NINJA BOOK

Financial Accounting & Repor ting 2020

Inventory
 Copyright & Disclaimer
This book contains material copyrighted © 1953 through 2020 by the American Institute of Certified Public
Accountants, Inc., and is used or adapted with permission.

Material from the Uniform CPA Examination Questions and Unofficial Answers, copyright © 1976 through 2020,
American Institute of Certified Public Accountants, Inc., is used or adapted with permission.

This book is written to provide accurate and authoritative information concerning the covered topics for the
Uniform CPA Examination and is to be used solely for studying for the Uniform CPA Examination and for no
other purpose.

© 2020 NINJA CPA Review, LLC. All Rights Reserved.

2
 INVENTORY
Introduction
Basics
• Definition Inventory is defined as items of tangible personal property that are held for sale in the ordinary
course of business, in the process of production for such sale, or which are to be currently consumed in the
production of goods or services to be available for sale.

Inventory = Raw materials (held for use in production) +

Work in Process (in process for production) +
Finished Goods (held for sale) +
Retail Inventory (held for resale)

• Objective The objective of inventory accounting is to identify costs applicable to goods on hand at the end
of the period and costs that should be included in the cost of goods sold for the period.

Ownership Criteria
Ownership generally determines when items should be included in inventory. Items purchased for which title
(and, in some cases, even possession) remains with the vendor until the items are paid for should not be
included in the buyer’s inventory until the significant risks of ownership rest with the buyer.

Title Passes Recognized on Balance Sheet

FOB Shipping Point When goods are delivered by seller to Buyer
the common carrier (shipped), title
passes from Seller to Buyer
FOB Destination When goods are received by the Seller
buyer (reach destination), title passes
from Seller to Buyer
Shipment of non-conforming When goods are rejected by the Seller
goods (Sale Returns) buyer, title reverts from Buyer to
Seller (even if goods are with the
buyer)
Sales with a Right to Return If goods likely to be returned can be Seller (unless amount of returns can be
(i.e., goods are sold but buyer estimated, record as a sale with an reasonably estimated)
has right to return the goods) allowance for estimated returns
Consignment Sales (Seller or Title remains with consignor until Consignor
consignor delivers goods to the goods are sold by the consignee;
agent or consignee to hold and thus, title passes directly to the third- Note that inventory is never owned by
sell goods on behalf of the party buyer at point of sale consignee who:
consignor) Further, costs incurred by consignor - possesses the goods but not the title
in transferring goods to consignee - acts as an agent with a commission on
considered inventory costs. Include: sales and reimbursable expenses,
- freight on shipments to consignee - treats consignment inventory as
(not freight-out since no sale has purchase only when they are sold to a
occurred yet), third-party buyer
- in-transit insurance,
- warehousing costs

3
Application } 1 Goods in Transit
Herc Co.’s inventory at December 31 of the previous year was $1,500,000, based on a physical count priced at cost, and
before any necessary adjustment for the following:
• Merchandise costing $90,000, shipped FOB shipping point from a vendor on December 30 of the previous year
was received and recorded on January 5 of the current year.
• Goods in the shipping area were excluded from inventory although shipment was not made until January 4 of the
current year. The goods, billed to the customer FOB shipping point on December 30 had a cost of $120,000.
What amount should Herc report as inventory in its December 31, previous year balance sheet?
a. $1,500,000
b. $1,590,000
b. $1,620,000
d. $1,710,000
(d) Goods are included in the purchaser's inventory when legal title passes to the purchaser. Herc should include the
$90,000 cost of goods shipped to it FOB shipping point in inventory at 12/31 of the previous year because title to these
goods passed to Herc when the goods were picked up by the common carrier on 12/30. Herc should also include the
$120,000 cost of goods in its shipping area in inventory at 12/31 of the previous year. These goods should be included in
inventory because shipment of these goods to the customer was not made until the current year.

