out (LIFO)
Periodic Inventory System
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
=
80 units
10
units @
@ $11
$11 per
perunit
unit =
70
units @
0 units
@ $12
$12 per
perunit
unit =
Ending Inventory…………
$1,000
110
0
$1,110
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
$1,000
+ $1,720 –
$1,110
=
$1,610
30
Last-In, First Out (LIFO)
Perpetual Inventory System
Apr. 1
Apr. 10
Apr. 20
90
100
800
70
units @ $10 per unit
units
@ $11
$11 per
perunit
unit
units @
units @ $12 per unit
Sold 90 units during April
Sold 10
Purchased
Sold 80
80
Purchased
Sold 50
70
31
Last-In, First Out (LIFO)
Perpetual Inventory System
Apr. 1
Apr. 10
Apr. 20
90 units @ $10 per unit
0 units @ $11 per unit
=
=
20 units @ $12 per unit =
Ending Inventory…………
$ 900
0
240
$1,140
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
$1,000
+ $1,720
–
$1,140
=
$1,580
32
Comparison of Inventory Assumptions
Cost Flow
Assumption
and Method
FIFO, periodic
FIFO, perpetual
Weighted average
Moving average
LIFO, periodic
LIFO, perpetual
Cost of Goods Cost of
Available
Goods
Ending
for Sale
Sold
Inventory
$2,720
2,720
2,720
2,720
2,720
2,720
$1,440
1,440
1,523
1,496
1,610
1,580
$1,280
1,280
1,197
1,224
1,110
1,140
33
Holding Gains Comparisons
FIFO matches the oldest cost with revenue.
LIFO matches the most recent cost with revenue.
34
Liquidation of LIFO Layers
2006: 10,000 units @ $20 per unit =
2007: 6,000 units @ $22 per unit =
2008: 8,000 units @ $24 per unit =
2009: 4,000 units @ $30 per unit =
Inventory, Jan. 1, 2010…..
$200,000
132,000
192,000
120,000
$644,000
In 2010 the company purchases 50,000
units at $35 per unit but sells 60,000 units.
35
Liquidation of LIFO Layers
2006:
10,000 units @ $20 per unit
2007:
6,000 units @ $22 per unit
2008:
2,000
8,000 units @
at $24 per unit
4,000
at $30 per unit
0 units @
@ $35 per unit
50,0000 units at
2009:
2010:
=
=
=
=
=
$ 200,000
132,000
192,000
Sold
6,000
120,000
Sold
4,000
$1,750,000
Sold 50,000
In 2010 the company purchases 50,000
units at $35 per unit and sells 60,000 units.
36
Liquidation of LIFO Layers
2006:
10,000 units @ $20 per unit
2007:
6,000 units @ $22 per unit
2008:
2,000 units @ $24 per unit
2008:
2009:
2010:
6,000 units @ $24 per unit = $ 144,000
120,000
4,000 units @ $30 per unit =
50,000 units @ $35 per unit = 1,750,000
Cost of Goods Sold……….. $2,014,000
37
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.
38
Dollar-Value LIFO
Step 1: Value the total ending inventory at
current-year costs.
01/01/09
$10,000
12/31/09
$12,100
12/31/10
$13,125
12/31/11
$16,800
12/31/12
$12,360
39
Dollar-Value LIFO
Step 2: Convert the ending inventory cost to
base-year costs.
12/31/09
$12,100
12/31/10
$13,125
12/31/11
$16,800
12/31/12
$12,360
12/31/09
×
100/110 = $11,000
Base-Year
Ending
Cost Index
Inventory at ×
Current
Current Costs
Cost Index
40
Dollar-Value LIFO
Step 3: Compute the change in the inventory
level for the year at base-year costs.
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$11,000 – $10,000
$1,000
Base year, $10,000
12/31/09
1/1/09
41
Dollar-Value LIFO
Step 4a: If there is an increase in the inventory
levels at base-year costs, convert this
increase to current-year costs.
$1,000
× 110/100 = $ 1,100
Base year, $10,000
× 100/100 = 10,000
$11,100
12/31/09
Ending inventory,
12/31/09
42
Dollar-Value LIFO
Step 2: Convert the ending inventory cost to
base-year costs.
