kieso, weygandt “et *. wr Intermediate ACCOUNTING IFRS EDITION Prepared by ‘Coby Harmon University of California, Santa Barbara Westmont College. Coll WILEY atValuation of CHAPTER 8 Inventories: A Cost- Basis Approach LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Describe inventory 3. Compare the cost flow classifications and different assumptions used to account inventory systems. for inventories. 2. Identify the goods and costs 4. Determine the effects of included in inventory. inventory errors on the financial statementsPREVIEW OF CHAPTER 8 VALUATION OF INVENTORIES: A COST-BASIS APPROACH Inventory Issues Goods and Costs Which Cost Flow Effect of Inventory « Classification Inclu Inventory Assumption to Adopt? Errors “wemyecctow || coodincudedin ||» specter Pa + Inventory control Tae + Average-cost misstated + Determining cost of en) |ppcne mceueany + First-in, first-out (FIFO) + Purchases and inventory eerie rv) fees Ore gree + Inventory valuation ‘methods—summary analysis Intermediate Accounting IFRS 3rd Edition Kieso » Weygandt Warfield 83LEARNING OBJECTIVE 1 Inventory Issues Describe inventory classifications and different inventory systems. Classification Inventories are asset: @ items held for sale in the ordinary course of business, or goods to be used in the production of goods to be sold. Businesses with Inventory Merchandising Manufacturing Company Company 84 LotClassification @ One inventory account. @ Purchase merchandise in a form ready for sale. 85 ILLUSTRATION 8.1 Merchandising Company Carrefour Statement of Financial Position (Balance Sheet) Current assets (in millions) Inventories € 6,213 Trade receivables 2,260 Consumer credit from financial companies—short term 3,420 Tax receivables 1,136 Other receivables 853 Current financial assets 504 Cash and cash equivalents Total current assets LotClassification 386 Three accounts @ Raw Materials @ Workin Process @ Finished Goods ILLUSTRATION 8.1 Manufacturing Company December 31, 2015 Current assets (in m Cash on hand and in banks Trade notes and accounts receivable Sales finance receivables Securities Merchandise and finished goods Work in process Raw materials and supplies Deferred tax assets Other Allowance for doubtful accounts Total current assets Statement of Financial Position (Balance Sheet) ¥ 918,71 837,704 6,653,237 73,384 857,818 86,313 330,435 251,689 825,080 (86,858) 73 LotActual materials cost Materials used Labor applied Actual ‘overhead cost Overhead applied MERCHANDISING COMPANY Cost of goods purchased MANUFACTURING COMPANY Cost of goods manufactured ILLUSTRATION 8.2 Flow of Costs through a7 Manufacturing and Merchandising Companies LotInventory Issues Inventory Cost Flow ILLUSTRATION 8.3 Beginning Cost of Goods Inventory Purchased ~ 7 Cost of Goods Available for Sale S Ending Inventory Two types of systems for maintaining inventory records — perpetual system or periodic system. 8 LotInventory Cost Flow Perpetual System 1. Purchases of merchandise are debited to Inventory. 2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase discounts are credited to Inventory. 3. Cost of goods sold is debited and Inventory is credited for each sale. 4. Subsidiary records show quantity and cost of each type of inventory on hand. The perpetual inventory system provides a continuous record of the balance in both the Inventory and Cost of Goods Sold accounts. te LotInventory Cost Flow Periodic System 1. Purchases of merchandise are debited to Purchases. 2. Ending Inventory determined by physical count. 