Rigos CPA Review Course - Part 2 Sample Chapter

Profit

Market

The term inventory is used to designate the aggregate of those items of tangible personal property that (a) are held for sale in the ordinary course of business (finished goods), (b) are in process of production for such sale (work in process), or (c) are to be currently consumed either directly or indirectly in the production of goods or services to be available for sale (raw materials and supplies).

The method of valuing inventories should be consistently applied. If a change in method is made, the nature of the change and the effect on income must be disclosed.

The major objective in accounting for the goods in inventory is the matching of costs against revenues in order that there may be proper determination of the realized income. Thus, the inventory at any given date is the balance of costs applicable to goods on hand remaining after the matching of absorbed costs with concurrent revenues. This balance is carried forward to future periods provided it does not exceed an amount properly chargeable against the revenues expected to be obtained from ultimate disposition of the goods carried forward.

Many inventory problems test your understanding of the following basic identity: the total costs to account for (inventory costs carried over from previous periods plus expenditures in the current period) is equal to the sum of costs relating to goods sold and costs of units on hand at the end of the period (expense for the period plus ending inventory).

1. Income Statements: Shown below are the top portions of example income statements for a merchandising firm and for a manufacturing firm. Notice that the basic format of the income statement is similar for the manufacturing firm. The main differences are (a) manufacturing firms do not have purchases of the goods for sale but instead have Cost of Goods Manufactured, which is calculated on a separate schedule (discussed below), and (b) the inventory of goods for sale for a manufacturing firm is called Finished Goods (FG), which must be differentiated from Work in Process (WIP) and Raw Materials (RM) inventories.

Sales		200
Beginning Inventory	20
+ Purchases	80
Cost of Goods Available for Sale	100
- Ending Inventory	10
Cost of Goods Sold		90
Gross Profit		110

Since both beginning and ending inventories affect the income statement, misstatements of either beginning or ending inventories will generally cause a misstatement of income. The effect of inventories on income can be determined by considering the effect on the Cost of Goods Sold calculation.

Example: Suppose that Beginning Inventory was understated for the above firm by $5. What would be the effect on Cost of Goods Sold and on Gross Profit? Cost of Goods Available for Sale and Cost of Goods Sold would each be understated by $5 and Gross Profit would be overstated by $5.

A manufacturing firm has three categories of Inventory. Finished Goods Inventory enters into the calculation of Cost of Goods Sold on the Income Statement.

Sales		200
Beginning FG Inventory	20
+ Cost of Goods Manufactured	80
Cost of Goods Available for Sale	100
- Ending FG Inventory	10
Cost of Goods Sold		90
Gross Profit		110

The beginning and ending RM and WIP inventories affect the Schedule of Cost of Goods Manufactured. This schedule uses the same basic structure as the Cost of Goods Sold Section of the income statement, i.e., start with costs in beginning WIP inventory, add the costs of inputs for the period, subtract costs in ending WIP inventory, leaving Cost of Goods Manufactured. This is illustrated by the following condensed example:

Beginning WIP Inventory			$50
Beginning RM Inventory	$10
+ Purchases of RM	+80
- Ending RM Inventory	-30

+ RM Used		$60
+ Direct Labor		+70
+ Overhead (Supplies, Utilities, Indirect Labor, etc.)		+40	+170
Total Manufacturing Costs to Account for			$220
- Ending WIP Inventory			-140
Cost of Goods Manufactured			$ 80

2. Balance Sheets: Ending inventory is shown as an asset on the balance sheet so any errors in valuing ending inventory will cause total assets to be misstated. Manufacturing firms have the three main categories of inventory discussed above shown on their balance sheets (FG, WIP, and RM) and may also have a Supplies inventory, composed of items used in the manufacturing process.

Inventory cost is defined as the sum of the applicable expenditures and charges directly or indirectly incurred in bringing inventories to their existing condition and location. Items in transit shipped FOB shipping point are included in the inventory of the buyer; those shipped FOB destination are included in the inventory of the seller.

Often consists of shipping costs paid by the firm in purchasing goods for sale, usually referred to as Freight-in. May also include costs of shipping goods to branch stores, etc.

