Chp. 10 – Flashcards

a short-term operating asset consisting of goods held for resale for a merchandising company and inventories of raw materials, work in progress, and finished goods for a manufacturing company. Inventory is typically a significant portion of a company's total assets. The valuation of inventory affects the company's balance sheet and the cost of goods sold on the income statement.

Retailers and wholesalers typically only hold merchandise inventory (consists of goods purchased to resell without any additional manufacturing.) Manufacturing firms generally report 3 types of inventory, based on the stage of the production process: 1. Raw materials 2. Work-in-process 3. Finished goods

comprised of inputs that the firms has not yet placed into production. Ex. Cloth would be included in the raw materials inventory for a clothing manufacturer. The raw materials inventory is increased by purchases and decreased when these items are transferred into work-in-progress inventory.

the goods that are currently in the manufacturing process, includes 3 different types of costs: raw materials, cost of labor, and allocated overhead costs. Overhead includes expenditures made for factory-related costs such as supervisory salaries, utilities, and supplies. Work-in-process inventory becomes finished goods at the end of the production process.

includes those goods for which the manufacturing process is complete. A company charges the value of finished goods to the costs of goods sold account when it sells the inventory. Increases in raw materials and work-in-progress inventories are often indicators that a company plans to expand production to meet expected future sales increases.

See Exhibit 10.1 (pg.494)

Companies use either a 1. periodic 2. perpetual inventory system.

A company determines the inventory balance and cost of goods sold at the end of the accounting period. Each time a sale is made, a company does not reduce inventory and increase cost of goods sold. Rather, a company determines them periodically. The beginning balance sheet includes the opening balance of inventory. Purchases made during the period increase inventory available for sale. Firms net any purchase returns, allowances, and discounts with purchases made. Firms record purchases in a separate purchases account, a temporary account used to accumulate inventory acquisitions during a period that is closed out at the end of the period. The beginning inventory balance plus the the net purchases is the cost of goods available for sale - that is, the total amount of the inventory that will either be sold during the period or remain in ending inventory. The ending inventory balance is based on a physical count of the inventory made by going into manufacturing and storage facilities and actually counting the inventory located at these sites. Exhibit 10.3 Computation of Cost of Goods Sold: Periodic Inventory System

Firms continually update inventory accounts for each purchase and each sale. A perpetual system is superior to a periodic system because it always provides current information about inventory levels, cost of goods sold, and gross profit. In practice, technological advances have made the periodic system obsolete and provided the computer software for firms to use a perpetual system. Inventory increases with net purchases and is reduced when units are sold. The inventory balance is always current. At the end of the period, a company performs a physical count of inventory. The company adjusts for the difference between the actual count and the perpetual records due to issues such as theft, breakage, and obsolescence.

The total dollar amount of inventory is equal to the number of units on hand

is equal to the number of units on hand multiplied by the cost per unit. ex. Inventory of sweaters at a clothing store. To assign a value, the firm multiplies the number of sweaters by the cost of each sweater. Although the total inventory value is a straightforward concept, there are four complexities in practice: 1. Determining what goods are included in inventory 2. Measuring cost per unit 3. Allocating the cost of goods purchased or manufactured by the company between the units that remain in inventory at the end 4. Accounting for a decrease in the market value of inventory.

Ending inventory typically consists of the goods that are in the company's physical possession as well as some goods in transit and some goods in consignment arrangements. (Companies selling products often give the buyer the right to return the product. If the company estimates that returns will be a material amount, then it must record the estimated returns.)

items that have left the seller's place of business but have not yet been received by the buyer. If inventory is in transit at the end of the reporting period, does the buyer or the seller report these items in inventory? The answer depends on who has title to the goods: 1. If the goods are shipped f.o.b. (free on board) shipping point, then title passes from the seller to the buyer when the goods are shipped. Consequently, the buyer reports the goods in its inventory because the buyer obtains title to the goods as soon as they leave the seller's location. 2. If goods are shipped f.o.b. destination, then title passes from the seller to the buyer when the goods are received by the buyer. Thus, the seller reports the goods in its inventory while in transit because the seller remains the owner until the goods arrive at the buyer's destination.

