LIFI FIFO Methods Accounting Ppt

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


9


Chapter 9

InventoriesInventories


9


Importance Of Inventories

■ Inventories typically represent the largest current assetof manufacturing and retail firms. Inventory should beconsidered a �high-risk� asset.

■ For many companies, inventories are asignificant portion of total assets as well.

■ Inventory accounting methods and managementpractices can become profit-enhancing tools.

■ Inventory effects on profits are more noticeablewhen business activity fluctuates

■ Topics: Types of inventory, Basic cost flowassumptions,Valuation issues and Estimation methods


9


Inventory Categories

■ Inventories consist of costs that have been incurred in anearnings process that are held as an asset until theearnings process is complete.

■ Inventory may include a wider range of costs incurred andheld in an inventory account for matching against revenuethat will be recognized later.

■ Items that may be capital assets to one company may beinventory to another.

■ The major classifications of inventories depend on theoperations of the business.


9



■ Merchandise inventory -� Goods on hand purchased by a retailer or a trading company

such as an importer or exporter for resale.

■ Production inventory� Raw materials inventory - Tangible goods purchased or obtained

in other ways (e.g., by mining) and on hand for direct use in themanufacture or further processing of goods for resale. Parts orsubassemblies manufactured before use are sometimes classified

as component parts inventory.

� Work-in-process inventory - Goods or natural resources requiringfurther processing before completion and sale. Work-in-processinventory includes the cost of direct material and direct labourincurred to date, and usually some allocation of overhead costs.


9



■ Finished goods inventory - Manufactured or fully processed itemscompleted and held for sale. Finished goods inventory cost includesthe cost of direct material, direct labour, and allocated manufacturingoverhead related to its manufacture

■ Production supplies inventory - Items on hand, such as lubricationoils for the machinery, cleaning materials, as well as small items thatmake up an insignificant part of the finished product, such as bolts orglue.

■ Contracts in progress - The accumulated costs of performingservices required under contract.

■ Miscellaneous inventories - Items such as office, janitorial, andshipping supplies. Inventories of this type are typically used in thenear future and may be recorded as selling or general expense when

purchased instead of being accounted for as inventory.


9


Inventory Policy Issues

■ Since cost of goods sold is often the largest singleexpense category on the income statement, andinventory is an integral part of current and total assets,it makes sense that accounting policies in this area cancause income and net assets to change materially. Inwhat areas can policies be set? We�ll look at:

� Items and costs to include in inventory

� Cost flow assumptions

� Application of LCM (lower ofcost or market) valuations


9


Items And Costs Included In Inventory

■ All goods legally owned by the company on the inventorydate, regardless of their location� Goods in transit depending on the FOB terms

� Goods on consignment

� Repurchase agreements to sell and buy back inventory items

� Special sales agreements

■ A strict legal determination is oftenimpractical. In such cases, the salesagreement, industry practices, andother evidence of intent should beconsidered


9


Elements Of Inventory Cost

■ Invoice price� Total cash equivalent outlay made to acquire the goods and to

prepare them for sale or, for a service company, to fulfill therequirements of the service contract.

■ Freight charges and other incidental costsincurred in connection with thepurchase of tangible inventory

■ Purchase Discounts

■ Cash discounts on purchases toencourage timely payment from buyers

■ Other costs to get the inventory ready for sale


9


Items Not Included In Inventory

■ (On grounds of materiality), examples include:� insurance costs on goods in transit,

� material handling expenses, and

� import brokerage and excise fees

� These costs may be included in overhead,which may then be allocated to inventory.

■ General and administrative (G&A) expenses are normallytreated as period expenses because they relate moredirectly to accounting periods than to inventory.

■ Distribution and selling costs are also considered to beperiod operating expenses and are not allocated toinventories.


9


Variable Vs. Fixed Overhead

■ Manufacturing companies and service firms engagedin long-term contracts often use variable costing(also called direct costing, although there are subtledifferences between the two approaches) for internalmanagement planning and control purposes.

