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B. Inventory Valuation and Cost-Flow Methods

# B. Inventory Valuation and Cost-Flow Methods

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Module 10: Inventory

219

EXAMPLE

A seller has for sale four identical machines costing \$260, \$230, \$180, and \$110. Since the machines are iden­tical,

a purchaser will have no preference as to which machine s/he receives when purchased.

NOTE: The seller is able to manipulate income as s/he can sell any machine (and charge the

appropriate amount to CGS). Significant dollar value items are frequently accounted for by

specific identification.

b. The use of the specific identification method is appropriate when there is a relatively small number of

signifi­cant dollar value items in inventory.

2.

Weighted-Average

a. The seller averages the cost of all items on hand and purchased during the period. The units in ending inven­

tory and units sold (CGS) are costed at this average cost.

EXAMPLE

Cost

Units

\$200

100

315

150

85

50

\$600

300

Weighted-average cost \$600/300 = \$2.00 unit

Beginning inventory

Purchase 1

Purchase 2

(\$2.00 unit)

(\$2.10 unit)

(\$1.70 unit)

3.

Simple Average

a. The seller does not weight the average for units purchased or in beginning inventory (e.g., the above \$2.00,

\$2.10, and \$1.70 unit costs would be averaged to \$1.93).

b. The method is fairly accurate if all purchases, production runs, and beginning inventory quantities are equal.

4.

Moving Average

a. The average cost of goods on hand must be recalculated any time additional inventory is purchased at a unit

cost different from the previously calculated average cost of goods on hand.

EXAMPLE

Beginning inventory

Sale of 50 units @ \$2.00 = \$100

Purchase of 150 units for \$320

Sale of 50 units @ \$2.10 = \$105

Purchase of 50 units for \$109

Dollar cost of units

on hand

\$200

100

420

315

424

Units on hand

100

50

200

150

200

Inventory unit cost

\$2.00

2.00

2.10

2.10

2.12

NOTE: Sales do not change the unit price because they are taken out of inventory at the average price.

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b. Moving average may only be used with perpetual systems which account for changes in value with each

change in inventory (and not with perpetual systems only accounting for changes in the number of units).

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 14 THROUGH 17

5.

Lower of Cost or Market

a. “A departure from the cost basis of pricing the inventory is required when the utility of the goods is no

longer as great as its cost.” The following steps should be used to apply the lower of cost or market rule:

(1) Determine market

(a) Market is replacement cost limited to

1]

Ceiling—which is net realizable value (selling price less selling costs and costs to complete).

2]

Floor—which is net realizable value less normal profit.

NOTE: If replacement cost is greater than net realizable value, market equals net realizable value. Like­wise,

market equals net realizable value minus normal profit if replacement cost is less than net realizable value

mi­nus normal profit.

(2) Determine cost

NOTE: The floor and ceiling have nothing to do with cost

(3) Select the lower of cost or market either for each individual item or for inventory as a whole (compute

to­tal market and total cost, and select lower).

EXAMPLE

LOWER OF COST OR MARKET EXAMPLE

Item

A

B

C

Cost

\$10.50

5.75

4.25

Replacement

cost

\$10.25

5.25

4.75

Item

A

B

C

Replacement

cost

\$10.25

5.25

4.75

NRV (ceiling)

\$12.50

6.50

4.50

Selling price

\$15.00

8.00

5.50

Selling cost

\$2.50

1.50

1.00

NRV-Profit

(floor)

\$10.00

5.50

3.00

Designated

market value

\$10.25

5.50

4.50

Normal profit

\$2.50

1.00

1.50

Cost

\$10.50

5.75

4.25

LCM

\$10.25

5.50

4.25

Item A—Market is replacement cost, \$10.25, because it is between the floor (\$10.00) and the ceiling (\$12.50).

Lower of cost or market is \$10.25.

Item B—Market is limited to the floor, \$5.50 (\$8.00 – \$1.50 – \$1.00) because the \$5.25 replacement cost is be­

neath the floor. Lower of cost or market is \$5.50.

Item C—Market is limited to the ceiling, \$4.50 (\$5.50 – \$1.00) because the \$4.75 replacement cost is above the

ceiling. Lower of cost or market is \$4.25.

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b. Observations about the lower of cost or market rule

(1) The floor limitation on market prevents recognition of more than normal profit in future periods (if mar­

ket is less than cost).

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221

(2) The ceiling limitation on market prevents recognition of a loss in future periods (if market is less than

cost).

