Chapter 8
Inventory Chapters
Valuation of Inventories:
A Cost-Basis Approach
§  Topic of chapters 8 and 9
§  Inventory: Asset on balance sheet
§  Cost of goods sold: Expense on I/S
See Safeway, Dr. Pepper, Campbell, Grainger,
Amazon, Coca-Cola, Peet’s, Tiffany Annual Reports
1
Learning Objectives
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Identify classifications of inventory
Explain perpetual and periodic inventory systems
Identify effects of inventory errors
Understand the items to include as inventory cost
Describe and compare cost flow assumptions
Explain the significance and use of a LIFO reserve
Understand the effect of LIFO liquidations
Explain the dollar-value LIFO method
Identify advantages and disadvantages of LIFO
Understand why inventory methods are selected
2
Learning Objectives
§  Identify classifications of inventory
3
4
Inventory
Inventory
§  Assets that a company intends to sell in
the normal course of business
§  Inventories may be
§  Purchase cost
§  Amount paid to make unit ready for sale
§  Proper location, proper condition
§  Asset on balance sheet: Inventory
§  Expense on income statement: CGS
§  Raw materials used to manufacture goods
§  Work in process (partially completed)
§  Finished goods held for sale
§  Selling price
§  Amount received from buyer (A/R)
§  Income statement: Sales
5
6
1
Merchandising Business
Manufacturing Business
§  Finished goods purchased from
manufacturer
§  One type of inventory (items for sale)
§  Examples
§  Three types of inventory
§  Raw materials
§  Work in process
§  Finished goods
§  Purchase raw materials
§  Apply labor and overhead
§  Produce finished goods
§  Costco
§  Target
§  Crate and Barrel
7
Raw Materials
8
Work in Process Inventory
§  Materials on hand but not yet placed
into process of production
§  Units started but not yet complete
§  WIP includes
§  Cost of raw materials
§  Cost of labor that can be directly applied to
the goods in process
§  Allocated portion of overhead
9
§  Indirect labor
§  Indirect materials
§  Indirect services
Raw
Materials
Finished Goods Inventory
(1) $XX
$XX (4)
Direct
Labor
§  Manufacturing process complete
§  Costs accumulated in work in process
transferred to finished goods
(2) $XX
$XX (5)
Manufacturing
Overhead
(3) $XX
11
(1) 
(2) 
(3) 
(4) 
(5) 
(6) 
(7) 
(8) 
10
Work in
Process
$XX
$XX (7)
Finished
Goods
$XX $XX (8)
Cost of Good
Sold
$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
12
2
Learning Objectives
§  Explain perpetual and periodic inventory
13
Inventory Cost Flow
14
Gross and Net Methods
§  Applies to both perpetual and periodic
§  Seller offer terms, 2/10 n/30
§  Gross method
§  Record inventory at invoice amount (gross)
§  Record discount if taken
§  Net method
15
Gross and Net Methods
§  Record inventory net of discount
§  Record “discounts lost expense” not taken
16
Perpetual and Periodic
§  Gross method views discounts not
taken as part of inventory cost
§  Net method views discounts not taken
as “Interest exp” or “Lost discount exp”
§  Small difference in amounts, ratios
§  Difference usually not material
§  Perpetual
Inventory account continuously updated
as purchases and sales are made
§  Periodic
Inventory account adjusted at end of
period
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18
3
Perpetual Inventory System
Perpetual Inventory System
§  Accounting records continuously show
§  Continuously tracks changes in
inventory quantity and inventory cost
§  Inventory (asset) debited when
§  Ending inventory (goods on hand)
§  Cost of goods sold
§  Accounting records wrong because
§  Merchandise purchased
§  Merchandise returned by customer
§  Errors
§  Theft
§  Breakage and spoilage
§  Shrinkage (unaccounted loss of inventory)
§  Inventory (asset) credited when
§  Merchandise sold
§  Merchandise returned to supplier
19
§  Physical count at end of period needed
20
Perpetual Inventory: Gross
Perpetual Inventory T-Account
Date
Description
Inventory
Debit
600,000
Accounts payable
Inventory
Credit
600,000
Purchased inventory, $600,000, terms 2/10 n/30
Beg inv
Our returns
Purchases
Discount
Cust returns
Sold (CGS)
Date
Gross method
Description
Accounts payable
Debit
100,000
Inventory
Credit
100,000
Returned inventory, $100,000
End inv
Date
Description
Accounts payable
Debit
500,000
Cash
All amounts at cost, not selling price
Description
Inventory
Debit
588,000
Accounts payable
Description
Accounts payable
Credit
Date
588,000
Debit
98,000
Inventory
Description
Accounts payable
Cash
Description
Inventory
Debit
588,000
Accounts payable
Credit
588,000
Purchased inventory, $600,000, terms 2/10 n/30
Credit
Date
98,000
Description
Accounts payable
Debit
98,000
Inventory
Returned inventory, $100,000
Date
22
Perpetual Inventory: Net
Purchased inventory, $600,000, terms 2/10 n/30
Date
10,000
Paid within discount period, 2% discount on $500,000
Perpetual Inventory: Net
Date
490,000
Inventory
21
Credit
Credit
98,000
Returned inventory, $100,000
Debit
490,000
Credit
Date
490,000
Paid within discount period, 2% discount on $500,000
Description
Accounts payable
Interest expense (Discounts lost)
23
Debit
490,000
Credit
10,000
Cash
Paid after discount period ended, $500,000
500,000
24
4
Perpetual: Sold Inventory
Periodic Inventory System
§  Selling price, $820,000
§  Cost, $540,000
Date
Description
Accounts receivable
Debit
820,000
Sales
§  Adjusts inventory (asset) and calculates
cost of goods sold only at end of period
§  Use temporary accounts to record
Credit
§  Merchandise purchases
§  Purchase returns
§  Purchase discounts
§  Freight-in
820,000
Selling price of inventory
Date
Description
Cost of goods sold
Debit
540,000
Inventory
Credit
540,000
Purchase cost of inventory, $540,000
25
26
Periodic Net Purchases
Periodic Cost of Goods Sold
Beginning Inventory
+ Net Purchases
Cost of Goods Available for Sale
− Ending Inventory
Cost of Goods Sold
Purchases
+ Freight-in
− Returns
− Discounts
Net purchases
27
28
Periodic Inventory: Gross
Date
Description
Purchases
Debit
600,000
Accounts payable
Periodic Inventory: Net
Credit
Date
600,000
Description
Accounts payable
Debit
100,000
Purchase returns and allow.