Application } 2 Goods on Consignment

During the current year, Kam Co. began offering its goods to selected retailers on a consignment basis. The following
information was derived from Kam's current year accounting records:

Beginning Inventory $122,000

Purchases 540,000
Freight in 10,000
Transportation to consignees 5,000
Freight out 35,000
Ending Inventory--held by Kam 145,000
Ending Inventory--held by consignees 20,000

In its current year income statement, what amount should Kam report as cost of goods sold?
a. $507,000
b. $512,000
c. $527,000
d. $547,000
(b) Transportation to consignees is an inventoriable cost. Freight out is not an inventoriable cost. Ending inventory—held
by consignees is not includable in cost of goods sold. Goods out on consignment remain the property of the consignor
and must be included in the consignor's inventory at cost, including freight and other costs incurred to process the goods
up to the time of sale.

Beginning inventory $ 122,000

Add: Purchases $540,000
Freight in shipping 10,000
Transportation to consignees 5,000
Add: Total inventoriable costs 555,000
Goods available for sale 677,000
Less: Ending inventory ($145,000 + $20,000) (165,000)
Cost of goods sold $ 512,000

4
Measuring Inventories
Physical Quantities

The measuring of inventories involves determining physical quantities, along with an appropriate dollar valuation.
Physical inventory quantities are determined using one, or both, of the following systems:

• Perpetual Inventory System In this system a continuous record is maintained of items entering into and
issued from inventory. The balance in the inventory account at any time reveals the inventory that should be
on hand.

Journal Entry for purchases (real-time inventory):

Inventory XXX
Cash or A/P XXX

Journal Entry as sales occur:

Cash or A/R XXX

Sales XXX

COGS XXX
Inventory XXX

• Periodic Inventory System The inventory on hand is periodically determined by physical count. No entries
are made to the inventory account during the period, the account reflects the amount at the beginning of the
period until inventory is counted. Acquisitions of inventory goods are debited to “Purchases” while issuances
are not recorded. Cost of goods sold (COGS) is obtained by subtracting the ending inventory from the sum
of beginning inventory and net purchases.

Journal Entry for purchases:

Purchases XXX
Cash or A/P XXX

Journal Entry at year-end:

Ending Inventory XXX

COGS (year-end plug) XXX
Beginning Inventory XXX
Purchases XXX

Cost of Goods Sold (COGS) at year-end in the Periodic System

Beginning Inventory Gross Purchases

(+) Cost of Goods Purchased (-) Purchase Discount
-------------------------------------------- (-) Purchase Returns
Cost of Goods Available for Sale (COGAS) ------------------------------------
(-) Ending Inventory Net Purchases
-------------------------------------------- (+) Freight-in
Cost of Goods Sold (COGS) ------------------------------------
Cost of Goods Purchased

5
Cost Associated with Inventory
Include Exclude
Direct Materials, Direct Labor and Direct & Indirect Unallocated fixed overheads esp. if production is
Overheads (both fixed and variable overheads) much below normal capacity

Freight-in, insurance, warehousing Freight-out, sales commissions

Handling costs, repacking, normal spoilage Abnormal costs, excess spoilage

Purchase Discount Adjustments Purchase Discounts Lost

Interest or Financing cost

Cost Flow Assumptions

The per-unit cost of inventory items purchased at different times will often vary. In order to allocate the total cost
of goods available for sale (i.e., beginning inventory plus net purchases) between cost of goods sold and ending
inventory, either the cost of specific items must be tracked or a cost flow method must be adopted.

• Specific Identification This costing method requires the ability to identify each unit sold or in inventory.
The cost of goods sold is the cost of the specific items sold, and the ending inventory is the cost of the
specific items still on hand. It is used when inventory goods are few in number, have individually high costs,
and can be clearly identified.

• Average Cost Method Average inventory methods assume that cost of goods sold and ending inventory
should be based on the average cost of the inventories available for sale during the period. A weighted
average is generally used with a periodic inventory system while a moving average requires the use of a per-
petual inventory system.