■ The CICA Handbook recommends thatmanufacturers� inventories include an allocation ofoverhead:� In the case of inventories of work in process and finished

goods, cost should include the laid-down cost of materialplus the cost of direct labour applied to the product and theapplicable share of overhead expense properly chargeableto production. [CICA 3030.06]

MaterialLabourOverhead


9


PERIODIC METHOD

vs.

PERPETUAL METHOD

Cost Flow Assumptions

■ Periodic inventory system

� Inventory value is determined only at particular times,such as end of the accounting period.

■ Perpetual inventory system

� The ongoing physical flow of inventory is monitored,and the cost of the inventory items is maintained on acontinual basis.


9


Periodic Vs. Perpetual � IllustrationLea Company

■ Beginning inventory 500 $4.00 $2,000

■ Purchases 1,000 4.00 4,000

■ Goods available for sale 1,500 $6,000

■ Less: Sales 900

■ Ending inventory, as calculated 600

■ Ending inventory,based on physical count 580

■ Shrinkage 20

UnitUnits Cost Total


9


Calculating Cost Of Goods Sold (COGS) LeaCompany

■ Beginning Inventory 500 x $4.00 $2,000

■ + Purchases (net) 1000 X $4.00 4,000

■ = Cost of Goods Available for Sale 6,000

■ - Ending Inventory 580 x $4.00 2,320

■ = Cost of Goods Sold (residual amount) $3,680


9


Periodic RecordingLea Company

GENERAL JOURNAL Page 7

Date DescriptionPost. Ref. Debit Credit

July 31 PurchasesAccounts Payable

$4,000$4,000

To Record the purchases

Cost of Goods soldInventory ( closing, per count)

Inventory ( opening)Purchases

$3,680$2,320

$2,000$4,000


9


Perpetual RecordingLea Company

GENERAL JOURNAL Page 7

Date DescriptionPost. Ref. Debit Credit

July 31 Inventory [$1,000 x $4]Accounts Payable

$4,000$4,000

Sales RevenueAccounts receivable [900 x $10]

Cost of goods sold [900 x $4]Inventory

$9,000

$3,600$3,600

$9,000


9


Periodic Vs. Perpetual Recording Methods

■ Choosing a Recording Method✜ The choice of a periodic or perpetual system is not really an

accounting policy choice, although modest differences ininventory and cost of goods sold amounts can arise under theaverage cost assumption and under LIFO, depending onwhich recording method is used. Instead, the choice ofrecording method is one of practicality � which method givesthe best cost-benefit relationship?

■ Common Cost Flow Assumptions✜ Specific Identification

✜ Average Cost

✜ First-In, First-Out

✜ Last-In, First-Out


9


Choosing A Recording Method

■ A perpetual inventory system is especially useful wheninventory consists of items with high unit values or when it isimportant to have adequate but not excessive inventory levels.

■ Perpetual inventory systems require detailed accountingrecords and therefore tend to be more costly to implement andmaintain than periodic systems. Computer technology hasmade perpetual inventory systems more popular today thanever before.

■ Theft and pilferage, breakage and other physical damage, mis-orders and mis-fills, and inadequate inventory supervisionpractices must be dealt with regardless of the type of inventoryaccounting system used.


9


Common Cost Flow Assumptions

■ LIFO is not a popular method in Canada, due largely to thefact that it is not acceptable for income tax purposes.Specific identification is used mainly for large, unique items,such as custom-built equipment, or in accounting for servicecontracts. For other types of business, average cost andFIFO are the popular methods

■ According to the CICA Handbook, themethod selected for determining costshould be one which results in thefairest matching of costs againstrevenues [CICA 3030.09].


9


Specific Identification

■ At the end of the year (periodic method) or on each sale(perpetual method) the specific units sold, and theirspecific cost, is identified to determine inventory and costof goods sold.� In the example in Exhibit 9-2, there are 300 units left in

closing inventory.

