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Copyright © 2012 John Wiley & Sons, Inc.Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-1 CHAPTER 8 Valuation of Inventories: A Cost-Basis Approach ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1. Inventory accounts; determining quantities, costs, and items to be included in inventory; the inventory equation; balance sheet disclosure. 1, 2, 3, 4, 5, 6, 8, 9 1, 3 1, 2, 3, 4, 5, 6 1, 2, 3 1, 2, 3, 5 2. Perpetual vs. periodic. 2 9, 13, 17, 20 4, 5, 6 3. Recording of discounts. 10, 11 7, 8 3 4 4. Inventory errors. 7 4 5, 10, 11, 12 2 5. Flow assumptions. 12, 13, 16, 18, 20 5, 6, 7 9, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22 1, 4, 5, 6, 7 5, 6, 7, 8, 11 6. Inventory accounting changes. 18 7 6, 7, 10 7. Dollar-value LIFO methods. 14, 15, 17, 18, 19 8, 9 22, 23, 24, 25, 26 1, 8, 9, 10, 11 8, 9 8-2 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems 1. Identify major classifications of inventory. 1 2. Distinguish between perpetual and periodic inventory systems. 2 4, 9, 13, 17, 20 4, 5, 6 3. Identify the effects of inventory errors on the financial statements. 4 5, 10, 11, 12 2 4. Understand the items to include as inventory cost. 3 1, 2, 3, 4, 5, 6, 7, 8 1, 2, 3 5. Describe and compare the cost flow assumptions used to account for inventories. 5, 6, 7 9, 13, 14, 15, 16, 17, 18, 19, 20, 22 1, 4, 5, 6, 7 6. Explain the significance and use of a LIFO reserve. 21 7. Understand the effect of LIFO liquidations. 8. Explain the dollar-value LIFO method. 8, 9 22, 23, 24, 25, 26 1, 8, 9, 10, 11 9. Identify the major advantages and disadvantages of LIFO. 10. Understand why companies select given inventory methods. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-3 ASSIGNMENT CHARACTERISTICS TABLE Item Description Level of Difficulty Time (minutes) E8-1 Inventoriable costs. Moderate 15–20 E8-2 Inventoriable costs. Moderate 10–15 E8-3 Inventoriable costs. Simple 10–15 E8-4 Inventoriable costs—perpetual. Simple 10–15 E8-5 Inventoriable costs—error adjustments. Moderate 15–20 E8-6 Determining merchandise amounts—periodic. Simple 10–20 E8-7 Purchases recorded net. Simple 10–15 E8-8 Purchases recorded, gross method. Simple 20–25 E8-9 Periodic versus perpetual entries. Moderate 10–15 E8-10 Inventory errors, periodic. Simple 10–15 E8-11 Inventory errors. Simple 10–15 E8-12 Inventory errors. Moderate 15–20 E8-13 FIFO and LIFO—periodic and perpetual. Moderate 15–20 E8-14 FIFO, LIFO and average cost determination. Moderate 20–25 E8-15 FIFO, LIFO, average cost inventory. Moderate 15–20 E8-16 Compute FIFO, LIFO, average cost—periodic. Moderate 15–20 E8-17 FIFO and LIFO—periodic and perpetual. Simple 10–15 E8-18 FIFO and LIFO; income statement presentation. Simple 15–20 E8-19 FIFO and LIFO effects. Moderate 15–20 E8-20 FIFO and LIFO—periodic. Simple 10–15 E8-21 LIFO effect. Moderate 10–15 E8-22 Alternate inventory methods—comprehensive. Moderate 25–30 E8-23 Dollar-value LIFO. Simple 5–10 E8-24 Dollar-value LIFO. Simple 15–20 E8-25 Dollar-value LIFO. Moderate 20–25 E8-26 Dollar-value LIFO. Moderate 15–20 P8-1 Various inventory issues. Moderate 30–40 P8-2 Inventory adjustments. Moderate 25–35 P8-3 Purchases recorded gross and net. Simple 20–25 P8-4 Compute FIFO, LIFO, and average cost. Complex 40–55 P8-5 Compute FIFO, LIFO, and average cost. Complex 40–55 P8-6 Compute FIFO, LIFO, and average cost—periodic and perpetual. Moderate 25–35 P8-7 Financial statement effects of FIFO and LIFO. Moderate 30–40 P8-8 Dollar-value LIFO. Moderate 30–40 P8-9 Internal indexes—dollar-value LIFO. Moderate 25–35 P8-10 Internal indexes—dollar-value LIFO. Complex 30–35 P8-11 Dollar-value LIFO. Moderate 40–50 8-4 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item Description Level of Difficulty Time (minutes) CA8-1 Inventoriable costs. Moderate 15–20 CA8-2 Inventoriable costs. Moderate 15–25 CA8-3 Inventoriable costs. Moderate 25–35 CA8-4 Accounting treatment of purchase discounts. Simple 15–25 CA8-5 General inventory issues. Moderate 20–25 CA8-6 LIFO inventory advantages. Simple 15–20 CA8-7 Average cost, FIFO, and LIFO. Simple 15–20 CA8-8 LIFO application and advantages. Moderate 25–30 CA8-9 Dollar-value LIFO issues. Moderate 25–30 CA8-10 FIFO and LIFO. Moderate 30–35 CA8-11 LIFO Choices—Ethical Issues. Moderate 20–25 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-5 LEARNING OBJECTIVES 1. Identify major classifications of inventory. 2. Distinguish between perpetual and periodic inventory systems. 3. Identify the effects of inventory errors on the financial statements. 4. Understand the items to include as inventory cost. 5. Describe and compare the cost flow assumptions used to account for inventories. 6. Explain the significance and use of a LIFO reserve. 7. Understand the effect of LIFO liquidations. 8. Explain the dollar-value LIFO method. 9. Identify the major advantages and disadvantages of LIFO. 10. Understand why companies select given inventory methods. 8-6 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 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 particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for the organization. Inventories are also significant because of their impact on both the balance sheet and the income statement. Chapter 8 initiates the discussion of the basic issues involved in recording, classifying, and valuing items classified as inventory. 