Financial Accounting

Module 8: Inventory Valuation Methods

Module Learning Outcomes

Module 8: Describe the accounting and reporting of inventory

8.1: Establish the cost of items in inventory

8.2: Apply the conservatism principle to inventory costing
8.3:
Demonstrate proper financial statement presentation of inve
ntory and cost of goods sold
Inventory Cost Flow Assumptions
Learning Outcomes: Inventory Cost Flow
Assumptions
8.1: Establish the cost of items in inventory
8.1.1: Illustrate the use of specific identification cost flow assumption
8.1.2: Illustrate the use of weighted average cost flow assumption
8.1.3: Illustrate the use of FIFO cost flow assumption
8.1.4: Illustrate the use of LIFO cost flow assumption
8.1.5: Compare and contrast the effect of different cost flow assumptions
on gross profit and net income
Inventory Cost Methods
 Illustrate the Use of Specific Identification Cost
Flow Assumption
Technically, the specific identification
method of assigning costs to items
in inventory isn’t an assumption
because it is a direct assignment of
the cost of the item purchased to the
item.

Normally, this system of specific

identification would be used for
unique items, like luxury yachts,
construction jobs, custom
motorcycles, even autos and smaller
boats, but not normally for baseball
bats, although with the increased
sophistication of our computer
programs, it’s not impossible to use
specific identification for a wide
variety of items.
Illustrate the Use of Weighted Average Cost Flow
Assumption
Total Purchases / Total Units =
Weighted Average Cost

This method may look easier than the

other methods, but it is not ideal for large
ticket items like cars, boats, yachts, or
even appliances and anything one of a
kind or unique in some way. If you had a
boutique store that sold fancy olive oil
from 5-gallon jugs with spigots, this
method could be ideal since the oils get
mixed together in the jug. It would be
really hard to use specific identification
with oils and other fungible items.
However, there is no rule that says you
have to use a cost flow assumption that
matches the physical flow of goods.
Illustrate the Use of First-in, First-out (FIFO) Cost
Flow Assumption

• First-in, First-out (FIFO) could also be called “last in still here.”

The first purchases we made are assumed to be the first
items sold, so the most recent purchases are the ones left in
ending inventory.

• The FIFO method assumes the oldest products in a

company's inventory have been sold first. The costs paid for
those oldest products are the ones used in the calculation.
Illustrate the Use of Last-in, First-out (LIFO) Cost
Flow Assumption

• LIFO, which stands for last-in-first-out, is an inventory

valuation method which assumes that the last items placed
in inventory are the first sold during an accounting period.

• Last-in, First-out (LIFO) is the exact opposite of FIFO. We

assume that the first items we sell come from the most
recent purchases. Another way to think of this, in terms of
the costs assigned to ending inventory, is “first in still here”
Compare and Contrast the Effect of Different
Cost Flow Assumptions on Gross Profit and Net
Income
NewCo Sporting Goods
Gross Profit Calculation –
periodic method
SpecID WAVE FIFO LIFO
$ $
Gross sales $ 620.00 $ 620.00
620.00 620.00
Cost of Goods Sold 368.00 374.88 352.00 396.00
Gross profit $252.00 $245.12 $268.00 $224.00
Gross profit % 40.65% 39.54% 43.23% 36.13%
Compare and Contrast the Effect of Different
Cost Flow Assumptions on Gross Profit and Net
Income

• LIFO gives the lowest gross profit, but only because the prices of our
inventory purchases were rising. If our costs were falling, LIFO would give
the highest gross profit. FIFO then, in periods of rising prices, will give us a
higher gross profit than LIFO because we would be using the oldest (lower)
costs for COGS.

