Chapter 8 Valuation of Inventories: A Cost-Basis Approach
CHAPTER
8
·
8–1
VALUATION OF INVENTORIES: A COST-BASIS APPROACH
This IFRS Supplement provides expanded discussions of accounting guidance under
International Financial Reporting Standards (IFRS) for the topics in Intermediate
Accounting. The discussions are organized according to the chapters in Intermediate
Accounting (13th or 14th Editions) and therefore can be used to supplement the U.S. GAAP
requirements as presented in the textbook. Assignment material is provided for each supplement chapter, which can be used to assess and reinforce student understanding of IFRS.
WHICH COST FLOW ASSUMPTION TO ADOPT?
During any given fiscal period, companies typically purchase merchandise at several
different prices. If a company prices inventories at cost and it made numerous purchases
at different unit costs, which cost price should it use? Conceptually, a specific identification of the given items sold and unsold seems optimal. Therefore, the IASB requires
use of the specific identification method in cases where inventories are not ordinarily
interchangeable or for goods and services produced or segregated for specific projects. For example, an inventory of single-family homes is a good candidate for use of
the specific identification method. Unfortunately, for most companies, the specific identification method is not practicable. Only in situations where inventory turnover is low,
unit price is high, or inventory quantities are small are the specific identification criteria met. In other cases, the cost of inventory should be measured using one of two cost
flow assumptions: (1) first-in, first-out (FIFO) or (2) average cost. [1]
To illustrate these cost flow methods, assume that Call-Mart Inc. had the following transactions in its first month of operations.
Date
March
March
March
March
Purchases
2
15
19
30
Sold or Issued
2,000 @ $4.00
6,000 @ $4.40
4,000 units
2,000 @ $4.75
Balance
2,000
8,000
4,000
6,000
units
units
units
units
From this information, Call-Mart computes the ending inventory of 6,000 units
and the cost of goods available for sale (beginning inventory ⴙ purchases) of $43,900
[(2,000 @ $4.00) ⫹ (6,000 @ $4.40) ⫹ (2,000 @ $4.75)]. The question is, which price or
prices should it assign to the 6,000 units of ending inventory? The answer depends on
which cost flow assumption it uses.
Specific Identification
Specific identification calls for identifying each item sold and each item in inventory.
A company includes in cost of goods sold the costs of the specific items sold. It includes
in inventory the costs of the specific items on hand. This method may be used only in
instances where it is practical to separate physically the different purchases made. As
a result, most companies only use this method when handling a relatively small number of costly, easily distinguishable items. In the retail trade, this includes some types
of jewelry, fur coats, automobiles, and some furniture. In manufacturing, it includes
special orders and many products manufactured under a job cost system.
To illustrate, assume that Call-Mart Inc.’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from
the March 30 purchase. Illustration 8-1 shows how Call-Mart computes the ending inventory and cost of goods sold.
U.S. GAAP
PERSPECTIVE
U.S. GAAP does not require
the use of specific
identification in the situations
identified by IFRS.
8–2
·
IFRS Supplement
ILLUSTRATION 8-1
Specific Identification
Method
No. of Units
Unit Cost
Total Cost
March 2
March 15
March 30
Date
1,000
3,000
2,000
$4.00
4.40
4.75
$ 4,000
13,200
9,500
Ending inventory
6,000
$26,700
Cost of goods available for sale
(computed in previous section)
Deduct: Ending inventory
$43,900
Cost of goods sold
$17,200
26,700
This method appears ideal. Specific identification matches actual costs against actual revenue. Thus, a company reports ending inventory at actual cost. In other words,
under specific identification the cost flow matches the physical flow of the goods.
On closer observation, however, this method has certain deficiencies in addition to its
lack of practicability in many situations.
Some argue that specific identification allows a company to manipulate net income.
For example, assume that a wholesaler purchases identical plywood early in the year
at three different prices. When it sells the plywood, the wholesaler can select either the
lowest or the highest price to charge to expense. It simply selects the plywood from a
specific lot for delivery to the customer. A business manager, therefore, can manipulate
net income by delivering to the customer the higher- or lower-priced item, depending
on whether the company seeks lower or higher reported earnings for the period.
Another problem relates to the arbitrary allocation of costs that sometimes occurs
with specific inventory items. For example, a company often faces difficulty in relating
freight charges, storage costs, and discounts directly to a given inventory item. This results in allocating these costs somewhat arbitrarily, leading to a “breakdown” in the
precision of the specific identification method.1
Average Cost
As the name implies, the average cost method prices items in the inventory on the
basis of the average cost of all similar goods available during the period. To illustrate
use of the periodic inventory method (amount of inventory computed at the end of
the period), Call-Mart computes the ending inventory and cost of goods sold using a
weighted-average method as follows.