A company enters into a consignment arrangement when one party (the consignee) agrees to sell a product for another party (the cosigner) without taking ownership of the merchandise. In this case, although the consignee has physical possession of the inventory, the inventory is reported on the consignor's balance sheet. Ex. Electronics Emporium may ship 100 DVD players to LookVideos, on consignment. In this case, Electronics Emporium is the consignor and LookVideos is the consignee. Although LookVideos has physical possession of the DVD players, it does not report them as part of its inventory. Electronics Emporium will include the DVD players in its inventory because the company still has control of the inventory.

Inventory costs reflect the price paid for the goods to be held for resale or the manufacturing costs incurred in producing the units, including materials, labor, and allocated overhead. The costs initially capitalized into inventory also include expenditures such as freight-in costs (the transportation costs incurred to bring the inventory to the appropriate location.) Other capitalized costs include packaging and handling costs. These reasonable and necessary expenditures are considered to have asset value because they are required to acquire the inventory. Freight-out costs (transportation costs incurred by the seller to move the inventory to the buyer), are expensed as a component of selling, general and administrative expenses when incurred. Although the accounting standards specify general rules, there is great deal of discretion regarding costs to capitalize in inventory and to expense as incurred. Theory: abnormal costs are not reasonable and necessary and do not represent asset value. Abnormal costs include abnormal spoilage and excess freight, which are costs that exceed the normal costs expected to be incurred.

Inventory costs are reduced by purchase discounts. Purchase discounts are related to sales discounts discussed in Chp. 9 The company selling the inventory offers a discount to the buyer. The selling company accounts for the sales discount. The company buying the inventory accounts for the purchase discount. A typical purchase discount us stated as 2/10, n/30, which means the buyer will receive a 2% discount by paying within 10 days; otherwise, the buyer must pay the balance within 30 days. There are 2 acceptable approaches to recording purchase discounts: the gross method and the net method.

Under the gross method, a company making a purchase initially records the inventory and accounts payable at the full (gross) purchase amount on the invoice. 1. If the buyer pays AFTER the discount period, the accounting is simple because the full amount is paid. That is, the amount of cash paid is the gross amount of the payable and inventory on the books. 2. If the buyer pays WITHIN the discount period, the journal entry must reflect the discount. That is, when a buyer takes a purchase discount, the buyer pays less cash than the gross amount payable on the books: the net amount is the difference between the gross amount and the discount. The company still needs to remove the gross amount of the payable because it is no longer owed to the seller, but less cash is needed to liquidate the liability. Under a perpetual system, the buyer credits the inventory account for the difference between the gross payable amount and the net cash paid, reducing the value of the inventory to the net amount. (A company using a periodic system would credit purchase discounts, a contra account to purchases)

Under the net method, the company making the purchase assumes that it will take the discount and initially records the accounts payable and inventory at the net amount. 1. If the buyer pays within the discount period, then the journal entry treats the amount of cash paid as the net amount of the payable on the books. 2. If the buyer pays after the discount period, the buyer pays more cash than the net payable on the books. The difference is the amount of the discount lost by not paying within the discount period. By not paying on time, the company incurs an additional cost that represents interest accrued on the unpaid balance after the discount period. The buyer debits the difference to interest expense to reflect the fact that this difference is an amount due to the seller for providing financing. In practice the net method is more appropriate than the gross method because buyers usually take the discount. Thus, recording the payable at the net amount is likely an accurate portrayal of the amount that the buyer will ultimately pay and therefore minimizes the need for adjustments.

Judgement is crucial in determining the initial measurement of inventory. Deciding what costs to include in inventory is often subjective, as indicated by the codification's statement that "although principles for the determination of inventory costs may be easily stated, their application...is difficult because of the variety of considerations in the allocation of costs and charges. The inventory balance is impacted by management's choice of the method to account for the discount.