These costs are part of the cost of bringing inventories to their existing condition and locations and thus should theoretically be included as part of the cost of inventory. However, it is costly to associate these costs with individual units or batches of inventory. For example, it would be difficult to assign the costs of running a purchasing department to individual items purchased. Moreover, it would be expensive to keep track of any costs assigned to individual items. Therefore, in practice, these costs are usually treated as period expenses.

1. Purchase Discounts: Purchases are often subject to discounts for prompt payment. For example, the terms "2/10, net 30" indicate that the purchase is subject to a 2 percent discount if paid for within 10 days, otherwise payment of the full amount is due within 30 days. There are two approaches to accounting for purchase discounts: the Gross Price Method (purchases are initially recorded at their gross price) and the Net Price Method (purchases are initially recorded at their net price).

Example: Purchases of $10,000 are made under terms 2/10, net 30. Invoices of $4,000 are paid within the discount period. Invoices of $6,000 are paid after the discount period has passed.

When the Gross Price Method is used, Purchase Discounts should be shown as a deduction from Purchases on the income statement. When the Net Price Method is used, Purchase Discounts Lost should theoretically be shown as an addition to Purchases. However, when the amount involved is not material, many firms treat Purchase Discounts Lost as a financial expense since it represents the costs of not paying for goods within the discount period.

2. Trade Discounts: Trade discounts represent adjustments to the list price which are applied sequentially to determine the net purchase price.

Example: Merchandise with a list price of $100,000 is subject to trade discounts of 20%, 10%, and 5%. The net purchase price is calculated as follows:

List price 100,000
Less: 20% discount 20,000
..................80,000
Less: 10% discount 8,000
..................72,000
Less: 5% discount 3,600
Net purchase price 68,400

In keeping with the principle that accounting is primarily based on historical cost, there is a presumption that inventories shall be stated at cost. However, a departure from the cost basis is required whenever the utility of the goods is no longer as great as its cost. In such cases, inventories should be stated at the lower of cost or market. Also, there are a few exceptional cases where inventory may be stated above cost.

Accounting Research Bulletin No. 43 states that if the utility of goods is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes, a loss shall be reflected as a charge against the revenues of the period in which it occurs. The measurement of such losses shall be accomplished by applying the rule of pricing inventories at lower of cost or market.

The term market means current replacement cost (CRC) subject to an upper and lower limit. The upper limit (or ceiling) is net realizable value (NRV) which is estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. The lower limit (or floor) is NRV minus an allowance for a normal profit margin. If CRC is greater than the upper limit, then use NRV as market. If CRC is below the lower limit, then use NRV minus a normal profit as market.

The application of lower of cost or market (LOCOM) is a two-step process: (1) determine the figure to use for "market" subject to the limits discussed above, and (2) value the inventory at the lower of cost or "market." Depending on which method most clearly reflects periodic income, LOCOM can be applied to individual items, components of inventory, or to total inventory.

Example: Inventory consists of three items with CRC, NRV, NRV-normal profit margin, and cost as shown in the table below. If LOCOM is applied to individual items, the three items in inventory will be valued at $120, as shown in the last column of the table.

Variation: If LOCOM is applied to total inventory, the inventory would be valued at $125:

If a decline in market value is substantial and unusual, it must be shown separately from Cost of Goods Sold as a Loss Due to Market Decline in Inventory. Also, note that once inventory has been written down to market, that amount becomes "Cost" for LOCOM purposes in subsequent periods. For example, in applying LOCOM to total inventory above for the next period, the "Cost" would be $125.

APB No. 28 states that inventory losses resulting from a decline in the market value of inventory are included in the financial statements of the period in which the decline occurred if it is anticipated that the decline will not be recovered by the end of the annual period. Gains in subsequent interim periods are recognized in those periods, but may not exceed the losses previously recorded. Losses from temporary declines that are expected to be made up before the end of the annual period are not reported. (See Chapter 10, Section XII, "Interim Financial Statements," Part C.1 - Product Costs.)

When a firm has a commitment to purchase goods at a cost which would result in a loss under LOCOM if the purchase were already completed, the loss must be recognized currently in income unless the firm has a corresponding sales commitment which reasonably assures that the goods will be sold without a decline in price.

