Intermediate Accounting

November 22nd, 2010

1. General Course Questions
2. Return Discussion Question #4 Revenue Recognition
3. Turn in Columbia Sportswear Annual Report Projects
4. Discuss Final Group Project
5. Chapter 8 Inventory (using assigned homework)
A. When is it Inventory (Ex 1, 3, 5)
B. Inventory Errors (BE 4 and exercise 5)
C. Inventory Costing Methods (Specific Identification, FIFO,
LIFO, Weighted/Moving Average) ?12,13,16. BE 5,6,7, P 6
D. Other Inventory Topics (? 3 , 5, 10)
E. Dollar Value LIFO, LIFO effect, LIFO reserve (Ex 21)
1
 What is Included in Inventory?
A company should record purchases when it obtains
legal title to the goods.

2
Ex 1, 3 and 5
 What is Included in Inventory?
Report inventory units at the lower of cost or market
(conservatism).
What is included in cost for:
- Retailer:
- Manufacturing Company:

3
 What is Included in Inventory?
Report inventory units at the lower of cost or market
(conservatism).
What is included in cost for:
- Merchandiser: items held for sale (Finished Goods)
- Manufacturing Company:
items held for sale (Finished Goods)
goods to be used in production (Raw Materials)
goods in production (Work in Process)

4
Inventory – Cost Flow
Merchandiser vs. Manufacturing Co.

5
Costs Included in Inventory?
Product Costs - costs directly connected with
bringing the goods to the buyer’s place of business
and converting such goods to a salable condition.
Period Costs – generally selling, general, and
administrative expenses.
Purchase Discounts – Gross vs. Net Method (? 10)
Product Financing (Question 5)

6
 Purchase Discounts: Gross or Net

Illustration 8-11

**

* $4,000 x 2% = $80 Solution on

** $10,000 x 98% = $9,800 notes page
Question 10 7
 Purchase Discounts: Gross or Net

Illustration 8-11

**

* $4,000 x 2% = $80 Solution on

** $10,000 x 98% = $9,800 notes page
8
 Inventory – Cost Flow
Perpetual vs. Periodic System

9
 Perpetual vs. Periodic System
Perpetual Method
• Purchases are debited
to Inventory account
• Freight-in, Purchases
Returns & Allowances
and Purchase Discounts
are recorded in the
Inventory account.
• Debit COGS and credit
Inventory account for
each sale.
The perpetual inventory system
provides a continuous record of
Inventory and Cost of Goods Sold.
Periodic Method
• Purchases are debited to
Purchases account.
• Freight-in, Purch. R & A
and Purch. Disc. are
recorded in their
respective accounts.
• COGS is computed only
periodically:
Cost of Goods Available
– Ending Inventory =
Cost of Goods Sold
Ending Inventory is determined
only by physical count at the end
of the period. 10
 Inventory System - Perpetual
Purchase of Inventory:
Dr. Inventory 1,000
Cr. A/P, Cash, etc. 1,000
Purchase Returns, Purchases Discounts
Dr. A/P 100
Cr. Inventory 100
Transportation In
Dr. Inventory 100
Cr. A/P, Cash, etc. 100
Sale of Inventory:
Dr. Cost of Goods Sold 1,000
Cr. Inventory 1,000
Dr. Cash, A/R, etc. 1,500
Cr. Sales Revenue 1,500
At Year-End: no j/e required, unless errors are found in inventory count
(physical inventory = perpetual inventory, than adjust to physical 11
 Inventory System - Periodic
Purchase of Inventory:
Dr. Purchases 1,000
Cr. A/P, Cash, etc. 1,000
Purchase Returns, Purchases Discounts
Dr. A/P 100
Cr. Purchases Returns or Purchases Discounts 100
Transportation In
Dr. Transportation In 100
Cr. A/P, Cash, etc. 100
Sale of Inventory:
Dr. Cash, A/R, etc. 1,500
Cr. Sales Revenue 1,500
At Year-End:
Dr. Ending Inventory (determined by count) 38,000
Dr. Cost of Sales (plug) 283,000
Dr. Purchase Returns and Purchase Discounts (close balance)
Cr. Purchases (also close Transportation In) 286,000
Cr. Opening Inventory (carried forward from prior year) 35,000
12
 Inventory Control – Physical Count

All companies need periodic verification of the inventory

records by actual count, weight, or measurement, with
the counts compared with the detailed inventory
records.
Companies should take the physical inventory near the
end of their fiscal year, to properly report inventory
quantities in their annual accounting reports.