ILLUSTRATION 8-2
Weighted-Average
Method—Periodic
Inventory
Date of Invoice
March 2
March 15
March 30
Total goods available
No. Units
Unit Cost
Total Cost
2,000
6,000
2,000
$4.00
4.40
4.75
$ 8,000
26,400
9,500
10,000
Weighted-average cost per unit
Inventory in units
Ending inventory
1
$43,900
$43,900
⫽ $4.39
10,000
6,000 units
6,000 ⫻ $4.39 ⫽ $26,340
Cost of goods available for sale
Deduct: Ending inventory
$43,900
26,340
Cost of goods sold
$17,560
The motion picture industry provides a good illustration of the cost allocation problem. Often
actors receive a percentage of net income for a given movie or television program. Some
actors, however, have alleged that their programs have been extremely profitable to the motion
picture studios but they have received little in the way of profit-sharing. Actors contend that
the studios allocate additional costs to successful projects to avoid sharing profits.
Chapter 8 Valuation of Inventories: A Cost-Basis Approach
·
8–3
In computing the average cost per unit, Call-Mart includes the beginning inventory, if
any, both in the total units available and in the total cost of goods available.
Companies use the moving-average method with perpetual inventory records.
Illustration 8-3 shows the application of the average cost method for perpetual records.
Date
Purchased
March 2
March 15
March 19
(2,000 @ $4.00)
(6,000 @ 4.40)
March 30
(2,000 @ 4.75)
Sold or Issued
$ 8,000
26,400
(4,000 @ $4.30)
$17,200
9,500
ILLUSTRATION 8-3
Moving-Average
Method—Perpetual
Inventory
Balance
(2,000 @ $4.00)
(8,000 @ 4.30)
$ 8,000
34,400
(4,000 @ 4.30)
(6,000 @ 4.45)
17,200
26,700
LIFO
Under IFRS, LIFO is not permitted for financial reporting purposes. In prohibiting LIFO,
the IASB noted that use of LIFO results in inventories being recognized in the statement
of financial position at amounts that may bear little relationship to recent cost levels of
inventories. While some argued for use of LIFO because it may better match the costs
of recently purchased inventory with current prices, the Board concluded that it is not
appropriate to allow an approach that results in a measurement of profit or loss for the
period that is inconsistent with the measurement of inventories in the statement of
financial position. [2] Nonetheless, LIFO is permitted for financial reporting purposes
in the United States, it is permitted for tax purposes in some countries, and its use can
result in significant tax savings.
U.S. GAAP
PERSPECTIVE
U.S. GAAP permits the use of
LIFO for inventory valuation.
IFRS prohibits its use.
AUTHORITATIVE LITERATURE
Authoritative Literature References
[1] International Accounting Standard 2, Inventories (London, U.K.: International Accounting Standards
Committee Foundation, 2001), paras. 23–25.
[2] International Accounting Standard 2, Inventories (London, U.K.: International Accounting Standards
Committee Foundation, 2001), paras. BC13–BC14.
EXERCISES
E8-1 (FIFO and Average Cost Determination) LoBianco Company’s record of transactions for the
month of April was as follows.
Purchases
April 1 (balance on hand)
4
8
13
21
29
Sales
600
1,500
800
1,200
700
500
@
@
@
@
@
@
$6.00
6.08
6.40
6.50
6.60
6.79
April 3
9
11
23
27
500
1,300
600
1,200
900
@
@
@
@
@
$10.00
10.00
11.00
11.00
12.00
4,500
5,300
Instructions
(a) Assuming that periodic inventory records are kept, compute the inventory at April 30 using
(1) FIFO and (2) average cost.
(b) Assuming that perpetual inventory records are kept in both units and dollars, determine the
inventory at April 30 using (1) FIFO and (2) average cost.
8–4
·
IFRS Supplement
(c) In an inflationary period, which inventory method—FIFO or average cost—will show the highest
net income?
E8-2 (FIFO and Average Cost Inventory) Esplanade Company was formed on December 1, 2009. The
following information is available from Esplanade’s inventory records for Product BAP.
Units
January 1, 2010 (beginning inventory)
Purchases:
January 5, 2010
January 25, 2010
February 16, 2010
March 26, 2010
Unit Cost
600
$ 8.00
1,100
1,300
800
600
9.00
10.00
11.00
12.00
A physical inventory on March 31, 2010, shows 1,500 units on hand.
Instructions
Prepare schedules to compute the ending inventory at March 31, 2010, under each of the following
inventory methods (round to two decimal places).
(a) Specific identification.
(b) FIFO.