12/31/09
$12,100
×
100/110 = $11,000
12/31/10
$13,125
×
100/125 = $10,500
12/31/11
$16,800
12/31/12
$12,360
12/31/10
Base-Year
Ending
Cost Index
Inventory at ×
Current
Current Costs
Cost Index
43
Dollar-Value LIFO
Step 3: Compute the change in the inventory
level for the year at base-year costs.
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$11,000 – $10,500
$1,000
Base year, $10,000
12/31/10
44
Dollar-Value LIFO
Step 3: Compute the change in the inventory
level for the year at base-year costs.
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$500
Base year, $10,000
12/31/10
45
Dollar-Value LIFO
Step 4b: If there is a decrease in the inventory
levels at base-year costs, this decrease
reduces the inventory.
$500
Base year, $10,000
12/31/10
× 110/100 = $
550
× 100/100 = 10,000
$10,550
Ending inventory,
12/31/10
46
Dollar-Value LIFO
Step 2: Convert the ending inventory cost to
base-year costs.
12/31/09
$12,100
×
110/100 = $11,000
12/31/10
$13,125
×
100/125 = $10,500
12/31/11
$16,800
×
100/140 = $12,000
12/31/12
$12,360
12/31/11
Base-Year
Ending
Cost Index
Inventory at ×
Current
Current Costs
Cost Index
47
Dollar-Value LIFO
Step 3: Compute the change in the inventory
level for the year at base-year costs.
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$500
Base year, $10,000
12/31/11
48
Dollar-Value LIFO
Step 3: Compute the change in the inventory
level for the year at base-year costs.
12/31/09
$11,000
12/31/10
$10,500
$1,500
12/31/11
$12,000
$500
12/31/12
$10,300
Base year, $10,000
12/31/11
49
Dollar-Value LIFO
Step 4a: If there is an increase in inventory levels
at base-year costs, convert this increase
to current-year costs.
$1,500
$500
Base year, $10,000
12/31/11
× 140/100 = $ 2,100
× 110/100 =
550
× 100/100 = 10,000
$12,650
Ending inventory,
12/31/11
50
Dollar-Value LIFO
Step 2: Convert the ending inventory cost to
base-year costs.
12/31/09
$12,100
×
110/100 = $11,000
12/31/10
$13,125
×
100/125 = $10,500
12/31/11
$16,800
×
100/140 = $12,000
12/31/12
$12,360
×
100/120 = $10,300
12/31/12
Base-Year
Ending
Cost Index
Inventory at ×
Current
Current Costs
Cost Index
51
Dollar-Value LIFO
12/31/09
$11,000
12/31/10
$10,500
$1,500
12/31/11
$12,000
$500
12/31/12
$10,300
Base year, $10,000
12/31/12
52
Dollar-Value LIFO
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$500
Base year, $10,000
12/31/12
53
Dollar-Value LIFO
12/31/09
$11,000
12/31/10
$10,500
12/31/11
$12,000
12/31/12
$10,300
$300
Base year, $10,000
12/31/12
54
Dollar-Value LIFO
Step 4a: If there is an increase in the inventory
levels at base-year costs, convert this
increase to current-year costs.
$300
Base year, $10,000
12/31/12
× 110/100 = $
330
× 100/100 = 10,000
$10,330
Ending inventory,
12/31/12
55
Alternate 8-12
Current Cost
at Base-Year
Prices
Current
Costs
12/31/09 $12,100 × 100
110
=
$11,000
Historical
Cost
$10,000 × 100
100
=
$10,000
1,000 × 110
100
=
1,100
$11,100
12/31/10 $13,125 ×
100
120
=
$10,000 × 100
100
=
$10,000
500 × 110
100
=
550
$10,500
$10,550
Continued
56
Alternate 8-12
Current Cost
at Base-Year
Prices
Current
Costs
12/31/11 $16,800 × 100
140
=
$12,000
Historical
Cost
$10,000 × 100
100
=
$10,000
500 × 110
100
=
550
1,500 × 140
100
=
2,100
$12,650
12/31/12 $12,360 ×
100
120
=
$10,000 × 100
100
=
$10,000
300 × 110
100
=
330
$10,300
$10,330
57
Determination of Cost Index
Cost Index =
Sample of Ending Inventory
at Current-Year Costs
Sample of Ending Inventory
at Base-Year Costs
Double-Extension Method
× 100
58
Determination of Cost Index
Sample of Ending Inventory
at Current -Year Costs
PreviousCost Index =
× Year Cost
Sample of Ending Inventory
Index
at Previous-Year Costs
Link-Chain Method
59
Inventory Pools
A company may use inventory pools in
conjunction with dollar-value LIFO. The purpose
of the pools is to maintain the benefits from using
LIFO when fluctuations in the physical quantities
or similar inventory items occur and when
technological change takes place.