The phrase cost flow assumptions often refers to the methods available for moving the costs of a company's products from its inventory to its cost of goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and average. (If specific identification is used, there is no need to make an assumption.) Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption. FIFO, LIFO, and average are cost flow assumptions because the costs flowing out of inventory do not have to match the specific physical units being shipped. A company usually does not track each individual item of inventory in its accounting system as the item is purchased and eventually sold. Rather, a company will choose a cost-flow assumption to move the cost of the item from inventory to cost of goods sold in the accounting system. If the cost of hats is constant over time, or if a company can specifically identify the exact cost of the units sold, the allocation is straightforward. However, prices are seldom constant over time, and it is not always practical to specifically identify each unit. In the case of changing prices, firms usually make cost-flow assumptions. Specifically, rather than tracking the cost of each item purchased and sold, the company can use cost-flow assumptions to allocate the total cost of goods available for sale to the x number of hats in ending inventory and the x amount of hats sold. Cost-flow assumptions are needed because inventory costs are tracked separately from the physical flow of inventory.

4 Common Methods to allocate the cost of goods available for sale between ending inventory and cost of goods sold. (Specific-identification method, Moving-average method, First-in, first out (FIFO) method, Last-in, first-out (LIFO) method.) 1. Specific identification method: The company identifies each unit and tracks the cost associated with that specific unit. 2. Moving-average method: The company determines an average cost for the units on hand and applies that average unit cost to the next sale to determine cost of goods sold. 3. First-in, first-out (FIFO) method: The company assigns the most recent costs to ending inventory and the oldest costs to cost of goods sold. 4. Last-in, first-out (LIFO) method: The company assigns the oldest costs to ending inventory and the most recent costs to costs of goods sold. Note: a company does not have to sell their inventory in a pattern that resembles their accounting assumptions. ex. A grocery store is likely to sell gallons of older milk first. Yet it could choose to use a moving-average cost to determine the cost of goods sold because it is easier to implement. 2 other approach stop inventory allocation - the retail inventory and gross profit method - each approximate the ending inventory balance reported.

The company identifies each unit and tracks the cost associated with that specific unit. Suitable for companies that sell high-dollar products with low sales volume. Ex. A truck dealer can identify a vehicle that was available for sale by referencing its vehicle identification number and determining whether it was sold or is still in ending inventory. The method is impractical, however, for most companies.

The company determines an average cost for the units on hand and applies that average unit cost to the next sale to determine cost of goods sold. (used in a perpetual inventory system) Under a periodic inventory system, this approach is generally referred to as the weighted-average method. The ending inventory is the remaining (unsold) units valued at the average unit cost. Useful for firms selling high volume of a homogenous product (oil and gas) and is often used for inventory of raw materials and supplies.

The company assigns the most recent costs to ending inventory and the oldest costs to cost of goods sold. The first in, first out (FIFO) method of inventory valuation is a cost flow assumption that the first goods purchased are also the first goods sold. In most companies, this assumption closely matches the actual flow of goods, and so is considered the most theoretically correct inventory valuation method. The FIFO flow concept is a logical one for a business to follow, since selling off the oldest goods first reduces the risk of obsolescence. This cost flow assumption closely follows the actual flow of goods. In other words, the items purchased first are assumed to have been sold first. Goods purchased at the end of the accounting period remain in ending inventory. This cost flow assumption is logically appealing, since it follows the normal actual movement of goods. Under a perpetual system, the company records the cost of goods sold at the point of each sale. FIFO is conceptually could for firms selling products that can perish or are subject to style changes, obsolescence, or rapid technological changes. The FIFO cost-flow assumption accurately portrays the actual flow of goods in most companies. Ex. it is logical that a computer manufacturer will attempt to sell its oldest models first, because they will certainly be replaced by units with more advanced technology. (The allocation between cost of goods sold and ending inventory is the same using either the perpetual or the period system for the FIFO method. This is not the case for the LIFO and moving-average cost methods.)

The company assigns the oldest costs to ending inventory and the most recent costs to costs of goods sold. LIFO is conceptually sound for any company that accumulates inventory, sells units from its most recent acquisitions, and maintains a base stock (such as a mining company). However, actual inventory management at most firms does not follow this pattern. This cost flow assumption was developed for tax purposes. However, because of tax law requirements, if a company uses this assumption for tax purposes it must also use it for its financial statements. It does not coincide with the actual movement of goods. LIFO is used during inflationary times to defer income tax payments. Under LIFO the goods in inventory at the beginning of the period is assumed to remain in the ending inventory (perhaps for decades). Obviously, this does not actually happen! Remember, this is an assumption only. LIFO is a method to defer taxes until the "beginning" inventory is sold (either because the company changes to a different method or because it has not replenished its inventory of the particular goods or class of goods). If this event occurs, the lower cost of goods (based on costs incurred at a much earlier time) will result in higher income and correspondingly higher income taxes. In other words, the taxes deferred during earlier times will now become payable, assuming there have been no changes in tax law/rates. LIFO requires significant record keeping and careful management of purchases. It also results in significantly understated inventory values (assets) if it has been used for a significant length of time and/or if there is significant inflation. However, it results in significant tax savings (cashflow!)