3. Calculation of Cost of Goods Sold: Beginning inventory $ 100,000 Purchases, net + 800,000 Goods available for sale 900,000 Ending inventory - 125,000 Cost of goods sold $ 775,000 8-10 Lotatt Inventory Cost Flow Comparing Perpetual and Periodic Systems Illustration: Fesmire Company had the following transactions during the current year. Beginning inventory 100 units at $6 = $600 Purchases 900 units at $6 = $5,400 Sales 600 units at $12 = Ending inventory 400 units at $6 = Record these transactions using the Perpetual and Periodic systems. LotInventory Cost Flow Compara Entice— Perpetual vs. Periodic 4 Perpetual Inventory System Periodic Inventory System Beginning inventory, 100 units at $6 The Inventory account shows the inventory The Inventory account shows the inventory on hand at $600, on hand at $600, Purchase 900 units at $6 Sale of 600 units at $12 End-of-period entries for inventory accounts, 400 units at $6 12 Lo18-13 Inventory Cost Flow Illustration: Assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The entry to record the necessary write-down is as follows. Inventory Over and Short 200 Inventory 200 Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over and Short in the “Other income and expense” section of the income statement. Lot14 Inventory Issues Inventory Control All companies need periodic verification of the inventory records @ by actual count, weight, or measurement, with counts compared with detailed inventory records. Companies should take the physical inventory near the end of their fiscal year, @ to properly report inventory quantities in their annual accounting reports. LotInventory Issues 815 Determining Cost of Goods Sold Companies must allocate the cost of all the goods available for sale (or use) between the goods that were sold or used and those that are still on hand. Beginning inventory, Jan. 1 $100,000 Cost of goods acquired or produced during the year 800,000 Total cost of goods available for sale 900,000 Ending inventory, Dec. 31 200,000 Cost of goods sold during the year $700,000 ILLUSTRATION 8.5 Computation of Cost of Goods Sold LotLEARNING OBJECTIVE 2 Goods and Costs Identify the goods and costs included in inventory. Included an “Inventory — © 8-16 Goods Included in Inventory Acompany recognizes inventory and accounts payable at the time it controls the asset. Passage of title is often used to determine control because the rights and obligations are established legally. Lo2Goods Included In Inventory Goods in Transit Example: LG (KOR) determines ownership by applying the “passage of title” rule. ¢@ If asupplier ships goods to LG f.0.b. shipping point, title passes to LG when the supplier delivers the goods to the common carrier, who acts as an agent for LG. ¢ Ifthe supplier ships the goods f.o.b. destination, title passes to LG only when it receives the goods from the common carrier. “Shipping point” and “destination” are often designated by a particular location, for example, f.o.b. Seoul. 817 Lo28-18 Goods Included In Inventory Consigned Goods Example: Williams Art Gallery (the consignor) ships various art merchandise to Sotheby’s Holdings (USA) (the consignee), who acts as Williams’ agent in selling the consigned goods. Sotheby's agrees to accept the goods without any liability, except to exercise due care and reasonable protection from loss or damage, until it sells the goods to a third party. ¢@ When Sotheby's sells the goods, it remits the revenue, less a selling commission and expenses incurred, to Williams. Goods out on consignment remain the property of the consignor (Williams). Lo28-19 Goods Included In Inventory Sales with Repurchase Agreements Example: Hill Enterprises transfers (“sells”) inventory to Chase, Inc. and simultaneously agrees to repurchase this merchandise at a specified price over a specified period of time. Chase then uses the inventory as collateral and borrows against it. ¢@ Essence of transaction is that Hill Enterprises is financing its inventory—and retains control of the inventory—even though it transferred to Chase technical legal title to the merchandise. Often described in practice as a “parking transaction.” Hill should report the inventory and related liability on its books. Lo28-20 Goods Included In Inventory Sales with Rights of Return Example: Quality Publishing Company sells textbooks to Campus Bookstores with an agreement that Campus may return for full credit any books not sold. Quality Publishing