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C-
Inventory and
Depreciation
Learning Unit C-1 HOW TO ASSIGN COSTS TO ENDING INVENTORY ITEMS
The method one uses to assign costs to ending inventory will have a direct effect on the company’s cost of goods sold and profit. Look at the accompanying diagram and note that in each column that ending inventory has a different value assigned to it. Note also how this affects gross profit in each of the four columns.
If all inventory brought into a store had the same cost, it would be simple to calculate ending inventory, and we would not have to include this appendix in the book. Unfortunately, things are not that easy; often the very same products are pur- chased and brought into the store at different costs during the same accounting period. Over the years there have developed four generally accepted methods to assign a cost to ending inventory. They are: (1) specific invoice, (2) weighted-average, (3) first-in, first-out, and (4) last-in, first-out. Each is based on the flow of costs, not the flow of goods (the actual physical movement of goods sold in a store).
SPECIFIC INVOICE METHOD
Jones Hardware sells rakes. At the end of the period 12 rakes remain unsold. Notice in the accompanying table on page C-2 that on January 1, at the start of the accounting period, 10 rakes were on hand, but during the period additional pur- chases of rakes were made. The price given is the purchase price paid by the store — it is not the same as the selling price, which is what the store charges its customers for the rakes. The selling price is not involved here. At the bottom of the chart you can see that 44 rakes cost Jones Hardware $543.
A B C D
Net sales $50,000 $50,000 $50,000 $50, Beginning Inventory $ 4,000 $ 4,000 $ 4,000 $ 4, Net Purchases 20,000 20,000 20,000 20, Cost of Goods Available 24,000 24,000 24,000 24, for Sale Ending Inventory 5,000 6,000 7,000 8, Cost of Goods Sold 19,000 18,000 17,000 16, Gross Profit $31,000 $32,000 $33,000 $34,
C-2 INVENTORY AND DEPRECIATION
In the specific invoice method, one assigns the cost of ending inventory by iden- tifying each item in that inventory by a specific purchase price and invoice number. Items can be identified by serial number, physical description, or location. Using this method, Jones Hardware knew that six of the rakes not sold were from the March 15 invoice and the other six were from the August 18 purchase. Thus $150 was assigned as the actual cost of ending inventory. If the total cost of goods available for sale is $543 and we subtract the actual cost of ending inventory ($150), this method pro- vides a figure of $393 for cost of goods sold.
Specific Invoice Method
Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $ March 15 Purchased 9 @ 12 = 108 6 @ $12 $ 72 August 18 Purchased 20 @ 13 = 260 6 @ 13 78 November 15 Purchased 5 @ 15 = 75 44 $543 12 $
Cost of Goods Available for Sale $ Less: Cost of Ending Inventory 150 = Cost of Goods Sold $
Let’s look at pros and cons of this method:
Specific Invoice Method
Cons
- Difficult to use for goods with large unit volume and small unit prices — for example, nails at a hardware store, packages of tooth paste at a drug store.
- Difficult to use for decision- making purposes — ordinarily an impractical approach.
WEIGHTED-AVERAGE METHOD
The weighted-average method calculates an average unit cost by dividing the total cost of goods available for sale by the total units of goods available for sale. Since we don’t know exactly which items are left in ending inventory, we will calculate the aver- age of all the goods we have available in order to come up with a fair approximation of the cost of the ending inventory.
Pros
- Simple to use if company has small amount of high-cost goods — for example, autos, jewels, boats, antiques, etc.
- Flow of goods and flow of cost are the same.
- Costs are matched with the sales they helped to produce.
C-4 INVENTORY AND DEPRECIATION
First-In, First-Out (FIFO) Method
Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $ March 15 Purchased 9 @ 12 = 108 August 18 Purchased 20 @ 13 = 260 7 @ $13 = 91 November 15 Purchased 5 @ 15 = 75 5 @ 15 = 75 44 $543 12 $
Cost of Goods Available for Sale $ Less: Cost of Ending Inventory 166 = Cost of Goods Sold $
If you are having difficulty with this, think of the inventory as being taken from the bottom layer first, then the next one up, and the next one up, etc. The pros and cons of this method:
First-In, First-Out (FIFO) Method
Pros Cons
- The cost flow tends to follow the 1. During inflation this method physical flow (most businesses try will produce higher income to sell the old goods first — for on the income statement — example, perishables such as fruit thus more taxes to be paid. or vegetables). (We will discuss this later in
- The figure for ending inventory this appendix.) is made up of current costs 2. Recent costs are not matched with on the balance sheet (since recent sales, since we assume old inventory left over is assumed to goods are sold first. be from goods last brought into the store).