ü Under periodic system, use Weighted Average Method

o Cost of units calculated at the end of the period based upon the weighted average price paid
(including freight, etc.)

o Weighted Average price = Cost of goods available for sale

# of units available for sale

ü Under perpetual system, use Moving Average Method

o Cost of units calculated in the same manner as for weighted average except that a new weighted
average cost is calculated after each purchase (that is why we call it ‘moving’ average)

6
Example } 1 Average Inventory Methods
During the year, ABC Inc. purchased and sold several lots of inventory item X, as follows:
Purchases: Units Unit Cost Extended Cost
2/15 10,000 $3.00 $ 30,000
6/1 5,000 3.30 16,500
8/10 6,000 3.38 20,280
Goods available 21,000 $ 66,780
Sales:
7/1 7,000
9/10 9,000
Goods sold 16,000
Ending inventory 5,000
The cost of the ending inventory of item X using the weighted-average method is $15,900, determined as follows:
Ending inventory in units 5,000
Weighted average cost per unit ($66,780 / 21000) × $3.18
Ending inventory $15,900
The cost of the ending inventory of item X using the moving-average method is $16,100, determined as follows:
1 2 3 4
Moving Avg.
Date Units Cost Extended (3 / 1)
2/15 Purchases 10,000 $3.00 $ 30,000 $3.00
6/1 Purchases 5,000 3.30 16,500 --
15,000 46,500 3.10
7/1 Sales (7,000) 3.10 (21,700) --
8,000 24,800 3.10
8/10 Purchases 6,000 3.38 20,280 --
14,000 45,080 3.22
9/10 Sales (9,000) 3.22 (28,980) --
Ending inventory 5,000 $ 16,100 3.22

FIFO & LIFO

First-In / First-Out (FIFO) Last-In / First-Out (LIFO)

Cost Flow Assumption Beginning inventory and earliest Most recent purchases sold first. Therefore,
purchases sold first. Therefore, inventory in hand consists of the earliest
inventory in hand consists of the purchases
most recent purchases
Financial Statement Impact COGS (Net Income ) COGS ok (Net Income ok)
in Periods of Rising Prices Ending Inventory ok Ending Inventory
I/S not ok, B/S ok I/S ok, B/S not ok

Periodic vs. Perpetual Results are same in both Results are different in both inventory
inventory systems – Periodic & systems – Periodic & Perpetual
Perpetual

IFRS Allowed Not Allowed

7
Example } 2 FIFO & LIFO
During October 2019, Ninja Co. records the following information pertaining to its inventory.
Date Description Units Unit cost Total Cost Units in hand
10/1 Beginning Inventory 400 $10 $4,000 400
10/3 Purchase 600 $15 $9,000 1000
10/14 Sales 800 200
10/26 Purchase 500 $20 $10,000 700

Calculate Value of COGS and Ending Inventory as per FIFO & LIFO under both periodic and perpetual system?

Solution:

Beginning Inventory: 400

Purchases: 1100
Sales: 800
Ending Inventory: 700

FIFO Periodic
COGS is 800 units from earliest purchases Ending Inventory is 700 units from latest
10/1 - 400 units @$10.00 = $4,000 purchases
10/3 - 400 units @$15.00 = $6,000 10/26 - 500 units @20.00 = $10,000
COGS = $10,000 10/3 - 200 units @15.00 = $3,000
Ending Inventory = $13,000
FIFO Perpetual
COGS for goods sold on 10/14 Ending Inventory is the balance left
10/1 - 400 units @10.00 = $4,000 10/3 - 200 units @15.00 = $3,000
10/3 - 400 units @15.00 = $6,000 10/26 - 500 units @20.00 = $10,000
COGS = $10,000 Ending Inventory = $13,000
LIFO Periodic
COGS is 800 units from latest purchases Ending Inventory is 700 units from earliest
10/26 - 500 units @20.00 = $10,000 purchases
10/3 - 300 units @15.00 = $4,500 10/1 - 400 units @$10.00 = $4,000
COGS = $14,500 10/3 - 300 units @$15.00 = $4,500
Ending Inventory = $8,500
LIFO Perpetual
COGS for goods sold on 10/14 Ending Inventory is the balance left
10/3 - 600 units @15.00 = $9,000 10/1 - 200 units @$10.00 = $2,000
10/1 - 200 units @10.00 = $2,000 10/26 - 500 units @$20.00 = $10,000
COGS = $11,000 Ending Inventory = $12,000