should recognize a) Revenue from the textbooks sold that it expects will not be returned. b) Arefund liability for the estimated books to be returned. c) Anasset for the books estimated to be returned which reduces the cost of goods sold. If Quality Publishing is unable to estimate the level of returns, it should not report any revenue until the returns become predictive. Loza2 Costs Included In Inventory Product Costs Costs directly connected with bringing the goods to the buyer’s place of business and converting such goods to a salable condition. Cost of purchase includes all of: 1. The purchase price. 2. Import duties and other taxes. 3. Transportation costs. 4 Handling costs directly related to the acquisition of the goods. Lo2Costs Included In Inventory Period Costs Costs that are indirectly related to the acquisition or production of goods. Period costs such as ¢@ selling expenses and, general and administrative expenses are not included as part of inventory cost. 8-22 Lo2Costs Included In Inventory Treatment of Purchase Discounts Purchase or trade discounts are reductions in the selling prices granted to customers. IASB requires these discounts to be recorded as a reduction from the cost of inventories. 8-23 Lo2Treatment of Purchase Discounts Gross Method Net Method Purchase cost $10,000, terms 2/10, net 30 Invoices of $4,000 are paid within discount period Invoices of $6,000 are paid after discount period ILLUSTRATION 8.6 . 2% = as % = Entice unos oxces and $4,000 x 2% = $80 $10,000 x 98% = $9,800 Net Methods 8-24 Lo2LEARNING OBJECTIVE 3 Which Cost Flow Compare the cost flow assumptions used to account Assumptions to for inventories. Adopt? Cost Flow Methods @ Specific Identification or @ Two cost flow assumptions > First-in, First-out (FIFO) or >» Average Cost 8-25 Lo3Cost Flow Methods To illustrate the cost flow methods, assume that Call-Mart SpA had the following transactions in its first month of operations. 8-26 Date Purchases Sold or Issued Balance March 2 2,000 @ €4.00 2,000 units March 15, 6,000 @ €4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ €4.75 6,000 units Calculate Goods Available for Sale Beginning inventory (2,000 x €4) € 8,000 Purchases: 6,000 x €4.40 26,400 2,000 x €4.75 9,500 Goods available for sale €43,900 Lo3Cost Flow Methods Specific Identification a4 827 Method may be used only in instances where it is practical to separate physically the different purchases made. Cost of goods sold includes costs of the specific items sold. Used when handling a relatively small number of costly, easily distinguishable items. Matches actual costs against actual revenue. Cost flow matches the physical flow of the goods. May allow a company to manipulate net income. Lo3Specific Identification 8-28 Illustration: Call-Mart Inc.'s 6,000 units of inventory consists of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the amount of ending inventory and cost of goods sold. ILLUSTRATION 8.7 Date No.of Units UnitCost ‘Total Cost March 2 4,000 March 15 3,000 March 30 2,000 Ending inventory 6,000 Cost of goods available for sale (computed in previous section) Deduct: Ending inventory Cost of goods sold Lo3Cost Flow Methods Average-Cost ¢ Prices items in the inventory on the basis of the average cost of all similar goods available during the period. ¢@ Not as subject to income manipulation. @ Measuring a specific physical flow of inventory is often impossible. 8-29 Lo3Average-Cost ILLUSTRATION 8.8 Weighted-Average Method Weighted-average Method—Periodic Inventory Date of Invoice No. Units Unit Cost Total Cost March 2 2,000 €4.00 € 8,000 March 15 6,000 4.40 26,400 March 30 2,000 4.75 9,500 Total goods available 10,000 €43,900 Weighted-average cost per unit Inventory in units 6,000 units Ending inventory Cost of goods available for sale €43,900 Deduct: Cost of goods sold 8-30 Lo3Average-Cost Moving-Average Method Meng Average Method — Perpetual Inventory Date Purchased Sold or Issued Balance March 2 (2,000 @ €4.00) 8,000 March 15 (6,000 @ 4.40) 26,400 March 19 March 30 (2,000 @ 4.75) 9,500 In this method, Call-Mart computes a new average unit cost each time it makes a purchase. ast Lo3Cost Flow Methods First-In, First-Out (FIFO) Assumes goods are used in the order in which they are purchased, @ Approximates the physical flow of goods. @ Ending inventory is close to current cost. @ Fails to match current costs against current revenues on the income statement. 