2

Inventories:
Measurement

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin
 Identify the Industry

• Manufacturing firm? Service firm?

– Gross Profit? D,G
• Service Company
– A,B,C,E,F
– B must be a bank because higher A/R and A/P
– E must be an IT company because higher Employee
cost/total revenue
– F must be E-commerce because the days of inventory
and days of payables exist
– C must be insurance company because relatively
higher debt-to-equity
8-2
– A must be stock exchange as higher operating margin
 Final Answer

8-3
 Recording and Measuring Inventory
Types of Inventory

Merchandise Manufacturing
Inventory Inventory
Goods acquired for •Raw Materials
resale •Work-in-Process
•Finished Goods
8-4
 Manufacturing Inventories
Raw Work in Finished
Materials Process Goods

  $XX
 $XX

Direct
Labor

  Cost of Goods Sold

$XX
Manufacturing
Overhead

   Raw materials purchased

 Direct labor incurred
 Manufacturing overhead incurred
 Raw materials used
 Direct labor applied
 Manufacturing overhead applied
 Work in process transferred to finished goods

8-5
 Finished goods sold
 Inventory Systems
Two accounting systems are used to record
transactions involving inventory:

Perpetual Periodic Inventory

Inventory System System
The inventory
account is The inventory
continuously account is
updated as adjusted at the end
purchases and of a reporting
sales are made. cycle.
8-6
 Perpetual Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins
2021 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2021
Inventory 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account

Returns of inventory are credited to the inventory

account.
Discounts on inventory purchases can be recorded
using the gross or net method.

8-7
 Perpetual Inventory System
During 2021, LWBC sold, on account, inventory with a retail
price of $820,000 and a cost basis of $540,000, to customers.
2021
Inventory 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account.

2021
Accounts receivable 820,000
Sales revenue 820,000
Record sales on account.

Cost of goods sold 540,000

Inventory 540,000
Record cost of goods sold.

8-8
 Periodic Inventory System
The periodic inventory system is not designed to track
either the quantity or cost of merchandise inventory. Cost
of goods sold is calculated, using the schedule below, after
the physical inventory count at the end of the period.

Beginning Inventory
+ Net Purchases
Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold

8-9
 Periodic Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins
2021 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2021
Purchases 600,000
Accounts payable 600,000
Purchase of merchandise inventory on account

8 - 10
 Periodic Inventory System
During 2021, LWBC sold, on account, inventory with a retail
price of $820,000 to customers, and a cost basis of $540,000.

2021
Accounts receivable 820,000
Sales revenue 820,000
Record sales on account.

No entry is made to record Cost of Goods Sold. A physical count

of Ending Inventory shows a balance of $180,000. Let’s
calculate Cost of Goods Sold at the end of 2021.

8 - 11
 Periodic Inventory System
Calculation of Cost of Goods Sold
Beginning inventory $ 120,000
Plus: Purchases 600,000
Cost of goods available for sale 720,000
Less: Ending inventory (180,000)
Cost of goods sold $ 540,000

We need the following adjusting entry to record cost of good sold.

December 31, 2021
Cost of goods sold 540,000
Inventory (ending) 180,000
Inventory (beginning) 120,000
Purchases 600,000
To adjust inventory, close purchases, and record cost of goods sold.

8 - 12
 Comparison of Inventory Systems

Transaction or
Periodic Inventory Perpetual Inventory
Event

Routine purchases of Costs debited to Costs debited to

various inventory items purchases account inventory account

Debit Cost of goods

No accounting entries
Sale of inventory sold and credit
made to inventory
inventory

Physical count to
End-of-period No separate
determine ending
accounting entries and determination of cost of
inventory and cost of
related activities goods sold necessary
goods sold

8 - 13
 What is Included in Inventory?

General Rule
All goods owned by the company on the inventory
date, regardless of their location.

Goods in Transit Goods on

Consignment

Depends on FOB
shipping terms.

8 - 14
 Expenditures Included in Inventory

Purchase
Invoice Price Returns and
Allowances

Freight-in on Purchase
Purchases Discounts

8 - 15
 Purchase Returns
On November 8, 2011, LWBC returns merchandise that had a cost
to LWBC of $2,000, and a cost basis to the seller of 1,600.