■ May be inconvenient and difficult to establish just whichitems were sold and what their specific initial cost was.


9


Average Cost

■ When the average cost method is used in a periodicsystem, it is called a weighted average system.

■ Exhibit 9-3 illustrates

beginning inventory cost + total current period purchase costs

number of units in the beginning inventory + units purchased during the period

Weighted-average unit cost =

Unit TotalUnits Price Cost

Goods available: 1 January − Beginning inventory 200 $1.00 $ 200 9 January − Purchase 300 1.10 330 15 January − Purchase 400 1.16 464 24 January − Purchase 100 1.26 126

January − Total available 1,000 $1,120Weighted-average unit cost ($1,120 ÷ 1,000) 1.12

Ending inventory at weighted-average cost: 31 January 300 1.12 336

Cost of goods sold at weighted-average cost:Sales during January 700* 1.12 784 Total cost allocated $ 1,120

* 400 units on January 10 plus 300 units on January 18.

Exhibit 9-3 Weighted-Average Inventory Cost Method(Periodic Inventory System):

Purchases Sales Inventory BalanceUnit Total Unit Total Unit Total

Date Units Cost Cost Units Cost Cost Units Cost Cost 1 January 200 $1.00 $200 9 January 300 $1.10 $330 500 1.06(a) 530 10 January 400 $1.06 $424 100 1.06 106 15 January 400 1.16 464 500 1.14(b) 570 18 January 300 1.14 342 200 1.14 228 24 January 100 1.26 126 300 1.18(c) 354

Ending inventory $354Cost of goods sold $766 766Total cost allocated $1,120

(a) $530 ÷ 500 = $1.06.(b) $570 ÷ 500 = $1.14.(c) $354 ÷ 300 = $1.18.

Exhibit 9-4 Moving-Average Inventory Cost,Perpetual Inventory System


9


First-In, First-Out

■ The first-in, first-out (FIFO) method treats the first goodspurchased or manufactured as the first units costed outon sale or issuance. Goods sold (or issued) are valued atthe oldest unit costs, and goods remaining in inventoryare valued at the most recent unit cost amounts.

■ Exhibit 9-5 demonstrates FIFO for the periodic system.

■ Exhibit 9-6 demonstrates the perpetual system.

■ Using the perpetual system, a sale is costed out eithercurrently throughout the period each time there is awithdrawal, or entirely at the end of the period, with thesame results.

Beginning inventory (200 units at $1) $ 200Add purchases during period (computed as in Exhibit 9-2) 920 Cost of goods available for sale 1,120Deduct ending inventory (300 units per physical inventory count): 100 units at $1.26 (most recent purchase − 24 January) $126 200 units at $1.16 (next most recent purchase − 15 January) 232 Total ending inventory cost 358Cost of goods sold $ 762*

* Can also be calculated as 200 units on hand 1 January at $1 plus 300 units purchased9 January at $1.10, plus 200 units purchased 15 January at $1.16.

Exhibit 9-5 FIFO Inventory Costing,Perpetual Inventory System

Page 7 GENERAL JOURNAL Periodic Perpetual

Date DescriptionPost. Ref. Debit Credit Debit Credit

Jan 9 Purchases 330

Inventory 330

Cash, etc. 330 330

Jan 10 Cost of goods sold 420

Inventory 420

Jan 15 Purchases 464

Inventory 464

Cash, etc. 464 464


Inventory 342

Page 7 GENERAL JOURNAL Periodic Perpetual

Date DescriptionPost. Ref. Debit Credit Debit Credit

Jan 24 Purchases 126

Inventory 126

Cash, etc. 126 126


Inventory (closing) 358

Inventory (opening) 200

Purchases 920

Accounting entries � Illustration

Purchases Sales Inventory BalanceUnit Total Unit Total Unit Total

Date Units Cost Cost Units Cost Cost Units Cost Cost 1 January 200 $1.00 $200

9 January 300 $1.10 $330 200 1.00 200300 1.10 330

10 January 200 $1.00 $200200 1.10 220 100 1.10 110

15 January 400 1.16 464 100 1.10 110400 1.16 464

18 January 100 1.10 110200 1.16 232 200 1.16 232

24 January 100 1.26 126 200 1.16 232100 1.26 126

Ending inventory ($232 + $126) $358Cost of goods sold $762 762Total cost allocated $1,120

