Perpetual Inventory System and Inventory Valuation Methods

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Reporting and Analyzing Inventory

Kimmel ● Weygandt ● Kieso

Financial Accounting, Eighth Edition

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CHAPTER OUTLINE

Discuss how to classify and determine

inventory.

Apply inventory cost flow methods and discuss their financial effects.

LEARNING OBJECTIVES

Explain the statement presentation and analysis of inventory.

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One Classification:

Merchandise Inventory

Three Classifications:

Raw Materials

Work in Process

Finished Goods

Merchandising Company

Manufacturing Company

▼ HELPFUL HINT Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.

LEARNING OBJECTIVE

Discuss how to classify and determine inventory.

LO 1

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ACCOUNTING ACROSS THE ORGANIZATION

A Big Hiccup

JIT can save a company a lot of money, but it isn’t without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings themselves cost only $1.50, but you cannot make a car without them. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars. Similarly, a major snowstorm halted production at the Canadian plants of Ford. A Ford spokesperson said, “Because the plants run with just-in-time inventory, we don’t have large stockpiles of parts sitting around. When you have a somewhat significant disruption, you can pretty quickly run out of parts.”

Sources: Amy Chozick, “A Key Strategy of Japan’s Car Makers Backfires,” Wall Street Journal (July 20, 2007); and Kate Linebaugh, “Canada Military Evacuates Motorists Stranded by Snow,” Wall Street Journal (December 15, 2010).

LO 1

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Physical Inventory taken for two reasons:

Perpetual System

Check accuracy of inventory records.

Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.

Periodic System

Determine the inventory on hand.

Determine the cost of goods sold for the period.

DETERMINING INVENTORY QUANTITIES

LO 1

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Involves counting, weighing, or measuring each kind of inventory on hand.

Taken,

when the business is closed or business is slow.

at the end of the accounting period.

Taking a Physical Inventory

LO 1

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ETHICS INSIGHT

Falsifying Inventory to Boost Income

Managers at women’s apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income in an attempt to increase management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classified “defective goods as new or refurbished” and claimed that it owned certain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.

Leslie Fay

LO 1

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GOODS IN TRANSIT

Purchased goods not yet received.

Sold goods not yet delivered.

Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale.

Determining Ownership of Goods

LO 1

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Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

Ownership of the goods remains with the seller until the goods reach the buyer.

Freight costs incurred by the seller are an operating expense.

Determining Ownership of Goods

ILLUSTRATION 6-2

Terms of sale

LO 1

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Review Question

Goods in transit should be included in the inventory of the buyer when the:

public carrier accepts the goods from the seller.

goods reach the buyer.

terms of sale are FOB destination.

terms of sale are FOB shipping point.

Determining Ownership of Goods

LO 1

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Consigned Goods

To hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods.

Many car, boat, and antique dealers sell goods on consignment. Why?

Determining Ownership of Goods

LO 1

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LO 1

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1. Goods of $15,000 held on consignment should be deducted from the inventory count.

2. The goods of $10,000 purchased FOB shipping point should be added to the inventory count.

3. Item 3 was treated correctly.

Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. You have been given the information listed below. Discuss how this information affects the reported cost of inventory.

1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.

2. The company did not include in the count purchased goods of $10,000, which were in transit (terms: FOB shipping point).

3. The company did not include in the count inventory that had been sold with a cost of $12,000, which was in transit (terms: FOB shipping point).

Solution

Inventory should be $195,000 ($200,000 - $15,000 + $10,000).

Rules of Ownership

DO IT!

LO 1

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Inventory is accounted for at cost.

Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale.

Unit costs are applied to quantities to determine the total cost of the inventory and the cost of goods sold using the following costing methods:

Specific identification

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Average-cost

Cost Flow Assumptions

LEARNING OBJECTIVE

Apply inventory cost flow methods and discuss their financial effects.

LO 2

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Illustration: Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year Crivitz sold two sets at $1,200 each. These facts are summarized below.

SPECIFIC IDENTIFICATION

ILLUSTRATION 6-3

Data for inventory costing example

LO 2

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If Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750.

SPECIFIC IDENTIFICATION

ILLUSTRATION 6-4

Specific identification method

LO 2

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Actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory.

Practice is relatively rare.

Most companies make assumptions (cost flow assumptions) about which units were sold.

SPECIFIC IDENTIFICATION

LO 2

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Illustration 6-12

Use of cost flow methods in major U.S. companies

Cost flow assumption does not need to be consistent with the physical movement of goods

COST FLOW ASSUMPTIONS

LO 2

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Illustration: Data for Houston Electronics’ Astro condensers.

