Chapter 8: Valuation of Inventories

What are the major advantages of LIFO?

(1) It matches recent costs against current revenues to provide a better measure of current earnings; (2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO; (3) Because of the deferral of income tax, cash flow improves; (4) A company's future reported earnings will not be affected substantially by future price declines (future earnings hedge).

Why is the net method of accounting for purchase discounts considered superior?

(1) It provides a correct reporting of the cost of the asset and related liability. (2) It can measure management inefficiency by holding management responsible for discounts not taken.

What are the major disadvantages of LIFO?

(1) Reduced earnings; (2) Inventory is stated in terms of old costs which may be far below current costs; (3) The cost flow does not approximate the physical flow of the items except in unique situations; (4) Poor buying habits caused by involuntary liquidations

What's the approach and explanation of solving dollar-value LIFO?

(1) The ending inventory must first be converted form current dollars to base-year dollars (ending inventory at current prices / current price index). (2) The ending inventory at base-year prices is apportioned into layers, according to individual years in which the inventory was acquired. (3) Each layer is priced using the index of the year in which it was acquired in order to obtain the inventory at dollar-value LIFO cost.

What are the effects of a company misstating purchases (and related accounts payable) and ending inventory by the same amount?

(1) inventory and accounts payable will be misstated in the balance sheet, which leads to miscalculation of the current ratio, (2) cost of goods sold and net income will not be misstated in the income statement (even though purchases and ending inventory are both misstated in the income statement)

What are the effects of a company misstating ending inventory?

(1) inventory and retained earnings will be misstated in the balance sheet, which leads to miscalculation of working capital and the current ratio, (2) cost of goods sold and net income will be misstated in the income statement

If prices increase over the current year by 8%, the current price index would be _

108.

If ending inventory is given at $128,800 at current cost and $115,000 at base prices, the current price index is __

112.

Average days to sell inventory ratio

365 / inventory turnover ratio

Days' Sales Inventory; What does it tell us?

365 days in a year / inventory turnover in a year; The average number of days that it took to sell the average inventory during the year. This statistic is only as good as the Inventory Turnover figure.

What is the LIFO reserve and how is it reported?

A LIFO reserve is the difference between the ending inventory amount derived by the inventory method used for internal reporting purposes (FIFO, for example) and the ending inventory amount derived by the use of the LIFO method employed for external reporting purposes. This difference is often recorded in an account called Allowance to Reduce Inventory to LIFO. The change in the balance of this account from one period to the next is called the LIFO effect. Credit COGS and debit Allowance to Reduce Inventory to LIFO. Either the amount of the LIFO reserve or the replacement cost of the inventory should be disclosed in the financial statements of the accompanying notes.

Double-extension method

A method for computing a specific internal price index, when a relevant external price index is not readily available, by determining current costs with reference to the actual cost of the goods most recently purchased. The price measure provides a measure of the change in the price or cost levels between the base year and the current year. The company then computes the index for each year after the base year. (p. 404).

Net method

A method in which a company considers purchase discounts lost as a financial expense and reports it in the "Other expenses and losses" section of the income statement. (p. 392).

Gross method

A method in which a company reports purchase discounts as a deduction from purchases on the income statement. (p. 392).

Specific-goods pooled LIFO approach

A method used to alleviate LIFO liquidation problems and to simplify LIFO accounting, by grouping goods into pools of similar items. Thus, instead of tracking specific inventory units, a company combines, and accounts for together, a number of similar units or products, which usually results in fewer LIFO liquidations. (p. 400).

Modified perpetual inventory system

A system that provides detailed inventory records of increases and decreases in quantities only, not dollar amounts. (p. 385).

Dollar-value LIFO

A variation of the LIFO inventory-costing method; it determines and measures any increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool. The dollar-value LIFO method overcomes the problems of redefining pools and eroding layers that occur with the regular LIFO method. (p. 401).

Purchase Discounts

An account in a periodic inventory system that indicates the company is recording its purchases and accounts payable at the gross amount. (p. 392).

Explain the dollar-value LIFO method.

An important feature of the dollar-value LIFO method is that companies determine and measure increases and decreases in a pool in terms of total dollar value, not the physical quantity of specific goods in the inventory pool.

Perpetual inventory system

An inventory system in which a company continuously tracks changes in the Inventory account. The company records all purchases and sales (issues) of goods directly in the Inventory account as they occur. The accounting records continuously show the balances in both the inventory account and the cost of goods sold account. A computerized recordkeeping system records nearly instantaneously any additions to and issuances from inventory. (p. 383).