Exhibit 9-6 FIFO Inventory Costing, Perpetual Inventory System


9


Last-In, First-Out

■ The last-in, first-out (LIFO) method of inventory costingmatches inventory valued at the most recent unitacquisition cost with current sales revenue.

■ The units remaining in ending inventory are costed atthe oldest unit costs incurred, and the units included incost of goods sold are costed at the newest unit costsincurred, the exact opposite of the FIFO costassumption.

■ Like FIFO, application of LIFO requires the use ofinventory cost layers for different unit costs.

Exhibit 9-7LIFO Inventory Costing Periodic Inventory System:

Cost of goods available (see Exhibit 9-2) $1,120Deduct ending inventory (300 units per physical inventory count): 200 units at $1 (oldest costs available, from 1 January inventory) $200 100 units at $1.10 (next oldest costs available; from 9 January purchase) 110 Ending inventory 310Cost of goods sold $ 810*

* Can also be calculated as 100 units at $1.26 plus 400 units at $1.16 plus 200 units at $1.10.

Exhibit 9-8 LIFO Inventory Costing Perpetual InventorySystem:

Unit Total Unit Total Unit TotalDate Units Cost Cost Units Cost Cost Units Cost Cost 1 January* 200 $1.00 $200

9 January 300 $1.10 $330 200 1.00 200300 1.10 330

10 January 300 $1.10 $330100 1.00 100 100 1.00 100

15 January 400 1.16 464 100 1.00 100400 1.16 464

18 January 300 1.16 348 100 1.00 100100 1.16 116

24 January 100 1.26 126 100 1.00 100100 1.16 116100 1.26 126

Ending inventory ($100 + $116 + $126) $342Cost of goods sold $778 778Total cost allocated $1,120

* Beginning inventory.

Purchases Sales Inventory


9


Income Tax Factors

■ Revenue Canada will not accept LIFO for tax purposes.Companies must use either the FIFO or the averagecost method when they compute their taxes payable. Ifa company uses LIFO for financial reporting, it mustmaintain two different inventory costing systems − onefor financial reporting (LIFO) and another for income tax(FIFO or average). Since there is a substantialadditional work load to maintaining two differentsystems, Canadian companies rarely use LIFO.Financial Reporting in Canada 1997 reported that onlyabout 3% of the sample companies use LIFO for anypart of their inventory.


9


Review

■ When prices are rising, as they often are:

■ FIFO will produce higher inventory, lower cost of goods sold, andhigher income. It�s probably popular with firms that would like tosee higher income and net assets in their financial statements.

■ LIFO has the opposite effect: lower inventories, higher cost ofgoods sold, and lower incomes.

■ Average cost methods provide inventory and cost of goods soldamounts between the LIFO and FIFO extremes, and is the nextbest thing to LIFO for income and tax minimization when inventorycosts are rising.

■ Canadian practice is about evenly divided between FIFO andaverage cost. LIFO is very seldom used in Canada, except byCanadian subsidiaries of U.S. companies that mandate its use inorder to be consistent with the parent�s accounting policies.


9


Exhibit 9-9Comparison of the Effects of FIFO vs. LIFO

If purchase prices are:

The impact on Ending inventory is:

The impact on Cost of goods sold is:

The impact on Net income and retained earnings is:

Rising FIFO > LIFO FIFO < LIFO FIFO > LIFO

Falling FIFO < LIFO FIFO > LIFO FIFO < LIFO


9


Disadvantages■ Does not match current cost

of goods sold with currentrevenues

■ Inventory (or phantom) profits■ In periods of rising prices, pay

higher income taxes.