Description
Accounts payable
Cash
Purchase discounts
Credit
588,000
Purchased inventory, $600,000, terms 2/10 n30
Credit
Date
100,000
Description
Accounts payable
Debit
98,000
Purchase returns and allow.
Returned inventory, $100,000
Date
Debit
588,000
Accounts payable
Purchased inventory, $600,000, terms 2/10 n30
Date
Description
Purchases
Credit
98,000
Returned inventory, $100,000
Debit
500,000
Credit
Date
490,000
10,000
Paid within discount period, 2% discount on $500,000
Description
Accounts payable
Cash
29
Debit
490,000
Credit
490,000
Paid within discount period, 2% discount on $500,000
30
5
Periodic Inventory: Net
Date
Description
Purchases
Debit
588,000
Periodic: Sold Inventory
Credit
Accounts payable
§  Selling price, $820,000
§  Cost, $540,000
588,000
Purchased inventory, $600,000, terms 2/10 n30
Date
Description
Accounts payable
Debit
98,000
Credit
Purchase returns and allow.
Date
98,000
Debit
820,000
Credit
Sales
Returned inventory, $100,000
Date
Description
Accounts receivable
820,000
Selling price of inventory
Description
Accounts payable
Debit
490,000
Interest expense
10,000
Credit
Cash
500,000
Paid after discount period ended, $500,000
No entry is made to record Cost of Good Sold.
Calculate Cost of Goods Sold at end of period.
31
32
Periodic Inventory AJE
Periodic Inventory AJE
Calculation of Cost of Goods Sold
Calculation of Cost of Goods Sold
Beginning inventory
$120,000
Plus: Net purchases
490,000
610,000
Beginning inventory
$120,000
Plus: Net purchases
490,000
Goods available for sale
Goods available for sale
610,000
Less: Ending inventory
Less: Ending inventory
180,000
Cost of goods sold
Cost of goods sold
Date
Date
$430,000
Description
Cost of goods sold (plug)
Debit
430,000
Inventory (ending)
180,000
Credit
120,000
Purchases (actual)
490,000
Debit
430,000
Inventory (ending)
180,000
Purchase returns (actual)
33
Credit
10,000
100,000
Inventory (beginning)
120,000
Purchases (actual)
600,000
34
Comparison of Perpetual and
Periodic Inventory Systems
Periodic Inventory T-Account
§  Impact on financial statements generally
not significant
§  Perpetual provides more timely
information, more costly to implement
§  Periodic inventory less costly to
implement but requires a physical count
before ending inventory and cost of
goods sold can be determined
Inventory
Beg inv
Description
Cost of goods sold (plug)
Purchase discounts (actual)
Inventory (beginning)
180,000
$430,000
Beg inv
End inv
End inv
All amounts at cost, not selling price
35
36
6
Perpetual and Periodic:
Purchase of Inventory
Perpetual and Periodic:
Freight-In
Perpetual
Date
Description
Inventory
Perpetual
Debit
600,000
Accounts payable
Credit
Date
600,000
Description
Inventory
Debit
2,000
Accounts payable
Purchased inventory, $600,000, terms 2/10 n30
Description
Purchases
Periodic
Debit
600,000
Accounts payable
Credit
Date
600,000
Purchased inventory, $600,000, terms 2/10 n30
Inventory
Credit
Description
Accounts payable
Date
Debit
100,000
Credit
Description
Accounts payable
Periodic
Debit
500,000
Credit
490,000
10,000
40
Perpetual and Periodic:
Sale of Inventory
Perpetual
Debit
820,000
Sales
Credit
Date
820,000
Description
Cost of goods sold
Debit
540,000
Inventory
Selling price of inventory
Credit
540,000
Purchase cost of inventory, $540,000
Periodic
Sales
10,000
Paid within discount period, 2% discount on $500,000
39
Perpetual
Description
Accounts receivable
Credit
490,000
Purchase discounts
Perpetual and Periodic:
Sale of Inventory
Date
Debit
500,000
Cash
100,000
Returned inventory, $100,000
Description
Accounts receivable
38
Paid within discount period, 2% discount on $500,000
Purchase returns and allow.