Inventories

Asset items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold. The investment in inventories is frequently the largest current asset of merchandising (retail) and manufacturing businesses. (p. 382).

What are several reasons why a company may choose to use LIFO for tax purposes and for general purpose financial statements while using the FIFO inventory costing method for internal reports?

Companies often base their pricing decisions on a FIFO, average, or standard cost assumption, rather than a LIFO basis; Record keeping on some basis other than LIFO is easier because the LIFO assumption usually does not approximate the physical flow of product; Profit-sharing and other bonus arrangements often depend on a non-LIFO inventory assumption; The use of a pure LIFO system is troublesome for interim periods, for which estimates must be made of year-end quantities and prices

What costs are assigned to raw materials?

Companies report the cost assigned to goods and materials on hand but not yet paced into production as raw materials inventory.

What costs are assigned to work in process inventory?

Companies report the cost of the raw materials on which production has been started but not yet completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs.

What costs are assigned to finished goods inventory?

Companies report the costs identified with the completed but unsold units on hand at the end of the fiscal period.

Freight-out

Cost of transporting goods to a customer. It is a selling expense. When the freight is included in the selling price, it is deducted from sales.

Period costs

Costs that attach to a specific accounting period. Examples are officers' salaries and other administrative expenses. Companies charge off such period costs in the immediate period, even though benefits associated with these costs may occur in the future. Period costs are not included as part of inventory cost; instead, they are matched with revenue of a specific time period and expensed as incurred. (p. 392).

LIFO liquidation

Erosion of the LIFO inventory under a specific-goods (unit LIFO) approach. Such erosion matches costs from preceding periods against sales revenues reported in current dollars, which often distorts net income and leads to substantial tax payments. (p. 399).

During rising prices, which method yields the lowest cost of goods sold figure?

FIFO

Which inventory cost method yields the most realistic amount for inventory, compared to replacement cost, on the balance sheet?

FIFO

Merchandise inventory

For a merchandising business, the cost assigned to unsold units left on hand, but ready for sale. Only one inventory account, Merchandise Inventory, appears in a merchandiser's financial statements. (p. 382).

F.O.B. destination

Freight term indicating that shipped goods are placed free on board ("f.o.b.") to the buyer's place of business and the seller pays the freight costs; the goods belong to the seller while in transit and title passes to the buyer when the buyer receives the goods from the shipping carrier. (p. 387).

F.O.B shipping point

Freight term indicating that shipped goods are placed free on board ("f.o.b.") to the shipping carrier by the seller and the buyer pays the freight costs; the goods belong to the buyer while in transit. (p. 387).

When do companies usually not prefer LIFO?

In the following circumstances: (1) if sales prices tend to lag behind changes in costs; (2) if specific identification is traditional such as in the sales of automobiles, farm equipment, art, and antique jewelry; and (3) when unit costs tend to decrease as production increases, thereby nullifying the tax benefit the LIFO might provide.

When do companies usually prefer LIFO?

In the following circumstances: (1) if selling prices and revenues have been increasing faster than costs; and (2) if a company has a fairly constant "base stock" (which is typical in companies dealing with refining, chemicals, and glass).

What are the two common financial ratios for monitoring inventory levels?

Inventory Turnover Ratio and the Days' Sales in Inventory

Consigned goods

Inventory held by one party (the consignee) who acts as the agent for the owner of the goods (the consignor) in selling the goods. The consignee accepts and holds the consigned goods without any liability, except to exercise due care and reasonable protection from loss or damage until it sells the goods to a third party. When the consignee sells the goods, it remits the revenue to the consignor, less a selling commission and expenses incurred in accomplishing the sale. (p. 387).

Periodic inventory system

Inventory system in which a company uses a Purchases account to record purchases of inventory during the period. The Inventory account represents the beginning inventory amount throughout the period; at the end of the accounting period the company adjusts the inventory account by closing out the beginning inventory amount and recording the ending inventory amount, which is determined by a physical count of the items on hand, valued at cost or at the lower-of-cost-or-market. (p. 384).

FIFO Method

Inventory-costing method that assumes that a company uses goods in the order in which it purchases them. Thus, the costs of the earliest goods purchased are the first to be allocated to cost of goods sold. FIFO often approximates the physical flow of goods, prevents manipulation of income, and prices ending inventory close to current cost, but it fails to match current costs against current revenues on the income statement, possibly distorting gross profit and net income. (p. 396).