Evaluation Of FIFO

■ Advantages

■ Easy to apply

■ Inventory value approximates currentcost

■ Flow of costs tends to be consistentwith usual physical flow of goods

■ Systematic and objective

■ Not subject to manipulation


9


Special Aspects

■ Standard Cost

■ Just-In-Time Inventory Systems

■ Inventories Carried At Market Value

■ Losses On Purchase Commitments


9


Standard Cost

■ In manufacturing entities using a standard cost system, the inventoriesare valued, recorded, and reported for internal purposes on the basis ofa standard unit cost which approximates an ideal or expected cost.

■ This prevents the overstatement of inventory values because it excludesfrom inventory all losses and expenses that are due to inefficiency,waste, and abnormal conditions.

■ Actual historical cost is used only once, on acquisition which simplifiesrecord-keeping significantly!

■ Under this method, the differences between actual cost and standardcost are recorded in separate variance accounts.

■ These accounts are usually written off as a current period loss ratherthan capitalized in inventory.

■ Under standard cost procedures there would be no need to considerinventory cost flow methods (such as LIFO, FIFO, and average)because only one cost − standard cost − appears


9


Just-In-Time Inventory Systems

■ Just-in-time (JIT) inventory systems are a response to the highcosts associated with stockpiling inventories of raw materials,parts, supplies, and finished goods

■ The ultimate goal is to see goods and materials arrive at thecompany's receiving dock just in time to be moved directly to theplant's production floor for immediate use in the manufacturingor assembly process.

■ Finished goods roll off the production floor and move directly tothe shipping dock just in time for shipment to the customers.

■ The ideal result is zero inventory levels and zero inventory costs.

■ Minimum inventories are needed. If a small buffer inventory isnot maintained, the JIT system runs the risk of becoming a NQIT(not-quite-in-time)


9


Inventories Carried At Market Value

■ When revenue is recognized at the point of production, inventory is writtenup to its net realizable value, prior to sale. This is the increase in netassets that substantiates revenue recognition.

� Gold Mining

� Farm products

■ Special inventory categories often include items for resale that aredamaged, shopworn, obsolete, defective, or are trade-ins orrepossessions. These inventory items are valued at current replacementcost, defined as the price for which the items can be purchased in theirpresent condition.

■ When the replacement cost cannot be determined reliably, such itemsshould be valued at their estimated net realizable value (NRV), definedas the estimated sale price less all costs expected to be incurred inpreparing the item for sale


9


Losses On Purchase Commitments

■ Purchase commitments (contracts) To lock in pricesand ensure sufficient quantities, companies oftencontract with suppliers to purchase a specified quantityof materials during a future period at an agreed unitcost.

■ A loss must be accrued on a purchase contract when:• the purchase contract is not subject to revision or

cancellation, and

• when a loss is likely and material and

• when the loss can be reasonably estimated.


9


Lower Of Cost Or Market Valuation

■ GAAP requires that inventories be valued either at costor at current market value, whichever is less.

■ Assets should always be substantiated by some kind offuture economic benefit.

■ For inventory, it�s clear that if you can�t sell the asset,the inventory can�t really be called an asset.

■ LCM tests are complicated by a couple of policychoices:

✜ What is the definition of market value?

✜ Should the LCM test be applied to individual inventoryitems, to categories, or to totals? The question ofaggregation is not trivial.


9


Definition of market value

■ The basic difficulty with determining market value is thatthere are two markets − the supplier market(replacement cost) and the customer market (salesprice).

■ Sales price is called net realizable value (NRV) whencosts expected to be incurred in preparing the item forsale are deducted.

■ Net realizable value can be taken further, deductingexpected costs and also a normal gross profit margin;use of net realizable value less a normal profitmargin will preserve normal profits when the item isfinally sold.