Date
Perpetual
Inventory
Periodic
Description
Accounts payable
2,000
Cash
100,000
Returned inventory, $100,000
Date
Credit
Perpetual and Periodic:
Purchase Discounts (2/10 n/30)
Date
Debit
100,000
Debit
2,000
FOB shipping point, $2,000 to transport goods
37
Perpetual
Description
Accounts payable
Description
Freight-in
Accounts payable
Perpetual and Periodic:
Return of Inventory
Date
2,000
FOB shipping point, $2,000 to transport goods
Periodic
Date
Credit
Periodic
Debit
820,000
Credit
No entry is made to record Cost of Good Sold.
Calculate Cost of Goods Sold at end of period.
820,000
Selling price of inventory
41
42
7
Perpetual and Periodic:
Buyer Returns Inventory
Perpetual and Periodic:
Buyer Returns Inventory
Perpetual
Date
Description
Sales returns
Perpetual
Debit
50,000
Accounts receivable
Credit
Date
Description
Inventory
50,000
Debit
50,000
Cost of goods sold
Buyer returns inventory, $50,000
Description
Sales returns
50,000
Buyer returns inventory, $50,000
Periodic
Date
Credit
Periodic
Debit
50,000
Accounts receivable
Credit
No entry is made to Inventory or Cost of Good Sold.
Calculate Cost of Goods Sold at end of period.
50,000
Buyer returns inventory, $50,000
43
44
Perpetual and Periodic:
End of Period AJE
Comparison of Perpetual and
Periodic Inventory Systems
Perpetual
Date
Description
Inventory over and short (or CGS)
Debit
6,000
Inventory
Credit
6,000
Adjust inventory to physical count (shrinkage)
Date
Description
Periodic
Cost of goods sold (plug)
Debit
432,000
Inventory (ending)
180,000
Purchase discounts (actual)
Purchase returns (actual)
Credit
10,000
100,000
Freight-in
Transaction
Perpetual
Periodic
Purchase inventory
Debit Inventory (asset)
Debit Purchases (exp)
Freight-in
Debit Inventory (asset)
Debit Freight-in (exp)
We return inventory
Credit Inventory (asset)
Credit Purch Returns (contra)
Purchase disc (2/10 n/30)
Credit Inventory (asset)
Credit Discounts (contra)
Inventory sold
Credit Inventory (asset)
No entry for inventory
Buyer returns inventory
Debit Inventory (asset)
No entry for inventory
End of period AJE
Adjust Inventory to physical cnt
Plug Cost of goods sold
2,000
Inventory (beginning)
120,000
Purchases (actual)
600,000
45
46
Gross Profit Calculation: Periodic Method
Sales
Gross Profit Calculation: Periodic Method
Net sales
4,400
500
4,400
Cost of goods sold calculation:
Beginning inventory
500
Cost of net purchases
3,600
Cost of goods available for sale
4,100
Less ending inventory
100
Less sales returns and allowances
Net sales
Cost of goods sold calculation:
Beginning inventory
5,000
Less sales discounts
Purchases
Less purchase discounts
Less purchase returns and allowances
700
Net purchases
500
4,000
300
200
3,500
Cost of goods sold
3,400
Add freight-in
Gross profit
1,000
Cost of purchases
3,600
Cost of goods available for sale
4,100
Less ending inventory
47
100
700
Cost of goods sold
3,400 48
Gross profit
1,000
8
Basic Issues in
Inventory Valuation
Learning Objectives
§  Basic Issues in Inventory Valuation
§  Physical goods (which units to include)
§  Costs to include (product vs. period)
§  Cost flow assumption
§  FIFO, LIFO, Average cost, others
Substance over form
49
Included in Inventory
Goods in Transit
§  All goods owned by company at end of
period regardless of location
§  In general, goods will be at physical
location of company
§  Exceptions
§  FOB determines where legal ownership
of the goods changes hands
§  FOB point in sales contract
§  FOB: Free on board
§  FOB shipping point
§  FOB destination
§  Goods in transit
§  Goods on consignment
§  Estimated sales returns
51
FOB Shipping Point
52
FOB Shipping Point
§  Legal title changes hands when seller
delivers goods to common carrier
§  Buyer owns goods in transit
§  Buyer pays shipping costs, insurance
§  When seller delivers goods to common
carrier
§  Seller records revenue, reduces inventory
§  Buyer records purchase, increases
inventory
§  Expense recorded as Freight-In
§  Product cost, included inventory cost
§  Part of CGS when inventory sold
53
54
9
FOB Destination
FOB Destination
§  Legal title does not pass until goods
arrive at customer's location
§  When goods taken off common carrier
and placed on buyer’s receiving dock
§  Seller owns goods in transit
§  Seller pays shipping costs, insurance
§  When goods taken off common carrier
and placed on buyer’s receiving dock
§  Seller records revenue, reduces inventory
§  Buyer records purchase, increases
inventory
Google search incoterms
Shipping costs are part of “Selling and marketing exp”
55
Shipping Terms
FOB
Shipping Point
Legal ownership
changes hands
