Chapter 7 . Inventories: Cost Measurement and Flow Assumptions. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.. ID: 322186
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Chapter 7 Inventories: Cost Measurement and Flow Assumptions
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.Slide2
What is Inventory?
Inventories are assets of a company that are:held for sale to customers in the ordinary course of business.in the process of production for sale.held for use in the production of goods or services to be made available for sale.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.Slide3
How Do Companies Classify Inventory?
Merchandising companiesMerchandise inventory: Includes goods acquired for resale with no alteration to their physical form.Manufacturing companiesRaw Materials: Raw materials inventory includes the tangible goods acquired for direct use in the production process.Work in Process Inventory: Work in process inventory (or goods in process inventory) includes the products that have been started in the manufacturing process but are not yet complete.Finished Goods Inventory: Finished goods inventory includes the completed manufactured products awaiting sale.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.Slide4
Flow of Inventory Costs
Cost of Goods Sold Model
How Do Companies Report Inventory in Their Financial Statements?
Manufacturing companies will generally disclose, either directly on the balance sheet or in the notes to the financial statements, the dollar amount of each inventory category.Inventory cost reported is the final amount that results from the following steps:Step 1. The company must decide what items to include in the inventory and count the physical inventory quantities.Step 2. The company must determine the costs of the units it purchased or produced during the accounting period, taking into consideration the costs for freight-in and the reductions for purchases discounts, returns, and allowances.Step 3. The company uses a cost flow assumption to allocate the costs of the beginning inventory plus the units purchased or produced during the year between the ending inventory and the cost of goods sold.
Alternative Inventory Systems
Perpetual Inventory System: A company using a perpetual inventory system keeps a continuous record of the physical quantities in its inventory.Periodic Inventory System: A company using a periodic inventory system does not maintain a continuous record of the physical quantities (or costs) of inventory on hand. It takes physical counts periodically, which should be at least once a year and generally at the end of the year.
How Do Companies Determine Inventory Quantities? (Slide 1 of 6)
Goods in Transit: When goods are in transit at the end of the accounting period, the shipping terms determine whether the seller or the buyer includes them in its inventory.If the goods are shipped FOB (free-on-board) shipping point, control of (and legal title to) the goods is transferred at the shipping point.If goods are shipped FOB destination, control of (and legal title to) the goods is not transferred until the goods are delivered to the buyer’s destination.
How Do Companies Determine Inventory Quantities? (Slide 2 of 6)
How Do Companies Determine Inventory Quantities? (Slide 3 of 6)
Consigned Goods: Sometimes, a manufacturer or wholesaler may transfer goods to a retailer under a consignment arrangement.In this arrangement, the company delivering the goods (the consignor) retains economic control and ownership, while the company receiving the goods (the consignee) acts as a sales agent of the consignor and attempts to sell the goods to a third party. Such an arrangement gives the consignor access to a broader market of potential customers by encouraging the consignee to stock goods
How Do Companies Determine Inventory Quantities? (Slide 4 of 6)
Product Financing Arrangements: Some companies will engage in product financing arrangements as a way of financing the cost of inventory.In a product financing arrangement, one company ‘‘sells’’ the inventory to a financing company. Then, in a related transaction, the seller agrees to purchase the inventory (or a substantially identical item) back from the ‘‘financier’’ at specified prices over specified periods.
How Do Companies Determine Inventory Quantities? (Slide 5 of 6)
Bill and Hold Sales: In some situations, a company may purchase inventory yet not be ready to take delivery for various reasons such as lack of available space to store the goods or an unanticipated delay in the production schedule.In these cases, the buyer may request that the seller holds the goods to be delivered at a later date. In general, the goods should remain in the inventory of the seller (and no revenue should be recognized) until delivery has occurred.
How Do Companies Determine Inventory Quantities? (Slide 6 of 6)
Purchase Obligations: To ensure a sufficient supply of inventory, many companies will enter into agreements to purchase inventory well in advance of when the actual purchase will occur.Accounting principles generally do not require a company to record either an asset (inventory) or a purchase obligation when entering into a purchase commitment because neither an asset nor a liability is created by placing an order. Therefore, these purchase obligations are not recognized in inventory until delivery. Instead, if a company has incurred an unconditional purchase obligation at a fixed price or a price to be determined, the company discloses this commitment in a note to its financial statements.
