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Accounting 300A 23-A Inventory Valuation Methods Page 1 of 13
INVENTORIES: ALTERNATIVES FOR INVENTORY VALUATION
I. Review of Key Concepts and Terms:
A. Inventory is defined by ARB-43 as items of tangible personal property which are owned by the business and are:
- He ld for resale in the normal course of business;
- In the process of production for sale; or
- Goods that will soon be used in the production process.
Note: Ownership is determined by possession of title, rather than physical possession and include goods in transit if shipped FOB shipping point and exclude goods held on consignment.
B. The process of inventory valuation is one of the most important processes in producing the financial statements. The process involves sometimes conflicting goals : the accurate valuation of inventories on the balance sheet and the proper matching of inventory costs against revenues on the income statement. In addition, the cost of goods sold , a major component on the income statement is affected by the proper valuation of inventories.
- Effects of Inventory Errors:
a. Selection of an inventory system such as: i. Periodic Inventory System ii. Perpetual Inventory System b. Selection of a cost flow assumption such as: i. specific identification ii. FIFO (First In First Out) iii. LIFO (Last In First Out) iv. Average Cost (Weighted or Moving Average Cost)
- Determination of physical quantities on hand by taking a physical count or determination from the accounting records.
- Computing the value of ending inventory by multiplying the physical quantity on hand by the value of the inventory based on historical cost.
- Application of Lower of Cost or Market rule to insure that inventory is not overvalued on the books.
Note: Refer to 21A for a complete discussion and illustration of periodic and perpetual inventory systems
Note: The cost of inventory includes all cost normal and necessary to prepare the inventory for sale such as invoice cost, transportation-in, dealer preparation etc.
C. Selection of the periodic or perpetual inventory system is becoming increasingly academic as the cost of computer based inventory systems declines. The existence of low cost computer based inventory systems coupled wish laser bar code readers has virtually eliminated periodic inventory systems in all but the smallest operations.
- Advantages of Perpetual inventory systems: a. Inventory quantities are maintained on a constant basis, normally on a per product basis; b. Internal control is enhanced by allowing spot checks of inventory quantities on a random basis at any time; c. knowledge of inventory trends is produced in a timely manner so that management can react to changing trends to avoid stock outs of fast moving items and unnecessary orders of slow moving items; d. due to timely knowledge of inventory trends it may be possible to reduce inventory costs through better inventory control procedures.
- Advantages of the Periodic Inventory System: a. Allows firms to determine inventory and cost of goods sold at end of year without recording the effect (on inventory) of every sale and purchase made throughout the year. b. Requires no computer system and relatively simple record keeping
D. Selection of a cost flow assumption is dependent upon which financial statement (income statement or balance sheet) that the firm wants to emphasize. All the methods discussed below are acceptable under GAAP but:
- Whichever method is selected must be used consistently and must be disclosed in the financial statements;
- A firm can use different cost flow assumptions for different components of inventory as long as they are consistently applied;
- If a firm elects to change one cost flow assumption for another, the change in inventory cost flow assumptions must also be disclosed in the financial statements.
NOTE: the physical flow of goods through any company is unrelated to the flow of costs. In almost all cases the physical flow will be FIFO because the firm does not want older goods on hand irrespective of the nature of the inventory. The cost flow assumption (flow of costs) is only related to the valuation of inventory.
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E. Summary of Cost Flow Assumptions:
Cost Flow Assumption Statement Emphasized Reason Potential Problem Specific Identification Neither Based on actual physical flow of goods
- Inventory must be separately identifiable (i.e. by serial # etc.);
- Allows management to manipulate cost of goods sold by determining which items are charged to COS.
- Due to this potential manipulation, this approach is usually reserved for items of high unit value that can be separately identified
- Not considered GAAP for items that fail test 3 above FIFO (First In First Out)
Balance Sheet (Emphasis is on the accuracy of Ending Inventory)
- The most recent goods purchased are included in ending inventory;
- This means that the most recent costs are reflected in the value of Ending Inventory (EOY) on the balance sheet
- The COS is understated in periods of rising prices (because the flow of costs matches the FOFO costs against current revenues).
- Net Income is overstated in periods of rising costs (part of profit must be utilized to replace higher cost inventory).
- This overstatement of inventory is sometimes referred to as “ Phantom Profits”.
