Chp 8: Inventories Measurement(Additional Concepts)

Assets a company:

1. Intends to sell in the normal course of business

2. Has in production for futures sale(work in process)

3. uses currently in the production of goods to be sold(raw materials)

Proper accounting for inventories is essential for manufacturing, wholesale, and retail companies; inventory usually most valuable asset listed in balance sheet for these firms

Historical cost principle and the desire to match expenses and revenues offers guidance for measuring inventory and COGS.

Retailers carry this type of inventory and are intermediaries between manufacturer and consumer.

Cost includes the purchase price plus any costs necessary to bring the goods in condition and location for sale(sellable condition).

The cost of work in process and finished goods includes the cost of raw materials, direct labor, and an allocated portion of manufacturing overhead.

Overhead costs: include electricity, and other utility costs to operate the manufacturing facility, depreciation of manufacturing equipment, and many other manufacturing costs that cannot be directly linked to the production of specific goods.

Dollar of amount of each inventory category disclosed in a note or on the balance sheet for manufacturing companies.

1. Perpetual

2. periodic

system errors, theft, breakage, or spoilage cause differences between perpetual system and physical count

Scanning systems, bar codes keep track of sales; control and measure inventory

Perpetual system records addition and reduction to quantity of inventory and cost of inventory purchased/sold.

Physical count of ending inventory is made and costs are assigned to the quantities determined.

Temporary accounts: purchases, purchase returns, purchase discounts, freight-in)

Net purchases= Purchases+freight-in less returns and discounts.

COGS=Beginning Inventory+Net Purchases-Ending Inventory

Damaged or stolen items must be removed from beginning inventory or purchases before calculating COGS and then classified as separate expense items.

BI+Net Purchases=Cost of goods available for sale

periodic system allocates cost of goods available for sale between ending inventory and COGS at the end of the period.

Perpetual system allocates costs of goods available for sale to inventory and COGS each time goods are sold by decreasing inventory and increasing COGS.

Financial statement impact not significant

Management control considerations and comparative costs of use motivate the choice of which system to use.

Perpetual:

1. Provide more information about dollar amounts of inventory levels on a continuous basis

2. facilitate preparation of interim financial statements

3. May be more expensive, especially with large quantities of low cost items

4. More workable with inventories of high-cost items

Periodic:

1. Less costly

2. requires physical count to determine COGS and EI

3. Interim financial statement preparation more costly unless an inventory estimation technique is used

4. do not have inventory monitoring features of perpetual system

Perpetual system tracks both costs and quantities.

Many companies determine costs periodically, but use systems to constantly monitor quantities.

1. Goods in transit

2. goods on consignment

3. sales returns

1. f.o.b. shipping point

2. f.o.b. destination

We assign dollar amounts to quantities of goods sold and goods remaining in ending inventory by assuming how units of goods flow through the system.

Inventory methods that allow us to allocate goods available for sale to COGS and EI:

1. specific identification

2. average cost

3. LIFO

4. FIFO

1. average cost falls in between FIFO and LIFO

2. pattern of unit cost changes such as rising or decline unit costs determine whether FIFO or LIFO has higher COGS and EI.

3. During periods of rising costs, FIFO results in lower COGS and higher EI than LIFO, and in periods of declining costs, LIFO has lower COGS and higher EI than FIFO.

4. Each inventory method permissible under GAAP and a company need not use the same inventory method for the entire inventory, such as using LIFO for raw materials, and other methods for other inventories.

5. Company must disclose the method it uses

IAS No. 2 prohibits use of LIFO.

Multinational U.S. companies use LIFO for only domestic purposes.

U.S. convergence to IFRS could be very expensive for many corporations, particularly for companies that use LIFO for tax purposes.

Companies' may choose inventory method that mirrors physical flow of goods, but are not required.

matching inventory method with physical flow of goods is not primary motivator

The effect of inventory method on income and taxes is the primary motivation that influences method choice.

Companies may use LIFO reserves when they use LIFO for external reporting and income tax purposes, but maintain their internal records using FIFO or average cost. 3 reasons:

1. higher recordkeeping costs for LIFO

2. contractual agreements such as bonus or profit sharing plans that calculate net income with a method other than LIFO

3. Using FIFO or average cost information for pricing decisions.

Generally, conversion to LIFO from the internal records occurs at the end of the reporting period without actually entering the adjustment into the company's records.

1. actual physical flow of inventory

2. effect of inventory method on reported net income and amount of income taxes payable

3. provide a better match of revenues and expenses.

1. To ensure that the inventories needed to sustain operations are available

2. hold the cost of ordered and carrying inventories to the lowest possible level

Objectives often conflict with one another.

Company must meet quantity of inventory that customers demand, but it may be costly.

Changes in ratio, such as inventory turn over ratio, provide information about a company's earnings quality.

LIFO liquidation profit or loss reduces the quality of current period earnings.

Periodic LIFO COGS calculation more susceptible to manipulation than is FIFO; year-end purchases on COGS in rapid cost-change environments.

1. Can be very costly to implement because it requires records of each unit of inventory, which are costly to maintain, particularly when the company has numerous individual units of inventory and when unit costs change often during a period.

2. LIFO liquidation of a layer, which in a period of rising costs, noncurrent lower costs will be included in COGS and matched with current selling prices, resulting in LIFO liquidation profit.

1. Simplifies recordkeeping process because no information about unit flows is needed.

2. minimizes the probability of liquidation of LIFO inventory layers through the aggregation of many types of inventory into larger pools.

3. Can be used by firms that do not replace units sold with new units of the same kind, such as for firms whose products are subject to annual model changes

4. Under pooled LIFO, new replacement items must be substantially identical, while under DVL, no distinction is drawn between the old and new merchandise on the basis of their physical traits, so a much broader range of goods can be included in the pool.

5. Acquisition of new items viewed as replacement of DVL of old items.

6. Old layers are maintained

1. Unit LIFO and pooled LIFO focus on units of inventory to determine new LIFO layer, while DVL determines new layer by focusing on inventory value(comparing ending dollar amount with beginning dollar amount).

2. We use cost indexes to determine whether a price level change is the result of a real increase(an increase in the quantity of inventory) or one caused by an increase in prices; thus inventory amounts are deflated by any increase in prices, so that both the ending and beginning inventory amounts are measured in terms of the same price level.

3. Cost Index in layer year= Cost in layer year/cost in base year

4. Base year is the year in which the DVL method is adopted, and layer years are any subsequent years in which an inventory layer is created.

5. Several techniques to determine an index for a DVL pool, such as external indexes(CPI and PPI) and internally generated indexes, which are calculated using double-extension method or the link-chain method.

Starting point: determine current year's ending inventory valued at year end costs.

STEP 1: Convert ending inventory valued at year-end cost to base year cost.

Ending Inventory at base year cost= Ending Inventory at year-end cost/ year's cost index; reflects ending inventory deflate to base year costs

STEP 2:

Identify the layers of ending inventory and the years they were created.

STEP 3:

Convert each layer's base year cost to layer year cost using the cost index for the year it was acquired; the cost are totaled to obtain ending inventory at DVL cost