8-32 Lo3First-In, First-Out (FIFO) Periodic Inventory System EON Ne inventory Date No. Units Unit Cost. Total Cost March 30 March 15 Ending inventory Cost of goods available for sale €43,900 Deduct: Ending inventory Cost of goods sold Determine cost of ending inventory by taking the cost of the most recent purchase and working back until it accounts for all units in the inventory. 8-33 Lo3First-In, First-Out (FIFO) ILLUSTRATION 6.11 Perpetual Inventory System ILLUSTRATION Perpetual Inventory Date Purchased Sold or Issued Balance March 2 (2,000 @ €4.00) € 8,000 March 15. (6,000 @ 4.40) 26,400 March 19 March 30 (2,000 @ 4.75) 9,500 In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. 834 Lo3Inventory Valuation Methods—Summary Comparison assumes periodic inventory procedures and the following selected data. Selected Data Beginning cash balance Beginning retained earnings Beginning inventory: Purchases: Sales: Operating expenses Income tax rate 4,000 units @ €3 6,000 units @ €4 5,000 units @ €12 € 7,000 €10,000 €12,000 €24,000 €60,000 €10,000 40% 8-35 Lo3Inventory Valuation Methods—Summary Average- Cost Sales €60,000 Cost of goods sold 18,000" Gross profit 42,000 Operating expenses 10,000 Income before taxes 32,000 Income taxes (40%) 12,800 Net income €19,200 *4,000 @ €3 = €12,000 ILLUSTRATION 8.12 Comparative Results of €36,000 + 10,000 ‘Average-Cost and FIFO RS €3,.60 x 5,000 Lo3 8-36Inventory Valuation Methods—Summary When prices are rising, average-cost results in the higher cash balance at year-end (because taxes are lower). Gross Net Retained Inventory Profit Taxes Income Earnings Cash Average- €18,000 €29,200 . Cost | (6,000 x €3,60) | €42,000 | €12,800 | €19,200 | (19.000 + €19,200) | £20,200 He €20,000 4 4 4 €30,400 — (6.000 x ¢4) | £44,000 | €13,600 ) €20.400 | (e49,999 + €20,400) | £19:400" “Cash at year-end = Beg.Balance + Sales - Purchases — Operating expenses - Taxes Average-cost—€20,200 = —€7,000 + €60,000 - €24,000 - €10,000 — €12,800 FIFO—€19,400 = €7,000 + ‘€60,000 - €24,.000 — €10,000 — €13,600 ILLUSTRATION 8.13 Balances of Selected Items under Alternative Inventory Valuation Methods LOo3 837LEARNING OBJECTIVE 4 Effect of Inventory Errors Determine the effects of inventory errors on the financial statements. Ending Inventory Misstated Pharell Satonent fects of Misstated Ending Inventory Statement of Financial Position Income Statement Inventory Understated Cost of goods sold Overstated Retained earnings Understated Working capital Understated Net income Understated Current ratio Understated The effect of an error on net income in one year will be counterbalanced in the next, however the income statement will be misstated for both years. 8-38 Lo4Ending Inventory Misstated Illustration: Yei Chen Ltd. understates its ending inventory by HK$10,000 in 2019; all other items are correctly stated. ILLUSTRATION 8.15, Effect of Ending Inventory YEI CHEN LTD. Error on Two Periods (iw tHousanos) Incorrect Recording Correct Recording 2019 2020 2019 2020 Revenues {HK$100,000 {HK$100,000 HK$100,000—_HK$100,000 Cost of goods sold Beginning inventory 25,000 20,000 25,000 30,000 Purchased or produced 45,000 60,000 45,000 60,000 Goods available for sale 70,000 80,000 70,000 90,000 Less: Ending inventory 20,000" 40,000 30,000 Cost of goods sold 50,000 40,000 Gross profit 50,000 60,000 ‘Administrative and selling expenses 40,000 Net income Total income Total income for two years =HK$30,000 for two years = HK$30,000 “Ending inventory understated by HKS10,000in 2019, 8-39 Lo4Effect of Inventory Errors ILLUSTRATION 8.16 Purchases and Inventory Financial Statement . Erect of Msatod Misstated Purchases and Inventory ‘Statement of Financial Position Income Statement Inventory Understated Purchases Understated Retained earnings No effect Cost of goods sold No effect Accounts payable Understated Net income. No effect Working capital No effect Inventory (ending) Understated Current ratio Overstated The understatement does not affect cost of goods sold and net income because the errors offset one another. 