• Weighted average (or moving weighted average if you are using a

perpetual inventory accounting system) will always fall between FIFO and
LIFO. Specific identification will usually be somewhere between the two,
but depending on the actual physical flow of goods, it could also be very
close to one or the other.
Practice Question 1

The Orange Juice Factory company is using a FIFO inventory system. On

January 15 they received an inventory shipment of 600 bottles of OJ at the
cost of $1.00. On Jan. 27 another 400 at the cost of $1.50 arrived. Then sold
800 bottles to a customer on Jan 28 while another shipment of 675 OJ
bottles at the cost of $1.75 arrived Jan. 30. On Feb. 3 a customer purchased
700 OJ bottles. What is the price of the bottles remaining as of Feb. 4?

A. $1.50
B. $1.42
C. $1.00
D. $1.75
Conservatism in Reporting Inventory
Learning Outcomes: Conservatism in Reporting
Inventory
8.2: Apply the conservatism principle to inventory costing
8.2.1: Compare methods of computing lower of cost or net realizable value
8.2.2: Apply the lower of cost or net realizable value rule to merchandise
inventory
8.2.3: Create journal entries to adjust inventory to net realizable value
 Compare Methods of Computing Lower of Cost
or Net Realizable Value
• Net realizable value (NRV) sounds complicated, and a lot of accountants may still use
the old term: Lower of Cost or Market (LCM). However, in July 2015, the Financial
Accounting Standards Board (FASB) adopted ASU 2015-11, FASB’s Accounting Standards
Codification (ASC) Topic 330, Inventory, (https://asc.fasb.org/imageRoot/22/66710722.pdf,
accessed July 7, 2020) that replaced LCM with LCNRV.
• The old rule (that still applies to entities that use LIFO or a retail method of inventory
measurement) required entities to measure inventory at the LCM. The term market
referred to either replacement cost, net realizable value (commonly called “the ceiling”),
or net realizable value (NRV) less an approximately normal profit margin (commonly called
“the floor”).
• In other words, market was the price at which you could currently buy it from your
suppliers. Except, when you were doing the LCM calculation, if that market price was
higher than net realizable value (NRV), you had to use NRV. If the market price was lower
than NRV minus a normal profit margin, you had to use NRV minus a normal profit margin.
 Compare Methods of Computing Lower of Cost
or Net Realizable Value

• The new rule, LCNRV, was designed to simplify this calculation. NRV is the
estimated selling price in the ordinary course of business, minus costs of completion,
disposal, and transportation.
• Inventory measured using any method other than LIFO or the retail inventory method
(for example, inventory measured using first-in, first-out (FIFO) or average cost) shall
be measured at the lower of cost and net realizable value. When evidence exists that
the net realizable value of inventory is lower than its cost, the difference shall be
recognized as a loss in earnings in the period in which it occurs. That loss may be
required, for example, due to damage, physical deterioration, obsolescence, changes
in price levels, or other causes.
• One final note: ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic
330 carved out an exception to the new rule for LIFO and retail inventory methods.
One of the simplest versions of the retail inventory method calculates ending
inventory by totaling the value of goods available for sale, which includes beginning
inventory and any new purchases of inventory. Total sales are multiplied by the cost-
to-retail ratio (or the percentage by which goods are marked up from their wholesale
purchase price to their retail sales price) in order to get an estimate of COGS.
Apply the LCNRV Rule to Merchandise Inventory
The LCNRV rule can be applied to each inventory item, each inventory class, or total inventory, and each
may have different results. We see that market is lower than cost, so the amount we would report on the
balance sheet would be $186,872.
Geyer, Co.

12/31/20XX

Product ID Description Cost Quantity in Stock Total Cost (FIFO) NRV LCNRV Total at LCNRV

A101 Wiring harness 99.000 30 2,970.00 102.00 99.00 2,970.00

CAB 500 HQ Speakers 58.000 500 29,000.00 50.00 50.00 25,000.00

CAB 600 HQ Speakers 99.000 15 1,485.00 50.00 50.00 750.00

MMM 333 GPS enabled sound system 1,255.500 64 80,352.00 2,625.00 1,255.50 80,352.00

Rel 5 HQ Speakers 110.000 100 11,000.00 50.00 50.00 5,000.00

RFS-212 GPS enabled sound system 650.000 150 97,500.00 400.00 400.00 60,000.00

XPS-101 GPS enabled sound system 102.375 160 16,380.00 80.00 80.00 12,800.00

Total Inventory FIFO $ 238,687.00 $ 186,872.00

Create Journal Entries to Adjust Inventory to NRV

Instead of adjusting the merchandise inventory account, which would

involve adjusting the cost of each individual item in the subsidiary ledger,
you may want to post the adjustment to a contra-asset account called
something like “Allowance to Reduce Inventory to NRV.”