- NOTE: In FIFO, phantom profits are primarily on the Income Statement while the Balance Sheet reflects the most recent (accurate) costs. LIFO (Last In First Out)
Income Statement (Emphasis is on the accuracy of COS)
- The most recent costs are charged against revenue in computing the COS.
- LIFO has the affect of matching the most recent costs with sales thereby producing a more accurate and relevant net income
- Inventory layers are produced and over time may be produce an inventory carried on the books (balance sheet) at an amount significantly below replacement costs.
- When these undervalued inventory layers are charged against revenues, the result is a potentially serious overstatement of net income.
- This overstatement of net income is referred to as “ inventory profits” and are produces as the result of current revenues being compared to old (and lower ) cost inventory values.
- LIFO retains the “Phantom Profit” on the balance sheet (in the undervalued ending inventory).
- These lover value inventory layers are not moved to the income statement until the inventory is used to compute COS.
- In periods of rising prices reported income is less under LIFO than under FIFO Weighted Average Cost Neither 1. A weighted average cost is computed after each purchase of inventory.
- This average is “ weighted” by multiplying the number purchased by the purchase price.
- This approach produces an average cost that favors neither statement
- The Weighted average cost approach is a compromise method that produces neither and accurate balance sheet (ending inventory valuation) nor an accurate income statement (an accurate COS valuation)
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4. Average Cost Approaches : These methods assume that inventory valuation should be based on the average cost of all inventory available for sale during the period. A weighted average is used with periodic inventory systems and a moving average is used with perpetual systems.
- --Assume the following: Unit Weighted Moving Units Cost Total Average Cost Beginning inventory 100 $ 5 $ 500 $ 500/ 100 = $ 5. Purchased 1/1/x1 100 6 600 1,100/ 200 = 5. Purchased 3/1/x1 200 7 1,400 2,500/ 400 = 6. Purchased 6/1/x1 300 8 2,400 4,900/ 700 = 7. Purchased 9/1/x1 300 9 2,700 7,600/1,000 = 7. Purchased 12/1/x1 200 10 2,000 9,600/1,200 = 8. Goods available: 1,200 $ 9, Ending Inventory 250 2,000 (250 @ $8) Cost of Goods Sold 950 $ 7,
G. The "Lower of Cost or Market Rule" :
- Inventory, like all current assets, should be carried on the books at its net realizable value. In order to insure that inventory that has been damaged or otherwise reduced in value is not overvalued on the balance sheet, ARB 43, chapter 4, paragraph 8 requires that all inventory be valued at "cost or market, whichever is lower". Although this rule is applicable to all inventories, in actual practice it will be applied rarely. In order to apply the lower of cost or market rule it is necessary to understand the following terms:
- Replacement Cost: the full cost of preparing inventory for sale; this value is defined as market value in those cases that replacement cost does not exceed the ceiling value of or fall below the floor value;
- Ceiling Value: The Net Realizable Value i.e. the estimated selling price in the normal course of business less reasonably predictable selling expenses; this value is defined as the market value in those cases that replacement cost exceeds the ceiling value;
- Floor Value: The Net Realizable Value less Normal Profit; this value is defined as market value in those cases that the replacement cost is less than the floor value;
- Market Value: the replacement cost except: a. where replacement cost is greater than the ceiling, use the ceiling value (market is defined as ceiling value) b. where replacement cost is less than the floor, use the floor value (market is defined as the floor value)
- Cost: The historical cost of the inventory, including all normal and necessary cost to prepare the inventory for sale
Note: The lower of cost or market rule can be applied to individual items, groups of items, or total inventory.
- Application of the Lower of Cost or Market Rule: Consider the following four (A, B, C and D) independent examples:
Normal Normal Normal Net Realizable Selected Lower of Inventory Historical Replacement Selling Selling Profit (Ceiling) Floor Market Cost (1) or Item Cost Cost Price Expense Value Value Value Market (6) (3)-(4) (3)-(4)-(5) (2),(6),or (7) A $ 22.00 $ 20.00 $ 25.00 $ 1.00 $ 2.50 $ 24.00 $ 21.50 $ 21.50 $ 21. B 27.00 26.00 28.00 2.50 3.00 25.50 22.50 25.50 25. C 5.00 7.00 9.00 .50 1.00 8.50 7.50 7.50 5. D 26.00 25.00 30.00 4.00 3.00 26.00 23.00 25.00 25.