LAST-IN, FIRST-OUT METHOD (LIFO)
Under the LIFO method, it is assumed that the rakes most recently acquired by Jones are sold first. In other words, the last merchandise brought into the store is the first to be sold. As an example of this method, think of a barrel of nails. It is the most recently purchased nails, which are at the top of the barrel, that are sold first — the nails at the bottom of the barrel are sold last. Note in the accompanying table on page C-4 that the 12 rakes not sold were assigned costs based on the old inventory of January and March that totaled $124, giving Jones a cost of goods sold of $419.
INVENTORY AND DEPRECIATION C-
Last-In, First-Out (LIFO) Method
Goods Available Calculating Cost of for Sale Ending Inventory Units Cost Total Units Cost Total January 1 Beg. Inventory 10 @ $10 = $100 10 @ $10 = $ March 15 Purchased 9 @ 12 = 108 2 @ 12 = $ 24 August 18 Purchased 20 @ 13 = 260 November 15 Purchased 5 @ 15 = 75 44 $543 12 $
Cost of Goods Available for Sale $ Less: Cost of Ending Inventory 124 = Cost of Goods Sold $
These are the pros and cons of this method:
Last-In, First-Out (LIFO) Method
Pros Cons
- Cost of goods sold is stated at or 1. Ending inventory is valued at near current costs, since costs of very old prices. latest goods acquired are used. 2. Doesn’t match physical flow of
- Matches current costs with current goods (but can still be used to selling prices. calculate flow of costs).
- During periods of inflation this method produces the lowest net income, which is a tax advantage. (The lower cost of ending inventory means a higher cost of goods sold; with a higher cost of goods sold, gross profit and ultimately net income are smaller, and thus taxes are lower.)
Now we will compare the methods that could be used by Jones Hardware to see the cost of ending inventory and the assigned cost of goods sold.
Comparison of Methods for Jones Hardware
Cost of Ending Inventory Cost of Goods Sold Specific Invoice $150.00 $393. Weighted-Average 148.08 394. FIFO 166.00 377. LIFO 124.00 419.
All four methods are acceptable accounting procedures, and each has its own virtues:
1. The specific invoice method matches exactly costs with revenue — as we have noted before, this is very important in the accrual basis of accounting. 2. The weighted-average method tends to smooth out the fluctuations between FIFO and LIFO.
INVENTORY AND DEPRECIATION C-
Depreciation expense is directly related to use, not to passage of time.
Cost of Yearly*^ Accumulated Book Value, End of Delivery Depreciation Depreciation, End of Year Year Truck Expense End of Year (Cost 2 Accum. Dep.) 1 $20,000 $3,600 $ 3,600 $16, 2 20,000 3,600 7,200 12, 3 20,000 3,600 10,800 9, 4 20,000 3,600 14,400 5, 5 20,000 3,600 18,000 2,
(Cost of (Note that (Accumulated (Book value each year machine depreciation depreciation is lowered by $3, doesn’t expense is the increases by until residual value of change) same each $3,600 each $2,000 is reached) year) year)
*The depreciation rate is 100 percent ÷ 5 years = 20 percent. The 20 percent is then multiplied times the cost minus the residual value.
UNITS-OF-PRODUCTION METHOD
With the units-of-production method it is assumed that passage of time does not determine the amount of depreciation taken. Depreciation expense is based on use , be it total estimated miles, tons hauled, or estimated units of production — for example, the number of shoes a machine could produce in its expected useful life. The accom- panying table shows the calculations that Melvin Company makes for its truck using the units-of-production method (note that the truck is assumed to have an estimated life of 90,000 miles). The formula:
Cost of Yearly Accumulated Book Value, End of Delivery Miles Driven Depreciation Depreciation, End of Year Year Truck in Year Expense End of Year (Cost 2 Accum. Dep.) 1 $20,000 30,000 $6,000 $ 6,000 $14, 2 20,000 21,000 4,200 10,200 9, 3 20,000 15,000 3,000 13,200 6, 4 20,000 5,000 1,000 14,200 5, 5 20,000 19,000 3,800 18,000 2,
(After 5 years, (Depreciation truck has been expense is driven 90,000 directly related miles) to number of miles driven)
SUM-OF-THE-YEARS’-DIGITS METHOD
The sum-of-the-years’-digits method places more depreciation expense in the early years rather than the later years in order to better match revenue and expenses, since an asset’s productivity may be reduced in later years. For this reason it is called an
cost residual value estimated units of production
90, 000 miles
$.20 per mile
($.20) (no. of miles driven) Depreciation expense for period
× =
C-8 INVENTORY AND DEPRECIATION
Cost Yearly Accumulated Book Value, End of
Minus
Fraction
= Depreciation Depreciation, End of Year Year residual for Year Expense End of Year (Cost 2 Accum. Dep.)