Exhibit 9-10 Net Realizable Value and Net Realizable ValueLess a Normal Profit Margin

a. Inventory item A, at original cost $ 70b. Inventory item A, at estimated current selling pricein completed condition $100c. Less: Estimated costs to complete and sell* −40d. Net realizable value $ 60e. Less: Allowance for normal profit (10% of sales price) −10f. Net realizable value less normal profit $ 50

* For goods already completed, as in a retail company, this amountwould be the cost to sell.

Exhibit 9-11 Methods of Market Determination, 1996

MethodNumber ofcompanies,

1996Net realizable value 142Replacement cost 43Net realizable value less normal profit margin 3Estimated net realizable value 4

Source: Boyd & Chen, Financial Reporting in Canada 1997 (Toronto: CICA, 1997), p.169.


9


Extent of grouping■ Application of LCM can follow one of three approaches:

• Comparison of cost and market separately for each item of inventory.

• Comparison of cost and market separately for each classification ofinventory.

• Comparison of total cost with total market for the inventory.

■ Exhibit 9-12 shows the application of each approach.

■ Consistency in application over time is essential.

■ The individual unit basis produces the most conservativeinventory value because units whose market value exceedscost are not allowed to offset items whose market value is lessthan cost. This offsetting occurs to some extent in the otherapproaches. The more you aggregate, the less you write down.The less you aggregate, the more you write down.

Exhibit 9-12 Application of LCM to InventoryCategories

LCM Applied to Individual

Inventory Types Cost Market Items Classifications TotalClassification A: Item 1 $10,000 $ 9,500 $ 9,500 Item 2 8,000 9,000 8,000 18,000 18,500 $18,000Classification B: Item 3 21,000 22,000 21,000 Item 4 32,000 29,000 29,000 53,000 51,000 51,000Total $71,000 $69,500Inventory valuation under different approaches $67,500 $69,000 $69,500


9


LCM Recording and reporting

■ Two methods of recording and reporting the effects ofthe application of LCM are used in practice:

✜ Direct inventory reduction method. The LCM amount, if it isless than the original cost of the inventory, is recorded andreported each period. Thus, the inventory holding loss isautomatically included in cost of goods sold, and endinginventory is reported at LCM.

✜ Inventory allowance method. The inventory holding loss isseparately recorded using a contra inventory account,allowance to reduce inventory to LCM.

� Holding loss on inventory 1,000

� Allowance to reduce inventory to LCM 1,000


9


Cash Flow Statement

■ To determine the amount of cash provided byoperations, net income must be adjusted by the changein inventory during the period:

• an increase in inventory means that the cash flow topurchase inventory was higher than the amount of expensereported as cost of goods sold − the increase must besubtracted from net income in order to reflect higher cashoutflow.

• a decrease in inventory means that the cash flow to acquireinventory was less than the amount of expense reported incost of goods sold − the decrease must be added to netincome.


9


Disclosure

■ According to the inventory section of the CICA Handbook,recommended disclosures are as follows:

• the basis for valuation (e.g., historical cost, lower of cost or market,market value) [CICA 3030.10];

• major categories of inventory (desirable, not required) [CICA3030.10];

• method of determining cost, if the method used for determining costdiffers from recent cost of the inventory items [CICA 3030.11];

• a definition of market value (desirable, not required), if �market� isused in some aspect of inventory valuation [CICA 3030.11]; and

• any change in valuation from that used in the prior period, and theeffect of a change on net income [CICA 3030.13].


9


Inventory Estimation Methods

■ Many large companies rely on the periodic inventorymethod. Does this mean that they can�t preparemonthly or quarterly statements without also taking aphysical inventory?

■ So what can be done when statements are needed?The answer is quite simple: inventory can be estimated.

■ In a small business, the owner or inventory managermight be able to provide an accurate estimate.

■ Alternatively, a more formal calculation can be made,

� Gross Margin Method

� Retail Inventory Method


9


Gross Margin Method

■ The gross margin method (also known as the grossprofit method) assumes that a constant gross marginestimated on recent sales can be used to estimateinventory values from current sales.