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 inventory refers to the goods held for resale by a merchandising concern. The inventory of a manufacturing firm is composed of three separate items: raw materials, work in process, and finished goods. 3. (L.O. 2) 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 to inventory quantities. Under this inventory system, data are available at any time relative to the quantity of material or type of merchandise on hand. In a perpetual inventory system, purchases and sales of goods are recorded directly in the Inventory account as they occur. A Cost of Goods Sold account is used to accumulate the issuances from inventory. The balance in the Inventory account at the end of the year should represent the ending inventory amount. 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 a periodic inventory system is in use. The computation of cost of goods sold is made by adding beginning inventory to net purchases and then subtracting ending inventory. Ending inventory is determined by a physical count at the end of the year under a periodic inventory system. Even in a perpetual inventory system, a physical inventory count at year-end is normally taken due to the potential for loss, error, or shrinkage of inventory during the year. 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 the danger of loss owing to obsolescence. If the supply of inventory is inadequate, the potential for lost sales exists. This dilemma makes inventory an asset to which manage- ment must devote a great deal of attention. 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 and involves counting all inventory items and comparing the amount counted with the amount shown in the detailed inventory records. Any errors in the records are corrected to agree with the physical count. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-7 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 period (ending inventory). The process of computing cost of goods sold is complicated by the determination of (a) the physical goods to be included in inventory, (b) the costs to be included in inventory, and (c) the cost flow assumption to be used. Physical Goods to be Included in Inventory 8. 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 which the company has legal title be included in ending inventory. Goods in transit at the end of the period, shipped f.o.b. shipping point, should be included in the buyer’s ending inventory. If goods are shipped f.o.b. destination, they belong to the seller until actually received by the buyer. Inventory out on consignment belongs to the consignor’s inventory. 9. In actual practice a few exceptions exist regarding the general rule that inventory is recorded by the company that has legal title to the merchandise. These exceptions are known as special sale agreements. Three of the more common special sale agreements are (a) sales with buy back agreement, (b) sales with high rates of return, and (c) sales on installment. Effect of Inventory Errors 10. (L.O. 3) Errors in recording inventory can affect the balance sheet, 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 inventory count would result in the following items being overstated (O) or understated (U): ending inventory (U); working capital (U); cost of goods sold (O); and net income (U). If merchandise was not recorded as a purchase nor counted in the ending inventory, the result would be an under- statement of inventory and accounts payable in the balance sheet and an understatement of purchases and inventory in the income statement. Net income would be unaffected by this omission as purchases and ending inventory would be misstated by the same amount. Costs Included in Inventory 11. (L.O. 4) 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 recorded in the inventory account. These costs include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs. The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process. 12. The accounting profession allows for the capitalization of interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease. In the case of inventories that are routinely manufac- tured or produced in large quantities on a repetitive basis, interest costs should not be capitalized. 8-8 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) Purchase Discounts 13. 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 used, purchase discounts should be reported as a deduction from purchases on the income statement. If the net method is used, purchase discounts lost should be con- sidered a financial expense and reported in the “other expense and loss” section of the income statement. Cost Flow Assumptions 14. Determining the specific cost of inventory items that have been sold as well as those remaining in ending inventory is sometimes a difficult process. This is due, in part, to the fact that there is no requirement that the cost flow assumption adopted be consistent with the physical flow of the goods through the inventory account. Thus, it is important when accounting for inventory costs that a company make consistent use of a cost flow assumption. The major objective in selecting a method should be to choose the one which most clearly reflects periodic income. 15. (L.O. 5) Inventory cost flow assumptions include (a) specific identification, (b) average cost, (c) first-in, first-out (FIFO), (d) last-in, first-out (LIFO), and (e) dollar-value LIFO. It should be remembered that these assumptions relate to the flow of costs and not the physical flow of inventory items into and out of the company. 