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

COST FLOW ASSUMPTIONS

ILLUSTRATION 6-5

Data for Houston Electronics

LO 2

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Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.

Often parallels actual physical flow of merchandise.

Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.

First-In, First-Out (FIFO)

LO 2

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First-In, First-Out (FIFO)

ILLUSTRATION 6-6

Allocation of costs—FIFO method

LO 2

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▼ HELPFUL HINT

Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.

First-In, First-Out (FIFO)

LO 2

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Costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.

Seldom coincides with actual physical flow of merchandise.

Exceptions include goods stored in piles, such as coal or hay.

Last-In, First-Out (LIFO)

LO 2

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Last-In, First-Out (LIFO)

ILLUSTRATION 6-8

Allocation of costs—LIFO method

LO 2

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▼ HELPFUL HINT

Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.

Last-In, First-Out (LIFO)

ILLUSTRATION 6-8

Allocation of costs—LIFO method

LO 2

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Allocates cost of goods available for sale on the basis of weighted-average unit cost incurred.

Applies weighted-average unit cost to the units on hand to determine cost of the ending inventory.

Average-Cost

LO 2

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Average-Cost

ILLUSTRATION 6-11

Allocation of costs—average-cost method

LO 2

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Average-Cost

ILLUSTRATION 6-11

Allocation of costs—average-cost method

LO 2

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FINANCIAL STATEMENT AND TAX EFFECTS

ILLUSTRATION 6-13

Comparative effects of cost flow methods

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In periods of changing prices, the cost flow assumption can have significant impacts both on income and on evaluations of income, such as the following.

In a period of inflation, FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue.

In a period of inflation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.

If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest.

Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO.

Income Statement Effects

LO 2

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Review Question

The cost flow method that often parallels the actual physical flow of merchandise is the:

FIFO method.

LIFO method.

average cost method.

gross profit method.

COST FLOW ASSUMPTIONS

LO 2

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Review Question

In a period of inflation, the cost flow method that results in the lowest income taxes is the:

FIFO method.

LIFO method.

average cost method.

gross profit method.

COST FLOW ASSUMPTIONS

▼ HELPFUL HINT

A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes, they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.

LO 2

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INTERNATIONAL INSIGHT

Is LIFO Fair?

ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for financial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold figure that was $5.6 billion higher than under FIFO. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair “tax dodge.” As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against inflation. International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies such as BP and Royal Dutch Shell are not directly comparable to U.S. companies, which can make analysis difficult.

Source: David Reilly, “Big Oil’s Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.

ExxonMobil

LO 2

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Method should be used consistently, enhances comparability.

Although consistency is preferred, a company may change its inventory costing method.

ILLUSTRATION 6-14

Disclosure of change in cost flow method

USING INVENTORY COST FLOW METHODS CONSISTENTLY

LO 2

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4,000 units × $3 = $12,000

3,000 units × $4 = 12,000

$24,000

The accounting records of Shumway Ag Implement show the following data.

Beginning inventory 4,000 units at $3

Purchases 6,000 units at $4

Sales 7,000 units at $12

Determine the cost of goods sold during the period under a periodic system using FIFO.

SOLUTION

Cost Flow Methods

DO IT!

LO 2

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6,000 units × $4 = $24,000

1,000 units × $3 = 3,000

$27,000

The accounting records of Shumway Ag Implement show the following data.

Beginning inventory 4,000 units at $3

Purchases 6,000 units at $4

Sales 7,000 units at $12

Determine the cost of goods sold during the period under a periodic system using LIFO.

SOLUTION

Cost Flow Methods

DO IT!

LO 2

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$36,000 ÷ 10,000 units = $3.60 average cost per unit

$36,000 – ($3,000 ending units × $3.60) = $25,200

The accounting records of Shumway Ag Implement show the following data.

Beginning inventory 4,000 units at $3 = $12,000

Purchases 6,000 units at $4 = $24,000

Sales 7,000 units at $12

Determine the cost of goods sold during the period under a periodic system using average cost.

SOLUTION

Cost Flow Methods

DO IT!

$36,000

LO 2

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PRESENTATION

Inventory is classified in the balance sheet as a current asset immediately below receivables.

In a multiple-step income statement, cost of goods sold is subtracted from net sales.

There also should be disclosure of

the major inventory classifications,

the basis of accounting (cost, or lower-of-cost-or-market), and

the cost method (FIFO, LIFO, or average-cost).