So, we end up with four possible combinations (using the “by item”
analysis):

1. Post the adjustment to inventory and COGS.

2. Post the adjustment to inventory and a loss account.
3. Post the adjustment to a contra-asset account and COGS.
4. Post the adjustment to a contra-asset account and a loss account.
Financial Statement Presentation
Learning Outcomes: Financial Statement
Presentation
8.3: Demonstrate proper financial statement presentation of
inventory and cost of goods sold
8.3.1: Prepare a multi-step income statement
8.3.2: Identify the effects of common inventory errors on the financial
statements
8.3.3: Discuss common financial statement disclosures with regard to
inventory
Prepare a Multi-Step Income Statement

A merchandising company uses the same four financial statements we

learned before:

1. income statement
2. statement of retained earnings
3. balance sheet
4. statement of cash flows

The income statement for a merchandiser is expanded to include

groupings and subheadings necessary to make it easier for investors to
read and understand. We will look at the income statement only as the
other statements have been discussed previously.
Prepare a Multi-Step Income Statement
Identify the Effects of Common Inventory Errors
on the Financial Statements
• First, a merchandising company must be sure that it has properly valued its ending
inventory. If the ending inventory is overstated, COGS is understated, resulting in an
overstatement of gross margin and net income. Also, the overstatement of ending
inventory causes current assets, total assets, and retained earnings to be overstated.
Thus, any change in the calculation of ending inventory is reflected (ignoring any
income tax effects) dollar for dollar in net income, current assets, total assets, and
retained earnings.
• Second, when a company misstates its ending inventory in the current year, the
company carries forward that misstatement into the next year. This misstatement
occurs because the ending inventory amount of the current year is the beginning
inventory amount for the next year.
• Third, an error in one period’s ending inventory automatically causes an error in net
income in the opposite direction in the next period. After two years, however, the error
washes out, and assets and retained earnings are properly stated.
 Discuss Common Financial Statement
Disclosures with Regard to Inventory
Inventory makes up a substantial portion of total assets, second only to
property, plant, and equipment. But the number on the face of the
financials is only part of the story. GAAP requires additional disclosures
with regard to inventory that cover the following financial accounting
principles and policies:

● Conservatism (using LCM or LCNRV)

● Estimates
● Internal controls
● Materiality
Practice Question 2

XYZ merchandising company conducted a physical inventory at the end of

the year. One of the sheets of paper with the physical count ended up being
duplicated and the inventory was recorded incorrectly, as an overstatement
of inventory. This inventory overstatement showed up on the Balance Sheet
as well. What happens to the gross profit with an overstated ending
inventory?

A. Gross Profit is also overstated.

B. Gross Profit is then understated.
C. Gross Profit is unaffected.
D. Gross Profit is increased by 25%.
Quick Review

• How is the specific identification cost flow assumption used?

• How is the weighted average cost flow assumption used?
• How is the FIFO cost flow assumption used?
• How is the LIFO cost flow assumption used?
• What is the effect of different cost flow assumptions on gross profit and net income?
• What are the differences between computing lower of cost or net realizable value?
• How is the lower of cost or net realizable value rule applied to merchandise
inventory?
• How are journal entries created to adjust inventory to net realizable value?
• What is the process for preparing a multi-step income statement?
• What are the effects of common inventory errors on the financial statements?
• What common financial statement disclosures are needed for inventory?