(3) Cost or market applied to individual items will always be as low as, and usually lower than, cost or

market ap­plied to the inventory as a whole. They will be the same when all items at market or all items

at cost are lower.

(4) Once inventory has been written down there can be no recovery from the write-down until the units are

sold. Recall that this differs from marketable securities where recoveries of prior write-downs are re­

quired to be taken into the income stream.

c. Methods of recording the write-down

(1) If market is less than cost at the end of any period, there are two methods available to record the market

de­cline. The entry to establish the ending inventory can be made using the market figure. The difficulty

with this procedure is that it forces the loss to be included in the cost of goods sold, thus overstating the

cost of goods sold by the amount of the loss.

NOTE: Under this method the loss is not separately disclosed.

(2) An alternative treatment is to debit the inventory account for the actual cost (not market) of goods on

hand, and then to make the following entry to give separate recognition to the market decline.

Loss due to market decline

Inventory

xx

xx

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 18 THROUGH 22

6. Losses on Purchase Commitments

a.

Purchase commitments (PC) result from legally enforceable contracts to purchase specific quantities of

goods at fixed prices in the future. When there is a decline in market value below the contract price at the

balance sheet date and the contracts are noncancellable, an unrealized loss has occurred and, if material,

should be re­corded in the period of decline.

Estimated loss on PC

Accrued loss on PC

b. If further declines in market value are estimated to occur before delivery is made, the amount of the loss to

be ac­crued should be increased to include this additional decline in market value. The loss is taken to the in­

come statement; the accrued loss on PC is a liability account and shown on the balance sheet.

When the goods are subsequently received

Purchases

Accrued loss on PC

Cash

(excess of PC over mkt.)

(excess of PC over mkt.)

xx

xx

xx

c. If a partial or full recovery occurs before the inventory is received, the accrued loss account would be

reduced by the amount of the recovery. Likewise, an income statement account, “Recovery on Loss of PC,”

would be credited.

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 23 THROUGH 24

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7.

First-In, First-Out (FIFO)

a. The goods from beginning inventory and the earliest purchases are assumed to be the goods sold first.

b. In a period of rising prices, cost of goods sold is made up of the earlier, lower-priced goods resulting in a

larger profit (relative to LIFO). The ending inventory is made up of more recent purchases and thus repre­

sents a more current value (relative to LIFO) on the balance sheet.

NOTE: This cost-flow assumption may be used even when it does not match the physical flow of goods.

c. Whenever the FIFO method is used, the results of inventory and cost of goods sold are the same at the end

of the period under either a perpetual or a periodic system.

8.

Last-In, First-Out (LIFO)

a. Under this cost-flow method, the most recent purchases are assumed to be the first goods sold; thus, ending

in­ventory is assumed to be composed of the oldest goods. Therefore, the cost of goods sold contains rela­

tively current costs (resulting in the matching of current costs with sales).

NOTE: This cost-flow assumption usually does not parallel the physical flow of goods.

b. LIFO is widely adopted because it is acceptable for tax purposes and because in periods of rising prices it

re­duces tax liability due to the lower reported income (resulting from the higher cost of goods sold).

c. LIFO smoothes out fluctuations in the income stream relative to FIFO because it matches current costs with

cur­rent revenues.

d. A primary disadvantage of LIFO is that it results in large profits if inventory decreases because earlier,

lower va­l­ued layers are included in the cost of goods sold. This is generally known as a LIFO liquidation.

(1) Another disadvantage is the cost involved in maintaining separate LIFO records for each item in inven­tory.

e. If LIFO is used for tax purposes, it must be used for financial reporting purposes. This is known as the

LIFO con­formity rule.

(1) Under current tax law, inventory layers may be added using the (1) earliest acquisition costs, (2)

weighted-av­erage unit cost for the period, or (3) latest acquisition costs.

NOTE: In solving questions on the CPA Exam, use the earliest acquisition costs unless you are instructed to

use one of the other alternatives.

f. When a company uses LIFO for external reporting purposes and another inventory method for internal pur­

poses, a LIFO Reserve account is used to reduce inventory from the internal valuation to the LIFO valua­

tion. LIFO Reserve is a contra account to inventory, and is adjusted up or down at year-end with a corre­

sponding in­crease or decrease to Cost of Goods Sold.

9.