- Recording the write-down: When the historical cost of inventory exceeds market valuation computed under the lower of cost or market rule, inventories must be reduced valuation must be reduced (written down) using either the direct write-down method or the valuation account method. Assume that a physical count of goods on hand shows 200 units of inventory in ending inventory. Using the information in part 1 above the required journal entries would be:
Item Direct Charge Method Valuation Account Method A Cost of Goods Sold (200 x $22.00 - $21.50)... 100 Inventory holding loss (200 x $22.00 - $ 21.50)... Inventory................................. 100 A llowance to reduce inventory to LCM........... 100
B Cost of Goods Sold (200 x $26.00 - $25.50).. 100 B Inventory holding loss (200 x $26.00 - $ 25.50)... Inventory................................. 100 Allowance to reduce inventory to LCM........... 100
C Cost of Goods Sold (200 x $ 5.00 - $ 5.00)...no entry C Inventory holding loss (200 x $ 5.00 - $ 5.00)....no entry Inventory................................. no entry Allowance to reduce inventory to LCM...........no entry
D Cost of Goods Sold (200 x $26.00 - $25.00)...200 D Inventory holding loss (200 x $26.00 - $ 25.00)... Inventory................................. 200 Allowance to reduce inventory to LCM........... 200
H. Inventory Estimation Methods: In many cases there are times that a company needs to know (or estimate) the dollar amount of ending inventory when taking a physical inventory is either impossible or impractical. For instance, the inventory may have been destroyed and an estimate is needed for insurance purposes, or the expense of taking a physical inventory may be prohibitive. Two methods are commonly used to estimate inventory when a physical count is deemed impractical:
- Gross Margin Method: Used primarily for estimations by management and auditors to check the reasonableness of amounts computed from other sources. This approach is not GAAP for financial reporting purposes. This approach simply examines the income statement and computes a ratio of gross margin to sales. By examining the accounting records with respect to beginning inventory, purchases (and related returns and allowances) ending inventory can be estimated by working backward. To illustrate, consider the income statement on the following page. If one assumes that the gross profit percentage is historically fairly constant and that the numbers (other than ending inventory) in cost of goods sold are known (by an examination of the accounting records), it is a straightforward process to work backward and compute the value of ending inventory.
Accounting 300A 23-A Inventory Valuation Methods Page 5 of 13
Sales............................................................. $ 1 02, Less: Sales returns and allowances....... $ 5, Sales discounts....................... 1,000 6, Net Sales......................................... $ 96,000 (100%) Cost of Goods Sold: Beginning Inventory.......................... $ 78, Add: Purchases......................... $ 63, Transportation In............... 1,000 (Note: Transportation In is part of COGS) Less: Purchase Returns and allowances... (2,000) Purchases discounts (700) Net Purchases 61, Cost of goods available for sale............. $ 139, Less: Ending Inventory.......................? Note: the correct amount is (75,300)work backwards to compute Cost of Goods Sold...................................... 64,000 (.677) ratio of COS/Sales Gross Profit on Sales............................................. $ 32,000 (.333) ratio of GP/Sales
NOTE: The presentation above assumes the use of the periodic inventory system. The differences between the periodic and perpetual inventory systems are discussed in part C below.
- Retail Inventory Method: Used by department stores and retailers to estimate inventories marked at retail values. Prior to computerized perpetual inventory systems the advantage of the retail system was that it was a cost effective method of estimating ending inventories. Application of this method requires that records at both cost and retail amounts be kept for beginning inventory and purchases. The cost of ending inventory is estimated by multiplying the cost/retail ratio of goods available for sale by the ending inventory carried at retail value.