Periodic Inventory Method Perpetual Inventory Method

November 8, 2011
Accounts payable 2,000 Accounts payable 2,000
Purchase returns and allowances 2,000 Inventory 2,000

Returns of inventory are credited to the Purchase Returns

and Allowances account when using the periodic
inventory method.
The returns are credited to Inventory using the perpetual
inventory method.
8 - 16
 Purchase Discounts
Gross Method Net Method
October 5, 2011
Purchases 20,000 Purchases 19,600
Accounts payable 20,000 Accounts payable 19,600

October 14, 2011

Accounts payable 14,000 Accounts payable 13,720
Purchase discounts 280 Cash 13,720
Cash 13,720

November 4, 2011
Accounts payable 6,000 Accounts payable 5,880
Cash 6,000 Interest expense 120
Cash 6,000

Discount terms are $20,000

2/10, n/30. Partial payment not x 0.02
$14,000 made within the $ 400
x 0.02 discount period -120
$ 280 $ 280
8 - 17
 Inventory Cost Flow Assumptions

• Specific identification
• Average cost
• First-in, first-out (FIFO)
• Last-in, first-out (LIFO)

8 - 18
 STUDY OBJECTIVE 2
INVENTORY COSTING – PERIODIC SYSTEM

Pool of Costs
Cost of Goods Available for Sale
Beginning inventory $ 20,000
Cost of goods purchased 100,000
Cost of goods available for sale $120,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
Unit Total Cost of goods available for sale $120,000
Units Cost Cost Less: Ending inventory 15,000
5,000 $ 3.00 $15,000 Cost of goods sold $105,000

8 - 19
 SPECIFIC IDENTIFICATION

Tracks actual flow of goods. Each item marked with its unit cost.

Inventory
Purchases

Item 1 SOLD
$700

Item #2
Cost of Goods Sold
$750 $1,500
1

Item #3
$800 SOLD

8 - 20
 ASSUMED COST FLOW METHODS

These methods assume cost flows that may be

unrelated to the actual physical flow of goods.

FIFO LIFO AVERAGE

COST

These cost flow assumptions do not have to be

consistent with the actual flow of goods.

8 - 21
 FIFO
FIRST-IN, FIRST-OUT

FIFO ASSUMPTIONS

1. Earliest goods purchased are the first to be sold.

2. Cost of earliest goods purchased are the first to
be recognized as cost of goods sold.
3. Ending inventory consists of items purchased late
in the year.
 ALLOCATION OF COSTS
FIFO METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 12,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
Unit Total
Date Units Cost Cost
11/27 400 $ 13 $ 5,200 Cost of goods available for sale $ 12,000
08/24 50 12 600 Less: Ending inventory 5,800
450 $5,800 Cost of goods sold $6,200
 COGS PROOF
FIFO METHOD

The accuracy of the cost of goods sold

can be verified by recognizing that the
first units acquired are the first units sold.

Unit Total
Date Units Cost Cost
01/01 100 X $ 10 = $ 1,000
04/15 200 X 11 = 2,200
08/24 250 X 12 = 3,000
Total 550 $ 6,200
 REVIEW QUESTION

FIFO METHOD

In a period of rising prices, will FIFO will produce

a higher or lower net income than LIFO? Why?

Answer:
FIFO will produce a higher net income
when prices are rising because cost of goods
sold is made up of items purchased early
in the year at lower prices.
 LIFO
LAST-IN, FIRST-OUT

LIFO ASSUMPTIONS

1. Latest goods purchased are the first to be sold.

2. Cost of latest goods purchased are the first to be
recognized as cost of goods sold.
3. Ending inventory consists of items purchased
early in the year.
 ALLOCATION OF COSTS
LIFO METHOD
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 $12,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
Unit Total
Date Units Cost Cost
01/01 100 $ 10 $ 1,000
04/15 200 11 2,200 Cost of goods available for sale $ 12,000
08/24 150 12 1,800 Less: Ending inventory 5,000
450 $5,000 Cost of goods sold $7,000
 COGS PROOF
LIFO METHOD

The cost of the last goods in are the first to be assigned to

cost of goods sold. Under a periodic inventory system,
all goods purchased during the period are assumed to be
available for the first sale, regardless of the date of purchase.

Unit Total
Date Units Cost Cost
11/27 400 X $ 13 = $ 5,200
08/24 150 X 12 = 1,800
Total 550 $ 7,000
 REVIEW QUESTION

LIFO METHOD

In a period of rising prices, will LIFO will produce

a higher or lower ending inventory than FIFO? Why?

Answer:
LIFO will produce a lower ending inventory
than FIFO when prices are rising because
ending inventory is made up of items
purchased early in the year at lower prices.
 AVERAGE COST

AVERAGE COST ASSUMPTIONS

1. Goods available for sale are homogeneous.

2. Cost of goods available for sale is allocated on the
basis of the weighted average unit cost incurred.
3. The weighted average unit cost is applied to the
units on hand to determine the cost of ending
inventory.
 ALLOCATION OF COSTS
AVERAGE COST
Pool of Costs
Cost of Goods Available for Sale
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 $ 12,000

Step 1 Step 2
Ending Inventory Cost of Goods Sold
$ 12,000 ÷ 1,000 = $12.00
Unit Total Cost of goods available for sale $ 12,000
Units Cost Cost Less: Ending inventory 5,400
450 x $ 12.00 = $ 5,400 Cost of goods sold $ 6,600
COST FLOWS—PERPETUAL INVENTORY