Dollar-Value LIFO

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a. Dollar-value LIFO is LIFO applied to pools of inventory items rather than to individual items. Thus, the

cost of keeping inventory records is less under dollar-value LIFO than under unit LIFO.

(1) Because the LIFO conformity rule (if LIFO is used for tax, it must also be used for external financial

state­ments) also applies to dollar-value LIFO, companies using dollar-value LIFO define their LIFO

pools so as to conform with IRS regulations.

(2) Under these regulations, a LIFO pool can contain all of the inventory items for a natural business unit,

or a multiple pool approach can be elected whereby a business can group similarly used inventory items

into several groups or pools.

b. The advantage of using inventory pools is that an involuntary liquidation of LIFO layers is less likely to

occur be­cause of the increased number of items in the pool (if the level of one item decreases it can be offset

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223

by in­creases in the levels of other items), and because the pools can be adjusted for changes in product

composi­tion or product mix.

c. Like unit LIFO, dollar-value LIFO is a layering method. Unlike unit LIFO, dollar-value LIFO determines

in­creases or decreases in ending inventory in terms of dollars of the same purchasing power rather than in

terms of units. Dollar-value LIFO seeks to determine the real dollar change in inventory.

(1) Ending inventory is deflated to base-year cost by dividing ending inventory by the current year’s conver­

sion price index and comparing the resulting amount with the beginning inventory, which has also been

stated in base-year dollars. The difference represents the layer which, after conversion, must be added

or subtracted to arrive at the appro­priate value of ending inventory.

NOTE: The individual layers in a dollar-value LIFO inventory are valued as follows:

\$ value LIFO = Inventory at base-year prices × Conversion price index

d. In applying dollar-value LIFO, manufacturers develop their own indexes while retailers and wholesalers use

pub­lished figures. In computing the conversion price index, the double-extension technique is used, named

so because each year the ending inventory is extended at both base-year prices and current-year prices. The

index, computed as follows, measures the change in the inventory prices since the base year.

EI at end-of-year prices

EI at base-year prices

= Conversion price index

EXAMPLE 1

To illustrate the computation of the index, assume that the base-year price of products A and B is \$3 and

\$5, respec­tively, and at the end of the year, the price of product A is \$3.20 and B, \$5.75, with 2,000 and

800 units on hand, re­spectively. The index for the year is 110%, computed as follows:

EI at

end-of-year prices

Product A

Product B

2,000 @ \$3.20 = \$ 6,400

800 @ \$5.75 = \$ 4,600

\$11,000

÷

EI at

base-year prices

2,000 @ \$3 = \$ 6,000

800 @ \$5 = \$ 4,000

\$10,000

Conversion price

index

1.10 (or 110%)

e. Steps in dollar-value LIFO

Manufacturers

1. Compute the conversion price index

2. Compare BI at base-year prices to EI at base-year prices to determine the

a. New inventory layer added, or

b. Old inventory layer removed (LIFO liquidation)

3. If there is an increase at base-year prices, value this new layer by

multiplying the layer (stated in base-year dollars) by the conversion price

index. If there is a de­crease at base-year prices, the remaining layers are

val­ued at the index in effect when the layer was first added.

c07.indd 223

=

Retailers and wholesalers

1. Determine index from appropriate pub­

lished source

2. Divide EI by conversion price index to

re­state to base-year prices

3. Same as 2 for manufacturers

4. Same as 3 for manufacturers

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224

EXAMPLE

Assume the following:

EI at end-ofyear prices

Conversion

EI at base-year

Change as measured in

price index =

prices

base-year dollars

Year 1 (base)

\$100,000

1.00

\$100,000

Year 2

121,000

1.10

110,000

>

\$10,000

Year 3

150,000

1.20

125,000

>

15,000

Year 4

135,000

1.25

108,000

>

(17,000)

In both year 2 and year 3, ending inventory in terms of base-year dollars increased 10,000 and 15,000 base-year

dollars, respectively. Since layers are added every year that ending inventory at base-year prices is greater than

the previous year’s ending inventory at base-year prices, the ending inventory for year 3 would be computed as

follows:

¸

Ending inventory, Year 3

Base-year prices

Year 1 (base)

Year 2 layer

Year 3 layer

Ending inventory

\$100,000

10,000

15,000

\$125,000

×

Index

1.00

1.10

1.20

=

EI at dollar-value LIFO

cost

\$100,000

11,000

18,000

\$129,000

NOTE: Each layer added is multiplied by the conversion price index in effect when the layer

was added. Thus, the year 2 layer is multiplied by the year 2 index of 1.10 and the year 3

layer is multi­plied by the year 3 index of 1.20.

