CHAPTER 8

VALUATION OF INVENTORIES: A
COST-BASIS APPROACH

Intermediate Accounting
IFRS Edition
Kieso, Weygandt, and Warfield

8-1
Inventory Issues

Classification
Inventories are:
items held for sale, or
goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandiser or Manufacturer

8-2 LO 1 Identify major classifications of inventory.

Inventory Issues

Classification Illustration 8-1

One inventory
account.

Purchase goods
in form ready for
sale.

8-3 LO 1 Identify major classifications of inventory.

Inventory Issues

Classification Illustration 8-1

Three accounts

• Raw materials

• Work in process

• Finished goods

8-4 LO 1
Inventory Issues

Inventory Cost Flow Illustration 8-2

8-5 LO 1 Identify major classifications of inventory.

Inventory Issues

Inventory Cost Flow

Illustration 8-3

Companies use one of two types of systems for maintaining

inventory records — perpetual system or periodic system.

8-6 LO 1 Identify major classifications of inventory.

Inventory Cost Flow

Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each
sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.

The perpetual inventory system provides a continuous

record of Inventory and Cost of Goods Sold.

8-7 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow

Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net 800,000
Goods available for sale 900,000
Ending inventory 125,000
Cost of goods sold $ 775,000

8-8 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow

Illustration: Fesmire Company had the following transactions

during the current year.

Record these transactions using the Perpetual and Periodic

systems.

8-9 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow
Illustration: Illustration 8-4

8-10 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow

Illustration: Assume that at the end of the reporting period,

the perpetual inventory account reported an inventory balance
of $4,000. However, a physical count indicates inventory of
$3,800 is actually on hand. The entry to record the necessary
write-down is as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies
sometimes report Inventory Over and Short in the “Other income and expense” section
of the income statement.

8-11 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Issues

Inventory Control
All companies need periodic verification of the inventory
records by actual count, weight, or measurement, with the
counts compared with the detailed inventory records.

Companies should take the physical inventory near the

end of their fiscal year, to properly report inventory
quantities in their annual accounting reports.

8-12 LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Issues

Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available
for sale (or use) between the goods that were sold or used
and those that are still on hand.
Illustration 8-5

8-13 LO 2 Distinguish between perpetual and periodic inventory systems.

Basic Issues in Inventory Valuation

Valuation requires determining

The physical goods (goods on hand, goods in transit,

consigned goods, special sales agreements).

The costs to include (product vs. period costs).

The cost flow assumption (specific Identification,

average cost, FIFO, retail, etc.).

8-14 LO 2 Distinguish between perpetual and periodic inventory systems.

Physical Goods Included in Inventory

A company should record purchases when it obtains

legal title to the goods.
Illustration 8-6

8-15 LO 2 Distinguish between perpetual and periodic inventory systems.

GOODS INCLUDED IN INVENTORY

Goods in Transit
Example: LG (KOR) determines ownership by applying the
“passage of title” rule.
 If a supplier ships goods to LG f.o.b. shipping point, title
passes to LG when the supplier delivers the goods to the
common carrier, who acts as an agent for LG.
 If the supplier ships the goods f.o.b. destination, title passes
to LG only when it receives the goods from the common
carrier.
“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.

8-16 LO 3
GOODS INCLUDED IN INVENTORY

Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (USA) (the consignee), who
acts as Williams’ agent in selling the consigned goods.
 Sotheby’s agrees to accept the goods without any liability,
except to exercise due care and reasonable protection from
loss or damage, until it sells the goods to a third party.
 When Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Williams.
Goods out on consignment remain the property of the consignor
(Williams).
8-17 LO 3
GOODS INCLUDED IN INVENTORY

Sales with Repurchase Agreements

Example: Hill Enterprises transfers (“sells”) inventory to Chase,
Inc. and simultaneously agrees to repurchase this merchandise at
a specified price over a specified period of time. Chase then uses
the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though it
transferred to Chase technical legal title to the merchandise.
 Often described in practice as a “parking transaction.”
 Hill should report the inventory and related liability on its books.

8-18 LO 3
GOODS INCLUDED IN INVENTORY

Sales with Rights of Return

Example: Quality Publishing Company sells textbooks to Campus
Bookstores with an agreement that Campus may return for full
credit any books not sold. Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be
returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces
the cost of goods sold.
If Quality Publishing is unable to estimate the level of returns, it
should not report any revenue until the returns become predictive.
8-19 LO 3
Physical Goods Included in Inventory

Ending
Effect of Inventory Errors Inventory
Misstated
Illustration 8-7

The effect of an error on net income in one year (2010) will be counterbalanced in
the next (2011), however the income statement will be misstated for both years.

8-20 LO 3 Identify the effects of inventory errors on the financial statements.

Effect of Inventory Errors
Illustration: Yei Chen Corp. understates its ending inventory by
HK$10,000 in 2010; all other items are correctly stated.
Illustration 8-8

8-21 LO 3
Physical Goods Included in Inventory

Purchases
Effect of Inventory Errors and Inventory
Misstated

Illustration 8-9

The understatement does not affect cost of goods sold and net income because the
errors offset one another.

8-22 LO 3 Identify the effects of inventory errors on the financial statements.

Costs Included in Inventory

Product Costs - costs directly connected with

bringing the goods to the buyer’s place of business
and converting such goods to a salable condition.

Period Costs – generally selling, general, and

administrative expenses.

Treatment of Purchase Discounts – Gross vs.

Net Method

8-23 LO 4 Understand the items to include as inventory cost.

Costs Included in Inventory

Treatment of Purchase Discounts

Illustration 8-11

**

* $4,000 x 2% = $80
** $10,000 x 98% = $9,800

8-24 LO 4 Understand the items to include as inventory cost.