Companies typically use either the moving-average cost, FIFO, or LIFO methods for costing inventory. While the specific identification method is allowed, virtually no firms use it. FIFO is the most popular method The 3 primary cost-flow assumptions produce different results for the cost of goods sold reported on the income statement and the valuation of inventory on the balance sheet. The different results can have a significant impact on reported income and several key financial ratios. The cost-flow assumptions only affect the allocation of ending inventory and cost of goods sold: the choice of inventory valuation method does not affect cash flows directly. If costs are rising for inventory acquisitions and if units in inventory are constant or increasing: FIFO: lowest COGS, (highest NI), highest inventory, as long as the unit cost of inventory is increasing. Moving average: middle (falls between FIFO and LIFO) LIFO: highest COGS (lowest NI), lowest inventory, as long as the unit cost of inventory is increasing. If costs are declining, the comparison is exactly the opposite, with LIFO resulting in higher net income and a higher inventory valuation.

mandates that a company using LIFO for tax purposes must also use it for financial reporting. The effect of inventory valuation methods on cost of goods sold, and thus net income, and the required book-tax conformity for LIFO lead to possible tax and cash-flow consequences. LIFO generally results in a lower income figure in a period of rising inventory costs. Thus it is advantageous to use LIFO for tax purposes because its use will increase cash flow by decreasing cash paid for income taxes. Investors and other financial statement users understand that even though using LIFO results in lower net income, using LIFO increases cash the company retains and can use in operations. Therefore, they do not penalize a company for using LIFO and reporting lower net income.

IFRS does not allow the LIFO approach. International accounting standard setters view LIFO as imposing an unrealistic cost flow assumption that lacks representational faithfulness of inventory flows. As the US considers the use of IFRS, the fact that IFRS does not allow the LIFO cost-flow assumption is a major obstacle for US companies. There could be significant cash flow effects for companies currently saving taxes as a result of using LIFO. A company ceasing the use of LIFO is obligated to pay the IRS all the tax savings it received from using LIFO over a 4-year period. ex. Chevron, a petroleum company that uses the LIFO cost-flow assumption saved approx. $3 billion in taxes by using LIFO in 2013

While US GAAP allows LIFO, many argue that this method is generally not a conceptually sound assumption for the cost flow of inventory. It is rare for a company to sell its most recent purchases before its earlier purchases. A concrete plant might use the most recent cement first because it is on the top of the pile - but in reality few other types of companies would operate this way. IFRS does not permit the use of LIFO for this reason. In addition to being theoretically deficient, LIFO is the most difficult and costly method to implement in practice. The primary reason that LIFO is used by a significant amount of US firms is due to the fact that LIFO can provide significant tax benefits for a firm. Before the LIFO conformity rule, many firms adopted LIFO for tax purposes while continuing to use FIFO for financial reporting. This dual approach allowed firms to report higher net income to their shareholders, while reducing income for tax purposes. Congress believed that this was misleading because if LIFO is used for tax, then LIFO must be viewed by a company to be the proper valuation of inventory. As a result, the IRS LIFO conformity rule requires that if a company wants to maximize tax benefits (lower taxable income) by using LIFO for tax purposes, it must also adopt LIFO for financial reporting.

A firm that reports externally on the LIFO basis will often measure inventory on its trial balance for internal records on another basis, such as FIFO. If costs are increasing, the firm will then uses an allowance account, referred to as the LIFO reserve, to reduce the inventory to the measurement under LIFO. The balance in the LIFO reserve account is the difference between the inventory measured using FIFO and LIFO. The footnotes to the financial statement disclose the LIFO reserve. In the process of recording the LIFO reserve account adjustment, the company will also adjust the cost of goods sold account. The income statement adjustment the LIFO reserve account is referred to as the LIFO effect (change in the LIFO reserve account during the year and its impact on cost of goods sold)

the LIFO reserve account is the difference between the inventory balance measured using FIFO and LIFO.