At seller’s location when
merchandise placed into
method of transit
56
Goods on Consignment
FOB
Destination
§  Consignor (manufacturer or reseller)
At buyer’s location when
merchandise placed on
receiving dock
§  Delivers merchandise to consignee (store)
§  Lists merchandise in inventory until sold
Who owns goods in transit Buyer
Seller
Who pays shipping costs
Buyer
Seller
Account name
Freight-In
Shipping expense
Where is cost
Added to inventory
(Asset on balance sheet)
Selling expense
(Expense on income stmt)
§  Consignee (store or seller)
Company with legal title to the goods while in transit
pays the transportation costs
§  Sells units
§  Remits to consignor selling price less
commissions and expenses
§  No inventory on books
57
Goods on Consignment
58
Goods on Consignment
§  Goods on consignment included in
inventory of the consignor even though
not in company's physical possession
§  Consignor records a sale only when the
consignee sells the goods
Pepsi Corporation
delivers end-cap with
drinks and chips
to Safeway for
Super Bowl promotion
on consignment
for two weeks
59
Safeway
Drinks
and
chips
The goods on display at Safeway (consignee) are
legally owned by Pepsi (consignor) and appear in the
inventory of Pepsi; Safeway records sale and remits
cash to Pepsi less a fee
60
10
High Rates of Sales Returns
Sales With Buyback
§  If reasonable estimates can be made
§  Seller agrees to repurchase inventory
from buyer at defined time and price
§  Product financing arrangement or
“Parking transaction”
§  Seller reports inventory on books even
though legal title has changed hands
§  Record sale (realize revenue)
§  Adjusting journal entry required
§  Estimate returns and include in inventory
§  If estimates cannot be made
§  Do not record sale until returns known
§  Keep inventory on books even though legal
title has changed hands
61
Installment Sales
62
Inventory Cutoff
§  Buyer pays in installments, long time
§  Legal title not transferred to buyer until
all payments made
§  If uncollectible accounts estimated
§  Must accurately measure inventory at
balance sheet date
§  Record sales and allow, reduce inventory
§  If not possible to estimate uncollectibles
§  Do not record sale, keep inv on books
63
Learning Objectives
§  Analyze 10 days before and after
§  FOB point of purchases and sales
§  Sales returns
§  Buybacks
§  Installment sales
§  Consignment
§  Inventory count
64
Inventory Errors
§  Identify effects of inventory errors
§  Textbook method confusing
§  If this goes up this goes down
§  Instead arbitrarily select numbers
§  First create gross profit calculation with
numbers you select
§  Next create a second column and change
one number to introduce an error and see
how the error changes the numbers
65
66
11
Inventory Error: Year 1
Inventory Error: Year 1
§  Overstatement of ending inventory
§  Understates cost of goods sold and
§  Overstates pretax income
Beginning inventory
Add purchases
Goods available for sale
Less ending inventory
Cost of goods sold
§  Understatement of ending inventory
§  Overstates cost of goods sold and
§  Understates pretax income
67
Inventory Error: Year 2
If ending inventory too high
Cost of goods sold too low
§  Overstates cost of goods sold and
§  Understates pretax income
Beginning inventory
Add purchases
Goods available for sale
Less ending inventory
Cost of goods sold
§  Understatement of beginning inventory
§  Understates cost of goods sold and
§  Overstates pretax income
69
Net Effect of Inventory Error
Correct
400
500
900
68
Inventory Error: Year 2
§  Overstatement of beginning inventory
CGS year 1
CGS year 2
CGS two year period
Year 1
Correct
Error
200
200
300
300
500
500
100
150
400
350
Year 2
Correct
Error
100
150
600
600
700
750
200
200
500
550
If beginning inventory too high
Cost of goods sold too high
70
Learning Objectives
Error
350
550
900
§  Items to include as inventory cost
Over two year period
errors cancel out
71
72
12
Product Costs
Inventory Cost
§  Can be directly matched to unit of
inventory
§  All costs incurred to place item in
location and condition for sale
§  Debit inventory when incurred
§  Match to revenue at time of sale (CGS)
§  Product costs: All costs incurred to
make inventory ready for sale
§  Desired condition
§  Desired location
Invoice
cost
$14
Inventory Cost
Insurance
$1
Freight
charges
$3
Purchase price
1 Insurance in transit
3 Freight charges
+Transportation (freight in)
2 Import duties
− Purchase returns
$20 Cost of inventory
− Purchase allowances
− Purchase discounts
Description
Inventory
74
Net Purchases
$14 Purchase cost
