978-1259722660 Chapter 8 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

CHAPTER 8

INVENTORIES: MEASUREMENT

Overview

The next two chapters continue our study of assets by investigating the measurement and

reporting issues involving inventories and the related expense—cost of goods sold. Inventory refers

to the assets a company (1) intends to sell in the normal course of business, (2) has in production for

future sale, or (3) uses currently in the production of goods to be sold.

Learning Objectives

LO8–1 Explain the types of inventory and the differences between a perpetual inventory system

and a periodic inventory system.

LO8–2 Explain which physical units of goods should be included in inventory.

LO8–3 Account for transactions that affect net purchases and prepare a cost of goods sold

schedule.

LO8–4 Differentiate between the specific identification, FIFO, LIFO, and average cost methods

used to determine the cost of ending inventory and cost of goods sold.

LO8–5 Discuss the factors affecting a company’s choice of inventory method.

LO8–6 Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net

income.

LO8–7 Calculate the key ratios used by analysts to monitor a company’s investment in inventories.

LO8–8 Determine ending inventory using the dollar-value LIFO inventory method.

LO8–9 Discuss the primary difference between U.S. GAAP and IFRS with respect to determining

the cost of inventory.

Lecture Outline

Part A: Recording and Measuring Inventory

I. Types of Inventory

A. Inventory for a wholesale or retail company consists of goods purchased in finished form

for resale. Inventory for a manufacturing company includes raw materials, work in

process, and finished goods.

B. For a manufacturing company, the costs of raw materials, direct labor, and manufacturing

overhead flow into work in process, then to finished goods when the manufacturing

process is completed, and finally to cost of goods sold when goods are sold.

II. Types of Inventory Systems

A. Perpetual inventory system

1. A perpetual inventory system continuously tracks changes in both inventory quantity

and inventory cost.

2. Inventory is debited when merchandise is purchased or returned by a customer and

credited when merchandise is sold or returned to a supplier.

3. An important control feature of a perpetual system is that it is designed to track

inventory quantities from their acquisition to their sale.

Instructors Resource Manual 8-1

McGraw-Hill Education.

B. Periodic inventory system

1. A periodic inventory system adjusts inventory and records cost of goods sold only at

the end of each reporting period.

2. Merchandise purchases, purchase returns, purchase discounts, and freight-in are

recorded in temporary accounts.

3. Purchases plus freight-in less returns and discounts equals net purchases.

4. A period’s cost of goods sold is determined at the end of the period by combining the

temporary accounts with the inventory account:

Beginning inventory + Net purchases − Ending inventory = Cost of goods sold

C. A comparison of the perpetual and periodic inventory systems

1. The impact on the financial statements of choosing one system over the other

generally is not significant.

2. The perpetual system provides more timely information but is more costly to

implement.

3. The periodic inventory system is less costly to implement during the period but usually

requires a physical count before ending inventory and cost of goods sold can be

determined.

4. Advances in technology have made the perpetual system more feasible and

cost-efficient.

III. What Is Included in Inventory?

A. Generally, physical units included in inventory consist of items in the possession of the

company.

1. For goods in transit, ownership depends on whether the merchandise is shipped f.o.b.

shipping point or f.o.b. destination.

2. Goods held on consignment are included in the inventory of the consignor until sold

by the consignee.

3. A company includes in inventory the cost of merchandise it anticipates will be returned

by customers.

B. The net purchase cost of inventory includes all costs necessary to bring inventory to its

condition and location for sale (or use for raw materials).

1. Freight-in paid by the purchaser is included in inventory cost.

2. Shipping charges on outgoing goods are not included in the cost of inventory. They are

reported in the income statement either as part of cost of goods sold or as an operating

expense, usually among selling expenses.

3. Purchase returns represent reductions in net purchases.

4. Purchase discounts represent reductions in the amount to be paid if remittance is made

within a designated period of time. The purchaser can record purchase discounts using

either the gross method or the net method.

C. Comprehensive example comparing perpetual and periodic systems.

Instructors Resource Manual 8-2

McGraw-Hill Education.

VI. Inventory Cost Flow Assumptions

A. Regardless of the system used, it’s necessary to assign dollar amounts to physical

quantities of goods sold and goods remaining in ending inventory.

1. The specific identification method matches each unit sold or each unit on hand at the

end of the period with its actual cost. The method is not feasible for most inventories.