8
Application } 3
Which inventory costing method would a company that wishes to maximize profits in a period of rising prices
use?
a. FIFO
b. Dollar-value LIFO
c. Weighted average
d. Moving Average
(a) The FIFO inventory costing method assumes that the goods first acquired are the first sold and, as such,
would maximize profits in a period of rising prices. The FIFO inventory costing method assumes that the goods
first acquired are the first sold and, as such, would maximize profits in a period of rising prices. The weighted
average and moving average methods use an average and thus would not lead to maximizing profits in a period
of rising prices.

Dollar- Value LIFO

Variation of the LIFO method in which inventory is measured in $ (NOT units) and is adjusted for changing price
levels

Inventory is combined into pools of items which are valued separately. For each pool, an overall price index
used to calculate $ value LIFO

Dollar-value LIFO Conformity Rule applies (if used for tax, also use for financial reporting) - so to conform to IRS
regulations, entities usually define LIFO pools in dollar value

Advantages over LIFO

ü Reduces costs of maintaining extensive inventory records as entity only needs to track annual layers
of inventory cost and price indices for each inventory pool (no need to retain detailed records of each
unit cost of each item purchased over the life of the entity)

ü Reduces possibilities of liquidation as related items grouped together into inventory pools (so decrease
in certain items may be offset by an increase in other items)

Steps to calculate ending inventory by the $ value LIFO method:

Step 1: Calculate Ending Inventory @base year-end price =

Ending Inventory @current year-end price
Cumulative price index

Step 2: Calculate Change in Inventory Layers @base year price

Step 3: Calculate Change in Inventory Layers @current year price =

Change in layer @base year price * Cumulative price index

Step 4: In case of increase in layers, simply add the layers; however, in case of a liquidation, as per LIFO rules,
latest layer is liquidated first

9
 Example } 3 Dollar-Value LIFO
On the basis of the quantity and price information in Table 1, columns 1 and 2, a price index is computed
(columns 3, 4, and 5). This price index is used to value each inventory layer in Table 2. The price indices in Table
1 are figured by comparing current year prices to the base year prices.
Table 1—Price Indices
1 2 3 4 5
Base Current
Year Amount Year Price
Ending Inventory (1A × $2.50) Amount Index
Year Item Quantity @* (1B × $4.00) (1 × 2) (4 / 3)
Year 1 (base) A 10,000 $2.50 $25,000 $25,000 --
B 6,000 4.00 24,000 24,000 --
Year 1 Total $49,000 $49,000 1.00
Year 2 A 11,600 2.60 $29,000 $30,160 --
B 6,100 4.25 24,400 25,925 --
Year 2 Total $53,400 $56,085 1.05
Year 3 A 12,200 2.95 $30,500 $35,990 --
B 6,200 4.45 24,800 27,590 --
Year 3 Total $55,300 $63,580 1.15
Year 4 A 10,600 ** $26,500 ** --
B 5,800 ** 23,200 ** --
Year 4 Total $49,700 **