Assume that the accounting records show that sales for the period are $80,000. An examination of the records reveals the following facts:
At At Cost Retail
Beginning inventory ....................... $ 10,000 $ 16, Net purchases ............................. 65,000 84, Goods available for sale ............. $ 75,000 $ 100,000 Cost percentage ($75,000/$100,000) = 75%) Less: Sales to date (at retail)............ (80,000) Ending inventory at retail:................ $ 20, Compute ending inventory at cost. $ 15,000 (Inventory @ retail x ratio = $20,000 x .75) Computed cost of goods sold: ($10,000 + $65,000 - $15,000 = $60,000, or $80,000 x 75% = $60,000)
--A limitation of the retail method is that the cost percentage is simply an average of all goods bought and sold. This average only results in accurate estimates if the same relationship between cost and selling price exists for all goods or if the mix of goods in ending inventory is the same as that in the goods available for sale. Consequently, the retail method produces accounting values of ending inventory and cost of goods sold that are loose approximations. In addition, when the relationship between cost and selling price varies substantially between departments, the retail method must be applied separately to each department.
--When computing net purchases (in the cost column) add transportation-in and subtracts purchase discounts. These two items are not added or subtracted in the retail column because the original retail price of the inventory is ordinarily set in a manner that reflects them. Purchase returns and purchase allowances are subtracted in the cost and retail columns because these items reduce the amount of goods purchased.
--When subtracting sales in the retail column, deduct any sales returns and allowances, employee discounts, normal shrinkage (due to damage, theft, etc.) or other items that represent normal reductions of the original retail value of goods available for sale during the period. Do not deduct sales discounts , because the sales price less any available discount is considered to be the actual price of the product (discounts lost would be a financial expense, and not part of the purchase price).
I. Effects of Inventory Errors on Financial Reporting: It is essential to understand the effects of inventory errors on the financial statements of a business because of the relative importance of inventory in the computation of net income and the reporting the assets of many firms. The following equation simplifies the analysis of inventory errors on the financial statements:
Evaluating the Affect of Inventory Errors Net Income = Sales - Beginning Inventory - Purchases + Ending Inventory. By noting the effect (plus or minus) of an error, it is possible to analyze the affect of the error on the financial statements.
Accounting 300A 23-A Inventory Valuation Methods Page 7 of 13
- The use of a weighted average (periodic inventory system) or the moving average method (perpetual inventory system) will result in different cost of goods sold for each system.
Problem 1 (Inventory valuation)
Larkin Inc. deals in a single product. The volume of sales in 19x1 was $587,200 at a unit price of $8. Unit Date Units Price Value Beginning Inventory: 1/1/x1 1,100 $ 4,
Purchases: 2/10/x1 29,000 $4.50 $ 130, 4/15/x1 47,000 5.00 235, 11/1/x1 4,100 5.20 21, Total Purchases.............................. $ 386,
Larkin uses the periodic inventory system.
Required:
- Compute the December 31, 19x1 periodic inventory using: a. Weighted average method (compute average cost to the nearest cent) b. FIFO c. LIFO
Date Units Total Cost Unit Cost a: Weighted Average
b: FIFO
c: LIFO
- Complete the following partial income statements using each of the three methods of inventory valuation.
Weighted Average
FIFO LIFO
SALES:
COST OF GOODS SOLD
a. beginning inventory
b. purchases
c. closing inventory
TOTAL COST OF GOODS SOLD
GROSS PROFIT
Accounting 300A 23-A Inventory Valuation Methods Page 8 of 13
Problem 2 (Inventory Valuation)
The following information is available from the records of Kahn, Inc. for the month of June. The company sells one product and utilizes a perpetual inventory system.
Unit Date Units Price Value
Beginning Inventory: 1/1/x1 3,000 $6.00 $ 18, Purchased: 1/4/x1 2,300 6.20 14, Sold: 1/7/x1 2, Purchased: 1/13/x1 2,000 6.40 12, Sold: 1/20/x1 1, Purchased: 1/26/x1 1,000 6.50 6. Sold: 1/30/x1 1,
Required: 1.a. Compute the June 30 inventory using LIFO b. Compute the June 30 inventory using FIFO
2.Assume that Kahn Inc. uses a periodic inventory system. a. Compute the June 30 inventory value using LIFO b. Compute the June 30 inventory value using FIFO
Problem 3 (Lower of Cost or Market Rule)
Unique Stereo Corp. has the following inventory items on hand of December 31:
Type Qty
Unit Cost
Marke t TVs Black & White Color Color-remote
VCRs Beta VHS VHS-Deluxe
Required:
- Using the lower of cost or market rule, calculate the ending inventory: a. on an item basis b. by category c. by entire inventory
Problem 4 (Inventory estimation: Gross profit method)
Hinds Inc. is undergoing an audit in which the auditors wished to test the validity of the accounting system by testing the computed value of the ending inventory with an estimate derived from the gross profit method. The auditors have the following data available:
Beginning Inventory................$ 42, Purchases.......................... 87, Purchases returns.................. 3, Transportation-in.................. 2, Sales.............................. 171, Sales returns...................... 3, Delivery Expense................... 5,
Required:
- Prepare a schedule showing the estimated value of ending inventory if Hinds Inc. has an average gross profit of 32% on net sales over the past 5 years.