■ That is, the gross margin rate (gross margin divided bysales), based on recent past performance, is assumedto be reasonably constant in the short run.

■ The gross margin method has two basic characteristics

� (1) it requires the development of an estimated grossmargin rate for different lines or products, and

� (2) it applies the rate to relevant groups of items.


9


Gross Margin MethodSteps To Follow

■ Estimate historical gross margin rate.

■ Add beginning inventory and net purchases to get costof goods available for sale(COGAS).

■ Multiply sales by the gross margin rate to get estimategross margin in dollars.

■ Subtract gross margin in dollars from net sales to getcost of goods sold(COGS).

■ Subtract COGS from COGAS to get the estimated costof ending inventory.


9


Gross Margin Method - Example

■ NoteCo, Inc. uses the gross margin method to estimateend of month inventory value. At the end of May thecontroller develops the following information: Grossmargin 43% of sales; Inventory at May 1 $237,400; netpurchases for May $728,300; net sales for May$1,213,000.

■ Estimate Inventory at May 31.


9


Sales for May 1,213,000$ Cost of goods sold: Beginning inventory 237,400$ Net purchases 728,300 Cost of goods available for sale 965,700 Estimated ending inventory 274,290 Cost of goods sold 691,410 Gross margin for May 521,590$

Gross Margin MethodSolution

■ Proof of Estimate


9


Retail Inventory Method

■ The retail inventory method is often used by retailstores, especially department stores that sell a widevariety of items.

■ In such situations, perpetual inventory procedures maybe impractical, and a complete physical inventory countis usually taken only once annually.

■ The retail inventory method is appropriate when itemssold within a department have essentially the samemarkup rate and articles purchased for resale arepriced immediately. Two major advantages of the retailinventory method are its ease of use and reducedrecord-keeping requirements.


9


Markups And Markdowns

■ To apply the retail inventory method, it is important todistinguish among the following terms:

✜ Original sales price..

✜ Markup.

✜ Additional markup.

✜ Additional markup cancellation.

✜ Markdown..

✜ Markdown cancellation.

■ In the application of the retail method, markups and markup cancellations,markdowns and markdown cancellations are all included in the earlycalculations that determine goods available for sale at cost and at retail.However, in order to provide a conservative cost ratio that will approximatelower of cost or market (LCM), the denominator of the cost ratio excludes netmarkdowns.


9


Gross Margin MethodSteps To Follow

■ Estimate historical gross margin rate.

■ Add beginning inventory and net purchases to get costof goods available for sale(COGAS).

■ Multiply sales by the gross margin rate to get estimategross margin in dollars.

■ Subtract gross margin in dollars from net sales to getcost of goods sold(COGS).

■ Subtract COGS from COGAS to get the estimated costof ending inventory.


9


Gross Margin Method - Example

■ NoteCo, Inc. uses the gross margin method to estimateend of month inventory value. At the end of May thecontroller develops the following information: Grossmargin 43% of sales; Inventory at May 1 $237,400; netpurchases for May $728,300; net sales for May$1,213,000.

■ Estimate Inventory at May 31.


9


Sales for May 1,213,000$ Cost of goods sold: Beginning inventory 237,400$ Net purchases 728,300 Cost of goods available for sale 965,700 Estimated ending inventory 274,290 Cost of goods sold 691,410 Gross margin for May 521,590$

Gross Margin MethodSolution

■ Proof of Estimate


9


Retail Method

■ To use this method we must know:

� Sales for the period.

� Beginning inventory at retail and cost.

� Net purchases at retail and cost.

� Adjustments to the original retail price:✜ Additional markups and markdowns, markup and markdown

cancellations, employee discounts


9


Retail MethodSteps To Follow

■ Determine cost of goods sold and retail value of goodssold.

■ Calculate the cost to retail percentage.

■ Subtract retail value of goods available for sale fromsales to get ending inventory at retail.

■ Multiply the cost to retail percentage times endinginventory at retail to get ending inventory at cost.