2. Most companies use cost flow assumptions to determine cost of goods sold and ending

inventory.

a. The average cost method assumes that items sold and items in ending inventory

come from a mixture of all the goods available for sale.

b. The first-in, first-out (FIFO) method assumes that items sold are those that were

acquired first. Ending inventory consists of the most recently acquired items.

c. The last-in, first-out (LIFO) method assumes that items sold are those that were

most recently acquired. Ending inventory consists of the items acquired first.

B. The financial statement effect of using the different methods depends on the direction of

any change in the unit cost of goods.

C. There are a number of factors that motivate company management to choose one method

over another.

1. A company is not required to choose an inventory method that approximates actual

physical flow.

2. Many companies choose LIFO to reduce income taxes in periods when prices are

rising.

a. The IRS LIFO conformity rule requires that if a company uses LIFO to measure

its taxable income, LIFO also must be used to measure income reported to

investors and creditors.

b. The LIFO conformity rule permits LIFO users to present in a disclosure note the

effect of using another method on inventory valuation rather than LIFO.

3. Proponents of LIFO argue that it results in a better match of revenues and expenses.

a. However, the use of LIFO could result in an unrealistic ending inventory balance.

b. A decline in inventory quantity results in LIFO liquidation profit in periods of

rising costs.

4. International Financial Reporting Standards do not permit the use of LIFO.

Instructors Resource Manual 8-3

McGraw-Hill Education.

Decision Makers’ Perspective—Inventory Management

A. A company should maintain sufficient inventory quantities to meet customer demand

while at the same time minimizing inventory ordering and carrying costs.

B. Analysts should make adjustments when evaluating companies that use different inventory

methods. Supplemental LIFO disclosures can be used to convert LIFO inventory and cost

of goods sold amounts.

C. Two important ratios used by analysts in assessing profitability are:

1. The gross profit or gross margin ratio, computed by dividing gross profit (sales less

cost of goods sold) by net sales, indicates the percentage of each sales dollar available

to cover expenses other than cost of goods sold and to provide a profit.

2. The inventory turnover ratio, computed by dividing cost of goods sold by average

inventory, is designed to evaluate a company’s effectiveness in managing its

investment in inventory.

Part B: Methods of Simplifying LIFO

I. LIFO Inventory Pools

A. Unit LIFO can be costly to implement and can lead to LIFO liquidations.

B. The objectives of using LIFO inventory pools are (1) to simplify recordkeeping by

grouping inventory units into pools based on physical similarities and (2) to reduce the

risk of LIFO layer liquidation.

C. The average cost for all of the pool purchases during the period is applied to the current

year’s LIFO layer.

II. Dollar-Value LIFO

A. The dollar-value LIFO (DVL) method extends the concept of inventory pools by

allowing a company to combine a large variety of goods into one pool. Most LIFO

applications are based on this approach.

B. Inventory is viewed as a quantity of value instead of a physical quantity of goods. Instead

of layers of units from different purchases, the DVL inventory pool is viewed as

comprising layers of dollar value from different years.

C. A DVL pool is made up of items that are likely to face the same price change pressures,

not items with physical similarities.

D. Under DVL, we determine whether a new LIFO layer was added by comparing the ending

dollar amount with the beginning dollar amount after deflating inventory amounts to base

year with the aid of a cost index.

E. The starting point in DVL is determining the current year’s ending inventory valued at

year-end costs. The DVL estimation technique then employs three steps:

1. Step 1: Convert ending inventory to base year cost.

2. Step 2: Identify the layers of ending inventory created each year.

3. Step 3: Restate each layer using the cost index in the year acquired.

Instructors Resource Manual 8-4

McGraw-Hill Education.

PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

Instructors Resource Manual 8-5

McGraw-Hill Education.

Suggestions for Class Activities

1. Research Activity

Costco Wholesale Corporation (formerly Price/Costco) operates membership warehouses in the

United States, Puerto Rico, Canada, the United Kingdom, Mexico, Korea, Japan, Australia, and

Taiwan. It offers very low prices on a limited selection of nationally branded and selected private

label products in a wide range of merchandise categories in no-frills, self-service warehouse

facilities. Wal-Mart Stores, Inc., the largest retailer in the U.S., is engaged in the operation of mass

merchandising stores located in all 50 states and a number of other countries. Have students,

individually or in groups:

A. Access Wal-Mart’s most recent annual report using EDGAR, which can be located at

www.sec.gov.