The change in the LIFO reserve account during the year, and is the impact on cost of goods sold.

If costs are declining, using LIFO will result in lower cost of goods sold, and thus higher Net Income, when compared to FIFO. If inventory units are decreasing and costs are increasing, then using LIFO may also result in higher net income than FIFO. As a company uses LIFO over time, it builds LIFO layers (annual increases in the quantity of inventory). When inventory levels decline under the LIFO method and costs are increasing, the company sells older low-cost LIFO layers, reducing cost of goods sold and increasing book(and taxable) income. A decrease in inventory layers under the LIFO method is called a LIFO liquidation. Companies choose LIFO to lower their tax bills. Because of the possibility that a LIFO liquidation decreases cost of goods sold and increases taxable income, companies seek to avoid liquidating their LIFO layers. (*A LIFO liquidation will not always result in an increase to net income)

annual increases in the quantity of inventory

Techniques to simplify the LIFO computation aggregate inventory items into groups called pools and perform the LIFo computations of the inventory pool, as opposed to individual items. The most common technique is the dollar-value LIFO method, pools inventory items and uses the dollar as the common unit of measure of the inventory. Because the unit of measure (the dollar) applies to all inventory items, firms can aggregate multiple items into a single LIFO pool. Dollar-value LIFO offers several advantages: 1. Firms account for dollars and not units. Dollars are a common unit of measure, regardless of the specific inventory item. Therefore, an extremely diverse inventory cam be made homogenous by restating the physical units into dollars. 2. It avoids problems when there are changes in the product mix. When a firm adds or deletes a product or product line, it simply replaces dollars with other dollars (both products are carried at the same common unit of measure) 3. It can minimize the likelihood of liquidation because the removal of one stock number is not going to liquidate an entire cost pool. Again, dollars are replaced by dollars and the units of measure are the same.

involves computing the pool of inventory on the basis of the dollar, not in terms of units. Consequently, when comparing beginning inventory to ending inventory, the firm determines how much of the change is due to changes in price (unit cost of inventory) and how much is due to changes in quantity. Comparing the LIFO layers indicates the change in quantity. 1. Determine the ending inventory stated in terms of base-year prices (base year is the first year that the company reports under dollar-value LIFO). To determine the ending inventory in terms of base-year prices, a company divides the ending inventory at year-end prices by the cumulative price index. 2. Determine the increase(or decrease) in quantity at base-year prices. The difference measures the increase in quantity. 3. Determine the increase (or decrease) in quantity at current-year prices. 4. Add all of the layers together to get the dollar-value LIFO ending inventory. 5. Calculate the LIFO reserve 6. Record the journal entry to make the LIFO adjustment *Liquidating a layer does not result in a change to prior inventory balances. However, the liquidation of a prior layer is priced at the index for that year, meaning that a company liquidates LIFO layers in LIFO order.

Choosing LIFO or FIFO is just an internal accounting decision. Yet, because each method results in different measurements of ending inventory on the balance sheet and cost of goods sold on the income statement, this decision can be quite critical.

After a company has established its method for valuing inventory, it must monitor its inventory over time for business planning and financial reporting purposes to assess its future revenue-generating ability. The Lower-of-Cost-or-Market rule: requires that if a measure of the market value of inventory falls below its cost basis (as determined by an inventory allocation method), then the company must report inventory at the lower of its cost or market value. Specifically, whenever the market value of inventory falls below its cost, a company: 1. Reports the difference between the cost basis and the market-based measure as a loss on the income statement (indirect method) or an increase in cost of goods sold (direct method) 2. Carries the inventory at the lower amount on the balance sheet. Ex. Technology companies often have short product life cycles that can lead to rapid obsolescence and price erosion. If a company builds its inventories during periods of anticipated growth, and that growth does not materialize, the result may be excess or obsolete inventory. (Blackberry had to write-down inventory by about $1.6 billion in 2013 when it experienced lower-than-anticipated future demand for certain products)

The portion of the asset definition requiring that an asset provide probable future economic benefits is critical to understanding the lower-of-cost-or-market rule. The most relevant inventory method better measures the future economic benefits. If the expected economic benefits are less than the amount the firm is currently reporting in inventory, then the firm should reduce the amount on the balance sheet.