9


Retail MethodExample

■ Webb Clothiers, Inc. uses the retail method to estimateinventory at the end of each month. For the month ofMay the controller gathers the following information:Beginning inventory at cost $60,000, at retail $92,000,net purchases at cost $200,000, at retail $308,000; netsales for May $300,000.

■ Estimated inventory at May 31.


9


RETAIL METHOD - SOLUTION

Cost RetailInventory, May 1 60,000$ 92,000$ Net purchases for May 200,000 308,000 Goods available for sale 260,000 400,000 Cost ratio (260,000 ÷ 400,000)

65%Sales for May 300,000 Ending inve ntory at retail 100,000$ Cost ratio 65%Ending inve ntory at cost 65,000$


9


Retail MethodMarkups And Markdowns

■ Original Sales Price - sale price first marked on themerchandise.

■ Markup - original amount by which item is marked upabove cost.

■ Additional Markup - Increase in sales price above theoriginal sales price.

■ Additional Markup Cancellation - cancellation of someor all of an additional markup.

■ Markdown - reduction in original sales price

■ Markdown Cancellation - increase is sales price after amarkdown


9


Cost of net purchases FIFO cost ratio = Retail value of (net purchases + net markups - net markdowns)


■ Estimating Inventory on a FIFO Basis

■ Exclude beginning inventory from the cost ratio.


9


Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases + net markups - net markdowns)

Averagecost =ratio


■ Average Cost Basis


9


Cost of (beginning inventory + net purchases) Retail value of (beginning inventory + net purchases - net markups)

LCMcost =ratio

Exclude net markdowns from the ratio.Exclude net markdowns from the ratio.Exclude net markdowns from the ratio.


■ Lower-of-Cost-or-Market Basis


9


Summary Of Key Points

■ Inventories are assets consisting of goods owned bythe business and held for future sale or for use in themanufacture of goods for sale.

■ Cost at acquisition, including the costs to obtain theinventory, such as freight, is used to value inventory.

■ Work in process and finished goods inventories ofmanufacturers should include raw materials, directlabour, and at least the variable portion ofmanufacturing overhead.


9



■ All goods owned at the inventory date, including thoseon consignment, should be counted and valued.

■ Either a periodic or a perpetual inventory system maybe used for merchandise inventories and formanufacturer�s inventories of raw materials and finishedgoods, but computer technology now makes it easierand less costly to use a perpetual system, which alsoprovides up- to- date inventory records.


9



■ Several cost flow assumptions are in current use, includingspecific identification, average cost, FIFO, and LIFO. LIFOis very rarely used in Canada, except by subsidiaries ofU.S. parent companies that also use that method.

■ Special accounting problems are encountered by firmsusing standard cost, just-in-time inventory systems, or netrealizable value to recognize inventory.

■ Losses on firm purchase commitments, when they can bereasonably estimated and are material, are recognized inthe accounts if the loss is likely and can be estimated.Otherwise, such commitments are often disclosed only inthe notes.


9



■ The lower-of-cost-or-market (LCM) method of estimatinginventory recognizes declines in market value in the periodof decline. The lower-of-cost-or-market method valuesinventories at market if market is below cost. Market maybe interpreted to be net realizable value, net realizablevalue less a normal profit margin, or replacement cost. Useof net realizable value is most common.

■ The gross margin method is used to estimate inventoryvalues when it is difficult or impractical to take a physicalcount of the goods. The method is most accurate whenprofit margins are stable.


9



■ The retail method of estimating inventory applies the ratioof actual cost to sales value to the ending inventory at salesvalue to estimate the inventory value at lower of cost ormarket.

■ The cash flow from operations is affected by (1) changes ininventory levels and (2) amortization that has been includedin the inventory. Cash flow must be adjusted to reflect theamount of inventory purchased rather than sold, and mustbe adjusted by adding back any amortization.

Documents

LIFI FIFO Methods Accounting Ppt