(c) Weighted-average.
Under (a), 400 units from the beginning inventory are on hand and 1,100 units from the January 5 purchase are on hand.
E8-3 (Compute FIFO and Average Cost—Periodic) Presented below is information related to radios
for the Couples Company for the month of July.
Date
July 1
6
7
10
12
15
18
22
25
30
Transaction
Balance
Purchase
Sale
Sale
Purchase
Sale
Purchase
Sale
Purchase
Sale
Totals
Units
In
Unit
Cost
Total
100
800
$4.10
4.30
$ 410
3,440
400
4.51
1,804
300
4.60
1,380
500
4.58
2,290
2,100
$9,324
Units
Sold
Selling
Price
Total
300
300
$7.00
7.30
$ 2,100
2,190
200
7.40
1,480
400
7.40
2,960
200
7.50
1,400
1,500
$10,230
Instructions
(a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31
under each of the following cost flow assumptions.
(1) FIFO.
(2) Weighted-average.
(b) Answer the following questions.
(1) Which of the methods used above will yield the highest figure for gross profit for the income
statement? Explain why.
(2) Which of the methods used above will yield the highest figure for ending inventory for the
statement of financial position? Explain why.
E8-4 (FIFO and Average Cost, Income Statement Presentation) The board of directors of Oksana Corporation is considering whether or not it should instruct the accounting department to change from a
first-in, first-out (FIFO) basis of pricing inventories to an average cost basis. The following information is
available.
Sales
Inventory, January 1
Purchases
Inventory, December 31
Operating expenses
20,000 units @ €50
6,000 units @ 20
6,000 units @ 22
10,000 units @ 25
7,000 units @ 30
9,000 units @ ?
€200,000
Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Instructions
Prepare a condensed income statement for the year on both bases for comparative purposes (round to two
decimal places).
E8-5 (Compute Specific Identification, FIFO, and Average Cost) Hull Company’s record of transactions concerning part X for the month of April was as follows.
Purchases
April 1 (balance on hand)
4
11
18
26
30
Sales
100
400
300
200
600
200
@
@
@
@
@
@
$5.00
5.10
5.30
5.35
5.60
5.80
April 5
12
27
28
300
200
800
150
Instructions
(a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inventory records are kept in units only. Carry unit costs to the nearest cent.
(1) Specific identification; ending inventory is comprised of 100 units from beginning inventory
and 250 units from the April 26 purchase.
(2) First-in, first-out (FIFO).
(3) Average cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each
withdrawal, what amount would be shown as ending inventory in 1, 2, and 3 above? Carry average
unit costs to four decimal places.
CONCEPTS FOR ANALYSIS
CA8-1
(Average Cost and FIFO) Draft written responses to the following items.
(a) Describe the cost flow assumptions used in average cost and FIFO methods of inventory valuation.
(b) Distinguish between weighted-average cost and moving-average cost for inventory costing
purposes.
(c) Identify the effects on both the statement of financial position and the income statement of using
the average cost method instead of the FIFO method for inventory costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why these effects
take place.
USING YOUR JUDGMENT
FI NANCIAL REPORTI NG
Financial Statement Analysis Cases
Case 1
Lumber Supply International
Lumber Supply International, a manufacturer of specialty building products, has its headquarters in
Boise, Idaho. The company, through its partnership in the Trus Joist MacMillan joint venture, develops
and manufactures engineered lumber. This product is a high-quality substitute for structural lumber,
and uses lower-grade wood and materials formerly considered waste. The company also is majority
owner of the Outlook Window Partnership, which is a consortium of three wood and vinyl window
manufacturers.
·
8–5
8–6
·
IFRS Supplement
Following is Lumber Supply International’s adapted income statement and information concerning
inventories from its statement of financial position.
Lumber Supply International
Sales
Cost of goods sold
$618,876,000
475,476,000
Gross profit
Selling and administrative expenses
143,400,000
102,112,000
Income from operations
Other expense
41,288,000
24,712,000
Income before income tax
Income taxes
16,576,000
7,728,000
Net income
$ 8,848,000
Inventories. Inventories are valued at the lower-of-cost-or-market and include material, labor, and
production overhead costs. Inventories consisted of the following:
Finished goods
Raw materials and
work-in-progress
Reduction to average cost
Current Year
Prior Year
$27,512,000
$23,830,000
34,363,000
33,244,000
61,875,000
(5,263,000)
57,074,000
(3,993,000)
$56,612,000
$53,081,000
The average cost (AC) method is used for determining the cost of lumber, veneer, Microllam lumber, LSI
joists, and open web joists. Approximately 35 percent of total inventories at the end of the current year
were valued using the AC method. The first-in, first-out (FIFO) method is used to determine the cost of
all other inventories.