Example: On November 1, Slippery Oil Company enters into an agreement to purchase 100,000 barrels of oil for $16 per barrel, with the oil to be delivered in January of the next year. By December 31, the price of a barrel of oil has declined to $14. The oil is shipped and title passes to Slippery Oil on January 18.

12/31 Loss on Purchase Commitments 200,000
....Estimated Liability on Purchase Commitments 200,000

1/18 Purchases 1,400,000
Estimated Liability on Purchase Commitments 200,000
.....Accounts Payable 1,600,000

Variation: If Slippery Oil had a firm commitment to sell this oil without a decline in sales price, the loss would not be recognized.

Variation: If title had passed on November 1, the oil would have been recorded as part of inventory on that date and thus the loss would have been recognized when LOCOM was applied to inventory at December 31.

Inventories can be stated above cost only in exceptional cases. Some examples are precious metals having a fixed value and no substantial cost of marketing at that fixed value. Other exceptions can be justified only if it is impossible to determine appropriate approximate costs, the inventory is immediately marketable, and the units are interchangeable. Examples of items which may satisfy these three criteria are agricultural and mineral products. When inventories are valued using sales prices rather than costs, the stated value must reflect estimated costs of disposal.

The perpetual inventory method records the effect on inventory of each purchase and each sale. Thus, there is no need for any closing or adjusting entries at the end of the period except to account for goods that are lost, stolen, damaged, etc.

The gross profit inventory method relies on two ideas: (1) Cost of Goods Sold can be estimated from Sales by using information about the normal relationship between selling price and cost of goods sold. For example, suppose past experience indicates that Cost of Goods Sold is typically 60 percent of Sales. If Sales are $100,000, a reasonable estimate of Cost of Goods Sold is $60,000. (2) Cost of Goods Sold plus Ending Inventory must equal Goods Available for Sale. Therefore, if Goods Available for Sale is $90,000 and estimated Cost of Goods Sold is $60,000, the estimated ending inventory would be $30,000. At the end of the period, these estimates are used for Cost of Goods Sold and for Ending Inventory. The gross profit method is acceptable only for interim financial statements or in situations where it is impossible to determine ending inventory directly, e.g., in the event of a fire or other casualty.

The periodic method is the most widely used. The effects of purchases and sales on Inventory and on Cost of Goods Sold are determined at the end of each period. Most of the valuation methods discussed in Section V are used with the periodic method of accounting for inventory.

The cost of individual items in inventory is used to calculate the cost of ending inventory and the cost of goods sold. This method is not practical unless the number of items in inventory is fairly small, and items can be individually identified. Some items where this method is used are automobiles, large appliances, and heavy equipment.

1. Perpetual Moving Average: The average cost per unit is recomputed after each purchase by dividing total costs in inventory by the total units in inventory. Cost of Goods Sold for each sale is recorded at the average cost per unit in inventory at the time of the sale.

2. Periodic Weighted Average: At the end of each period, the average cost per unit is calculated by dividing the cost of goods available for sale by the number of units available for sale.

Under the LIFO cost flow assumption, the costs associated with the most recently acquired goods are the first costs to flow out of Cost of Goods Sold. Tax regulations require that LIFO be used for financial reporting if it is used for tax purposes and that LIFO must be used for tax purposes if it is used for financial reporting. Permission of the IRS is required to adopt LIFO. When LIFO is adopted, the beginning inventory for the year of the change is converted to weighted average and becomes the LIFO base layer. LIFO inventory in subsequent years will usually consist of the base layer and additional layers added in later years. These additional layers will typically come from purchases made throughout the year; each layer, therefore, requires some cost flow assumption.

Example: In 20x4, Kotz Corporation obtained permission to switch to LIFO. Beginning Inventory for the year consisted of 50 units at $8; 100 units at $11; and 150 units at $10. Ending Inventory consisted of 425 units.