1 $18,000 3 = $6,000 $ 6,000 $14,000 ($20,000 2 $6,000)
(20,000 2 2,000)
2 18,000 3 = 4,800 10,800 9,
3 18,000 3 = 3,600 14,400 5,
4 18,000 3 = 2,400 16,800 3,
5 18,000 3 = 1,200 18,000 2,
(Fraction for year is (Depreciation (Each year de- (Book value multiplied times cost expense in first preciation accu- goes down each minus residual) year is highest) mulates by a year until resid-- smaller amount) ual is reached)
1 15
2 15
3 15
4 15
5 15
Take a moment to make sure you see how the figures for these calculations are arrived at before moving on to the next method.
DOUBLE DECLINING-BALANCE METHOD
The double declining-balance method is also an accelerated method, in which a larger depreciation expense is taken in earlier years and smaller amounts in later years. This method uses twice the straight-line rate, which is why it is called the double declining-balance method. A key point in this method is that residual value is not deducted from cost in the calculations, although the asset cannot be depreciated below its residual value. To cal- culate depreciation, take the following steps:
accelerated depreciation method. To use it, you multiply cost minus residual times a certain fraction. This fraction is made up of the following:
1. The denominator: The denominator is based on how many years the asset is likely to last (say 5). You then add the sum of the digits of 5 years (1 + 2 + 3 + 4 + 5), which equals 15; 15 is the denominator. [There is also a formula to use for the denominator: N ( N + 1)/2, where N stands for number of years of useful life (in our case, 5 years). In our case the formula would look like this: 5(5 + 1)/2 = 15.] 2. The numerator: The years in reverse order are the numerator (in our case, 5, 4, 3, 2, 1).
Thus, in year 1 the fraction would be 5/15; in year 2, 4/15; in year 3, 3/15; in year 4, 2/15; in year 5, 1/15. And in each year you would multiply this fraction times cost minus residual to find the depreciation expense. This is shown in the accompanying table.
C-10 INVENTORY AND DEPRECIATION
TABLE C-1 Accelerated Cost Recovery System:
Annual Depreciation as a Percentage of Original
Cost
For Property in the Three-Year Class^1 Five-Year Class^2 Ten-Year Class^3 1st year 25 15 8 2nd year 38 22 14 3rd year 37 21 12 4th year 21 10 5th year 21 10 6th year 10 7th year 9 8th year 9 9th year 9 10th year 9
(^1) Three-year class includes autos, some tools, and light trucks. (^2) Five-year class includes most machinery and equipment. (^3) Ten-year class includes amusement parks, pipelines, and nuclear plants.
The important points to remember are:
1. ACRS is generally not acceptable in preparing financial reports, because it allocates depreciation over a much shorter period than estimated useful life. 2. ACRS for tax reporting defers payment of income tax, since large amounts of depreciation are charged to earlier years.
MACRS AFTER THE TAX REFORM ACT OF 1986
(GENERAL DEPRECIATION SYSTEM)
This tax act generally overhauls the depreciation setup of property placed in service after December 31, 1986. Look for a moment at Figure C-1. This is a chart that summa- rizes the Tax Reform Act update. As you can see, some new classes are introduced (7- and 20-year property); cars and light trucks are moved from the 3-year class to the 5-year class; and office equipment moves from the 5-year class to the 7-year class. According to this act, classes 3, 5, 7, and 10 use 200 percent declining-balance, switching to straight-line, while classes 15 and 20 use 150 percent declining-balance, switching to straight-line. Both residential and nonresidential real property must use straight-line. Note that the recovery period is extended to years for residen- tial property and to years for nonresidential property. Let’s use Table C-2 (which was developed for this tax law) to calculate deprecia- tion on the purchase of a nonluxury car for $5,000 on March 19, 1987. Using Table C-2 to figure our example, we get the following:
Year Depreciation
1 .20 3 $5,000 = $1, 2 .32 3 $5,000 = 1, 3 .1920 3 $5,000 = 960 4 .1152 3 $5,000 = 576 5 .1152 3 $5,000 = 576 6 .0576 3 $5,000 = 288
INVENTORY AND DEPRECIATION C-
The following classes use a 200 percent declining-balance, switching to straight-line: l 3-year: Race horses more than two years old or any horse other than a race horse that is more than 12 years old at time placed into service; special tools of certain industries. l 5-year: Automobiles (not luxury); taxis; light general-purpose trucks, semiconductor manufacturing equipment; computer-based telephone central office switching equipment; qualified tech- nological equipment; property used in connection with research and experimentation. l 7-year: Railroad track; single-purpose agricultural (pigpens) or hor- ticultural structure; fixtures, equipment, and furniture. l 10-year: The 1986 law doesn’t add any specific property under this class.
