CHAPTER 8
Valuation of Inventories: A Cost-Basis
Approach
LEARNING OBJECTIVES
1. Describe inventory classifications and different inventory systems.
2. Identify the goods and costs included in inventory.
CHAPTER REVIEW
1. Careful attention is given to the inventory account by many business organizations because
it represents one of the most significant assets held by the enterprise. Inventories are of
Inventory Issues
2. (L.O. 1) Inventories are asset items held for sale in the ordinary course of business or
goods that will be used or consumed in the production of goods to be sold. Merchandise
3. Inventory records may be maintained on a perpetual or periodic inventory system basis. A
perpetual inventory system provides a means for generating up-to–date records related
4. When the inventory is accounted for on a periodic inventory system, the acquisition of
inventory is debited to a Purchases account. Cost of goods sold must be calculated when
5. Inventory planning and control is of vital importance to the success of a merchandising
or manufacturing concern. If an excessive amount of inventory is accumulated, there is
6. Reconciliation between the recorded inventory amount and the actual amount of inventory
on hand is normally performed at least once a year. This is called a physical inventory
7. The cost of goods sold during any accounting period is defined as all the goods
available for sale during the period less any unsold goods on hand at the end of the
Physical Goods Included in Inventory
8. (L.O. 2) Normally, goods are included in inventory when they are received from the
supplier. However, at the end of the period, proper accounting requires that all goods to
9. In actual practice, a few exceptions exist regarding the general rule that inventory is
Costs Included in Inventory
10. Inventories are recorded at cost when acquired. Cost in terms of inventory acquisition
includes all expenditures necessary in acquiring the goods and converting them to a
saleable condition. Product costs are those costs that “attach” to the inventory and are
11. The IASB allows for the capitalization of interest costs related to assets constructed for
12. When purchases are recorded net of discounts, failure to pay within the discount period
results in the treatment of lost discounts as a financial expense. If the gross method is
13. Determining the specific cost of inventory items that have been sold as well as those
Cost Flow Assumptions
14. (L.O. 3) The IASB requires the use of the specific identification method, which is not a
cost flow assumption, when inventories are not interchangeable or for goods and services
15. Specific identification calls for identifying each item sold and each item in inventory.
The costs of the specific items sold are included in the cost of goods sold, and the costs
of the specific items on hand are included in the inventory. The average cost method
prices items in the inventory based on the average cost of all similar goods available
during the period.
a. Under the periodic inventory method, the average-cost method is implemented as a
weighted-average method. A weighted-average cost per unit is computed as (total
16. Use of the FIFO inventory method assumes that the first goods purchased are the first
an approximate current cost figure. However, because FIFO tends to reflect current costs
on the statement of financial position, a basic disadvantage of this method is that current
costs are not matched against current revenues on the income statement.
a. Under the periodic method, the FIFO method computes the ending inventory and cost
of goods sold at the end of an accounting period. The ending inventory cost is
Inventory Errors
17. (L.O. 4) Errors in recording inventory can affect the statement of financial position, the
income statement, or both, because inventory is used in the preparation of both financial
statements. For example, the failure to include certain inventory items in a year–end physical
LIFO Cost Flow Assumption
*18. (L.O. 5) Use of the LIFO inventory method assumes that the most recent inventory
LECTURE OUTLINE
This chapter can be covered in three class sessions. Students should have had previous
exposure to inventory accounting topics except for the modified perpetual system (perpetual
records kept in units only).
A. (L.O. 1) Among the most significant assets of many enterprises, inventories are asset items
held for sale in the ordinary course of business or goods that will be used or consumed in
the production of goods to be sold.
B. Inventory Systems.
2. Modified perpetual inventory system—The cost of purchases is recorded directly in
3. Periodic inventory system—The cost of purchases is recorded in a Purchases (nominal
or temporary) account. The balance in the Inventory account remains unchanged
C. Basic Issues in Inventory Valuation. These include the determination of the (1) goods to be
included in inventory, (2) the costs to be included in inventory, and (3) the cost flow
assumption to be adopted.
D. (L.O. 2). Goods to be Included in Inventory. Technically, purchases should be recorded when
legal title passes to the buyer. The following items require careful judgment:
1. Goods in Transit: If the goods are shipped f.o.b. shipping point, title passes to the
2. Consigned Goods: Goods out on consignment remain the property of the consignor.
3. Special Sale Agreements in which the transfer of legal title may not be accompanied
(1) In essence, the “seller” finances the cost of the inventory by transferring legal
title to a third party and receiving “payment.” The “seller” then agrees to “buy”
the inventory back at a specified price over a specified future period.
(2) These transactions are often referred to as “parking transactions” because
b. Sales with rights of return.
(1) When the amount of returns can be reasonably estimated, the goods should be
considered sold.
E. Costs Included in Inventory.
1. Distinguish between product costs and period costs. Product costs are those costs
directly connected with bringing goods to the buyer’s place of business and converting
2. Interest costs associated with getting inventories ready for sale are usually expensed
3. Manufacturing Costs. Includes all costs that are traceable to the production of the
4. Purchase Discounts. Discuss the gross and net methods.
a. Gross method. Purchases and accounts payable are recorded at the gross amount.
Purchase discounts taken are credited to the Purchase Discounts account that is
b. Net method (considered more appropriate than the gross method). Purchases and
F. (L.O. 3) Comparison of Cost Flow Assumptions. A problem arises when numerous
purchases have been made at different prices and it is necessary to identify which goods
remain on hand and which have been sold.
2. Average Cost: Items in the ending inventory and items sold are priced at the average
3. First-In, First-Out: Assumes goods are used in the order purchased. While this method
G. (L.O. 4) Effect of inventory Errors.
a. The three most common types of inventory errors:
(1) Correct recording of purchases but incorrect computing and recording of ending
b. Corrections of inventory errors may involve two procedures:
(1) Preparation of correcting journal entries. Generally, a purchase is recorded
when the invoice arrives. If this does not coincide with passage of legal title by
*H. (L.O. 5) Appendix 8A—LIFO Cost Flow Assumption
1. Not permitted under IFRS.