LIFO method

Inventory-costing method that assumes that a company uses the latest goods purchased before it uses the earlier goods purchased. Thus, the costs of the latest goods purchased are the first to be allocated to cost of goods sold. LIFO provides a good matching of recent costs against current revenues and tax benefits, but generally reports lower earnings, which some managers see as a disadvantage. (p. 397).

Moving-average method

Inventory-costing method, used by companies that use the perpetual inventory method. In this method, a company computes a new average unit cost (a "moving average") each time it makes a purchase. (p. 395).

Weighted-average method

Inventory-costing method, used in the periodic inventory method, that prices items in the inventory on the basis of the average cost of all similar goods available during the period. The method calculates the total cost of inventories of similar goods, divides the total cost by the number of inventory units, and applies the weighted-average cost per unit to the items in ending inventory. (p. 395).

Specific identification

Inventory-costing methods in which companies identify and cost each item sold and each item in inventory. Retailers use this method only when handling a relatively small number of costly, easily distinguishable items, such as fur coats, automobiles, some furniture; manufacturers use it for special orders and many products manufactured under a job cost system. (p. 394).

During rising prices, which method yields the lowest amount for inventory on the balance sheet?

LIFO

During rising prices, which method yields the lowest income tax bill for the current year?

LIFO

During rising prices, which method yields the lowest net income figure?

LIFO

Explain the effect of LIFO liquidations.

LIFO liquidations match costs from preceding periods against sales revenues reported in current dollars. This distorts net income and results in a substantial tax bill in the current period. LIFO liquidations can occur frequently when using a specific goods LIFO approach.

Does FASB allow capitalizing interest costs incurred for inventories that are routinely manufactured?

No, FASB does not allow this. Capitalization in this case means accounted for as a component of the cost of the inventory. These interest costs are expensed in the income statement as interest expense.

How many inventory accounts appear in a manufacturing concern? In a merchandising concern?

Only one - Merchandise Inventory. Three - Raw Materials, Work in Process, and Finished Goods.

__ and ___ are always the same.

Periodic system, FIFO cost method; Perpetual system, FIFO cost method

Product costs (inventory)

Product costs are the costs directly associated with the acquisition of goods and the conversion of such goods to a salable condition. Such charges would include purchases, freight charges on goods purchased, other direct costs of acquisition, labor, and other production costs incurred in processing the goods up to the time of sale. Manufacturing overhead costs are also allocated to inventory. Manufacturing overhead costs include indirect material, indirect labor, and such items as depreciation, taxes, insurance, heat, and electricity incurred in the manufacturing process. Selling, administrative and interest costs are generally not included as inventory costs; they are period costs and thereby charged to expense in the period incurred.

Cost flow assumptions

Several systematic assumptions about the flow of inventory, used by companies to value their inventory. The main cost flow assumptions are specific identification, average-cost, FIFO, and LIFO. The actual physical movement of goods need not match the cost flow assumption a company adopts, but the company must use its selected cost flow assumption consistently from one period to the next. The objective should be to choose a cost flow assumption that most clearly reflects periodic income. (p. 394).

LIFO effect

The change from one period to the next in the balance of the account (Allowance to Reduce Inventory to LIFO, also called the LIFO reserve) that companies use to record the difference between the non-LIFO inventory method used for internal-reporting purposes and LIFO used for tax or external-reporting purposes. (p. 398).

Raw materials inventory

The cost assigned to goods and materials on hand but not yet placed into production. Raw materials can be traced directly to the end product. This category of inventory appears on the balance sheets of manufacturing companies. (p. 382).

Work in process inventory

The cost of partially processed units in a continuous production process, consisting of the raw material for these unfinished units, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs. This category of inventory appears on the balance sheets of manufacturing companies. (p. 382).

Finished goods inventory

The costs identified with the completed but unsold units on hand at the end of the fiscal period. This category of inventory appears on the balance sheets of manufacturing companies. (p. 382).

LIFO reserve

The difference between the inventory amount reported using LIFO for tax or external-reporting purposes and the inventory amount using FIFO or some other method for internal-reporting purposes. (p. 398).

Explain the significance and use of a LIFO reserve.

The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the LIFO reserve is referred to as the LIFO Effect. Companies should disclose either the LIFO reserve or the replacement cost of the inventory in the financial statements.

What method of accounting for purchase discounts is considered more in alignment with the cost principle?

The net method is more in alignment with the cost principle in that the fair value of the item(s) received (cash equivalent price of the purchase) is the purchase price net of any discount allowed.