16. Specific identification calls for identifying each item sold and each item in inventory. The costs of the specific items sold are included in cost of goods sold, and the costs of the specific items on hand are included in inventory. The average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period. FIFO 17. Use of the FIFO inventory method assumes that the first goods purchased are the first used or sold. In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. A major advantage of the FIFO method is that the ending inventory is stated in terms of an approximate current cost figure. However, because FIFO tends to reflect current costs on the balance sheet, a basic disadvantage of this method is that current costs are not matched against current revenues on the income statement. LIFO 18. Use of the LIFO inventory method assumes that the most recent inventory costs are the first costs recorded for goods manufactured or sold. When inventory records are kept on a periodic basis, the ending inventory would be priced by using the total units as a basis of computation, disregarding the exact dates of purchases. The calculation of ending inventory and cost of goods sold changes somewhat when the LIFO method is used in connection with perpetual inventory records. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-9 LIFO Reserve 19. (L.O. 6) Many companies use LIFO for tax and external reporting purposes, but maintain a FIFO, average cost, or standard cost system for internal reporting purposes. The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO Reserve. The change in the allowance balance from one period to the next must be made each year. LIFO Liquidation 20. (L.O. 7) When the LIFO inventory method is used, many companies combine inventory items into natural groups or pools. Each pool is assumed to be one unit for the purpose of costing the inventory. Any increment above beginning inventory is normally identified as a new inventory layer and priced at the average cost of goods purchased during the year. When the inventory is decreased, the most recently added inventory layer is the first layer eliminated (last-in, first-out). The specific-goods pooled LIFO approach reduces record keeping and, accordingly, the cost of utilizing the LIFO inventory method. Dollar-Value LIFO 21. (L.O. 8) Use of the specific-goods pooled approach can result in problems for companies that often change the mix of their products, materials, and production methods. To overcome these problems, the dollar-value LIFO method has been developed. The important feature of the dollar-value LIFO method is that increases and decreases in a pool are determined and measured in terms of total dollar value, not the physical quantity of the goods as is done in the traditional LIFO pool approach. 22. In computing inventory under the dollar-value LIFO method, the ending inventory is first priced at the most current cost. Current cost is then restated to prices prevailing when LIFO was adopted. This is accomplished by using a price index. A new inventory layer is formed when the ending inventory, stated in base-year costs, exceeds the base-year costs of beginning inventory. Increases are priced at current cost. If the ending inventory, stated at base-year costs, is less than beginning inventory, the decrease is subtracted from the most recently added layer. A price index for the current year is computed by dividing Ending Inventory for the Period at Current-Year Costs by Ending Inventory for the Period at Base-Year Costs. The dollar-value method is a more practical way of valuing a complex, multiple-item inventory than the traditional LIFO method. Advantages and Disadvantages of LIFO 23. (L.O. 9) Proponents of the LIFO method advocate its use on the basis of its (a) proper matching of recent costs with current revenue, (b) tax benefits, (c) improved cash flow, and (d) future earnings hedge. Those opposed to the LIFO method claim that it (a) lowers reported earnings, (b) reports outdated costs on the balance sheet, (c) is contrary to normal physical flow, (d) creates involuntary liquidation problems, and (e) invites poor buying habits. 8-10 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) Selection of Inventory Method 24. (L.O. 10) LIFO is generally preferable to FIFO when: (a) selling prices and revenues have been increasing faster than costs, and (b) LIFO has been traditional, such as department stores and industries where a fairly constant “base stock” is present. LIFO would not be preferable when: (a) prices tend to lag behind costs, (b) specific identi- fication is traditional, and (c) unit costs tend to decrease as production increases, thereby nullyifying the tax benefit that LIFO might provide. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-11 LECTURE OUTLINE This chapter can be covered in three to four class sessions. Students should have had previous exposure to inventory accounting topics except for dollar-value LIFO and the modified perpetual system (perpetual records kept in units only). A. (L.O. 1) Inventory Classification. 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. 2. For manufacturing companies the inventory amount may be broken down into raw materials, work in process, and finished goods. B. (L.O. 2) Inventory Cost Flow. TEACHING TIP Contrast the accounting procedures under the perpetual and periodic inventory systems by using Illustration 8-1. This example is based on Illustration 8-4 in the textbook on page 438. 