Instructions
(a) How much would income before taxes have been if FIFO costing had been used to value all inventories?
(b) If the income tax rate is 46.6%, what would income tax have been if FIFO costing had been used to value
all inventories? In your opinion, is this difference in net income between the two methods material?
Explain.
(c) Does the use of a different costing system for different types of inventory mean that there is a different
physical flow of goods among the different types of inventory? Explain.
Case 2
Noven Pharmaceuticals, Inc.
Noven Pharmaceuticals, Inc. (USA), headquartered in Miami, Florida, describes itself in a recent annual
report as follows.
Noven Pharmaceuticals, Inc.
Noven is a place of ideas—a company where scientific excellence and state-of-the-art manufacturing
combine to create new answers to human needs. Our transdermal delivery systems speed drugs
painlessly and effortlessly into the bloodstream by means of a simple skin patch. This technology has
proven applications in estrogen replacement, but at Noven we are developing a variety of systems
incorporating bestselling drugs that fight everything from asthma, anxiety and dental pain to cancer,
heart disease and neurological illness. Our research portfolio also includes new technologies, such as
iontophoresis, in which drugs are delivered through the skin by means of electrical currents, as well as
products that could satisfy broad consumer needs, such as our anti-microbial mouthrinse.
Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Noven also reported in its annual report that its activities to date have consisted of product development efforts, some of which have been independent and some of which have been completed in conjunction with Rhone-Poulenc Rorer (RPR) (FRA) and Ciba-Geigy (USA). The revenues so far have
consisted of money received from licensing fees, “milestone” payments (payments made under licensing
agreements when certain stages of the development of a certain product have been completed), and
interest on its investments. The company expects that it will have significant revenue in the upcoming
fiscal year from the launch of its first product, a transdermal estrogen delivery system.
The current assets portion of Noven’s statement of financial position follows.
Cash and cash equivalents
Investment securities
Inventory of supplies
Prepaid and other current assets
$12,070,272
23,445,070
1,264,553
825,159
Total current assets
$37,605,054
Inventory of supplies is recorded at the lower of cost (first-in, first-out) or net realizable value and consists mainly of supplies for research and development.
Instructions
(a) What would you expect the physical flow of goods for a pharmaceutical manufacturer to be most
like: FIFO or random (flow of goods does not follow a set pattern)? Explain.
(b) What are some of the factors that Noven should consider as it selects an inventory measurement
method?
(c) Suppose that Noven had $49,000 in an inventory of transdermal estrogen delivery patches. These
patches are from an initial production run, and will be sold during the coming year. Why do you
think that this amount is not shown in a separate inventory account? In which of the accounts shown
is the inventory likely to be? At what point will the inventory be transferred to a separate inventory
account?
Case 3
SUPERVALU
SUPERVALU (USA) reported that its inventory turnover ratio decreased from 17.1 times in 2006 to 15.8
times in 2007. The following data appear in SUPERVALU’s annual report.
Total revenues
Cost of sales (using LIFO)
Year-end inventories using FIFO
Year-end inventories using LIFO
Feb. 26,
2005
Feb. 25,
2006
Feb. 24,
2007
$19,543
16,681
1,181
1,032
$19,864
16,977
1,114
954
$37,406
29,267
2,927
2,749
(a) Compute SUPERVALU’s inventory turnover ratios for 2006 and 2007, using:
(1) Cost of sales and LIFO inventory.
(2) Cost of sales and FIFO inventory.
(b) Some firms calculate inventory turnover using sales rather than cost of goods sold in the numerator.
Calculate SUPERVALU’s 2006 and 2007 turnover, using:
(1) Sales and LIFO inventory.
(2) Sales and FIFO inventory.
(c) Describe the method that SUPERVALU’s appears to use.
(d) State which method you would choose to evaluate SUPERVALU’s performance. Justify your choice.
·
8–7
8–8
·
IFRS Supplement
BRI DGE TO TH E PROFESSION
Professional Research
In conducting year-end inventory counts, your audit team is debating the impact of the client’s right of
return policy both on inventory valuation and revenue recognition. The assistant controller argues that
there is no need to worry about the return policies since they have not changed in a while. The audit senior wants a more authoritative answer and has asked you to conduct some research of the authoritative
literature before she presses the point with the client.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/ ). When you have accessed
the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations if necessary.)
(a) Which statement addresses revenue recognition when right of return exists?
(b) When is this statement important for a company?
(c) Sales with high rates of return can ultimately cause inventory to be misstated. Why are returns
allowed? Should different industries be able to make different types of return policies?
(d) In what situations would a reasonable estimate of returns be difficult to make?