* These unit prices may represent the weighted average of all purchase prices paid during the year or the latest price paid.
** No price indices are computed nor new layers added due to inventory liquidation.
Table 2—Valuation of the Ending Inventory, year 2 to year 4:
12/31/yr 2 Layers Index Valuation
Total $ 53,400
Year 1 layer (49,000) $ 49,000 1.00 $49,000
Year 2 layer $ 4,400 4,400 1.05 4,620
Total 12/31 year 2 $ 53,400 $53,620
12/31/yr 3 Layers Index Valuation
Total $ 55,300
Year 1 layer (49,000) $ 49,000 1.00 $49,000
Year 2 layer (4,400) 4,400 1.05 4,620
Year 3 layer $ 1,900 1,900 1.15 2,185
Total 12/31 year 3 $ 55,300 $55,805
12/31/yr 3 Reduction 12/31/yr 4 Index Valuation
Year 1 layer $49,000 $ 49,000 1.00 $49,000
Year 2 layer 4,400 $ 3,700 700 1.05 735
Year 3 layer 1,900 1,900 0 1.15 0
Total 12/31 year 4 $55,300 $ 5,600 $ 49,700 $49,735

Lower of Cost or Market (LCM) or Net Realizable Value (NRV)

The cost basis (specific identification or cost flow assumption) ordinarily achieves the objective of properly
matching inventory costs and revenue. This is only satisfactory, however, as long as the utility of the inventory
equals or exceeds its cost. When the utility of inventory is impaired or otherwise reduced by damage,
deterioration or any other cause, the decline in value should be charged against revenue in the period in which
the decline occurred. The measurement of this decline is accomplished by pricing the inventory at cost or
market and net realizable value, whichever is lower.

10
Under US GAAP, Inventory is valued using two methods:

• Lower of Cost or Market (LCM) - if LIFO or Retail Inventory Method are used

• Lower of Cost or NRV (LCNRV) – if other methods (FIFO, Average Cost) are used

Exhibit 1 } Lower of Cost or Market Rule

Rule of thumb:
Step 1: Compare “ceiling” with “floor” and “replacement costs.”
Step 2: Use middle amount.
Step 3: Compare that middle amount with “cost.”
Step 4: Use lower of the two.

Cost (Historical) $

Market (Take middle of 3):

Replacement Cost = $

Ceiling * $ – $ = $ $ $
(Middle) (Lower)
Floor ** $ –$ = $

* Market Ceiling = Net realizable value = Net selling price less cost to complete and dispose.
** Market Floor = Net realizable value (ceiling) minus normal profit.

Example } 4 Lower of Cost or Market Computation

Information related to Ellis Company’s inventory at December 31 is given in columns 1 through 6. Lower of
cost or market inventory calculations are illustrated in columns 7 through 10. The format shown in Exhibit 1 is
also shown for inventory Item 1.
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Market:
Limited
Replacement by Floor Lower of
Cost Selling Cost of Normal Ceiling Floor and Cost or Market
Item Cost (Market) Price Completion Profit Maximum Minimum Ceiling
(4) - (5) (7) - (6)
1 $ 20.50 $ 19.00 $ 25.00 $ 1.00 $ 6.00 $ 24.00 $ 18.00 $ 19.00 $ 19.00
2 25.00 17.00 30.00 2.00 10.00 28.00 18.00 18.00 18.00
3 10.00 12.00 15.00 1.00 3.00 14.00 11.00 12.00 10.00
4 40.00 55.00 60.00 6.00 4.00 54.00 50.00 54.00 40.00
$ 95.50 $ 103.00 $ 130.00 $ 10.00 $ 23.00 $ 120.00 $ 97.00 $ 103.00 $ 87.00

Item 1 LCM Calculation:

Cost (Historical) $20.50
Market (Take middle of 3):
Replacement Cost = $19.00
Ceiling $25.00 – $1.00 = $24.00 $19.00 $19.00
Floor $24.00 – $6.00 = $18.00 (Middle) (Lower)
If the lower of cost or market is applied on an item-by-item basis, Item 1 would be written down $1.50 and
Item 2 would be written down $7.00. However, Items 3 and 4 would not be written down as their costs are
already lower than market.