In year 4, ending inventory decreased by 17,000 base-year dollars. Therefore, a LIFO liquida­

tion has oc­curred whereby 17,000 base-year dollars will have to be removed from the previous

year’s ­ending inven­tory. Because LIFO is being used, the liquidation affects the most recently added

layer first and then, if necessary, the next most recently added layer(s). Ending inventory in year 4 is

­composed of

Base-year prices

×

Index

=

EI at dollar-value LIFO

cost

Year 1 (base)

Year 2 layer

Ending inventory

\$100,000

8,000

\$108,000

1.00

1.10

\$100,000

8,800

\$108,800

NOTE: The liquidation of 17,000 base-year dollars in year 4 caused the entire year 3 layer

of 15,000 base-year dollars to be liquidated as well as 2,000 base-year dollars from year 2.

Also note that the re­maining 8,000 base-year dollars in the year 2 layer is still multiplied by

the year 2 index of 1.10.

f.

Link-chain technique. The computations for application of the double-extension technique can become

very ar­duous even if only a few items exist in the inventory. Also, consider the problems that arise when

there is a constant change in the inventory mix or in situations in which the breadth of the inventory is large.

c07.indd 224

(1) The link-chain method was originally developed for (and limited to) those companies that wanted to use

LIFO but, because of a substantial change in product lines over time, were unable to recreate or keep

the historical records necessary to make accurate use of the double-extension method.

(2) The link-chain method is the process of developing a single cumulative index. Technological change

is al­lowed for by the method used to calculate each current year index. The index is derived by double

ex­tend­ing a representative sample (generally thought to be between 50% and 75% of the dollar value

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225

of the pool) at both beginning-of-year prices and end-of-year prices. This annual index is then applied

(multi­plied) to the previous period’s cumulative index to arrive at the new current year cumulative

index.

EXAMPLE

How the links and cumulative index are computed.

End of period

0

1

2

3

*

Ratio of end of period

prices to beginning prices*

-1.10

1.05

1.07

End of period prices

Beginning of period prices

=

Cumulative

index number**

1.000

1.100

1.155

1.236

Index number for this period only

** Multiply the cumulative index number at the beginning of the period by the ratio com­puted with the

formula shown above.

(a) The ending inventory is divided by the cumulative index number to derive the ending inventory at

base pe­riod prices. An increase (layer) in base period dollars for the period is priced using the

newly derived index number.

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 25 THROUGH 35

10. Gross Profit

a. Ending inventory is estimated by using the gross profit (GP) percentage to convert sales to cost of goods

pre­sumed sold.

b. Since ending inventory is only estimated, the gross method is not acceptable for either tax or annual

financial re­porting purposes.

c. Its major uses are to estimate ending inventory for internal use, for use in interim financial statements, and

for es­tablishing the amount of loss due to the destruction of inventory by fire, flood, or other catastrophes.

EXAMPLE

Suppose the inventory of the Luckless Company has been destroyed by fire and the following information is avail­

able from duplicate records stored at a separate facility: beginning inventory of \$30,000, purchases for the period of

\$40,000, sales of \$60,000, and an average GP percentage of 25%. The cost of the inventory destroyed is com­puted as

follows:

+

Beginning inventory

Purchases

Goods available

Cost of goods sold

Inventory destroyed

\$30,000

40,000

70,000

45,000*

\$25,000

*  Cost of goods sold is computed as (1) sales of \$60,000 – (\$60,000 × 25%) or (2) sales of \$60,000 × 75%.

c07.indd 225

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d. If you need to convert a GP rate on cost to a markup (MU) rate on the selling price, divide the GP rate on

cost by 1 plus the GP rate on cost, that is, if the GP rate on cost is 50%, then .50/(1 + .50) = 33 1/3% is the

MU rate on the selling price.

e. If you need to convert a MU rate on the selling price to a GP rate on cost, divide the MU rate on the selling

price by 1 minus the MU rate on the selling price, that is, if the MU rate on the selling price is 20%, then

.20/(1 – .20) = 25% GP rate on cost.

f. Always be cautious about gross profit rates (on cost or the selling price).

11. Standard Costs

a. Standard costs are predetermined costs in a cost accounting system, generally used for control purposes.

b. Inventory may be costed at standard only if variances are reasonable (i.e., not large).

