Chapter 9: Inventories: Additional Valuation Issues Flashcards
LIFO Reserve
The difference between the inventory method used for internal reporting (generally FIFO, average cost or standing cost) and LIFO
LIFO inventory + LIFO reserve = FIFO inventory
LIFO effect
Allowance account = contra asset = credit natural balance
the adjustment that companies must make to the accounting records in a given year
companies must disclose either LIFO reserve or replacement cost of inventory
Uses allowance to reduce inventory to LIFO account
Last-in, First-out costing method
Usually results in lower net income than FIFO)
- COGS valued at the most recent purchase
- ending inventory valued by taking the unit cost of the OLDEST purchase and working down until all units are accounted for (different ending inventory / COGS under periodic vs perpetual inventory)
- not actually reflective of movement of goods except for piled items
- tends to defer income tax liability
First-In, First-out costing method
FIFO
fails to match current costs with current revenue
- ending inventory valued by taking the unit cost at the most recent purchase and working backwards till all inventory is accounting for
- general good business practice? approximates actual flow, ending inventory near actual inventory
- highest income of costing methods = appealing to investors + higher taxes
- no difference between periodic + perpetual inventory COGS
Journaling Sale of Inventory: perpetual system
Debit Accounts Receivable/ Cash (increase)
Credit Sales/ Revenue (increase)
ALSO
Debit COGS (increase)
Credit Merchandise Inventory (decrease)
- happens when customer receives goods
- requires invoice receipt/ backup
any shipping costs are recording separately
Perpetual vs Periodic inventory systems
Cost flow methods
PERPETUAL - record cost of good + reduce inventory at time of sale (inventory always shows current amounts)
- uses merchandise inventory account
PERIODIC - COGS recorded only at the end of the accounting period
- uses purchases account (not merchandise inventory)
- COGS determined at end of period
Moving-average method
Average costing method used with perpetual system
new average unit cost calculated after any purchase is made
Weighted Average Unit Cost
= Cost of goods available for sale (total) / total units available for sale
Average Cost costing method
Practical - simple to apply
All units valued at weighted average unit cost
Assumes similarity of all goods
total cost of goods available for sale / total units available for sale
in perpetual system new weighted average calculated after each purchase
in periodic system weighted average only calculated at the end of a given period
usually results in a net income between FIFO (higher) and LIFO (lower)
Specific Identification Costing Method
Preferred by IFRS wherever possible
- rare
- items must be individually tagged to tracked costs
- generally large, high-value items
- cost flow matches physical flow
- can be difficult to allocate costs like shipping
- can be manipulated - boost income by selling low-cost units and vise versa
Classification of Selling Costs
per GAAP must be disclosed in statements
Gross method for purchases
Uses a purchase discounts account
reports purchases and payables at gross amounts
Reports discounts in purchase discounts contra account when taken
- then shows up below purchases on income statement
Net method for purchases
use purchase discounts forfeited account
Reports purchases at net amount (with discount)
if paid too late to get discount report amount of purchase discounts forfeited (expense account)
correct reporting of asset/ liability value
also tracks management efficiency
Product Costs
Recorded to the inventory account
- cost of bringing goods into a buyer’s place of business and converting to a salable condition
- freight charges
- acquisition costs
- labor/ production costs to time of sale
Too difficult to allocate purchasing department and storage costs so not usually included.
Capitalizing interest costs
FASB ruled companies should capitalize interest costs related to assets constructed for internal use or assets produced as discrete projects for sale or lease
Period Costs
Not included as inventory costs
Sales with high rate of return
Formal or informal agreements that permit purchasers to return the inventory for a full or partial refund (publishing)
requires an estimated inventory return account to recognise that some inventory will be returned
if returns are unpredictable then goods NOT removed from inventory
Sale with repurchase agreement
“parking transactions”
even though one company has the title the other maintains control
inventory as collateral on a loan
should be on the books of the entity with legal control
Consigned inventory
Remains in consigner’s inventory
may disclose inventory on consignment in notes or as a separate inventory item if material amount
Which goods to include in inventory
Control as key deciding factor: who has ability to use benefits of ownership.