The product data shown below for Bow Valley Electronics

will be used to explain perpetual inventory costing using
three assumed cost flow methods:

FIFO LIFO AVERAGE COST

Bow Valley Electronics

Z202 Astro Condensers
Unit Total
Date Explanation Units Cost Cost
01/01 Beginning inventory 100 $10 $ 1,000
04/15 Purchase 200 11 2,200
08/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total $ 12,000
 PERPETUAL INVENTORY – FIFO

Under FIFO, the cost of the earliest goods on hand prior to each sale
is charged to cost of goods sold. Therefore, the cost of goods sold on
September 10 consists of the units on hand January 1 and the units
purchased April 15 and August 24.

Date Purchases Sales Balance

January 1 (100 @ $10) $1,000
April 15 (200 @ $11) $2,200 (100 @ $10)
(200 @ $11) $3,200
August 24 (300 @ $12) $3,600 (100 @ $10)
(200 @ $11)
(300 @ $12) $6,800
September 10 (100 @ $10)
(200 @ $11) $6,200 (50 @ $12) $600
(250 @ $12)

November 27 (400 @ $13) $5,200 (50 @ $12)

(400 @ $13) $5,800
 PERPETUAL INVENTORY – LIFO

Under the LIFO method using a perpetual system, the cost of the most recent
purchase prior to sale is allocated to the units sold. The cost of the goods sold
on September 10 consists entirely of goods from the August 24 and April 15
purchases and 50 of the units in beginning inventory.

Date Purchases Sales Balance

January 1 (100 @ $10) $1,000
April 15 (200 @ $11) $2,200 (100 @ $10)
(200 @ $11) $3,200
August 24 (300 @ $12) $3,600 (100 @ $10)
(200 @ $11)
(300 @ $12) $6,800
September 10 (300 @ $20)
(200 @ $11) $6,300 (50 @ $10) $500
(50 @ $10)

November 27 (400 @ $13) $5,200 (50 @ $10)

(400 @ $13) $5,700
 PERPETUAL INVENTORY – AVG COST

• The average cost method in a perpetual inventory system is

called the moving average method.
• Under this method a new average is computed after each
purchase.
• The average cost is computed by dividing the cost of goods
available for sale by the units on hand.
• The average cost is then applied to:

Average Cost x Units Sold = COGS

Average Cost x Remaining Units = ENDING INVENTORY

 PERPETUAL INVENTORY – AVG COST

A new average is computed each time a purchase is made.

On April 15, after 200 units are purchased for $2,200,
a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand.
The average cost is $10.667 ($3,200/300).

Date Purchases Sales Balance

January 1 (100 @ $10)
$1,000
April 15 (200 @ $11) $2,200 (300 @ 10.667)
$3,200
August 24 (300 @ $12) $3,600 (600 @ 11.333)
$6,800
September 10 (550 @ 11,333)
$6,233 (50 @ $11.333)
$567
November 27 (400 @ $13) $5,200 (450 @ 12.816)
$5,767
 When Prices Are Rising . . .
FIFO LIFO
• Matches low (older) • Matches high (newer)
costs with current costs with current
(higher) sales. (higher) sales.
• Inventory is valued at • Inventory is valued
approximate
replacement cost. based on low (older)
• Results in higher cost basis.
taxable income. • Results in lower
taxable income.

8 - 41
 U. S. GAAP vs. IFRS
LIFO is an important issue for U.S. multinational
companies. Unless the U.S. Congress repeals the LIFO
conformity rule, in inability to use LIFO under IFRS will
impose a serious impediment to convergence.

• LIFO is permitted and used by

• IAS No. 2, Inventories, does
U.S. Companies.
not permit the use of LIFO.
• If used for income tax
• Because of this restriction,
reporting, the company must
many U.S. companies use
use LIFO for financial
LIFO only for domestic
reporting.
inventories.
• Conformity with IAS No. 2
would cause many U.S.
companies to lose a valuable
tax shelter.
8 - 42
 Reporting -- Lower of Cost or Market

Inventories are valued at the lower-

of-cost-or market.

LCM is a departure from historical cost. The method

causes losses to be recognized in the period the value
of inventory declines below its cost rather than in the
period that the goods ultimately are sold.