11
 Application } 4
The replacement cost of an inventory item is below the net realizable value and above the net realizable
value less the normal profit margin. The original cost of the inventory item is above the replacement cost and
below the net realizable value. As a result, under the lower-of-cost-or-market method, the inventory item
should be valued at the
a. Original cost
b. Replacement cost
c. Net realizable value
d. Net realizable value less the normal profit margin
(b) Market cannot exceed the net realizable value (ceiling) of the good (i.e., selling price less expected costs
to sell), and should not be less than this net realizable value reduced by an allowance for a normal profit
margin (floor). In this problem, the replacement cost is between the ceiling and floor amounts, so it is used as
the market value. Since the original cost is greater than replacement (i.e., market) cost, the item will be
carried at the lower market/replacement cost.

• Applied Per Item or Groups The lower of cost or market rule may be applied either directly to each item, or
to one or more groups of the inventory. If the lower of cost or market rule is applied item by item to each
component in inventory, the lowest possible inventory balance is computed. If the inventory items are
grouped into one or more groups and the LCM applied to each, decreases below cost of some items can be
partially offset by increases above cost of others, resulting in a higher inventory balance.

Example } 5 LCM Applied to Entire Inventory

Based on the information in Example 4, if lower of cost or market is applied to the entire inventory of Ellis
Company, there is no write-down because the total cost of $95.50 is lower than the market of $103.00.
Cost (Historical) $95.50
Market (Take middle of 3):
Replacement Cost = $103.00
Ceiling $130.00 – $10.00 = $120.00 $103.00 $95.50
Floor $120.00 – $23.00 = $ 97.00 (Middle) (Lower)

• Write-downs and Recoveries Write-downs should be charged to expense in the period in which the
conditions giving rise to the write-downs are first recognized. In addition, a write-down of inventory creates a
new cost basis. A previously recorded write-down should not be reversed when the circumstances that gave
rise to the write-down no longer exist. When a market write-down is necessary for finished goods, raw
materials and work-in-process inventories also may have to be written down, unless they are readily
marketable and may be sold for at least cost instead of being used in production.

• Obsolete, Damaged, and Excess Inventories Obsolete, damaged, and excess inventories should be
carried at net realizable value (which may be scrap value), with consideration being given to obsolescence
risks for excess stock.

12
Inventory Estimation Methods
Gross Margin Method

This method assumes that the gross margin (GM) percentage is relatively stable. Cost of goods sold (COGS) is
determined by applying the gross margin ratio to sales and subtracting this amount from the sales figure. Ending
inventory is computed by subtracting the estimated COGS from the actual goods available for sale (GAFS),
obtained from the beginning inventory and purchases accounts.

• Not GAAP The gross margin method is not generally accepted for annual financial reporting.

• Gross Margin Method Use This method is used to (a) verify the accuracy of the year-end physical count,
(b) estimate ending inventory and cost of goods sold for interim financial reporting, and (c) estimate
inventory losses from theft or casualties (fires, floods).

Application } 5
A flash flood swept through Hat, Inc.’s warehouse on May 1. After the flood, Hat’s accounting records showed
the following:
Inventory, January 1 $ 35,000
Purchases, January 1 through May 1 200,000
Sales, January 1 through May 1 250,000
Inventory not damaged by flood 30,000
Gross percentage on sales 40%
What amount of inventory was lost in the flood?
a. $ 55,000
b. $ 85,000
b. $ 120,000
d. $ 140,000
(a) The amount of inventory lost in the flood is calculated by determining the difference between the estimated
ending inventory using the gross margin method and the actual physical inventory not damaged by the flood.
Beginning inventory, January 1 $ 35,000
Purchases, January 1 through May 1 200,000
Goods available for sale 235,000
Sales, January 1 through May 1 $ 250,000
Less: Gross margin (40% × $250,000) (100,000)
Less: Estimated COGS (150,000)
Estimated ending inventory 85,000
Less: Physical ending inventory (30,000)
Estimated flood loss $ 55,000

Retail Method

This method requires records be kept of beginning inventory and purchases for the period both at cost and
retail, any additional markups and markdowns, and sales for the period. The ending inventory at cost is estimated
by converting the ending inventory expressed in retail dollars to cost dollars through the use of a cost/retail ratio.
The retail method is generally applied under one of the three following methods:

• Weighted Average, LCM Retail The weighted average is computed by combining beginning inventory and
net purchases to determine a single cost/retail ratio. The LCM effect is achieved by including net markups,
but not net markdowns, in the denominator of the ratio. This results in a larger denominator for the ratio and,
thus, a lower ratio is obtained. Applying this lower ratio to ending inventory at retail, the inventory is reported
at an amount below cost. This amount is intended to approximate lower of average cost or market.