(1) Large debit (unfavorable) variances would indicate inventory (and cost of sales) were undervalued,

whereas large credit (favorable) variances would indicate inventory is overvalued.

12. Direct (Variable) Costing

a. Direct costing is not an acceptable method for valuing inventory (ARB 43, chap 4).

b. Direct costing considers only variable costs as product costs and fixed production costs as period costs. In

con­trast, absorption costing considers both variable and fixed manufacturing costs as product costs.

13.Market

a. Inventory is usually valued at market value when market is lower than cost. However, occasionally,

inventory will be valued at market even if it is above cost. This usually occurs with

(1) Precious metals with a fixed market value

(2) Industries such as meatpacking where costs cannot be allocated and

(a) Quoted market prices exist

(b) Goods are interchangeable (e.g., agricultural commodities)

14. Cost Apportionment by Relative Sales Value

a. Basket purchases and similar situations require cost allocation based on relative value.

EXAMPLE

A developer may spend \$400,000 to acquire land, survey, curb and gutter, pave streets, etc. for a subdivi­sion. Due

to location and size, the lots may vary in selling price. If the total of all selling prices were \$600,000, the developer

could cost each lot at 2/3 (400/600; COST/RETAIL ratio) of its selling price.

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 36 THROUGH 37

C. Items to Include in Inventory

1. Goods shipped FOB shipping point which are in transit should be included in the inventory of the buyer since

2. Goods shipped FOB destination should be included in the inventory of the seller until the goods are received by

the buyer since title passes to the buyer when the goods are received at their final destination.

NOTE: The more complicated UCC rules concerning transfer of title should be used for the law portion, not

the financial accounting and reporting portion, of the exam.

c07.indd 226

D.Consignments

1. Consignors consign their goods to consignees who are sales agents of the consignors. Consigned goods remain

the property of the consignor until sold. Therefore, any unsold goods (including a proportionate share of freight

costs incurred in shipping the goods to the consignee) must be included in the consignor’s inventory.

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227

2. Consignment sales revenue should be recognized by the consignor when the consignee sells the consigned

goods to the ultimate customer. Therefore, no revenue is recognized at the time the consignor ships the goods

to the con­sign­ee.

NOTE: Sales commission made by the consignee would be reported as a selling expense by the consignor

and would not be netted against the sales revenue recognized by the consignor.

NOTE: The UCC rules concerning consignments should be used for the law portion, not the financial ac­

counting and reporting portion, of the exam.

E.Ratios

The two ratios below relate to inventory.

1.

Inventory turnover—Measures the number of times inventory was sold and reflects inventory order and

invest­ment policies

Cost of goods sold

Average inventory

2.

Number of days’ supply in average inventory—Number of days inventory is held before sale; reflects on

effi­ciency of inventory policies

365

Inventory turnover

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 38 THROUGH 50

F. Long-Term Construction Contracts

1. Long-term contracts are accounted for by two methods: completed-contract method and percentage-ofcompletion method.

a.

Completed-contract method—Recognition of contract revenue and profit at contract completion. All re­

lated costs are deferred until completion and then matched to revenues.

(1) The completed-contract method is preferable in circumstances in which estimates cannot meet the crite­

ria for reasonable dependability or one of the above conditions does not exist.

(2) The advantage of the completed-contract method is that it is based on results, not estimates, and the dis­

advantage is that current performance is not reflected and income recognition may be irregular.

b.

Percentage-of-completion—Recognition of contract revenue and profit during construction based on ex­

pected to­tal profit and estimated progress towards completion in the current period. All related costs are

recognized in the period in which they occur.

c07.indd 227

(1) The use of the percentage-of-completion method depends on the ability to make reasonably dependable

esti­mates of contract revenues, contract costs, and the extent of progress toward completion. For entities

which customarily operate under contractual arrangements and for whom contracting represents a

signifi­cant part of their operations, the presumption is that they have the ability to make estimates that

are suffi­ciently dependable to justify the use of the percentage-of-completion method of accounting.

(2) The percentage-of-completion method is preferable in circumstances in which reasonably dependable

esti­mates can be made and in which all of the following conditions exist:

(a) Contracts executed by the parties normally include provisions that clearly specify the enforceable

rights re­garding goods or services to be provided and received by the parties, the consideration to

be ex­changed, and the manner and terms of settlement.

(b) The buyer can be expected to satisfy obligations under the contract.

(c) The contractor can be expected to perform contractual obligation.

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