LEARNING OBJECTIVE

Explain the statement presentation and analysis of inventory.

LO 3

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PRESENTATION

ILLUSTRATION 6-15

Inventory disclosures by Wal-Mart

LO 3

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When the value of inventory is lower than its cost.

Applied to items in inventory after the company has used one of the cost flow methods (specific identification, FIFO, LIFO, or average-cost) to determine cost.

Companies can “write down” the inventory to its market value in the period in which the price decline occurs.

Market value = Replacement Cost

Example of conservatism.

LOWER-OF-COST-OR-MARKET

LO 3

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Illustration: Assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated.

LOWER-OF-COST-OR-MARKET

ILLUSTRATION 6-16

Computation of lower-of-cost-or-market

LO 3

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Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.

Cost Market

Gas $ 84,000 $ 79,000

Wood 250,000 280,000

Pellet 112,000 101,000

Determine the value of the company’s inventory under the lower-of-cost-or-market approach.

SOLUTION

LCM Basis

DO IT!

LO 3

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The lower value for each inventory type is gas $79,000, wood $250,000, and pellet $101,000. The total inventory value is the sum of these figures, $430,000.

Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.

Cost Market

Gas $ 84,000 $ 79,000

Wood 250,000 280,000

Pellet 112,000 101,000

Determine the value of the company’s inventory under the lower-of-cost-or-market approach.

SOLUTION

LCM Basis

DO IT!

LO 3

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Inventory management is a critical task

High Inventory Levels - storage costs, interest cost (on funds tied up in inventory), and costs associated with the obsolescence of technical goods or shifts in fashion.

Low Inventory Levels – may lead to lost sales.

ANALYSIS

LO 3

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Inventory Turnover

ILLUSTRATION 6-17

Inventory turnovers and days in inventory

LO 3

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Illustration: Data available for Wal-Mart.

Inventory Turnover

ILLUSTRATION 6-17

Inventory turnovers and days in inventory

LO 3

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ACCOUNTING ACROSS THE ORGANIZATION

Too Many TVs or Too Few?

Financial analysts closely monitor the inventory management practices of companies. For example, some analysts following Sony expressed concern because the company built up its inventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But in the next year, as a result of its inventory build-up, days in inventory rose to 59 days. Management said that it didn’t think that Sony’s inventory levels were too high. However, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.”

Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).

LO 3

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Companies using LIFO are required to report the difference between inventory reported using LIFO and Inventory using FIFO. This amount is referred to as the LIFO reserve.

ADJUSTMENTS FOR LIFO RESERVE

ILLUSTRATION 6-18

Caterpillar’s LIFO reserve

LO 3

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If Caterpillar had used FIFO all along, its inventory would be $14,635 million, rather than $12,205 million.

ADJUSTMENTS FOR LIFO RESERVE

ILLUSTRATION 6-19

Conversion of inventory from LIFO to FIFO

LO 3

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The LIFO reserve can have a significant effect on ratios analysts commonly use.

Illustration 6-20

ADJUSTMENTS FOR LIFO RESERVE

ILLUSTRATION 6-20

Impact of LIFO reserve on ratios

LO 3

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Early in 2017, Westmoreland Company switched to a just-in-time inventory system. Its sales, cost of goods sold, and inventory amounts for 2016 and 2017 are shown below

2016 2017

Sales revenue $2,000,000 $1,800,000

Cost of goods sold 1,000,000 910,000

Beginning inventory 290,000 210,000

Ending inventory 210,000 50,000

Determine the inventory turnover and days in inventory for 2016 and 2017.

Inventory Turnover

DO IT!

SOLUTION

LO 3

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Illustration:

Assuming the Perpetual Inventory System, compute Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost.

LEARNING OBJECTIVE

APPENDIX 6A: Apply inventory cost flow methods to perpetual inventory records.

ILLUSTRATION 6A-1

Inventoriable units and costs

LO 4

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FIRST-IN, FIRST-OUT (FIFO)

Cost of Goods Sold

Ending Inventory

ILLUSTRATION 6A-2

Perpetual system—FIFO

LO 4

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LAST-IN, FIRST-OUT (LIFO)

Cost of Goods Sold

Ending Inventory

ILLUSTRATION 6A-3

Perpetual system—LIFO

LO 4

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AVERAGE COST

Cost of Goods Sold

Ending Inventory

ILLUSTRATION 6A-4

Perpetual system—average-cost method

LO 4

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Inventory Errors

Common Cause:

Failure to count or price inventory correctly.