02/04 - 100 units at $11 $1,100
07/02 - 200 units at $12 2,400
08/18 - 100 units at $13 1,300
400 units $4,800

The Beginning Inventory forms the base layer of 300 units with an average cost of $10 per unit [(400 + 1100 + 1500) -- 300 = $10]. Since Ending Inventory is 425 units, an additional layer of 125 units was added this year. This layer must be costed using one of three cost flow assumptions for the layer. It is common to use either LIFO or weighted average for each layer. (Here, the weighted average cost of purchases during 20x4 was $4800 -- 400 = $12 per unit.) However, the layer could also be costed on the FIFO basis. Ending Inventory under each of these three assumptions is as follows:

LIFO
Base Layer 300 at $10 3,000
20x4 Layers 100 at $11 1,100
............ 25 at $12 300
Ending Inventory $4,400

Under the FIFO cost flow assumption, the cost associated with the goods first acquired are the first costs to flow out of Cost of Goods Sold. Thus, Ending Inventory includes the cost of the last goods acquired and usually consists of one or more layers of the most recent purchases.

Example: Nouveau Co. had beginning inventory for the year of 400 units with a total cost of $1,600. Ending Inventory was 450 units. Purchases for the year were as follows:

01/13 400 units at $4.50 $1,800
01/27 100 units at $4.25 425
06/16 300 units at $5.00 1,500
Total Purchases.........$3,725

300 units at $5.00 $1,500
100 units at $4.25 425
50 units at $4.50 225
Ending Inventory $2,150

There are several inventory methods which value ending inventory in the aggregate, rather than valuing individual units in inventory.

1. Basic Method: Dollar-value LIFO is widely used in situations where regular LIFO cannot be applied, e.g., where inventories are not continually replenished with substantially identical units. Under Dollar-value LIFO, increases and decreases in inventory are measured in terms of dollar value, rather than in terms of units. LIFO principles are then applied to dollars of inventory, rather than units of inventory. There are two basic steps in Dollar-value LIFO: (1) Take ending inventory at current prices and deflate it by the current price index to get ending inventory in constant dollars. Determine whether a new layer of inventory has been added or an old layer liquidated. (2) Reinflate each layer using the price index which applied when the layer was added.

The following example illustrates the similarities between regular LIFO and Dollar-value LIFO by demonstrating Dollar-value LIFO in a situation where regular LIFO could be used.

Example: AgriCo has an inventory of corn with the following quantities and values:

Year Ended	Bushels	Price Per Bushel	Total Value*
20x0	10,000	$1.00	$10,000
20x1	12,000	$1.20	14,400
20x2	11,000	$1.25	13,750
20x3	13,000	$1.30	16,900

(1) Ending Inventory in current dollars is deflated to constant dollars by dividing by a price index (in this case, the price per bushel of corn). The deflated inventory is then partitioned into layers. (Note that the dollar value of deflated inventory in this example corresponds to the number of bushels of corn in inventory.)

(2) The layers are then reinflated using the price index (price per bushel of corn) which applied during the year in which the layer was formed:

Year Ended	Ending Inventory in Current $s	Current Price/Bushel	Ending Inventory in Constant $s	Inventory Layers	Layer Price/Bushel	Reinflated Layer	$-Value LIFO End. Inv.
20x0	$10,000	$1.00	$10,000	$10,000	$1.00	$10,000	$10,000
20x1	14,400	1.20	12,000	10,000	1.00	10,000
				2,000	1.20	2,400	$12,400
20x2	13,750	1.25	11,000	10,000	1.00	10,000
				1,000	1.20	1,200	$11,200
20x3	16,900	1.30	13,000	10,000	1.00	10,000
				1,000	1.20	1,200
			10,000	1,000	1.20	1,200	$13,800

2. Price Indexes: Price indexes reflect prices relative to a base year. The price index is 100 for the base year. However, price indexes can be used to compare prices for years other than the base year. For example, if a price index was 120 in year 1 and 180 in year 2, then the price level in year 2 was 150 percent (180/120) of the price level in year 1. There may be different price indexes which apply to different categories of inventory; be sure to use the correct price index for each category. When a company needs to construct its own internal index, it may select from a variety of methods. Two of the more common methods tested on the exams are the double-extension method and the link-chain technique.

a. Double-extension Method: For each product item in the inventory, multiply the actual units on hand first by the current cost per unit and then by the base year cost. This produces two columns of extensions, hence the name "double-extension method." The total of the current year costs is then divided by the total of the base year costs to arrive at the index for the current year. Some companies will compute the extensions based on all of the actual units in the ending inventory; others will rely on a computation using a representative sample.