Implementation involves 3 steps: 1. Determine the market value of inventory 2. Compare the market value measure to cost as determined using an inventory allocation method 3. Record the write-down, if necessary

Firms measure the market value as the amount at which they could currently purchase or reproduce the inventory, know as the current replacement cost (CRC). However, there are two boundaries on the use of current replacement cost. 1. The CRC cannot exceed a ceiling equal to net realizable value (NRV), which is the item's selling price less the cost of disposal. Disposal costs include packaging, shipping, and commissions. Disposal costs are also referred to as the costs of completion and sale. The ceiling prevents overvaluing inventory or using a value above the amount that the firm reasonably expects to realize in cash from the disposal of the item. 2. The CRC cannot fall below a floor value of net realizable value less a normal profit margin (NRV - NP). The floor prevents undervaluation of inventory. For example, firms may undervalue inventory and report a large loss on their income statements if they are taking a big bath. A big bath occurs when a firm front loads expenses and losses in one year so that it can look much better, comparatively, in future years. The (NRV - NP) valuation is the lowest measure of market value at which the firm can carry inventory on its balance sheet. Firms determine the market value of inventory on an individual-item basis. In other words, firms compare the NRV, CRC, and NRV - NP for each item in inventory to determine that item's market value.

2 methods: 1. The direct method writes off the loss directly to the inventory account and records that loss in the cost of goods sold reported on the income statement. (Cost of goods sold method) 2. The indirect method reports the loss as a separate line item on the income statement within income from continuing operations and reduces the inventory account by the use of an allowance account. Under the indirect method, when the firm increases the allowance, it reports a loss. When it decreases the allowance, the firm records income. If the write-down is significant, then the indirect method is preferred because it disclose the loss separately from the cost of goods that were actually sold. When a loss is disclosed as an individual line item on the income statement, the financial statement user can easily identify that the loss has taken place and determine its magnitude. The direct method includes the loss in cost of goods sold and therefore is not as transparent to the financial statement user.

approximates the cost of ending inventory balance by taking into consideration the requirement that firms report inventory at lower of cost or market based on the relationship between cost and selling price.

Companies like Target and Walmart cannot track the costs of each sale of inventory. Instead, these companies may use the retail method by maintaining information on: - Beginning inventory and purchases in terms of cost to the company - Beginning inventory and purchases in terms of the sales price (retail values) - Net sales at retail The basic retail method does not, however, track information on sales at cost.

Retail selling prices fluctuate throughout the year. Therefore, companies must also account for markups and markdowns of selling price when implementing the retail method. - An initial markup is the difference between the selling price that the company originally sells the product for and the cost of the product. - An additional markup is the amount the firm increases the selling price above the original selling price. - A markdown is the amount that the firm decreases the original selling price. - A markup cancellation is the amount by which the firm reduces an additional markup but not below the original selling price. - A markdown cancellation is the amount by which the firm reduces a markdown and increases the selling price, but not to exceed the original selling price.

When to use: - to determine the balances of ending inventory and cost of goods sold for interim periods without performing a physical inventory count - to determine the cost of inventory that has been lost, stolen, or destroyed - In auditors' testing of the overall reasonableness of inventory amounts reported by clients. - For budgeting and forecasting purposes Estimates ending inventory as cost of goods available for sale less estimated cost of goods sold. Estimated cost of goods sold is based on sales to date multiplied by one minutes the gross profit percentage.

In the financial statement and footnotes, inventory disclosures include: 1. Accounting policies, including the measurement basis upon which amounts are stated with costing methods such as FIFO or LIFO. 2. Carrying amounts by type of inventory such as raw materials or finished goods. 3. Any inventory financing arrangements 4. Carrying amount of inventories carried at less than cost and the amount of write-downs recognized as expense 5. The use of the LIFO costing method when applicable, including the LIFO reserve (or replacement cost of inventory used to compute the reserve) and effects of any LIFO liquidations