How Do Companies Determine Inventory Costs?
Product Costs: The cost of inventory is the price paid or consideration given to acquire it. Thus, inventory cost includes costs directly or indirectly incurred in bringing an item to its existing condition and location for sale.Period Costs: such as general and administrative costs and selling costs, are normally expensed because they are not related directly or indirectly to bringing inventory to its existing condition and location for sale.
Under the gross price method, a company records the purchase at the gross price and records the amount of the discount in the accounting system only if the discount is taken. This discount should be deducted from the purchase price of the inventory.Under the net price method, a company records the purchase at its net price and records the amount of the discount in the accounting system only if the discount is not taken. This discount lost should be treated as a period expense.
Cost Flow Assumptions
Unless the company specifically identifies and traces each item of inventory through its operations, it must attach costs to the units of inventory using a cost flow assumption. The major cost flow assumptions are specific identification; first-in, first-out (FIFO); average cost; and last-in, first-out (LIFO). Note that there is no requirement that the cost flow assumption be related to the physical flow (except for the specific identification method).Both the unit relationship and the cost flow relationship are shown in the next slide.
Illustration of Unit and Cost Flow Relationships
Under the specific identification inventory cost flow assumption, a company identifies each unit sold and each unit remaining in the ending inventory and includes the actual costs of those particular units in cost of goods sold and ending inventory, respectively.
First-In, First-Out (FIFO)
The first-in, first-out (FIFO) cost flow assumption allocates the cost of goods available for sale between ending inventory and cost of goods sold based on the assumption that the oldest purchases (the first in) are the first ones sold (the first out).
Under the average cost flow assumption, the cost of ending inventory and cost of goods sold is based on the average of the cost of goods available at a particular point in time.When a company uses the periodic inventory system, the average cost method is known as the weighted average method. When a company uses the perpetual inventory system, the average cost method is known as the moving average method. Under this method, the weighted average cost per unit for the period is computed as follows:
Last-In, First-Out (LIFO) Periodic
The last-in, first-out (LIFO) cost flow assumption allocates the cost of goods available for sale between ending inventory and cost of goods sold based on the assumption that the most recent purchases (the last in) are the first ones sold (the first out).
In a Period of Rising Prices:
The FIFO method produces the lowest cost of goods sold because it includes the oldest and lowest costs. Because the cost of goods sold is lowest, the gross profit (and income) is highest.The FIFO method produces the highest cost of ending inventory because it includes the most recent and highest costs.The LIFO method produces the highest cost of goods sold and the lowest gross profit (and income) because it includes the most recent and highest costs.The LIFO ending inventory is lowest because it includes the earliest and lowest costs.The average cost amounts are between the FIFO and LIFO extremes because the ending inventory and the cost of goods sold include an average of both the lower and higher costs of the period.
What are the Consequences of Using Alternative Inventory Cost Flow Assumptions? (Slide 1 of 2)
Income Measurement: For financial reporting, the basic objective of accounting for inventory is to report a relevant and representationally faithful balance sheet value for inventory and to achieve a ‘‘proper determination of income through the process of matching appropriate costs against revenues.Unfortunately, there is no simple answer as to whether income is better measured under LIFO or FIFO. Both methods match historical costs with revenues, but the major argument in favor of LIFO is that it matches the most recent costs with revenue. The most recent costs are closer to replacement costs—the costs the company will have to incur to replace the inventory that was sold.
What are the Consequences of Using Alternative Inventory Cost Flow Assumptions? (Slide 2 of 2)
Income Tax Effects: The use of LIFO for computing taxable income may result in lower payments for income taxes. When purchase prices are rising, a company might prefer to use FIFO to report a higher income for financial reporting purposes but use LIFO to prepare its tax return. However, the Internal Revenue Code permits a company to use LIFO for income tax purposes only if it also uses LIFO in its financial statements. This requirement is known as the LIFO conformity rule.
Assuming rising costs, the LIFO method produces a lower inventory value on a company’s balance sheet because the oldest costs remain in this inventory.A financial statement user evaluating a company that uses LIFO will generally convert the inventory to non-LIFO (FIFO or average) amounts to enhance comparability.
