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Chapter 8 Kieso

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Chapter 8
Valuation of Inventories: A Cost-Basis Approach
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1. Introduction
DefinitionAssets held for sale in the ordinary course of business or goods that will be consumed in productionImportanceCost of inventoryall expenditures necessary in acquiring goods and converting them to saleable conditionCutoffWho owns inventory if “sale” is a(an)product financing arrangement, installment sale, consignment, sales with high rates of return
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2. Inventory Systems
Periodic systemno running balance of inventory & CGSpurchases account usedbeginninginvbalance unchanged during yeartake physical inventory at year-end and record ending balance through adjusting entryCGS calculatedCGS format
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2a. Inventory Systems
Perpetual systemkeeps running balance of inventory & CGSno purchases account usedall changes in inventory cost recorded in inventory accounttake physical inventory at year-end & adjust book balance to actual
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2b. Inventory Systems
Periodic & perpetual entriesNet and gross methods of recordingpurchase merchandise, $1,200; 2/10,n/30return merchandise, $200sell remainder for $1,800pay abovewithin discount periodafter discount period
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2c. Inventory Systems
Periodic inventory system YE adjusting entryAccount balances
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2c. Inventory Systems
Periodic inventory system YE adjusting entry
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3. Inventory Cost Flow Assumptions
Problempurchases made at different pricesFlow of costs v. flow of goodsFour GAAP methodsspecific identificationFIFOLIFOaverage
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3a. Inventory Cost Flow Assumptions
Specific identificationonly used if relatively small number of high priced goods that can be easily distinguishedcan manipulate income
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3b. Inventory Cost Flow Assumptions
FIFOassume goods used in order purchasedending inventory approximately at current costsCGS at old pricesperiodic and perpetual systems always give same result
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3c. Inventory Cost Flow Assumptions
LIFOassumes last goods purchased are first soldadvantagesmatches current costs with revenuestax benefitsimproved cash flowdisadvantagesreduction in reported earningsunderstatement of ending inventory on bal. sheetdoes not reflect underlying physical flow of goodscauses poor buying habitscan manipulate incomeLIFO conformity rulemust use LIFO for financial reporting if used for tax reporting
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3d. Inventory Cost Flow Assumptions
Average costweighted average or moving average usedvalues goods based on average cost of goods on hand and acquiredOther methodsbase stockstandard costNIFOLIFO/FIFO
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3e. Inventory Cost Flow Assumptions
Comparison of methods(during periods of rising prices)
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What would be the differences between the methods if all units had the same cost?
3f. Inventory Cost Flow Assumptions
Example of methods
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Calculate the value of ending inventory under FIFO, LIFO, and average for both the periodic and perpetual systems.
4.Special issues related to LIFO
Inventory PoolsUnrealistic to assume only one productIf multi productreplace one item with another – loose base layer of LIFO costPooled approachgroup similar items togetherreduces record keeping costsmore difficult to erode old LIFO layersNumber of pools?
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4.Special issues related to LIFO
LIFO reservesmaintain internal records using FIFOadjust to LIFO at year endCost of goods sold xxxAllow to reduceinventoryto LIFOxxx
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5. Dollar Value LIFO
Introductionemphasis is on dollar value of inventorynot units of inventorygreatly reduces problem of changes in mix of inventorymore practical method of valuing multi-product inventory than unit LIFOallowed for financial reporting and taxLIFO conformity rulemust use LIFO for financial reporting if used for tax
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5a. Dollar Value LIFO
Basics of methodwhen first adopt method (base year) value ending inventory at current costs (FIFO)end of each subsequent year, value ending inventory at current costs (FIFO)then restate current year-end cost to price level in base yeara new layer formed when EI (in base year $) exceeds base year cost of BIincrease priced at current costsif EI (in BY$) is less than BI (in BY$), the decrease is subtracted from most recent layer
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5b. Dollar Value LIFO
Price indexcompany may calculate owndouble extension method or link-chain methodmay use published price indexese.g., GNP implicit price deflator, CPI, or industry specific indexexample using market basket approach
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5c. Dollar Value LIFO
Example
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Calculate ending inventory using dollar value LIFO for each year.
6. Effect of errors
Self-correcting errorsmost errors correct themselves over timee.g., inventory – this year’s ending inventory is next year’s beginning inventorydepreciable assets – over the life of the assetsbut each year is incorrect over that periodPermanent errorsnever will correct themselvese.g., expensing land, recording wrong amount
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6a. Inventory Errors
Overstatement of ending inventoryUnderstates cost of goods soldOverstates incomeUnderstatement of ending inventoryOverstates cost of goods soldUnderstates incomeOverstatement of beginning inventoryOverstates cost of goods soldUnderstates incomeUnderstatement of beginning inventoryUnderstates cost of goods soldOverstates income
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6b. Effect of errors
Determining effect of errorsdetermine effect for all accounts involvedexamplesending inventory overstatedinterest expense not accrued on N/P this year, next year principle and interest paid in full
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Chapter 8 Kieso