LIFO conformity rule

This rule requires that if a company uses LIFO for tax purposes, it must also use LIFO for reporting in the general purpose financial statements (although neither tax law nor GAAP requires a company to pool its inventories in the same manner for book and tax purposes). A company often overcomes this disadvantage by providing supplemental disclosures in the notes to the financial statements. These supplemental disclosures often include non-LIFO income numbers as well as non-LIFE inventory numbers so that readers can more readily make meaningful interpretations of the statements and better comparisons with statements of other companies that do not use LIFO.

Freight-in

Transportation charge the company pays when it receives goods from a supplier. It is a separate account that is added to purchases in determining the cost of goods and ending inventory. Freight-in is a product cost.

___ is not included in the cost of inventory; How is it classified?

Transportation-out; as a selling expense on the income statement for the period in which the expense was incurred

When is "Inventory Over and Short" used?; Where is it reported?

When a company uses a perpetual system, it must periodically do a physical count to verify the accuracy of the perpetual records. When a difference exists, a company needs to record an adjusting entry. When physical count is less than the perpetual amount, debit Inventory Over and Short and credit Inventory; The over and short balance is normally included in cost of goods sold on the income statement, however, sometimes it is reported in the "Other expenses and losses"or "Other revenues and gains" section of the income statement.

Does FASB allow capitalizing interest costs incurred for assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease?

Yes, but such discrete projects should take considerable time to complete, entail substantial expenditures, and be likely to involve significant amounts of interest costs.

Depreciation for the current period of the office building and any showroom facilities for a manufacturing company is __

charged to the current period. It is not a product cost. Depreciation on the office building relates to the general administration of the business (operating expense). Depreciation of showroom facilities relates to the sales function (operating expense) and thus is not a cost of manufacturing the product.

Inventory turnover ratio

cost of goods sold / average inventory

Inventory Turnover Ratio; What does it tell us?

cost of goods sold for the year / average inventory for the year; The number of times per year that Inventory turns over. The result is an average, since sales and inventory levels are likely to fluctuate during the year. Since inventory is at cost (not sales value), it is important to use the Cost of Goods Sold. Also be sure to use the average balance of inventory during the year.

Palmer Company in Bay Hill sells to Tiger Woods in Orlando - what are three different ways to express that seller pays freight costs?

f.o.b. destination, f.o.b. buyer, or f.o.b. Orlando, Florida

Palmer Company in Bay Hill sells to Tiger Woods in Orlando - what are three different ways to express that buyer pays freight costs?

f.o.b. shipping point, f.o.b. seller, or f.o.b. Bay Hill, Florida

The inventory pricing method selected by an entity does not __

have to correspond to the actual physical flow of goods.

Many companies use LIFO for tax and external reporting purposes, but __

maintain a FIFO, average cost, or standard cost system for internal reporting purposes.

Depreciation of factory machinery is a component of __

manufacturing overhead; thus, it is an element of product cost. The amount of depreciation that pertains to the products produced during a period is first determined by use of the selected depreciation method. The amount of depreciation that ends up being reflected as an expense on the income statement for the same period depends on the number of products sold (not produced) during the period; it is included as part of cost of goods sold expense.

The amount of depreciation for the period of factory related items that pertains to the products that were produced during the current period bu that remain unsold at the end of the period is reflected as __. The amount of depreciation for the period that pertains to the goods that were partially processed during the current period and that remains in process at the end of the period is reflected as __

part of Finished Goods Inventory at the end of the period.; part of Work in Process Inventory at the end of the period.

Gross profit in __ is always the same as ___

periodic FIFO; perpetual FIFO

Average cost method

price items in the inventory on the basis of the average cost of all similar goods. periodic inventory method - weighted perpetual method - moving averages.

Costs incurred by a manufacturing company are often classified into two groups: __

product costs and period costs.

If a company uses the gross method, it reports __

purchase discounts contra to purchases (i.e., as a reduction of inventory cost).

If a company uses the net method, it considers __ and reports it in __.

purchase discounts lost as a financial expense; "Other expenses and losses"

Freight-out is classified as __, not a component of __. Freight-out is not a cost __; it is a cost __

selling expense; cost of goods old; necessary to get the inventory item to the place and condition for sale; incurred in the selling function

Product costs (Example)

such as material, labor, and manufacturing overhead attach to the product and are carried into future periods (as a balance in inventory) if the product remains unsold at the end of the current period, and, therefore, the revenue recognition is deferred to the period of sale. Product costs are thus expensed in the period the related product is sold.

Period costs (Example)

such as officers' salaries and other administrative expenses, advertising and other selling expenses, and interest expense (a financing cost) are charged to (expensed in) the period incurred.