Use of Inventory Cost Flow Assumptions
There are many financial accounting and tax issues involved in selecting an inventory cost flow assumption. Companies, however, are free to choose whichever cost flow assumption they prefer, regardless of whether the method matches the physical flow of goods.
How Do Companies Choose Between LIFO and FIFO? (Slide 1 of 2)
Because of the LIFO conformity rule, a company that wishes to lower its taxes by using LIFO must also use LIFO for financial reporting purposes.Evidence suggests that the anticipated tax benefits fHowever, LIFO does not always produce the lowest taxes. If costs are expected to fall, the use of FIFO would result in lower taxes and may be preferred.
How Do Companies Choose Between LIFO and FIFO? (Slide 2 of 2)
Factors that influence management’s selection:Tax considerationsBookkeeping and other related costsConceptual issuesStock price effectsPhysical flow of goodsContracting considerations
The dollar-value LIFO method follows the same cost flow assumption as the LIFO method, but it overcomes three difficulties involved in applying the simple LIFO approach:Record-keeping - The LIFO method requires a company to keep numerous detailed records of the physical quantities of each item in its inventory and apply unit costs in the LIFO order.LIFO Liquidations - Fluctuations in the physical quantities of similar inventory items may occur during a period, causing a partial liquidation of its LIFO layers that would remove many of the advantages of LIFO.Technology Change - As technological changes take place, inventory made with one material is replaced by inventory made with substitute materials, or an outdated design is replaced by a newer design.Strict application of the LIFO method would require a company to start a new LIFO base for the new inventory item, and as the old item is phased out, to reduce its inventory to zero. This would eliminate the advantages of LIFO built up in previous periods.
Cost Indexes(Slide 1 of 2)
A cost index refers to an internally generated index that relates the current year cost of inventory to a base year cost of inventory.Under the double-extension method, a sample of the ending inventory is priced at current-year costs and at base-year costs. Cost Index= x 100
Cost Indexes(Slide 2 of 2)
Under the link-chain method, the ratio of the current-year current cost to the previous-year current cost is used to compute a cost index for the year.This index is multiplied by the cost index carried forward from the previous year to determine the current year cumulative
Companies apply dollar-value LIFO to inventory pools by grouping inventory items that are similar as to types of material or use.The purpose of inventory pools is to maintain the benefits from using LIFO when fluctuations in the physical quantities of similar inventory items occur and when technological change takes place.When the quantity of one item of the inventory pool is reduced, the reduction may be offset with an increase in the quantity of another item in the inventory pool. Therefore, the liquidation of LIFO layers and the loss of the tax benefits of LIFO are normally avoided.
Application of Dollar-Value LIFO(Slide 1 of 2)
The general principle of the dollar-value LIFO method is that a company is trying to separate the change in the physical quantity of inventory from the change in costs of the inventory.A comparison of the year’s beginning and ending inventory pools at base-year costs indicates whether there has been a real increase (or decrease) in the physical quantity of the inventory.The company then ‘‘rolls forward’’ the increase (or decrease) in the physical quantity to the appropriate current cost level and adds this layer of current cost (or subtracts it from) the beginning inventory to determine its ending inventory.
Application of Dollar-Value LIFO(Slide 2 of 2)
Step 1. Value the total ending inventory at current year costs.Step 2. Convert (roll back) the ending inventory cost to base-year costs by applying the appropriate cost indexStep 3. Compute the base-year change in inventory level (physical quantity) by comparing the ending inventory at base-year costs with the beginning inventory at base-year costs.Step 4.If there is an increase in the inventory level at base-year costs, there has been a real increase in the physical quantity of the inventory for the year.If there is a decrease in the inventory level at base-year costs, there has been a real decrease in the physical quantity of the inventory for the year.
LIFO Valuation Allowance (LIFO Reserve)
Because the use of LIFO reduces the comparability between companies using LIFO and those using FIFO (which is an approximation of current cost), the SEC requires a company that uses LIFO to disclose the amount that the LIFO valuation of inventory differs from the valuation of inventory under FIFO.This difference has a variety of names including Valuation Allowance or LIFO reserve.