Date
Import
duties
$2
Debit
20
= Net purchases of inventory
Credit
Accounts payable
20
$600,000
4,000
(25,000)
(5,000)
(14,000)
$560,000
Freight out (Shipping) is a selling expense
75
NOT Inventory Cost
76
Period Costs
§  Buying costs
§  Costs of purchasing department
§  Selling expenses
§  Interest expense on
§  Indirectly related to purchase of goods
§  Cannot be matched to unit of inventory
§  Recognized in period incurred
§  Costs of purchasing department
§  Costs of sales employees
§  Interest on debt to purchase inventory
§  Finished goods
§  Units routinely manufactured large batches
Capitalize interest for discrete projects (ship, airplane)
Period costs not unit costs
77
13
Learning Objectives
Inventory Layers (Periodic)
§  Inventory cost flow assumptions
Date
Units
Unit Cost
June 5
2,000
$4.00
Total Cost
$ 8,000
June 15
6,000
$4.40
26,400
June 25
2,000
$4.75
Total
10,000
9,500
$43,900
Sold 4,000 units; Calc cost of goods sold, ending inv
79
Inventory Cost Flow Methods
80
Specific Cost Identification
§  Specific cost identification
§  Average cost / Moving average
§  First-in, first-out (FIFO)
§  Last-in, first-out (LIFO)
§  COGS for each sale is based on
specific cost of item sold
§  Specific cost of each inventory item
must be known
§  Only used for inventories which are
§  Low volume
§  High cost
§  Unique items
81
Specific Cost Identification
82
Inventory Cost Flow Methods
§  If inventory items are identical, do not
use specific identification
§  Manipulate expenses by selecting
specific items
§  If inventory items are identical, selection
of unit sold is random
§  Cost flow assumptions
§  Average cost / Moving average
§  First-in, first-out (FIFO)
§  Last-in, first-out (LIFO)
§  Apply both periodic and perpetual
83
84
14
Average Cost (Periodic)
Moving Average (Perpetual)
Average Cost Method
§  Avg cost = Total cost / Total units
§  Periodic
Calculate average cost of all units
available for period
§  Perpetual
Calculate average cost of units
available at time of sale
§  Called “Weighted Average” if periodic
§  Called “Moving Average” if perpetual
85
Weighted Average (Periodic)
Date
Units
Unit Cost
Moving Average (Perpetual)
Total Cost
June 5
2,000
$4.00
$ 8,000
June 15
6,000
$4.40
26,400
June 25
2,000
$4.75
9,500
Total
10,000
$43,900
Total Cost
CGS 4,000
× $4.39
= $17,560
End Inventory 6,000
× $4.39
= $26,340
Available 10,000
$43,900
Units
Unit Cost
June 15
6,000 @ $4.40
Balance
2,000 units
8,000 units
2,000 @ $4.75
5,000 units
7,000 units
1,000 units
6,000 units
Calculate costs of goods sold at time of sale on June 20
87
88
Moving Average (Perpetual)
Total Cost
June 5
2,000
$4.00
$ 8,000
Date
Purchases
June 15
6,000
$4.40
26,400
Revised
5,000 @ $4.30
Total
8,000
$34,400
June 25
2,000 @ $4.75
June 30
Sold 3,000 units; Calc cost of goods sold, ending inv
Units
Cost
Total Cost
CGS 3,000
× $4.30
= $12,900
End Inventory 5,000
× $4.30
= $21,500
$34,400
Sales
Balance
5,000 units
7,000 units
1,000 units
6,000 units
Calculate costs of goods sold at time of sale on June 30
Total cost / total units = Weighted average cost
$34,400 / 8,000 = $4.30
Available 8,000
Sales
3,000 units
June 30
Moving Average (Perpetual)
Date
Purchases
2,000 @ $4.00
June 25
Total cost / total units = Weighted average cost
$43,900 / 10,000 = $4.39
Cost
Date
June 5
June 20
Sold 4,000 units; Calc cost of goods sold, ending inv
Units
86
89
90
15
Moving Average (Perpetual)
Date
Units
Unit Cost
Revised
5,000
$4.30
June 25
2,000
$4.75
Total
7,000
Moving Average (Perpetual)
Total Cost
$ 21,500
9,500
$31,000
Date
Units
Unit Cost
End Inv
6,000
$4.43
Sold 1,000 units; Calc cost of goods sold, ending inv
Total cost / total units = Weighted average cost
$31,000 / 7,000 = $4.43
Units
Cost
Total Cost
CGS 1,000
× $4.43
= $ 4,420
End Inventory 6,000
× $4.43
= $26,580
Available 7,000
$31,000
Total Cost
$ 26,580
Date
Units
Cost of Goods Sold
June 20
3,000
$12,900
June 30
1,000
4,420
Total
4,000
$17,320
91
92
First-In, First-Out
First-In, First-Out
§  Items are sold in the chronological order
of their acquisition
§  Cost of the oldest inventory items are
charged to cost of goods sold
§  Cost of the newest inventory items
remain in ending inventory
§  Cost of goods sold and ending
inventory are the same under
§  Perpetual
§  Periodic
93
94
FIFO
FIFO
Sold 4,000 units; Calc cost of goods sold, ending inv
Date
Units
Unit Cost
June 5
2,000
$4.00
June 15
6,000
June 25
2,000
Total
10,000
Total Cost
Date
Units
Unit Cost
$ 8,000
June 5
2,000
$4.00
$4.40
26,400
June 15
2,000
$4.40
8,800
$4.75
9,500
June 15
4,000
$4.40
17,600
$43,900
June 25
2,000