1. Determine the company’s primary products and activities.

2. Using the data provided in the income statement and balance sheet,

determine what the company’s cost of goods sold (cost of sales) for the

most recent year would have been if the company had used FIFO instead of

LIFO to value its inventories.

B. Access Costco’s most recent annual report using EDGAR.

1. Determine the company’s primary products and activities.

2. Predict which company, Wal-Mart or Costco, has the higher gross profit

ratio and the higher inventory turnover ratio.

3. Using the data provided in the income statements and balance sheets for the

most recent fiscal year, confirm their predictions in 2 above.

Points to Note:

Students should predict a higher gross profit ratio and lower turnover ratio for Wal-Mart. Be sure

to point out the different strategies employed by the two companies. Wal-Mart marks up its product

much more than Costco, but Costco turns its inventory much faster.

2. Real World Activity

Deere & Company provides products and services primarily for agriculture and forestry. The

following disclosure note appeared in the company’s financial statements for the nine months ended

July 31, 2014:

(12) Inventories:

Instructors Resource Manual 8-6

McGraw-Hill Education.

Most inventories owned by Deere & Company and its U.S. equipment subsidiaries are valued at

cost, on the “last-in, first-out” (LIFO) basis. If all inventories had been valued on a “first-in,

first-out” (FIFO) basis, estimated inventories by major classification in millions of dollars would

have been as follows ($ in millions):

July 31, October 31,

2014 2013

Raw materials and supplies $ 1,848 $ 1,954

Work-in-process 792 753

Finished materials and supplies 4 ,361 3 ,757

Total FIFO value 7,001 6,464

Less adjustment to LIFO value 1 ,562 1 ,529

Inventories $ 5 ,439 $ 4 ,935

The company reported cost of goods sold of $18,679 million in its income statement for the nine

months ended July 31, 2014.

Suggestions:

Have the class answer the following questions:

1. What would cost of goods sold for the nine months ended July 31, 2014, have been if Deere

had used FIFO to value its entire inventory?

2. Using the reported numbers, what was Deere’s average days in inventory for the nine months

ended July 31, 2014?

Points to Note:

Cost of goods sold for the nine months ended July 31, 2014, would have been lower by $33

million ($1,562– $1,529) if Deere had used FIFO to value its entire inventory.

Instructors Resource Manual 8-7

McGraw-Hill Education.

3. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your

students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Case 8–4, Communication Case 8–5 can be

adapted to ask students to write a memo to the intern, and Communication Case 8–10 can be

adapted to ask students to write a memo to the chief financial officer. Ethics Case 8–7 does

well as a group assignment. Judgment Case 8–1 and Real World Case 8–8 create good class

discussions. Real World Case 8–8, Research Case 8–11, and Analysis Case 8–12 are suitable

for student presentation(s).

Research Skills. In their careers, our graduates will be required to locate and extract relevant

information from available resource material to determine the correct accounting practice,

perhaps identifying the appropriate authoritative literature to support a decision. Research Case

8–11 and Exercises 8–12 and 8–21 provide excellent opportunities to help students develop

this skill. In addition, Real World Case 8–8 can be adapted to require students to research the

authoritative literature on the presentation of supplemental LIFO disclosures.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct

students to gather, assemble, organize, process, or interpret data to provide options for making

business and investment decisions. In addition to Analysis Case 8–12, Exercise 8–22, and

Problems 8–6 and 8–9, Judgment Case 8–1 and Real World Case 8–9 also provide

opportunities to develop and sharpen analytical skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require

students to critically analyze issues to apply concepts learned to business situations in order to

evaluate options for decision-making and provide an appropriate conclusion. In addition to

Judgment Cases 8–1, 8–3, and 8–6, Ethics Case 8–7 also requires students to exercise

judgment.

CPA Simulation. Students can test their knowledge of the concepts discussed in this chapter and

at the same time practice critical professional skills necessary for career success and

preparation for the computer-based CPA Exam. The simulation for this chapter, Johnson

Company, tests students’ knowledge of the physical quantities and costs that should be

included in inventory. Access the simulations in the Connect library.

Instructors Resource Manual 8-8

McGraw-Hill Education.