Transit FOB shipping point vs destinatio
- shipping point: transfer occurs upon delivery to carrier
- destination: transfer occurs upon delivery to customer
Consignment - remains property of the consigner and in their inventory(not in the inventory of the agent)
Periodic system cost of goods sold
Beginning inventory \+ cost of goods acquired / produced in the period = cost of goods available for sale - ending inventory = cost of goods sold
Modified perpetual inventory system
Records quantity increases / decreases but does not track dollar amounts
Inventory over/short account
Adjusts cost of goods sold
sometimes reported in other revenues and gains or other expenses and losses
Journaling perpetual inventory adjustment
to adjust book count to match physical
short:
Debit Inventory Over/Short
Credit Inventory
Over:
Debit Inventory
Credit Inventory over/short
Inventory accounts for manufacturing concerns
- Raw materials (goods / materials on hand but not yet placed into production)
- work in progress inventory (unfinished units: Raw materials costs + direct labor costs + share of overhead)
- Finished goods inventory (cost of completed but unsold units)
- Supplies inventory (non-direct materials
Merchandise inventory
Single account for cost of unsold units for merchandising concerns
Inventory
Asset items a company holds for sale in the ordinary course of business or goods it will use or consume in the production of goods sold
Inventory Profits
When the inventory costs matched against sales are less than current replacement costs
Reduced by LIFO
Advantages of LIFO
Matching: recent costs to current revenue (during inflation FIFO creates “paper profits”
Tax benefits/ improved cashflow
Future earning hedge: future price declines have less effect on earnings. Minimizes write downs of high-priced inventory
Disadvantages of LIFO
Reduced earnings
understating inventory - working capital apparently diminished
Does not generally approximate physical flow
may result in poor buying habits
LIFO conformity rule
Tax rule: if LIFO used for tax purposes must also be used for financial reportin
Result of inventory misstatement on financial statements
if ending inventory understated: Balance sheet: - inventory: understated - Retained earnings: understated working capital: understated Current ratio: understated Income Statement: - COGS: overstated - Net income: understated
if ending inventory overstated: Balance sheet: - inventory: overstated - Retained earnings: overstated working capital: overstated Current ratio: overstated Income Statement: - COGS: Understated - Net income: overstated
EFFECTS TWO years though the total will be correct
Affect of failure to record inventory purchase on financial statements
Inventory + purchases understated
no affect on net income
Current ratio overstated
A/P understated
LIFO liquidation
Specific goods LIFO approach leads to LIFO liquidation leads to distortion of net income
Costs from preceding periods are matched against current sales dollars
countered with pooled LIFO approach
disclose on financial statments
Price index
% changes in prices from one year to another
often use CPI-U: consumer price index for urban consumers (or a specific industry index)
alternately:
Ending inventory for period @ current cost / ending inventory for the period at base year cost
Dollar value LIFO if ending inventory @ base prices < beginning inventory @ base prices
Company must subtract the decrease from the most recently added layer
basically just removes one later and then calcuates as if this was that following year (using the change from the base year x the previous year’s price index)
Dollar Value LIFO
Inventory at end current prices > inventory at beginning current prices
Need to know the price index: percentage prices have increased
End inventory / (1+ percent increase) = end inventory in terms of beginning prices
End inventory at beginning prices less beginning inventory = change in inventory quantity
Change (new layer) x (1 + % increase) = “real” dollar increase
Real dollar increase = new layer
Dollar Value LIFO
End inventory at base year prices = total of laters at base year prices
Determines and measures and increases and decreases in a pool of inventory in terms of total dollar value, not physical quantity of goods in the inventory pool
Pools with broad range of goods
New layers only added when ending inventory (at base year prices) exceeds beginning inventory at base year prices