$4.75
Total
10,000
CGS
End
Inv
Sold 4,000 units; Calc cost of goods sold, ending inv
95
Total Cost
CGS
End
Inv
$ 8,000
9,500
$43,900
Units
Cost
Total Cost
CGS 4,000
$8,000 + 8,800
= $16,800
End Inventory 6,000
$17,600 + 9,500
= $27,100
Available 10,000
$43,900
96
16
Last-In, First-Out
Last-In, First-Out
§  Newest items are sold first, leaving
older units in inventory
§  Cost of newest inventory items are
charged to cost of goods sold
§  Cost of oldest inventory items remain in
ending inventory
§  LIFO method may result in COGS and
ending inventory that differ under the
periodic and perpetual methods
97
98
LIFO (Periodic)
LIFO (Periodic)
Sold 4,000 units; Calc cost of goods sold, ending inv
Date
Units
Unit Cost
June 5
2,000
$4.00
June 15
6,000
$4.40
June 25
2,000
$4.75
Total
10,000
End
Inv
CGS
Total Cost
Date
Units
Unit Cost
$ 8,000
June 5
2,000
$4.00
26,400
June 15
4,000
$4.40
9,500
June 15
2,000
$4.40
$43,900
June 25
2,000
$4.75
Total
10,000
Total Cost
= $18,300
End Inventory 6,000
$8,000 + 17,600
= $25,600
Available 10,000
$43,900
2,000 units
Date
Units
Unit Cost
June 15
6,000 @ $4.40
8,000 units
June 5
2,000
$4.00
5,000 units
June 15
3,000
$4.40
7,000 units
June 15
3,000
$4.40
Total
8,000
June 30
1,000 units
100
LIFO (Perpetual)
Purchases
2,000 @ $4.75
9,500
Cost
2,000 @ $4.00
June 25
8,800
$9,500 + 8,800
Date
3,000 units
17,600
CGS
$43,900
June 5
June 20
$ 8,000
Units
LIFO (Perpetual)
Sales
Total Cost
CGS 4,000
Sold 4,000 units; Calc cost of goods sold, ending inv
99
End
Inv
Balance
6,000 units
Calculate costs of goods sold at time of sale on June 20
Units
101
Available 8,000
Total Cost
$ 8,000
13,200
CGS
13,200
$34,000
Cost
CGS 3,000
End Inventory 5,000
End
Inv
Total Cost
= $13,200
$8,000 + 13,200
= $21,200
$34,400
102
17
LIFO (Perpetual)
Date
Purchases
June 5
2,000 @ $4.00
2,000 units
Date
Units
Unit Cost
June 15
3,000 @ $4.40
5,000 units
June 5
2,000
$4.00
June 25
2,000 @ $4.75
7,000 units
June 15
3,000
$4.40
6,000 units
June 25
1,000
$4.75
June 25
1,000
$4.75
Total
7,000
June 30
Sales
LIFO (Perpetual)
Balance
1,000 units
Calculate costs of goods sold at time of sale on June 30
End
Inv
$ 8,000
13,200
4,750
CGS
4,750
$30,700
Units
Cost
Total Cost
$8,000 + 13,200 + 4,750
= $25,950
CGS 1,000
End Inventory 6,000
Total Cost
= $ 4,750
Available 7,000
103
$30,700
104
Comparison of
Cost Flow Methods
LIFO (Perpetual)
Date
Units
Unit Cost
June 5
2,000
$4.00
Total Cost
$ 8,000
June 15
3,000
$4.40
13,200
June 25
1,000
$4.75
4,750
Total
6,000
Average
Cost
Moving
Average
FIFO
LIFO
Periodic
LIFO
Perpetual
CGS
$17,560
$ 17,320
$16,800
$18,300
$25,950
End Inv
$26,340
$26,580
$27,100
$25,600
$17,950
$25,950
Date
Units
Cost of Goods Sold
June 20
3,000
$13,200
June 30
1,000
4,750
Total
4,000
$17,950
105
FIFO When Costs Are Rising
106
LIFO When Costs Are Rising
§  Matches low (older) costs with sales
§  Higher gross profit
§  Higher taxable income
§  Ending inventory approximates
replacement cost
§  Matches high (newer) costs with sales
§  Lower gross profit
§  Lower taxable income
§  Ending inventory lower (older) costs
§  Does not approximate replacement cost
§  Not allowed under IFRS
107
108
18
Match Replacement Cost
to Revenue
Decision Makers’ Perspective
§  How closely do reported costs reflect
actual flow of inventory? (not factor)
§  Are costs matched to revenues?
§  Does ending inventory = replacement
§  How does the choice effect
§  Selling price: $100, sell one unit
§  Two inventory layers
§  Older layer: 10 units at $95
§  Newer layer: 5 units at $104
§  Net income
§  Income taxes
§  Cash flow
Revenues
Cost of goods sold
FIFO
LIFO
100
100
95
104
5
(4)
Gross profit
109
Tax Advantage Of LIFO
LIFO Conformity Rule
FIFO
LIFO
Revenues
500
500
Cost of goods sold
210
280
Gross profit
290
220
Wages expense
60
60
Rent expense
40
40
190
120
76
48
114
72
Net income before taxes
Income tax (40%)
Net income
FIFO net income advantage
110
§  If LIFO used for tax purposes
§  IRS requires LIFO for book purposes
§  In notes can disclose value of ending
inventory using alternate method (FIFO
or weighted average)
42
LIFO tax savings / cash flow advantage
28
111
How Popular is Each
Cost Flow Method
112
Learning Objectives
§  LIFO reserve
Method
FIFO
Percentage
2003
46%1973
LIFO
30%
Average cost
20%
Other
4%
Total
100%
113
114
19
LIFO Reserve or Allowance
LIFO Reserve or Allowance
§  Many companies use LIFO for external
reporting and income tax purposes
§  Maintain internal records using FIFO or
average cost
§  Disclosure describes difference
between LIFO and book inventory
§  Conversion from FIFO or average cost