Question 3 13
 Effect of Inventory Errors

Error in Effect on Effect on

Ending Income Balance sheet
Inventory Items Items
Under- COGS (over) Inventory (under)
stated Net income (under) Retained Earn (under)

Over- COGS (under) Inventory (over)

stated Net income (over) Retained Earn (over)

14
Effect of Inventory Errors (U/S Ending)

15
 Cost Flow Assumptions

Cost flow assumptions DO NOT Need to be

consistent with physical flow of goods. The
objective is to most clearly reflect periodic income.
The cost flow assumptions are:
1 Specific identification
2 Average cost
3 First-in, first-out (FIFO) and
4 Last-in, first-out (LIFO) (prohibited under IFRS)

16
 Cost Flow Assumptions: Example

Spaworld reports the following transactions for 2010

(assume no opening inventory):
Date Purchases Cost/Unit Purchase Cost
May 12 100 units @ $10/unit = $1,000
Aug 14 200 units @ $11/unit = 2,200
Sep 18 120 units @ $15/unit = 1,800
420 units $5,000
On December 31, the company had 20 units on hand
and uses the periodic inventory system.
What is the cost of goods sold?
What is the cost of ending inventory?
17
 Average Cost Method
Date Purchases Cost
May 12 100 units $1,000
Aug 14 200 units $2,200
Sep 18 120 units $1,800
420 units $5,000
Dec. 31 Ending inventory 20 units
Steps:
1. Calculate per unit average cost: use four places to right of decimal

2. Apply this per unit average cost to units sold to get COGS:
round to nearest dollar

3. Apply the per unit average cost to units remaining in

inventory to determine Ending inventory: round to nearest dollar
18
 Average Cost Method
Date Purchases Cost
May 12 100 units $1,000
Aug 14 200 units $2,200
Sep 18 120 units $1,800
420 units $5,000
Dec. 31 Ending inventory 20 units
1. Calculate per unit average cost: use four places to right of decimal

Cost per unit: $5000/420 = 11.9047 per unit

2. Apply this per unit average cost to units sold to get COGS:
round to nearest dollar

11.9047 x 400 = $4,762 COGS

3. Apply the per unit average cost to units remaining in
inventory to determine Ending inventory: round to nearest dollar
19
11.9047 x 20 = $238 ending inventory
 Year End Entry – Average Cost

Journal Entry (Periodic Inventory):

20
20
 Year End Entry – Average Cost
Journal Entry:

Dr. Ending Inventory 238

Dr. Cost of Sales 4,762
Cr. Purchases 5,000
Cr. Opening Inventory 0

21
21
 First-In, First-Out (FIFO) Method
Given data:
Ending Inventory (FIFO)
Date Purchases Cost
May 12 100 units @ $10 $1,000
Aug 14 200 units @ $11 $2,200
Sep 18 120 units @ $15 $1,800
Cost of goods sold (FIFO)
420 $5,000
Ending Inventory 20 units

“Count” from one direction and “plug” the other

GAFS
COGS

$5,000 EI
22
 First-In, First-Out (FIFO) Method
Given data: Ending Inventory (FIFO)
Date Purchases Cost 20 x $15 = $300
May 12 100 units @ $10 $1,000
Aug 14 200 units @ $11 $2,200
Sep 18 120 units @ $15 $1,800
Cost of goods sold (FIFO)
420 $5,000
100 units @ $10 $1,000
Ending Inventory 20 units
200 units @ $11 $2,200
100 units @ $15 $1,500

