Chapter One:

Valuation of Inventories: A Cost Basis Approach

Learning Objectives
After studying this chapter, you should be able to:
1. Identify major classifications of inventory.
2. Distinguish between perpetual and periodic inventory systems.
3. Determine the goods included in inventory and the effects of inventory errors on
the financial statements.
4. Understand the items to include as inventory cost.
5. Describe and compare the cost flow assumptions used to account for inventories.
6. Explain the significance and use of a LIFO reserve.
7. Identify the major advantages and disadvantages of LIFO.
8. Understand why companies select given inventory methods.
 Inventory Classification

Inventory consists of:

1. Finished goods held for sale in the ordinary course of
business.
2. Goods held or consumed in the production of finished
goods.
 Inventory Cost Flows
Merchandising Operations

Merchandise
Inventory

Purchases C/G/Sold

Cost of goods
sold

$$$
Flow of Costs through Manufacturing and Merchandising Companies
 Inventory Control

Inventory control is important for:

1. Ensuring availability of inventory items
2. Preventing excessive accumulation of inventory items
The perpetual system maintains a continuous record of inventory
changes
The periodic system updates inventory records only periodically
 Inventory Systems
• Perpetual Method
• Purchases are debited
to Inventory account
• Freight-in, Purch. R & A
and Purch. Disc. are
recorded in Inventory
account.
• Debit COGS and credit
Inventory account for
each sale.
Periodic Method
• Purchases are debited
to Purchases account.
• Freight-in, Purch. R & A
and Purch. Disc. are
recorded in their
respective accounts.
• COGS is computed only
periodically:
COGAS
- Ending Inventory
COGS
Guidelines for Determining
Ownership
 Costs Included in Inventory

Generally accounted for on a cost basis.

• Product costs are “inventoriable” costs, whereas
• Period costs are not inventoriable costs
 Cost Flow Assumptions

The objective is to most clearly reflect periodic income.

Cost flow assumptions need not be consistent with physical flow of
goods.
The cost flow assumptions are:
1 Average cost
3 First-in, first-out (FIFO) and
4 Last-in, first-out (LIFO)
 Cost Flow Assumptions: Example
Susieworld reports the following transactions for 2004:
Date PurchasesPurchase Cost
May 12 100 units $1,000
Aug 14200 units 2,200
Sep 18120 units 1,800
420 units $5,000
On December 31, the company had 20 units on hand and uses the periodic
inventory system.
What are the cost of goods sold and the cost of ending inventory?
 Average (Weighted) Method

Given Data:
Date Purchases Cost
May 12 100 units $1,000
Aug 14 200 units $2,200
Sep 18 120 units $1,800
420 units $5,000

Steps:
1. Calculate per unit average cost: $5,000/420 = $11.905
2. Apply this per unit average cost to units sold to get COGS: 400 x $11.905 = $4,762
3. Apply the per unit average cost to units remaining in inventory to determine Ending
inventory: 20 x $11.91 = $238
 First-In, First-Out (FIFO) Method

Given data: Cost of goods sold (FIFO)

Date Purchases Cost $1,000 (100 sold)
May 12 100 units @ $10 $1,000 $2,200 (200 sold)
Aug 14 200 units @ $11 $2,200 $1,500 (100 sold; 20 end inv)
Sep 18 120 units @ $15 $1,800 $4,700
420 $5,000

Cost of goods
available $4,700
Cost of goods sold

$5,000 Ending inventory 20 * $15 = $300

 Last-In, First-Out (LIFO) Method

Given data: Cost of goods sold (LIFO)

Date Purchases Cost $ 800 (80 sold; 20, end inv)
May 12 100 units @ $10 $1,000 $2,200 (200 sold)
Aug 14 200 units @ $11 $2,200 $1,800 (120 sold)
Sep 18 120 units @ $15 $1,800 $4,800
420 $5,000

Cost of goods
available Cost of goods sold $4,800

$5,000 Ending inventory 20 * $10 = $200

 Cost Flow Assumptions: Notes

• The ending inventory in units is the same in all three

methods: the cost is different.
• The cost of goods sold and the cost of ending inventory are
different, but
• The cost of goods available is the same in all three methods.
• LIFO would result in the smallest reported net income (with
rising prices).
 LIFO Reserve

LIFO Reserve (Allowance) account is used, when:

LIFO is used for external reporting and a
non-LIFO basis is used for internal
reporting.
An Allowance to Reduce Inventory to LIFO is used
to reduce the cost to a LIFO basis.
 LIFO Reserve: Example
Jeppo Inc reports the following balances:
Inventory (FIFO basis) on Dec 31, 2004: $50,000
Inventory (LIFO basis) on Dec 31, 2004: $20,000

Adjust the cost of ending inventory to the LIFO basis

Cost of goods sold Dr. $30,000

Allowance to Reduce Inventory
to LIFO Cr. $30,000

Balance Sheet (Assets):

Inventory (FIFO) $50,000
less: Allowance to Reduce Inventory ($30,000)
Inventory (LIFO) basis $20,000
 Advantages of LIFO Method

• LIFO matches more recent costs with current revenues.

• With increasing prices, LIFO yields the lowest taxable
income (assuming inventory does not decrease).
• With reduced taxes, cash flow is improved.
• Under LIFO, the need to write down inventory to market is
lower.
 Disadvantages of LIFO Method
• LIFO does not approximate the physical flow of goods except in
special situations.
• LIFO yields the lowest net income and therefore reduced
earnings (when prices rise).
• Under LIFO, the ending inventory is understated relative to
current costs.
• LIFO involuntary liquidation may result in income that is
detrimental from a tax view.
• LIFO may cause poor buying habits (because of the layer
liquidation problem).