Not properly recognizing the transfer of legal title to goods in transit.

Errors affect both the income statement and balance sheet.

LEARNING OBJECTIVE

APPENDIX 6B: Indicate the effects of inventory errors on the financial statements.

LO 5

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Inventory errors affect the computation of cost of goods sold and net income.

INCOME STATEMENT EFFECTS

ILLUSTRATION 6B-2

Effects of inventory errors on current year’s income statement

ILLUSTRATION 6B-1

Formula for cost of goods sold

LO 5

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Inventory errors affect the computation of cost of goods sold and net income in two periods.

An error in ending inventory of the current period will have a reverse effect on net income of the next accounting period.

Over the two years, the total net income is correct because the errors offset each other.

Ending inventory depends entirely on the accuracy of taking and costing the inventory.

INCOME STATEMENT EFFECTS

LO 5

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($3,000)

Net Income understated

$3,000

Net Income overstated

Combined income for 2-year period is correct.

ILLUSTRATION 6B-3

Effects of inventory errors on two

years’ income statements

INCOME STATEMENT EFFECTS

Errors Cancel

LO 5

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Review Question

Understating ending inventory will overstate:

assets.

cost of goods sold.

net income.

owner's equity.

INCOME STATEMENT EFFECTS

LO 5

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Effect of inventory errors on the balance sheet is determined by using the basic accounting equation:

Assets = Liabilities + Stockholders’ Equity

Errors in the ending inventory have the effects shown:

BALANCE SHEET EFFECTS

ILLUSTRATION 6B-4

Effects of ending inventory errors

on balance sheet

LO 5

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KEY POINTS

A Look at IFRS

LEARNING OBJECTIVE

Compare the accounting for inventories under GAAP and IFRS.

Similarities

IFRS and GAAP account for inventory acquisitions at historical cost and value inventory at the lower-of-cost-or-market subsequent to acquisition.

Who owns the goods—goods in transit or consigned goods—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

LO 6

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A Look at IFRS

KEY POINTS

Differences

The requirements for accounting for and reporting inventories are more principles based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.

A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

LO 6

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A Look at IFRS

KEY POINTS

Differences

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost.

LO 6

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A Look at IFRS

LOOKING TO THE FUTURE

One convergence issue that will be difficult to resolve relates to the use of the LIFO cost flow assumption. As indicated, IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and, therefore, enables companies to compute a more realistic income.

LO 6

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IFRS Practice

Which of the following should not be included in the inventory of a company using IFRS?

Goods held on consignment from another company.

Goods shipped on consignment to another company.

Goods in transit from another company shipped FOB shipping point.

None of the above.

A Look at IFRS

LO 6

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IFRS Practice

Which method of inventory costing is prohibited under IFRS?

Specific identification.

FIFO.

LIFO.

Average-cost.

A Look at IFRS

LO 6

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Slide

Cost Flow Methods in Perpetual Systems

SO 7 Apply the inventory cost flow methods to perpetual invento

ry records.

“

First

Out (FIFO)

”

Cost of Goods Sold

Ending Inventory

Illustration 6A

Solution on

notes page

IncorrectCorrectIncorrectCorrect

Sales80,000$ 80,000$ 90,000$ 90,000$

Beginning inventory20,000 20,000 12,000 15,000

Cost of goods purchased40,000 40,000 68,000 68,000

Cost of goods available60,000 60,000 80,000 83,000

Ending inventory12,000 15,000 23,000 23,000

Cost of good sold48,000 45,000 57,000 60,000

Gross profit32,000 35,000 33,000 30,000

Operating expenses10,000 10,000 20,000 20,000

Net income22,000$ 25,000$ 13,000$ 10,000$

20162017

Sheet1

	2016		2017
	Incorrect	Correct	Incorrect	Correct
Sales	$ 80,000	$ 80,000	$ 90,000	$ 90,000
Beginning inventory	20,000	20,000	12,000	15,000
Cost of goods purchased	40,000	40,000	68,000	68,000
Cost of goods available	60,000	60,000	80,000	83,000
Ending inventory	12,000	15,000	23,000	23,000
Cost of good sold	48,000	45,000	57,000	60,000
Gross profit	32,000	35,000	33,000	30,000
Operating expenses	10,000	10,000	20,000	20,000
Net income	$ 22,000	$ 25,000	$ 13,000	$ 10,000

Perpetual Inventory System and Inventory Valuation Methods

Sheet1

Sheet2

Sheet3