The following classes use a 150 percent declining-balance, switching to straight-line: l 15-year: Municipal wastewater treatment plants; telephone distribu- tion plants and comparable equipment used for two-way exchange of voice and data communications. l 20-year: Municipal sewers.
The following classes use straight-line: l 27.5-year: Only residential rental property. l 31.5-year: Only nonresidential real property.
Figure C – 1 Summary of Classes for the Tax Reform Act Update
TABLE C-2 Annual Recovery (Percent of Original Depreciable
Basis)
3-Year 5-Year 7-Year 10-Year 15-Year 20-Year Class Class Class Class Class Class Recovery (200% (200% (200% (200% (150% (150% Year D.B.) D.B.) D.B.) D.B.) D.B.) D.B.)
1 33.00 20.00 14.28 10.00 5.00 3. 2 45.00 32.00 24.49 18.00 9.50 7. 3 15.00^ 19.20 17.49 14.40 8.55 6. 4 7.00 11.52^ 12.49 11.52 7.69 6. 5 11.52 8.93^ 9.22 6.93 5. 6 5.76 8.93 7.37 6.23 5. 7 8.93 6.55^ 5.90^ 4. 8 4.46 6.55 5.90 4. 9 6.55 5.90 4.46 10 6.55 5.90 4. 11 3.29 5.90 4. 12 5.90 4. 13 5.90 4. 14 5.90 4. 15 5.90 4. 16 5.90 4. 17 3.00 4.
*Identifies when switch is made to straight-line.
INVENTORY AND DEPRECIATION C-
b. LIFO 300 3 $40 = $12,000 COGAFS $96, 100 3 $50 = 5,000 2 Cost of End. Inv. 17, Cost of End. Inv. $17,000 COGS $79,
c. WEIGHTED-AVERAGE
SOLUTION TO DEPRECIATION PROBLEMS
(See Learning Unit C-2 Review.)
1. a. Straight-line
Acc. Dep. Book Value Year Cost Dep. Exp. E.O.Y. E.O.Y.
1 $34,000 $3,000 $3,000 $31, 2 34,000 3,000 6,000 28,
400 $60 $24, 000 Cost of Ending Inventory COGAFS $96, Cost of End. Inv. 24, COGS $72,
× =
1, 600 units
b. Yearly Cost Fraction Deprec. Acc. Dep. Book Value Year Less Residual 3 for Year = Expense E.O.Y. E.O.Y.
1 $30,000 10/55 = $5,454.55 $ 5,454.55 $28,545. 2 30,000 9/55 = 4,909.09 10,363.64 23,636.
c.
Acc. Dep. Book Value Acc. Dep. Book Value Year Cost B.O.Y. B.O.Y. Dep. Exp. E.O.Y. E.O.Y.
1 $34,000 — $34,000 $6,800 $ 6,800 $27, (34,000 3 .20) 2 34,000 $6,800 27,200 5,440 12,240 21,
2. Amusement Parks — Ten-Year Class
Year 1 .08 3 $200,000 = $16, 2 .14 3 200,000 = 28, 3 .12 3 200,000 = 24, Total Depreciation for Three Years $68,
C-14 INVENTORY AND DEPRECIATION
End of Acc. Dep. Book Value Acc. Dep. Book Value Year Cost B.O.Y. B.O.Y. Dep. Exp. E.O.Y. E.O.Y. 1 $ 29,000 — $29,000 $14,500 $14,500 $14, (29,000 3 .50) 2 29,000 14,500 14,500 5,500 20,000 9,
4. a.
Yearly Cost of Depreciation Acc. Dep. Book Value End of Year Equipment Expense E.O.Y. E.O.Y.
19X1 $29,000 $5,000 $ 5,000 $24, 19X2 29,000 5,000 10,000 19, 19X3 29,000 5,000 15,000 14, 19X4 29,000 5,000 20,000 9,
b.
Yearly Cost of Units Depreciation Acc. Dep. Book Value End of Year Equipment Produced Expense E.O.Y. E.O.Y.
19X1 $29,000 $ 8,000 $3,200 $ 3,200 $25, 19X2 29,000 17,000 6,800 10,000 19, 19X3 29,000 15,000 6,000 16,000 13, 19X4 29,000 10,000 4,000 20,000 9,
c.
Yearly Cost Less 3 Rate Depreciation Acc. Dep. Book Value End of Year Residual = Expense E.O.Y. E.O.Y. 19X1 $20,000 3 4/10 = $8,000 $ 8,000 $21, 19X2 20,000 3 3/10 = 6,000 14,000 15, 19X3 20,000 3 2/10 = 4,000 18,000 11, 19X4 20,000 3 1/10 = 2,000 20,000 9,
d.
50,000 units
$.40 per unit
4 Years
In year 2 we could only depreciate up to $5,500 so that Book Value does not go below Residual value of $9,000.