b. Link-chain Technique: One of the difficulties associated with the double-extension method is that historical information related to base year costs be available for the products. For companies whose product lines are constantly changing, base-year amounts are not available and the use of estimated figures can undermine the integrity of the inventory valuation. In addition, the double -extension method is cumbersome where the inventory is made up of more than a few different products. In certain circumstances, the link-chain technique can provide an alternative approach to constructing an internal index. In this method, a cumulative index is developed by multiplying the previous year's index number by the ratio of ending inventory units at end of the year costs to ending inventory units at beginning of the year costs. Thus, each year's current cost-change index is utilized to compute a link in a chain of cumulative indexes going back to the base year.

The retail methods rely on the identity discussed earlier under "Role of Inventories on Financial Statements" stated in terms of retail value rather than in terms of cost. Restated in terms of retail value, this identity is retail value of beginning inventory plus retail value of purchases must be equal to retail value of goods sold (sales) plus retail value of ending inventory.

Terminology which arises in connection with the retail method includes the following:

Original (or Normal) Retail: Price at which goods are normally sold
Markups: Increases in price which raise price above original retail
Markup Cancellations: Decreases in price which lower price back toward original retail
Net Markups: Markups less Markup Cancellations
Markdowns: Decreases in price which lower price below original retail
Markdown Cancellations: Increases in price which raise price back toward original retail
Net Markdowns: Markdowns less Markdown Cancellations

Example: Items which are normally sold for $40 are first offered for sale at $50 ($10 markup), then at $45 ($5 markup cancellation), then at $30 ($5 markup cancellation, $10 markdown), and then at $32 ($2 markdown cancellation).

a. Step 1: Find ending inventory at retail. (This step is done the same way for all the retail methods.)

Beginning Inventory at Retail 100
Purchases at Retail 1000
Less: Purchases Returns at Retail 50
+Net Purchases at Retail 950
Markups 80
Less: Markup Cancellations 10
+Net Retail Price Increases 70
Markdown 60
Less: Markdown Cancellations 20
-Net Retail Price Decreases (40)
Total Retail Value of Goods Available for Sale (100 + 950 + 70 - 40) 1080
Sales (Net of Discounts) Less Sales Returns 800
Discounts 100
Spoilage and Breakage 40
Total Retail Value of Goods Sold, Spoiled, or Broken (940)
Ending Inventory at Retail 140

b. Step 2: Find the cost-to-retail ratio to summarize the relationship between cost and retail value. (This ratio is calculated differently for different retail methods.)

The simplest case is the average cost retail method, where the ratio is the total cost of goods available for sale divided by the total retail value of goods available for sale.

Example: Continuing with the above example data, suppose Beginning Inventory at cost is $50, the cost of net purchases during the period is $500, and total Freight-In for purchases during the period is $44. Then the total cost of goods available for sale during the period was $594 and the cost-to-retail ratio is 594/1080 = 55%.

c. Step 3: Convert ending inventory at retail to ending inventory at cost by multiplying by the cost-to-retail ratio.

Some of the methods discussed below have different layers of inventory and different cost-to-retail ratios that apply to each layer. In the above example there is only one layer and one cost-to-retail ratio (Ending Inventory = $140 x 55% = $77).

The three steps of the retail method lead to an estimate of the cost of ending inventory. Once cost of ending inventory is estimated, Cost of Goods Sold can be found by subtracting Ending Inventory from Cost of Goods Available for Sale. In the above example, Cost of Goods Sold is $517 ($594 - $77).

2. Six Varieties of the Retail Method: The six versions of the retail method discussed below arise from two types of differences.

* Components of the Cost-to-retail Ratio: The "Lower of Cost or Market" methods (Versions 1, 3, and 5 below) do not consider Net Markdowns in the denominator of the cost-to-retail ratio. Since Net Markdowns (a negative amount) is excluded from the denominator, the denominator is larger and the cost-to-retail ratio is smaller. This is referred to as a "Lower of Cost or Market" approach because it results in a smaller valuation of Ending Inventory and a larger figure for Cost of Goods Sold. Versions 2, 4, and 6 include Net Markdowns in the denominator of the cost-to-retail ratio.