8-40 Lo4LIFO Cost Flow Assumption LEARNING OBJECTIVE 5 Describe the LIFO cost flow assumption Under IFRS, LIFO is not permitted for financial reporting purposes. Nonetheless, LIFO is permitted for financial reporting purposes in the United States, it is permitted for tax purposes in some countries, and its use can result in significant tax savings. In this appendix, we provide an expanded discussion of LIFO inventory procedures. ast LosLast-In, First-Out (LIFO) Recall that Call-Mart Inc. had the following transactions in its first month of operations. Date Purchases Sold or Issued Balance March 2 2,000 @ €4.00 2,000 units March 15 6,000 @ €4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ €4.75 6,000 units 842 LosLast-In, First-Out (LIFO) Periodic Inventory System iO Method Pare Inventory Date of Invoice No. Units Unit Cost Total Cost March 2 2,000 March 15 4,000 Ending inventory 6,000 Goods available for sale €43,900 Deduct: Ending inventory Cost of goods sold The cost of the total quantity sold or issued during the month comes from the most recent purchases. 8.43 LosLast-In, First-Out (LIFO) ILLUSTRATION 8A2 Perpetual Inventory System LIFO Method—Perpetual Inventory Date Purchased Sold or Issued Balance March 2 (2,000 @ €4.00) € 8,000 March 15, (6,000 @ 4.40) 26,400 March 19 March 30 (2,000 @ 4.75) 9,500 LIFO results in different ending inventory and cost of goods sold amounts than the amounts calculated under the periodic method. nas LosInventory Valuation Methods—Summary Comparison assumes periodic inventory procedures and the following selected data. Selected Data Beginning cash balance Beginning retained earnings Beginning inventory: Purchases: Sales: Operating expenses Income tax rate 4,000 units @ €3 6,000 units @ €4 5,000 units @ €12 € 7,000 €10,000 €12,000 €24,000 €60,000 €10,000 40% 845 LosInventory Valuation Methods—Summary Sales Cost of goods sold Gross profit Operating expenses Income before taxes Income taxes (40%) Net income ‘Average- Cost UFO €60,000 €60,000 42,000 40,000 10,000 10,000 32,000 30,000 12,800 12,000 €19,200 €18,000 €12,000 *4,000 @ €3 £24,000 1,000 @ €4 = 16,000 €36,000 ~ 10,000 = €3.60 €3.60 x 5,000 = €18,000 €12,000 € 4,000 "5,000 @ €4 = €20,000 ILLUSTRATION 8A3 Comparative Results of ‘Average-Cost and FIFO and LIFO Methods 8.46 Notice that gross profit and net income are lowest under LIFO, highest under FIFO, and somewhere in the middle under average-cost. LosInventory Valuation Methods—Summary Gross Net Retained Inventory Profit Taxes Income Earnings Cash Average- | €18,000 €29,200 4 Cost | (6,000 x €3.60) | 42,000 | €12,800 | €19,200 | ferg.909 + €19,200) | €20.200 €20,000 €30,400 FIFO g i 7 (e000 x 4) | 44000 | €13,600 | €20,400 | ‘¢19.090 + €20,400) | €19-400" €16,000 a LIFO (4,000 x €3) | €40,000 | €12,000 | €18,000 i €21,000° (1,000 x €4) (€10,000 + €18,000) SCash at year-end = Beg.Balance + Sales — Purchases - Operating expenses - Taxes ‘Average-cost—€20,200 €7,000 + €60,000 - €24,000 €10,000 — €12,800 FIFO—€19,400 £7,000 + €60,000 - €24,000 €10,000 — €13,600 UFO—€21,000 = €7,000 + ‘€60,000 - €24,000 €10,000 — €12,000 ILLUSTRATION 8A4 . Balances of Selected -—-LIFO results in the highest cash balance at year-end Items under Aternative Inventory Valuation (because taxes are lower). This example assumes that Methods prices are rising. The opposite result occurs if prices are declining. 847 Los3.48 COPYRIGHT Copyright © 2018 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.