to LIFO takes place at end of period
§  LIFO reserve may be contra account
§  Use disclosure note
Inventory at FIFO cost
2011
2010
$12,541
$11,544
Less: LIFO reserve (or allowance)
Inventory at LIFO cost
115
Inventory at FIFO cost,
which approximates replacement cost
116
Learning Objectives
§  For comparison with other companies, a
disclosure note is required to convert
LIFO inventory to replacement cost
2011
2010
$10,960
$9,737
1,581
1,807
$12,541
$11,544
Add: Conversion to FIFO
1,807
$9,737
Annual report: Dr. Pepper note 4
LIFO Reconciliation Note
Inventory at LIFO cost
1,581
$10,960
§  LIFO liquidations
Codification: 330-10-S99 (bottom of page)
117
118
LIFO Liquidation
LIFO Liquidation
§  In time of rising costs (usual case)
§  Older LIFO layers have lower cost
§  If older layers sold (LIFO liquidation)
§  Lower cost of goods sold
§  Higher net income before taxes
§  Higher taxes
§  “Paper profits”
Units
Cost
Total
January
1,000
$12
$12,000
May
1,200
$15
$18,000
September
1,500
$20
$30,000
If 2,000 units sold CGS = (1,500 × $20) + (500 × $15)
CGS = $37,500
If 2,000 had been purchased in September at $20
CGS = 2,000 × $20
CGS = $40,000
§  If material, disclose in notes
Problem: Old CGS expense matched to current revenue
Date
119
CGS $2,500 lower because LIFO liquidation
120
20
Learning Objectives
LIFO Inventory Pools
§  Dollar-value LIFO
§  Large retailers have
§  More than 10,000 different items in stock
§  More than 100,000 total units in inventory
§  Unit LIFO costly to implement
§  LIFO liquidations always possible, but
should be avoided
121
LIFO Inventory Pools
122
Dollar-Value LIFO (DVL)
§  Inventory pools consist of inventory
units grouped according to similarities
§  DVL extends concept of pools
§  Most LIFO applications use DVL
§  Pools based on similar cost changes
§  Physical similarities (lumber, tools, paint)
§  Inventory pool simplifies record keeping
§  Pools reduce risk of LIFO liquidation
§  Similar units purchased in same period
are “pooled”, assigned average cost
§  Costs increase 0% to 2%
§  Costs increase 2% to 5%
§  Costs increase 5% to 10%
123
Dollar-Value LIFO (DVL)
§  Not based upon physical similarities
§  Large variety of goods in one pool
124
Dollar-Value LIFO (DVL)
§  DVL pools layers of dollars, not units
§  Layers have similar cost changes
§  Each pool has one layer per year
§  Reduces risk of LIFO liquidations
§  Simplifies pool record-keeping
§  Inventory records during period
§  Do not record purchase costs as layers
§  Do not record unit inflows and outflows
§  At end of period
§  Count ending inventory
§  Value at end of period costs
125
126
21
Dollar-Value LIFO (DVL)
Dollar-Value LIFO (DVL)
§  Unit LIFO compares
§  Comparing costs creates a problem
§  Costs change over time
§  If end inv cost > beg inv cost
§  Ending units to beginning units
§  Dollar-Value LIFO compares
§  Ending inv cost to beginning inv cost
§  Do we have more inventory?
§  Do we have less inventory at higher cost?
127
128
Cost Index
Dollar-Value LIFO (DVL)
§  Similar to Consumer Price Index (CPI)
§  Companies create cost index internally
§  At end of period, determine if a new
inventory layer was added by
§  Converting ending inventory to beginning
inventory price level
§  Comparing converted ending dollar amount
to beginning dollar amount
§  Double-extension method
§  Link-chain method
§  In our class cost index given
§  If ending > beginning, create new layer
129
130
Dollar-Value LIFO (DVL)
Example 1
Dollar-Value LIFO (DVL)
§  Restate layers to actual cost
§  Purchase, sell 10,000+ chairs per year
§  Ending inventory always one chair
§  Identify layers in ending inventory and the
years they were created
§  Convert each layer’s base year cost to
actual cost by multiplying by cost index
§  Sum all the layers to arrive at ending
inventory at DVL cost
Inventory
Year Units Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
1
100
÷ 1.00
= 100
−
2012
1
105
÷ 1.05
= 100
0
2013
1
108
÷ 1.08
= 100
0
2014
1
112
÷ 1.12
= 100
0
Ending inventory valued at $100 at the end of each year
131
132
22
Dollar-Value LIFO (DVL)
Example 2
§  Purchase, sell 10,000+ chairs per year
§  Ending inventory varies
Inventory
Year Units Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
1
100
÷ 1.00
= 100
−
2012
4
420
÷ 1.05
= 400
300
2013
2
216
÷ 1.08
= 200
(200)
2014
6
672
÷ 1.12
= 600
400
Inventory
Base-Year $
Yearly
Change
2011
1
100
÷ 1.00
= 100
−
2012
4
420
÷ 1.05
= 400
300
2013
2
216
÷ 1.08
= 200
(200)
2014
6
672
÷ 1.12
Inventory at
Base-Year Prices
= 600
100
÷ 1.00
= 100
−
4
420
÷ 1.05
= 400
300
2013
2
216
÷ 1.08
= 200
(200)
2014