“Count” from one direction and “plug” the other

GAFS
COGS $4,700

$5,000 EI $300
23
 Last-In, First-Out (LIFO) Method
Given data:
Ending Inventory (FIFO)
Date Purchases Cost
May 12 100 units @ $10 $1,000
Aug 14 200 units @ $11 $2,200
Sep 18 120 units @ $15 $1,800
Cost of goods sold (FIFO)
420 $5,000
Ending Inventory 20 units

“Count” from one direction and “plug” the other

GAFS
COGS

$5,000 EI
24
 Last-In, First-Out (LIFO) Method
Given data:
Ending Inventory (FIFO)
Date Purchases Cost
20 x $10 = $200
May 12 100 units @ $10 $1,000
Aug 14 200 units @ $11 $2,200
Sep 18 120 units @ $15 $1,800
Cost of goods sold (FIFO)
420 $5,000
80 units @ $10 $ 800
Ending Inventory 20 units
200 units @ $11 $2,200
120 units @ $15 $1,800

“Count” from one direction and “plug” the other

GAFS
COGS $4,800

$5,000 EI $200
25
 Cost Flow Assumptions: Notes

• The ending inventory in units is the same in

all three methods: the cost is different
• The cost of goods available is the same for
all methods
• The cost of goods sold and the cost of
ending inventory are different
• In periods of rising prices, LIFO would result
in the smallest reported net income.

26
 Periodic vs. Perpetual
• FIFO: COGS and EI numbers are exactly the
same under either periodic or perpetual systems
• BUT – LIFO, Weighted Average will give you
different numbers
– Under perpetual LIFO, with each sale, you cut into only
existing layers (so you must stop and calculate the cost
of goods sold at each sale)
– Under perpetual Weighted Average (more accurately,
Moving Average), you stop and calculate a new
average cost for every sale

27
 Same Example - Perpetual Basis
Purchased
Unit Total Units
Units Cost Cost Sold
12-May 100 10 1000
1-Jun 85
14-Aug 200 11 2200
1-Sep 100
18-Sep 120 15 1800
20-Sep 215
420 5000 400

Unit Extended Unit Extended

FIFO: Units Cost Value LIFO: Units Cost Value
1-Jun 85 10 850 1-Jun 85 10 850
1-Sep 15 10 150 1-Sep 100 11 1100
85 11 935 20-Sep 120 15 1800
20-Sep 115 11 1265 95 11 1045
100 15 1500
COGS 400 4700 COGS 400 4795

EI 20 15 300 EI 15 10 150
Same as Periodic 5 11 55
205
Different from Periodic 28
Same Example - Perpetual Basis
Purchased Sold
Unit Extended
Units Cost Cost Units
12-May 100 10 1000
1-Jun 85
14-Aug 200 11 2200
1-Sep 100
18-Sep 120 15 1800
20-Sep 215
420 5000 400

Calculate the average cost at time of each sale

Unit Extended
Wt. Av. Units Cost Value 1-Sep
1-Jun 85 10 850 costs to date 3200
1-Sep 100 10.9 1093.02 costs expensed 850
20-Sep 215 13 2796.81 0 2350
0 215
0 Av Cost 10.9
COGS 400 4739.83
Sept. 20
EI 20 13 260.168 Costs to date 5000
Costs expensed 1943
Remaining costs 3057
29
Remaining units 235
Different from Periodic Av cost 13
 Advantages of LIFO Method

• LIFO matches more recent costs with

current revenues.
• With increasing prices:
– LIFO yields the lowest taxable income
(assuming inventory does not decrease).
– Under LIFO, there is less need to write
down inventory down to market

30
 Special Issues Related to LIFO:
Setting up a LIFO Reserve
LIFO Reserve (Allowance) account is used, when:

LIFO is used for tax & external financial reporting purposes

FIFO, average cost, or standard cost system for internal
reporting purposes.
Reasons:
1. Pricing decisions
2. Record keeping easier
3. Profit-sharing or bonus arrangements
4. LIFO troublesome for interim periods