* Cost Flow Assumptions for Inventory Layers: Versions 1 and 2 below are average cost methods which combine beginning inventory and current purchases in costing inventory. The remaining versions use a cost flow assumption, calculating separate cost-to-retail ratios for beginning inventory and current purchases. Versions 3 and 4 use a FIFO flow assumption and Versions 5 and 6 use a LIFO flow assumption.

Example: All six versions will be illustrated using the example started above. The first step is the same for all methods and yields ending inventory at retail of 140. The cost and retail value information for the cost-to-retail ratio is presented below:

1. Conventional (Lower of Average Cost or Market) Retail:
a. Ending Inventory at Retail = 140
b. Cost-to-retail Ratio = (50 + 500 + 44)/(100 + 950 + 70) = 53%
c. Ending Inventory at Cost = $74.25
Cost of Goods Sold = $519.75

2. Average Cost Retail:
a. Ending Inventory at Retail = 140
b. Cost-to-retail Ratio = (50 + 500 + 44)/(100 + 950 + 70 - 40) = 55%
c. Ending Inventory at Cost = $77.00
Cost of Goods Sold = $517.00

3. Lower of FIFO Cost or Market Retail:
a. Ending Inventory = 140
Under FIFO flow assumption, Ending Inventory is all from Current Purchases.
b. Cost-to-retail Ratio for Current Purchases = (500 + 44)/(950 + 70) = 53.3%
c. Ending Inventory at Cost = $74.67
Cost of Goods Sold = $519.33

4. FIFO Retail:
a. Ending Inventory at Retail = 140
Under FIFO flow assumption, Ending Inventory is all from Current Purchases.
b. Cost-to-retail Ratio for Current Purchases = (500 + 44)/(950 + 70 - 40) = 55.5%
c. Ending Inventory at Cost = $77.71
Cost of Goods Sold = $516.28

5. Lower of LIFO Cost or Market Retail:
a. Ending Inventory at Retail = 140
Under LIFO flow assumption, Ending Inventory is composed of two layers: 100 from Beginning Inventory and 40 from Current Purchases.
b. Cost-to-retail Ratio for Beginning Inventory = 50/100 = 50%
Cost-to-retail Ratio for Current Purchases = (500 + 44)/(950 +70) = 53.3%
c. Ending Inventory at Cost = 100 x 50% + 40 x 53.3% = $71.33
Cost of Goods Sold = $522.67

6. LIFO Retail:
a. Ending Inventory at Retail = 140
Under LIFO flow assumptions, Ending Inventory is composed of two layers: 100 from Beginning Inventory and 40 from Current Purchases.
b. Cost-to-Retail Ratio for Beginning Inventory = 50/100 = 50%
Cost-to-Retail Ratio for Current Purchases =
(500 + 44)/(950 + 70 - 40) = 55.5%.
c. Ending Inventory at Cost = 100 x 50% + 40 x 55.5% = $72.20
Cost of Goods Sold = $521.80

Dollar-value LIFO Retail combines the two steps of Dollar-value LIFO and the three steps of the LIFO retail methods.

Step 2: Deflate Ending Inventory by dividing by the price index. Determine whether a new layer of inventory has been added or an older layer liquidated.

Example: The Knox Company adopted the Dollar-value LIFO Retail inventory method on December 31, 20x5. At that time, inventory at retail was 100,000, the applicable price index was 100, and the cost-to-retail ratio was 60%. Data for the years 20x6 to 20x8 are as follows:

....Inventory at Retail...Price...Cost-to-Retail
Year...(Current Prices).....Index...Ratio
20x6...121,000....... 110 ..... 70%
20x7...156,000....... 120 ..... 65%
20x8...162,500....... 130 ..... 58%

121,000 / 1.10 = $110,000 Inventory at retail in current year prices.
Inventory Layers:
Beg. Inv. 100,000 at 100 price index at 60% cost ratio = $60,000
New layer 10,000 at 110 price index at 70% cost ratio = 7,700
Total inventory = 60,000 + 7,700 = $67,700

The other two years would be done in a similar fashion. The inventories for 20x7 and 20x8, respectively, would be $83,300 and $79,400.