1. Perpetual inventory system—The costs of purchases and sales are recorded directly in the Inventory account (perpetual record kept in units and dollars). 2. Periodic inventory system—The cost of purchases is recorded in a Purchases (nominal or temporary) account. The balance in the Inventory account remains unchanged during the period. No record is kept at the time of sale of the number or cost of the units sold. At the end of the period, the quantity of goods on hand is determined by physical count and the cost of ending inventory is recorded. Cost of goods sold is determined by adding the beginning inventory to the purchases and deducting the ending inventory. 3. Modified perpetual inventory system—The cost of purchases is recorded directly in the Inventory account. The cost of sales is not recorded at the time of sale, but a record is kept of the number of units sold (perpetual record kept in units only). C. (L.O. 2) Basic Issues in Inventory Valuation. These include the determination of the (1) physical goods to be include in inventory, (2) the costs to include in inventory, and (3) the cost flow assumption to adopt. 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 buyer when the seller delivers the goods to the common carrier. If the goods are shipped f.o.b. destination, title passes when the buyer receives the goods. 8-12 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 2. Consigned Goods: Goods out on consignment remain the property of the consignor. 3. Special Sales Agreements in which the transfer of legal title may not be accompanied by a transfer of the risks of ownership. (The concept of revenue realization can be discussed in connection with these special arrangements.) a. Sales with buyback agreement. (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 described as “parking transactions” because the seller simply parks the inventory on another firm’s balance sheet and uses it as a financing device. (3) In these arrangements, the inventory and related liability from the repurchase agreement should remain on the “seller’s” books. No sale should be recorded. b. Sales with high rates of return. (1) When the amount of returns can be reasonably estimated, the goods should be considered sold. (2) If returns are unpredictable, the goods should not be removed from the seller’s inventory accounts. c. Installment sales. The goods should be excluded from the seller’s inventory (i.e., considered sold) if the percentage of bad debts can be reasonably estimated. 4. (L.O. 3) 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 inventory count. (2) Recording purchase transactions in the wrong accounting period. However, ending inventory is computed and recorded correctly. (3) Failure to include an item as a recorded purchase combined with failure to include and record the item in the ending inventory count. 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 the end of the accounting period, correcting entries may be required to prevent “cut-off errors.” (See Exercises 8-4 and 8-5 in the textbook). Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-13 (2) Computation of the correct amounts of inventory and related items including purchases, cost of goods sold, net income, retained earnings, accounts payable, working capital, and the current ratio. (i) This is a good place to reinforce understanding of the basic inventory equation: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. (ii) Point out the obvious, but useful, fact that the ending inventory of one period is the beginning inventory of the next period. c. Discuss the impact of inventory errors on the affected accounts. TEACHING TIP Illustration 8-2 demonstrates the effects of inventory errors on the income statement by emphasizing the debit or credit balance of the affected items. Illustration 8-3 summarizes the effects of inventory errors on the income statement and the balance sheet. E. (L.O. 4) 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 them to a saleable condition. Period costs such as selling and general and adminis- trative expenses are not considered to be directly related to the acquisition or production of goods. 2. Manufacturing Costs. Includes all costs which are traceable to the production of the product. These costs are classified as direct materials, direct labor, and manufacturing overhead. 3. Interest costs associated with getting inventories ready for sale are usually expensed as incurred. However, SFAS No. 34 requires capitalization of interest cost related to construction of discrete projects such as ships or real estate projects. 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 which is reported in the income statement as a reduction of Purchases. b. Net method (considered more appropriate than the gross method). Purchases and accounts payable are recorded at the net amount. Purchase discounts not taken are debited to the Purchase Discounts Lost account which is reported in the other expense section of the income statement. 8-14 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) F. (L.O. 5) Choice of Cost Flow Assumption. This 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. TEACHING TIP Illustration 8-4 provides a comparison of ending inventory computations under FIFO, LIFO, and average cost under periodic and perpetual systems. 