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 difference between a perpetual inventory system and a periodic inventory
system.
LO8-2 Explain which physical quantities of goods should be included in inventory.
LO8-3 Determine the expenditures that should be included in the cost of inventory.
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. (T8-1)
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. (T8-2)
II. Perpetual Inventory System (T8-3)
A. A perpetual inventory system continuously tracks both changes in inventory quantity and
inventory cost.
B. Inventory is debited when merchandise is purchased or returned by a customer, and
credited when merchandise is sold or returned to a supplier.
C. An important control feature of a perpetual system is that it is designed to track inventory
quantities from their acquisition to their sale.
8-2 Intermediate Accounting, 8/e
III. Periodic Inventory System (T8-4)
A. A periodic inventory system adjusts inventory and records cost of goods sold only at the
end of each reporting period.
B. Merchandise purchases, purchase returns, purchase discounts, and freight-in are recorded
in temporary accounts.
C. Purchases plus freight-in less returns and discounts equals net purchases.
D. The 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
IV. A Comparison of the Perpetual and Periodic Inventory Systems
A. The impact on the financial statements of choosing one system over the other generally is
not significant.
B. The perpetual system provides more timely information but is more costly to implement.
C. 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.
V. What Is Included in Inventory?
A. Generally, physical quantities included in inventory consist of items in the possession of
the company. (T8-5)
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.
B. Expenditures necessary to bring inventory to its condition and location for sale (or use for
raw materials) are included in inventory cost. (T8-6)
2. Shipping charges on outgoing goods are not included in the cost of inventory. They
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 (T8-7)
C. Comprehensive example comparing perpetual and periodic systems. (T8-8)
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. (T8-9)
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. (T8-10)
12)
13)
B. The financial statement effect of using the different methods depends on the direction of
any change in the unit cost of goods. (T8-14)
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.
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. (T8-16)
4. International Financial Reporting Standards do not permit the use of LIFO. (T8-17)
8-4 Intermediate Accounting, 8/e
Decision Makers’ Perspective—Financial Analysis
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. (T8-18)
C. Two important ratios used by analysts in assessing profitability are: (T8-19)
1. The gross profit or gross margin ratio, computed by dividing gross profit (sales less
2. The inventory turnover ratio, computed by dividing cost of goods sold by average
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 is to (1) 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. (T8-20)
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. (T8-21)
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: (T8-22)
1. Step 1 converts ending inventory valued at year-end cost to base year cost.
2. Step 2 identifies the layers of ending inventory and the years they were created.
PowerPoint Slides
A PowerPoint presentation of the chapter is available in the Connect library.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or
8-6 Intermediate Accounting, 8/e
TYPES OF INVENTORY
Merchandising Companies
Manufacturing Companies
Raw materials — The cost of components purchased
from other manufacturers that will become part of the
finished product.
T8-1
INVENTORY COST FLOW FOR A
MANUFACTURING COMPANY
Raw Work in Finished Cost of
Materials Process Goods Goods Sold
————–———– ———————– ———————- ———————–
(1) $XX $XX (4) ➔ $XX $XX (7) ➔ $XX $XX (8) ➔ $XX
Direct Labor
————–———–
(1) Raw materials purchased
(2) Direct labor incurred
Manufacturing (3) Manufacturing overhead incurred
Overhead (4) Raw materials used
————–———– (5) Direct labor applied
(7) Work in process transferred to finished goods
Illustration 8-2
T8-2
8-8 Intermediate Accounting, 8/e
PERPETUAL INVENTORY SYSTEM
➢ A perpetual inventory system continuously records both
changes in inventory quantity and inventory cost.
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2016 with merchandise inventory of $120,000
on hand. During 2016 additional merchandise is purchased on
account at a cost of $600,000. Sales for the year, all on account,
totaled $820,000. The cost of the soft drinks sold is $540,000.
The following summary journal entries record the inventory
transactions for the Lothridge Company:
2016
Illustration 8–3
T8-3
PERIODIC INVENTORY SYSTEM
➢ A periodic inventory system adjusts inventory and records
cost of goods sold only at the end of each period.
Cost of goods sold equation:
Beginning inventory + Net purchases – Ending inventory = Cost of goods sold
The Lothridge Wholesale Beverage Company purchases soft drinks from
producers and then sells them to retailers. The company begins 2016 with
merchandise inventory of $120,000 on hand. During 2016 additional
merchandise was purchased on account at a cost of $600,000. Sales for the
year, all on account, totaled $820,000. The cost of the soft drinks sold is
$540,000. Lothridge uses the periodic inventory system. A physical count
determined the cost of inventory at the end of the year to be $180,000.