60
Inventory Pools
To illustrate the concept of an inventory pool,
consider Hermanns Soup Company, which
adopts dollar-value LIFO on January 1, 2010,
using a single pool. The pool includes three types
of soup that the company manufactures, and we
show the calculation of the total cost of the
beginning inventory. The company assigns a cost
index of 100 to the beginning inventory and uses
it as the base for calculating the cost index in later
years.
61
Inventory Pools
62
Inventory Pools
During 2010, the company purchased 150,000
cans of soup and sold 139,000 cans, leaving 51,000
cans in ending inventory, including the quantities
of each type as shown. Using the double-extension
method, the company calculates a cost index of
107 for the ending inventory by dividing the
ending inventory at current-year costs by the
ending inventory at base-year costs. Completing
the remaining steps in the dollar-value LIFO
calculations results in an ending inventory at
LIFO cost of $10,167.
63
Inventory Pools
64
Inventory Pools
65
Additional LIFO Considerations
Life Valuation Adjustment - Frequently, a
company uses LIFO for external financial
reporting and income tax purposes but uses
another method for internal management.
66
Additional LIFO Considerations
Interim Statements Using LIFO – If a company
uses LIFO for annual reporting purposes, it
must use LIFO for interim reporting purposes.
GAAP states that if a company using LIFO has
an inventory liquidation at an interim date that
it expects to replace by the end of the annual
period, it does not include the LIFO liquidation
in its inventory, and its cost of sales includes
the expected cost of replacement of the
liquidated LIFO inventory.
67
Additional LIFO Considerations
Change to or from LIFO - A company may
occasionally change its inventory cost flow
assumption.
 To – Usually, the effect on the results of prior
periods is not determinable. Then GAAP requires
that the company apply the change prospectively,
as of the earliest date practicable.
 From – Retroactively restate the results of prior
periods and treat the change as a retrospective
adjustment.
68
IFRS vs. U.S. GAAP
 IFRS do not allow the use of LIFO for both
financial and tax purposes.
 While both U.S. GAAP and IFRS allow the use
of multiple acceptable cost flow assumptions,
IFRS require that the same assumption be
used for all inventories that have a similar
nature and use. No such requirement exists
under U.S. GAAP.
69
Disclosure of Inventory Values and Methods
70
Appendix: Foreign Currency Transactions Involving Inventory
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:
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.
Continued
71
Appendix: 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.
RMB
72
Appendix: 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
$0.009.
¥50,000,000 × $0.009 = $450,000
Inventory (or Purchases)
Cash
450,000
450,000
73
Appendix: Foreign Currency Transactions Involving Inventory
Assume that the exchange rate on the
date of payment is $0.0088. The U.S.
company has to pay only $440,000.
¥50,000,000 × $0.0088 = $440,000
Accounts Payable
Cash
Exchange Gain
450,000
440,000
10,000
74
Appendix: Foreign Currency Transactions Involving Inventory
A U.S. company sells computer equipment (cost,
$200,000) to a German Company on account and
the agreed price is 300,000 euros. On the date of
the sale, the exchange rate is $1.40 (1 euro =
$1.40).
€300,000 × $1.40 = $420,000
Accounts Receivable
Sales Revenue
420,000
Cost of Goods Sold
Inventory
200,000
420,000
200,000
75
Appendix: Foreign Currency Transactions Involving Inventory
If the exchange rate is $1.38 when the German
company pays the amount owed, the U.S.
company can convert those euros into only
$414,000.
€300,000 × $1.38 = $414,000
Cash
Exchange Loss
Accounts Receivable
414,000
6,000
420,000
76
Chapter 8
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