Problem 5 (Inventory estimation: Retail Method)
At the end of year x4 the following information for April Co. Department Store was obtained: Cost Retail Beginning inventory..... $ 20,460 $ 31, Purchases............... 207,735 337, Purchases returns....... 7,320 12, Sales................... 316, Sales Returns........... 3,
Required: 1.Prepare a schedule computing April Co.'s ending inventory at cost using the retail method.
Part 1:
Step 1: Compute the number of units sold: = 73,400 units Date Units Total Cost Unit Cost Part 2: Weighted Average
- Accounting 300A 23-A Inventory Valuation Methods Page 10 of
- Solution Problem - = $587,200/$8. Sales in Units = Total sales in dollars/Unit price
- Total units available for sale.... 81, Step 2: Compute the number of units in ending inventory:
- Less: Number of units sold........ 73,
- Ending inventory.................. 7,
- WTD AVG price: $391,384/81,200=$4. a: Weighted Average
- 7,800 units x $4.82= $37, - Jan - Feb - Apr - Nov - 1, - 29, - 47, - 4, - 81, - $ 4, - 130, - 235, - 21, - $391, - $ 4. - 5. - 5.
- b: FIFO Nov - Apr - 4, - 3, - 7, - $ 21, - 18, - $ 39, - $ 5. - 5.
- c: LIFO Jan - Feb - 1, - 6, - 7, - $ 4, - 30, - $ 34, - $ 4.
- SALES: $587,200 $587,200 $587, FIFO LIFO
- a. beginning inventory 4,564 4,564 4, COST OF GOODS SOLD
- b. purchases 386,820 386,820 386,
- TOTAL COST OF GOODS SOLD $353,788 $351,564 $356, c. closing inventory (37,596) (39,820) (34,714)
- GROSS PROFIT $233,412 $235,636 $230,
Accounting 300A 23-A Inventory Valuation Methods Page 11 of 13
Solution Problem 2
Part 1: LIFO
Purchases Sales Balance Date Qty. Unit Cost
Total Cost
Qty. Unit Cost
Total Cost
Qty. Unit Cost
Total Cost 1/1 3,000 6.00 18, 1/4 2,300 6.20 14,260 3, 2,
Part 2: FIFO
Purchases Sales Balance Date Qty. Unit Cost
Total Cost
Qty. Unit Cost
Total Cost
Qty. Unit Cost
Total Cost 1/1 3,000 6.00 18, 1/4 2,300 6.20 14,260 3, 2,
Accounting 300A 23-A Inventory Valuation Methods Page 13 of 13
Problem 4 Solution
- Prepare a schedule showing the estimated value of ending inventory if Hinds Inc. has an average gross profit of 32% on net sales over the past 5 years.
Sales.............................. $ 171, Sales returns...................... (3,396) Net Sales........................ $168,450 (100%) Cost of goods sold: Beginning Inventory................ $ 42, Purchases................. $ 87, Add: Transportation-in... 2, Less: Purchases returns... (3,712) Net purchases............. 86, Cost of goods available for sale... 128, Less: Ending Inventory............. (14,184) (plug:128,730-114,546) Cost of goods sold................. 114,546 ( 68%) Gross profit on sales.............. $ 53,904 ( 32%)
Solution Problem 5
Cost Retail Beginning inventory........... $ 2 0,460 $ 31, Purchases...................... 2 07,735 3 37, Purchases returns.............. (7,320) (12,021) $ 220,875 $ 356, Cost/retail ratio: 220,875/356,250 =.
Sales.......................... $316, Sales Returns.................. (3,198) Net Sales.................... 312, Ending inventory at retail..... $ 43,
Ending inventory at cost: $43,300 x .62: $ 26,