8 - 43
 Determining Market Value
Market Should Not
Exceed Net Realizable
 GAAP defines
Value (Ceiling)
“market value” in
terms of current
replacement cost.
 Market should not be
greater than the
“ceiling” or less than
the “floor.” Market Should Not Be
Less Than Net Realizable
Value less Normal Profit
(Floor)

8 - 44
 Determining Market Value
Step 1 Step 2
Determine Designated Market Compare Designated Market with Cost

Ceiling
NRV

Not More Than

Replacement Designated Cost
Or
Cost Market
Not Less Than

Lower of Cost
Or Market
NRV – NP
Floor
8 - 45
 Lower of Cost or Market
• An item in inventory has a historical cost
of $20 per unit. At year-end we gather
the following per unit information:
• current replacement cost = $21.50
• selling price = $30
• cost to complete and dispose = $4
• normal profit margin of = $5

• How would we value this item in the

Balance Sheet?

8 - 46
 Lower of Cost or Market
Selling Cost to
- = Ceiling
Price Complete
$ 30.00 - $ 4.00 = $ 26.00

Replacement Designated
$21.50
Market?
Cost =$21.50

Historical cost of $20.00 is

less than designated
Normal
Ceiling - = Floor market of $21.50, so this
Profit
inventory item will be
$ 26.00 - $ 5.00 = $ 21.00
valued at cost of $20.00.

8 - 47
 Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.

[Link]
Apply
2. Apply
LCM
LCMLCM
to
tothe
each
to entire
logical
individual
inventory
inventory
itemasina
categories.
inventory.
group.

8 - 48
 Adjusting Cost to Market
1. Record the Loss as a Separate Item in
the Income Statement

Loss on write-down of inventory XX

Inventory XX

2. Record the Loss as part of Cost of Goods

Sold.

Cost of goods sold XX

Inventory XX

8 - 49
 U. S. GAAP vs. IFRS
International standards require inventory to be valued at
the lower of cost or market, but the process is slightly
different for the U.S. method of applying LCM.

• LCM requires selecting market • IAS No. 2, states that the

from replacement cost, net designated market will always
realizable value or NRV be net realizable value.
reduced by the normal profit
margin.
• Designated market is
compared to historical cost to
determine LCM.

8 - 50
 U. S. GAAP vs. IFRS
International standards require inventory to be valued at
the lower of cost or market, but the process is slightly
different for the U.S. method of applying LCM.

• Under U.S. GAAP, the LCM • The LCM assessment usually

rule can be applied to is applied to individual items,
individual items, logical although using logical
inventory categories, or the inventory categories is allowed
entire inventory. under certain circumstances.
• Reversals are not permitted • If an inventory write-down is
under GAAP. not longer appropriate, it must
be reversed.

8 - 51
 Exercise

Product 1 Product 2 Product 3

Cost 20 90 50

Replacement cost 18 85 40

Selling price 40 120 70

Selling costs 6 40 10

Normal profit margin 5 30 12

8 - 52
 Answers

(1) (2) (3) (4) (5)

Ceiling Floor
Per Unit
Designated Inventory
Market Value Value
NRV-NP [Middle value [Lower of (4)
Product RC NRV (*) (**) of (1), (2) & (3)] Cost and (5)]

1 $18 $ 34 $29 $29 $20 $20

2 85 80 50 80 90 80

3 40 60 48 48 50 48

8 - 53
 Analyzing Inventory

Inventory Costing Method

• The increase in gross profit under FIFO also results in higher pretax income and,
consequently, higher tax liability. In periods of rising prices, companies can get caught in
a cash flow squeeze as they pay higher taxes and must replace the inventories sold at
replacement costs higher than the original purchase costs.
• In periods of rising prices, LIFO reports ending inventories at prices that can be significantly
lower than replacement cost. As a result, balance sheets for LIFO companies do not
accurately represent the current investment that the company has in its inventories.
• When prices rise, LIFO method leaves inventories on the balance sheet at less recent,
often understated costs. Consequently understates current ratio and overstates
inventory turnover.
• Companies using LIFO inventory costing are required to disclose the amount at which
inventories would have been reported had the company used FIFO inventory costing. The
difference between these two amounts is called the LIFO reserve.

8 - 54
 Analyzing Inventory

LIFO Liquidations

(1) Companies maintain LIFO inventories in separate cost pools.

(2) When a reduction in inventory quantities occurs, which can occur as

a company becomes leaner or downsizes, companies dip into
earlier cost layers to match against current selling prices.

(3) In periods of rising prices, analysts need to be aware of the increase

in gross profit of these LIFO liquidations.

8 - 55
 Analyzing Inventory

Inventory Valuation
The lower-of-cost-or-market rule implies that if inventory declines
in market value below its cost for any reason, including
obsolescence, damage, and price changes, then inventory is written
down to reflect this loss.

Market is defined as current replacement cost through either

purchase or reproduction. Cost is defined as the acquisition cost of
inventory.

When prices are rising, this rule tends to undervalue inventories

regardless of the cost method used. This depresses the current ratio.

In practice, certain companies voluntarily disclose the current cost

of inventory, usually in a note.

8 - 56
End of Chapter