6
672
÷ 1.12
= 600
400
(4.20 / 1.05)
216
2013 200
(672 / 1.12)
2014 600
2011
2012
Inventory at
Base-Year Prices
672
2013
134
2014
Layers at
Base-Year Prices
Price
Index
(2011) 100
× 1.00
= 100
(2012) 300
× 1.05
= 315
420
Total
= 400
Inventory at
DV LIFO Cost
= 415
Reflate inventory to actual cost during year purchased
400
Inventory at
DV LIFO Cost
2011 100
(2011) 100
× 1.00
= 100
2012 300
(2012) 300
× 1.05
= 315
= 400
(300 × 1.05)
315
= 415
Inventory
Year Units Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
1
100
÷ 1.00
= 100
−
2012
4
420
÷ 1.05
= 400
300
2013
2
216
÷ 1.08
= 200
(200)
2014
6
672
÷ 1.12
= 600
2011
2012
Inventory at
Base-Year Prices
2013
136
2014
Layers at
Base-Year Prices
Price
Index
(2011) 100
× 1.00
= 100
(2012) 100
× 1.05
= 105
200
Total
= 200
Inventory at
DV LIFO Cost
= 205
Reflate inventory to actual cost during year purchased
400
Layers at
Base-Year Prices
Price
Index
Inventory at
DV LIFO Cost
2011 100
(2011) 100
× 1.00
= 100
2012 100
(2012) 100
× 1.05
= 105
= 200
420
(216 / 1.08)
2013: Dollar-Value LIFO (DVL)
Example 2
Total
1
2012 400
135
200
2011
Price
Index
Total
Yearly
Change
2012
Layers at
Base-Year Prices
420
Inventory at
Base-Year Prices
Inventory
Base-Year $
2011 100
2012: Dollar-Value LIFO (DVL)
Example 2
Price
Index
Price
Index
Deflate inventory at year-end cost to base year cost
133
Inventory
Year Units Year-End $
Inventory
Year Units Year-End $
(100 × 1.05)
105
= 205
137
2011
2012
2013
138
2014
23
2014: Dollar-Value LIFO (DVL)
Example 2
Inventory
Year Units Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
1
100
÷ 1.00
= 100
−
2012
4
420
÷ 1.05
= 400
300
2013
2
216
÷ 1.08
= 200
(200)
2014
6
672
÷ 1.12
= 600
400
Inventory at
Base-Year Prices
600
Inventory at
Base-Year Prices
2011 100
(2011) 100
× 1.00
= 100
2012 100
(2012) 100
× 1.05
= 105
(2014) 400
× 1.12
= 448
Inventory
Year-End $
Price
Index
Inventory
Base-Year $
× 1.00
= 100
× 1.05
= 105
(2014) 400
× 1.12
= 448
= 600
(100 × 1.05)
= 653
105
(400 × 1.12)
2014 400
139
Dollar-Value LIFO (DVL)
Example 3
Year
(2011) 100
Reflate inventory to actual cost during year purchased
Inventory at
DV LIFO Cost
= 653
Inventory at
DV LIFO Cost
(2012) 100
Total
Price
Index
= 600
Price
Index
600
Layers at
Base-Year Prices
Total
Layers at
Base-Year Prices
2011
2012
448
140
2013
2014
2011: Dollar-Value LIFO (DVL)
Example 3
Yearly
Change
Year
Inventory
Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
200,000
÷ 100
= 200,000
−
2011
200,000
÷ 1.00
= 200,000
−
2012
299,000
÷ 1.15
= 260,000
60,000
2013
300,000
÷ 1.20
= 250,000
(10,000)
2014
351,000
÷ 1.30
= 270,000
20,000
Inventory at
Base-Year Prices
Layers at
Base-Year Prices
Price
Index
Inventory at
DV LIFO Cost
200,000
200,000
× 1.00
= 200,000
First year using dollar-value LIFO
141
2012: Dollar-Value LIFO (DVL)
Example 3
Year
Inventory
Year-End $
Price
Index
Inventory
Base-Year $
2011
200,000
÷ 100
= 200,000
2012
299,000
÷ 115
= 260,000
Inventory at
Base-Year Prices
260,000
Total
142
2013: Dollar-Value LIFO (DVL)
Example 3
Yearly
Change
Year
Inventory
Year-End $
Price
Index
Inventory
Base-Year $
−
2011
200,000
÷ 100
= 200,000
−
60,000
2012
299,000
÷ 115
= 260,000
60,000
2013
300,000
÷ 120
= 250,000
(10,000)
Layers at
Base-Year Prices
Price
Index
Inventory at
DV LIFO Cost
(2011) 200,000
× 1.00
= 200,000
Inventory at
Base-Year Prices
(2012) 60,000
× 1.15
= 69,000
250,000
= 260,000
= 269,000
Total
143
Yearly
Change
Layers at
Base-Year Prices
Price
Index
Inventory at
DV LIFO Cost
(2011) 200,000
× 1.00
= 200,000
(2012) 50,000
× 1.15
= 250,000
= 57,500
= 257,500
144
24
2014: Dollar-Value LIFO (DVL)
Example 3
Year
Inventory
Year-End $
Price
Index
Inventory
Base-Year $
Yearly
Change
2011
200,000
÷ 100
= 200,000
−
2012
299,000
÷ 115
= 260,000
60,000
2013
300,000
÷ 120
= 250,000
(10,000)
2014
351,000
÷ 130
= 270,000
Inventory at
Base-Year Prices
270,000
How many times do we buy and sell
average inventory during year
20,000
Layers at
Base-Year Prices
Price
Index
Inventory at
DV LIFO Cost
(2011) 200,000
× 1.00
= 200,000
(2012) 50,000
× 1.15
= 57,500
(2014) 20,000
× 1.30
Total
Inventory Turnover
= 270,000
= 26,000
= 283,500
Inventory
turnover =
Cost of goods sold
Average inventory
145
146
Inventory Turnover
Days To Sell Inventory
How many times do we buy and sell
average inventory during year
How many days to sell $1 of inventory
Inventory
turnover =
Days to sell
inventory =
Cost of goods sold
(
Beg inv + End inv
2
365
Inventory turnover
)
147
Gross Profit Ratio
148
End of Chapter
How much of every $1 of sales becomes
gross profit?
Gross profit
ratio
=
Gross profit
Net sales
149
150
25