1. Specific Identification: Used where a small number of costly, distinctive items are sold. It matches actual costs against actual revenue, but offers the opportunity to manipulate income. 2. Average Cost: Items in the ending inventory and items sold are priced at the average cost of goods available during the period. Either weighted-average (periodic) or moving-average (perpetual) procedures may be used. 3. First-In, First-Out: Assumes goods are used in the order purchased. While this method presents ending inventory at approximately current cost, it does not match current costs against current revenues. a. Ending Inventory and cost of goods sold will be the same under both periodic and perpetual inventory systems. 4. Last-In, First-Out: Assumes that the last goods purchased are used or sold first. G. (L.O. 6) LIFO Reserve (or the Allowance to Reduce Inventory to LIFO). Used when a company maintains a FIFO, average cost, or standard cost system for internal reporting purposes and LIFO for tax and external reporting purposes. The change in the allowance balance from one period to the next is the LIFO effect. H. (L.O. 7) Effect of LIFO Liquidations. 1. LIFO Liquidations. A frequent occurrence when specific-goods LIFO is used. When the inventory balance is reduced (liquidated), the cost of the old inventory layers is included in cost of goods sold, resulting in higher net income. 2. Specific-goods pooled LIFO approach. Inventory items are combined in pools of similar items. This approach may help prevent LIFO liquidations because decreases in one quantity may be offset by increases in another quantity. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-15 I. (L.O. 8) Dollar-value LIFO. This differs from specific-goods pooled LIFO in that increases and decreases in a pool are measured in terms of the total dollar value and not the physical quantity of goods in the inventory pool. 1. Discuss the steps involved in the dollar-value LIFO approach. TEACHING TIP Illustration 8-5, which is based on the Enrico Company data in the textbook, shows a straightforward for presenting the dollar-value LIFO computations. a. Compute the quantity of ending inventory at current cost. (This approximates FIFO.) b. Divide (a) by the current price index to obtain the ending inventory at base-year cost. c. Split (b) into layers depending on the year the items were acquired. d. Multiply each layer in (c) by the appropriate price index (price index in the year of acquisition) to obtain the ending inventory at dollar-value LIFO cost. TEACHING TIP Under certain circumstances the dollar-value LIFO approach produces the same inventory cost as the specific goods LIFO approach. This can be demonstrated by using the example in Illustration 8-6. 2. Discuss the computation of a price index. a. Many companies may be able to use published external price indices. b. Some companies must compute internal price indices. The double-extension method is discussed in the chapter. The price index for the current year is computed as follows: Ending Inventory for the Period at Current Cost Ending Inventory for the Period at Base-Year Cost J. (L.O. 9) Major Advantages and Disadvantages of LIFO. 1. Advantages of LIFO. a. Matching. LIFO matches more recent costs against current revenues to provide a better measure of current earnings. b. Tax benefits/Improved cash flow. During times of rising prices, LIFO provides a deferral of income taxes payable. c. Future earnings hedge. With LIFO, future price declines will not substantially affect a company’s future reported earnings. 8-16 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 2. Disadvantages of LIFO. a. Reduced earnings. During times of rising prices, reported earnings under LIFO are less than they would be under FIFO. However, because the IRS has now relaxed the LIFO conformity rule, companies are permitted to make supplementary disclosure of non-LIFO income numbers in the financial statements. b. Inventory understated. Under LIFO, the oldest costs (which are the lowest costs if prices are rising) remain in inventory. c. Physical flow. LIFO does not approximate the actual physical flow of items except in unusual situations. d. Involuntary liquidation. If layers of old costs are eliminated, distortions in re- ported income can occur. e. Poor buying habits. A company may adopt an uneconomic pattern of purchases in order to avoid the liquidation problem or in order to manipulate net income. K. (L.O. 10) Why companies select given inventory methods. 1. LIFO will be the preferred method if: a. Selling prices and revenues have been increasing faster than costs, and b. A company has a fairly constant “base stock.” 2. LIFO would not be the preferred method if: a. Prices tend to lag behind costs. b. Specific identification is traditional. c. Unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide. Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-17 ILLUSTRATION 8-1 INVENTORY RECORDING SYSTEMS 8-18 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-2 ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-19 ILLUSTRATION 8-3 EFFECT OF INVENTORY ERRORS 8-20 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-4 COMPUTATION OF ENDING INVENTORY Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) 8-21 ILLUSTRATION 8-5 DOLLAR-VALUE LIFO 8-22 Copyright © 2012 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 14/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 8-6 COMPARISON OF UNIT LIFO AND DOLLAR-VALUE LIFO