• LIFO Retail As a LIFO cost flow is assumed, separate cost/retail ratios must be computed for beginning
inventory and net purchases, and LCM need not be used. Therefore, both net markups and net markdowns
are included in the denominator of the purchases’ cost/retail ratio. This results in a smaller denominator for
the ratio and, thus, a higher ratio is obtained.

13
 Weighted Average, LCM Retail LIFO Retail
Approximation of Ending Approximates ending inventory at Approximates ending inventory at
Inventory value LCM Original Cost
Beginning Inventory Included in cost-to-retail ratio Not included in cost-to-retail ratio

Net markups (Increase in Included in cost-to-retail ratio Included in cost-to-retail ratio

selling price above original retail
price, less markup
cancellations)
Net markdowns (Decrease in Not included in cost-to-retail ratio Included in cost-to-retail ratio
selling price below original retail
price, less markdown
cancellations)

• Dollar-Value LIFO Retail Combines retail and dollar-value LIFO methods.

ü Under the dollar-value LIFO retail method, ending inventory at retail is determined in the same manner as
LIFO retail. Ending inventory at retail is then divided by the current price index to determine ending
inventory at retail at base year dollars

ü Ending inventory at retail at base year dollars is then compared to beginning inventory at base year
dollars. If the ending inventory at retail at base year dollars is larger, a new layer has been added; this
layer is converted to current dollars by applying the current price index. If ending inventory at retail at base
year dollars is smaller, liquidation takes place by layers in LIFO order.

ü Any incremental layer for the year, as determined above, is then converted to cost by multiplying it by the
cost/retail for purchases for the period. This layer is then added to the previous LIFO ending inventory at
cost.

14
Example } 6 Retail Methods
The LFGW Company commenced operations on January 1. An external price index is used for dollar-value
LIFO computations. This index was 125 at January 1, and 150 at December 31. The following data was available
from the records of the Company for the year ended December 31:
Cost Retail
Merchandise inventory January 1 $120,000 $200,000
Purchases, net 720,000 990,000
Markups, net 10,000
Markdowns, net 40,000
Sales, net 860,000
Required: Estimate merchandise inventory at December 31 under the following methods:
a. Weighted average, LCM retail
b. LIFO retail
c. Dollar-value LIFO retail
Solution:
a. Weighted Average, LCM Retail:
Cost Retail
Beginning inventory $120,000 $ 200,000
Purchases, net 720,000 990,000
Markups, net -- 10,000
WA/LCM cost/retail ratio $840,000 / $1,200,000 = 70%
Less: Sales, net (860,000)
Markdowns, net (40,000)
Ending inventory at retail $ 300,000
Ending inventory at cost ($300,000 × 70%) $210,000
b. LIFO Retail:
Cost Retail
Beginning inventory $120,000 / $ 200,000 = 60%
Purchases, net 720,000 990,000
Markups, net 10,000
Markdowns, net (40,000)
Purchases cost/retail ratio $720,000 / $ 960,000 = 75%
Goods available for sale $1,160,000
Less: Sales, net (860,000)
Ending inventory at retail $ 300,000
Inventory layer EI at retail Cost/Retail ratio EI at retail cost
Beginning $200,000 × 60% = $120,000
Purchases 100,000 × 75% = 75,000
$300,000 $195,000

c. Dollar-Value LIFO Retail:

Cost Retail

Ending inventory at retail at base year dollars

($300,000 / 1.20*) $ 250,000
Base layer, January 1 year 1 $120,000 (200,000)
Incremental year 1 layer at base year dollars $ 50,000
Incremental year 1 layer at current year dollars
($50,000 × 1.20) $ 60,000
Incremental year 1 layer at cost
($60,000 × 75%) 45,000
Ending inventory, dollar-value LIFO $165,000