SEC reporting requirements – disclose the difference

between LIFO and current cost of inventory reported 31
on the Balance Sheet which is the LIFO RESERVE
 LIFO Reserve: Example
Jeppo Inc reports the following balances:
Inventory (FIFO basis) on Dec 31, 2004: $50,000
Inventory (LIFO basis) on Dec 31, 2004: $20,000
Adjust the cost of ending inventory to the LIFO basis

Dr. Cost of goods sold $30,000

Cr. Allowance to Reduce Inventory
to LIFO $30,000

Balance Sheet (Assets):

Inventory (FIFO) $50,000
less: Allowance to Reduce Inventory ($30,000)
Inventory (LIFO) basis $20,000
32
 LIFO Layers

• Under the LIFO approach, a business may

build up layers of inventory from prior
periods. A layer liquidation occurs, when:
– Earlier costs are matched against current sales
due to a reduction of quantities of inventory
during a period (results in “costing” items at
older prices)
– Such matching results in distorted income.

33
 Disadvantages of LIFO Method
• LIFO yields the lowest net income and therefore
reduced earnings (with increasing prices)
• Under LIFO, the ending inventory is understated
relative to current costs
• LIFO liquidation (reduction of quantities of
inventory during a period – results in “costing”
items at older prices):
– May result in income that is detrimental from a tax view
– May cause poor buying habits (because of the layer
liquidation problem)
• LIFO Conformity Rule: if you use LIFO for tax
purposes, you must use it for financial reporting
also.
34
 Dollar Value LIFO
• Dollar value LIFO applies LIFO procedures to pools of similar goods
based on dollars rather than units
• Used for external purposes (i.e., financial statements and taxes)
• Advantages over regular LIFO:
– Reduces record keeping (maximum of one layer per year).
– Mitigates likelihood of eroding old layers (some decreases in goods in the
pool are offset by increases in other goods in the pool).

• Price index – a measure of the change in prices from a base year

(the year dollar value LIFO is adopted in this case) to the current
year

– Internal = Ending inventory quantities X current year costs

Ending inventory quantities X base year costs

– External – calculated by the Bureau of Labor Statistics

35
 Dollar Value LIFO Calculation Steps

Compare ending inventory at base year prices to beginning of year

inventory, also at base year prices – if there is an increase –
we add a new LIFO layer at Current Year prices:
1. Calculate Ending Inventory at current year costs (FIFO)
2. Calculate or locate the current year price index.
3. Convert the ending inventory at current cost to inventory at base-year
cost by dividing the current year cost by the current price index (1 / 2 )
4. Split the ending inventory at current cost into layers depending on the
year the items were acquired by comparing current inventory at base
prices to prior inventory at base prices. If there is an increase add an
additional layer. If there is a decrease deduct from the most recently
purchased layer. Once a layer is eliminated (peeled off), it can not be
rebuilt.
5. Multiply each layer by the appropriate price index (price index of the
year of acquisition) to obtain the quantity in ending inventory at dollar-
value LIFO cost.
36
 Dollar Value LIFO: Example

Given:
Base layer (Dec 31, 2009): $20,000
Inventory (current prices)
Dec 31, 2010: $26,400
Prices increased 20% during 2010.

Determine dollar value LIFO at Dec 31,

2010
37
 Dollar Value LIFO: Example

Price increase, 20%

Dec 31, 2009 Dec 31, 2010

At base $: $26,400 / 1.20 At EOY prices:

$22,000 $26,400

Dollar value
Net increase LIFO Inventory

at base $: Restate at $20,000

$22,000 less current $: plus
$20,000 $2,000 * 1.20 $2,400 $2,400 =
(layer added) $22,400
38
 Dollar Value LIFO: Notes

When the ending inventory (at base year

prices) is less than the beginning inventory
(at base year prices) (i.e. in the example
above if EI at base year prices was <
$20,000):
– the decrease must be subtracted from the most
recently added layer.
– Once a layer is eliminated (peeled off), it
cannot be rebuilt.

39