Chapter 8 Topic 1. Chapter 8: Topic 1 Valuation of Inventories The Basics. Student Learning Outcomes. Inventories: Financial Analysis

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Chapter 8: Topic 1

Valuation of

Inventories

The Basics

Dr. Chula King ACG 3101

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Student Learning Outcomes

Perpetual versus periodic inventory system Effects of inventory errors

Items to include in inventory costs Topic 2

• Cost flow assumptions

• Dollar-value LIFO

• Advantages and disadvantages of LIFO

Inventories: Financial

Analysis

Liquidity – current ratio

Asset management – Inventory turnover and asset turnover

Financial leverage – All ratios except debt/equity Profitability – All ratios

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Inventory

Items that a company holds for sale in the ordinary course of business, or goods that it will use or consume in the production of goods to be sold.

• Merchandising – purchases goods in a form ready for sale, e.g., Wal-Mart

• Manufacturing – produces goods to sell to merchandising firms, e.g., Ford

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The Inventory Equation:

Merchandiser

Beginning Inventory + Additions (Purchases)

Goods Available for Sale - Ending Inventory

Cost of Goods Sold

Manufacturer: Cost of

Goods Sold

Beginning finished goods inventory + Cost of goods manufactured

= Cost of goods available

- Ending finished goods inventory

= Cost of goods sold

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Another View

Goods Available for Sale

Goods Sold (Expense)

Ending Inventory (Asset)

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Inventory Systems

Perpetual – continuously tracks changes in the Inventory account and Cost of Goods Sold (COGS)

• Purchases – recorded as increase in inventory

• Sales – inventory reduced for Cost of Goods Sold Periodic – inventory balance determined periodically

• Purchases – recorded in Purchases account (I/S)

• Sales – COGS not recorded at time of sale

• Closing – beginning inventory closed to COGS;

purchases closed to COGS; ending inventory established with credit to COGS.

Issues in Inventory Valuation

What goods should be included in inventory Costs to include in inventory

Cost flow assumption (Topic 2)

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Goods to Include in Inventory

Goods in Transit

• Company Purchases Goods

FOB Shipping Point – Include at point of shipment

FOB Destination – Include when company receives goods

• Company Sells Goods

FOB Shipping Point – Exclude at the time of shipment

FOB Destination – Include until goods reach destination

Goods on Consignment

• Remain property of consignor

Include in consignor’s inventory

Exclude from consignee’s inventory

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Special Sales Agreement

Sales with Buyback Agreement

• Company A transfers inventory to Company B, and simultaneously agrees to repurchase it at a specified price over a specified period of time.

• Company B uses the inventory as collateral and borrows against it

• Company B uses the loan proceeds to pay Company A

• Company A repurchases the inventory in the future

• Company B uses the proceeds from the repayment to meet its loan obligation.

• Essence – Company A is financing its inventory and retaining risk of ownership

Special Sales Agreement

Sales with High Rates of Return

• Returns are predictable – Consider the goods sold when company can reasonably estimate the amount of the returns.

• Returns are unpredictable – Do not consider the goods sold.

Sales on Installment

• Recognize revenues because they have been substantially earned and are reasonably estimitable.

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Back to Debits and Credits

Every account is the result of combinations of debits and credits.

Regardless of the type of account,

• Debits are added to debits.

• Credits are added to credits.

• Debits are subtracted from credits.

• Credits are subtracted from debits.

Stated differently, debits move together;

credits move together; but debits and credits move in opposite directions.

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Bring in the Debits and the

Credits

Beginning Inventory + Additions (Purchases)

Goods Available for Sale - Ending Inventory

Costs of Goods Sold Sales

Less: Cost of Goods Sold

Gross Profit

CR DR DR DR

CR CR

NI RE

So What?

Beginning Inventory and Cost of Goods Sold both have debit balances; Net Income has a credit balance. Therefore Beginning Inventory (BI) and Cost of Goods Sold (COGS) move in the same direction, but in opposite directions to Net Income (NI) and Retained Earnings (RE).

BI causes COGS causes NI BI causes COGS causes NI

RE RE

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So What?

Purchases and Cost of Goods Sold both have debit balances; Net Income has a credit balance.

Therefore Purchase (P) and Cost of Goods Sold (COGS) move in the same direction, but in opposite directions to Net Income (NI) and Retained Earnings (RE).

P causes COGS causes NI P causes COGS causes NI

RE RE

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So What?

Ending Inventory and Net Income both have credit balances; Cost of Goods Sold has a debit balance. Therefore, Ending Inventory (EI), Net Income (NI), and Retained Earnings (RE) move in the same direction, but in opposite directions to Cost of Goods Sold (COGS).

EI causes COGS causes NI EI causes COGS causes NI

RE RE

So What?

The ending inventory of one period becomes beginning inventory of the next period, causing counterbalancing effects on net income over a two year period.

Water Salad Oil

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Exercise 8-12

2002: Net Income Per Books $50,000 EI overstatedÎ NI overstated (3,000)

Correct Net Income $47,000

2003: Net Income Per Books $52,000 BI overstated Î NI understated 3,000 EI overstated Î NI overstated (9,000)

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Exercise 8-12 (continued)

2004: Net Income Per Books $54,000 BI overstated Î NI understated 9,000 EI understatedÎ NI understated 11,000

2005: Net Income Per Books $56,000 BI understated Î NI overstated (11,000)

EI OK -0-

Exercise 8-12 (continued)

2006: Net Income Per Books $58,000

BI OK -0-

EI understatedÎ NI understated 2,000

2007: Net Income Per Books $60,000 BI understated Î NI overstated (2,000) EI overstated Î NI overstated (8,000)

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Inventory Costs

Costs directly involved in bring the goods to the buyer’s place of business and converting the goods to a salable condition, e.g., freight, should be included

Costs indirectly related to the acquisition or production are generally treated as period costs and expensed

Purchase Discounts

• Gross Method

• Net Method

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Example

May 1, Apex, Inc., purchased goods for $10,000, subject to cash discount terms of 2/10, n/60. Apex paid for the goods on May 8, and uses the periodic inventory method.

Gross Method

May 1 Purchases 10,000

Accounts Payable 10,000 May 8 Accounts Payable 10,000

Purchase Discounts 200

Cash 9,800

Example (continued)

Net Method

Accounts Payable 9,800

May 8 Accounts Payable 9,800

Cash 9,800

What if Apex made payment on May 15, after the discount period?

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Example (continued)

Gross Method:

Cash 10,000

Net Method

Purchase Discounts Lost 200

Cash 10,000

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Topic 2: Financial Reporting

Issues

Determine the total product cost for a period (Topic 1)

Apportion the cost between goods sold during the period and goods in inventory at the period end Value the ending inventory

Topic 2: Inventory Valuation

Issues

What should be included in the acquisition cost of inventory? (Topic 1)

How should changes in the market value of inventories subsequent to acquisition be handled?

What cost flow assumption should be used?

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The Next Step

Topic 2 Lecture

Exercises related to Topic 1 material: 8-2, 8-5, 8- 9, 8-11, 8-12 (worked in this lecture)