*Current year external price index (150 / 125 = 1.20)

15
Firm Purchase Commitment
Legal non-cancelable agreement for future purchase of inventory
When there is a firm commitment to purchase goods in a future period at a set price (i.e., an enforceable
contract exists), any loss resulting from a drop in the market value of such goods, or cancellation of the contract
by the purchaser, should be recognized in the current period. There should be a note describing the nature of
the contract.

Exhibit 2 } Journal Entries for a Loss on Purchase Commitment

Loss on Purchase Commitment (PC) (Contract price – FV)
Allowance for Loss on PC (Contract price – FV)
Inventory (or purchases) (Current FV)
Allowance for Loss on PC (Allowance account balance)
Cash (Contract price)
Had there been a further change in FV, it would be recorded by crediting or debiting an unrealized income (or
loss) account, as appropriate.

Disclosures
Common Disclosures
The following disclosures should be made in the financial statements or accompanying notes:

• The basis of determining inventory amounts (e.g., the lower of cost or market) and the method of cost deter-
mination (e.g., first-in, first-out (FIFO), last-in, first-out (LIFO), average cost), including dollar amounts or
percentage of inventories priced using each method. The basis for stating any inventories at amounts that
are above cost (e.g., precious metals, and so forth) should also be disclosed.

• Amounts of major classes of inventories. For manufacturing companies, the categories, typically, would be
raw materials, work-in-process, and finished goods. If it is not practical under a LIFO method to determine
amounts assigned to major classes of inventories, the amounts of those classes may be stated under cost
flow assumptions other than LIFO, with the excess of such total amount over the aggregate LIFO amount
presented as a deduction to arrive at the amount of the LIFO inventory.

• When the LIFO method is used the dollar amount of inventory at current (e.g., FIFO) or replacement cost, or
the excess of that amount over the stated LIFO value, and the basis of determining the current or replace-
ment cost amount. In SEC filings, the excess of replacement or current cost over the stated LIFO value
must be disclosed. Also, the effects on income of the liquidation of LIFO inventories and, for interim periods,
the amount of any provision for temporary liquidation.

• The amount of any material, substantial and unusual write-downs resulting from the application of the lower
of cost or market rule (identified separately from cost of goods sold in the income statement), including
provisions for accrued net losses on firm, non-cancelable, and unhedged purchase commitments for
inventories (identified separately in the income statement)

• Reserves resulting from inventory write-downs should be netted against the inventory amounts and desirably
not disclosed

• Significant market declines after the balance sheet date not recognized in pricing the inventories

• Unusual or unusually significant purchase commitments

• Changes in pricing methods and the effects thereof

• Liens against and pledges of inventories

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Additional Disclosures
The following additional disclosures may be desirable to help explain differences in reported net income:

• The method used in applying LIFO (e.g., dollar value, link chain method).

• The approach used to price LIFO inventory increments (e.g., most recent acquisition price)

• Pooling arrangements (e.g., a natural business unit pool)

• The method used to price new items added to existing pools (e.g., reconstructed cost)

• Other significant LIFO methods or approaches, when alternatives exist

• Differences between the book and tax basis of LIFO inventories

• Differences between the application of LIFO for financial reporting and for income tax purposes

• Supplemental non-LIFO disclosures (e.g., disclosures pertaining to earnings information that would have
been presented using a method other than LIFO in the financial statements)

Review of US GAAP vs IFRS

US GAAP IFRS
Inventory Valuation LCM or LCNRV LCNRV

Inventory Cost Flow Assumptions LIFO Allowed LIFO not Allowed

Interest costs on Inventory Exclude Exclude, with exceptions (lengthy
production period)

Impairment Reversal Previously recognized impairment Previously recognized impairment

losses are not allowed to be losses allowed to be reversed
reversed

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