The following summary journal entries record the inventory transactions for
2016. Of course, each individual transaction would actually be recorded as
incurred:
2016
T8-4
8-10 Intermediate Accounting, 8/e
PERIODIC INVENTORY SYSTEM
(continued)
Cost of goods sold for 2016 is determined and recorded as
follows:
T8-4 (continued)
PHYSICAL QUANTITIES INCLUDED IN INVENTORY
Generally, physical quantities included in inventory consist of
items in the possession of the company.
Goods in transit
➢ If the goods are shipped f.o.b. (free on board) shipping
Goods on consignment
➢ Goods on consignment should be included in inventory
of the consignor even though not in the company’s
Sales Returns
➢ A company includes in inventory the cost of
merchandise it anticipates will be returned.
T8-5
8-12 Intermediate Accounting, 8/e
EXPENDITURES INCLUDED IN INVENTORY
The cost of inventory includes all expenditures necessary to
bring inventory to its desired condition and location for sale.
This includes:
➢ The purchase price of goods.
T8-6
PURCHASE DISCOUNTS
On October 5, 2016, the Lothridge Wholesale Beverage Company purchased
merchandise at a price of $20,000. The repayment terms are stated as 2/10, n/30.
Lothridge paid $13,720 ($14,000 less the 2% cash discount) on October 14 and the
remaining balance of $6,000 on November 4. Lothridge employs a periodic
inventory system.
The gross and net methods of recording the purchase and cash payment are
compared as follows:
Illustration 8-5
T8-7
8-14 Intermediate Accounting, 8/e
INVENTORY TRANSACTIONS —
PERPETUAL AND PERIODIC SYSTEMS
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company began 2016 with merchandise inventory of $120,000 on
hand. During 2016 additional merchandise is purchased on
account at a cost of $600,000.
INVENTORY TRANSACTIONS —
PERPETUAL AND PERIODIC SYSTEMS
(continued)
Perpetual System ($ in 000s) Periodic System
Purchases
End of period
No entry Cost of goods sold (below) 550 <———–
Inventory (ending) 154 |
|
Supporting schedule: |
Cost of goods sold: |
Beginning inventory $120 |
Purchases $588 |
T8-8 (continued)
8-16 Intermediate Accounting, 8/e
COST FLOW ASSUMPTIONS
The Browning Company began 2016 with $22,000 of inventory. The cost of
beginning inventory is composed of 4,000 units purchased for $5.50 each.
Merchandise transactions during 2016 were as follows:
Purchases
Date of
Purchase Units Unit Cost* Total Cost
Jan. 17 1,000 $6.00 $ 6,000
Sales
Date of Sale Units
Jan. 10 2,000
Illustration 8-7
Cost of inventory
\
on hand at end of period
Illustration 8-7B
T8-9
COST FLOW ASSUMPTIONS
➢ The average cost method assumes that items sold and items
in ending inventory come from a mixture of all the goods
available for sale.
T8–10
8-18 Intermediate Accounting, 8/e
COST FLOW ASSUMPTIONS
(continued)
AVERAGE COST
Cost of goods available for sale (11,000 units) $71,500
FIFO
Cost of goods available for sale (11,000 units) $71,500
Cost of ending inventory:
Date of
Purchase Units Unit Cost Total Cost
Mar. 22 1,500 $7.00 $10,500
Illustrations 8-7C, E, and G
AVERAGE COST — PERPETUAL INVENTORY SYSTEM
Date
Purchased
Sold
Balance
Beginning
inventory
4,000 @$5.50 = $22,000
4,000 @ $5.50 $22,000
Jan. 10
2,000 @$5.50 = $11,000
2,000 @ $5.50 $11,000
3,000 units
Mar. 22
6,000 units
3,000 @ $7.00 = $21,000
$17,000+$21,000 = $38,000
Apr. 15
1,500 @$6.333 = $9,500
4,500 @ $6.333 = $28,500
Oct. 15
7,500 units
Nov. 20
3,000 @$6.80 = $20,400
3,000 @ $7.50 = $22,500
$28,500+$22,500 = $51,000
Illustration 8-7D
T8–11