advance accounting ebook - part 9

8/13/2019 Advance Accounting eBook - Part 9

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Advanced Accounting E-Book

Part 9 of 12


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Discussion topics

Inventory Accounting

Types of Inventory

Classification of Inventory

Lower of the Cost or Market (LCM)

Methods of Inventory Accounting

First-In First-Out (FIFO)

Last-In First-Out (LIFO)

Weighted average costing

Financial Statement Effects

Stable Prices Environment

Rising Prices and Increasing or Stable Inventory

LIFO /FIFO Conversion

LIFO to FIFO Conversion

FIFO /Weighted Average to LIFO Conversion

Analytical adjustments to Inventory

Profitability / Liquidity / Solvency

Caterpillar Inc, Case Study

Other Important Topics

LIFO Reserve Declines

Changes in Inventory Accounting Methods


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Types of Inventory

What is Inventory?

Inventory for a merchandise business?

Finished goods?

Inventory for a Car Manufacturing Firm?

Raw Material?

Finished Goods?

Work-in-Process?


Raw Material: Purchased materials, component parts, & subassemblies

Work-in-Process: Materials that have entered the manufacturing process & are being worked on orwaiting to be worked on

Finished Goods Inventory: Finished products of the production process that are ready to be sold ascompleted items

Should we include goods in transit for inventory? Goods in transit belong to the party holding legal ownership

Goods sold FOB (Free on Board) Destination: Goods sold do not belong to the purchaser until theyarrive at their final destination

Goods sold FOB (Free on Board) Shipping Point: Goods sold become property of the purchaser onceshipped by the seller


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Classify the following in different types of Inventory

Yes No Raw Material Work-in-Progress Finished Goods

Finished Cars awaiting for sale

Cars under production that has been

bulk ordered by XYZ company and

deposit has been made

Finished Cars shipped to the dealer,

FOB Destination

Finished Cars shipped to the dealer,

FOB Shipping point

Gears in the company Warehouse

Rolled Sheets in the company

warehouse

Inventory CategoryCar Manufacturer


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Inventory costs are reported either on the balance sheet or they are transferred to theincome statement as an expense to match against sales revenues

When inventories are used up in production or are sold, their cost is transferred from thebalance sheet to the income statement as cost of goods sold

BASE Relationship

Beginning Additions Sold+ =

What we end up with

What we have for selling

Ending+

What we sold

Beginning Inventory

Purchases

Sold Goods

Sold Goods

Ending Inventory


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Lower of the Cost or Market (LCM)

Companies must write down the carrying amount of inventories on the balance sheet if thereported cost exceeds market value

This process is called reporting inventories at the lower of cost or market and creates thefollowing financial statement effects:

Inventory book value is written down to current market value (replacement cost); reducing inventory andtotal assets

Inventory write-down is reflected as an expense on the income statement

However, if the replacement cost is rising, the holding gains in the value of inventory are ignored and theinventory is valued at cost

Example

Assume that a company has inventory on its balance sheet at a cost of $55,000 and the managementlearns that the inventorys replacement cost is $48,000

As per the LCM method management writes inventories down to a balance of $48,000.

Assets Liability Shareholders Equity= +

$7,000 flows throughthe Income Statementas expense

$7,000 Inventorywrite-down


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First-In First-Out (FIFO)

This method assumes that the first units purchased are the first units sold

The cost of most recent purchases is assigned to ending inventory

Last-In First-Out (LIFO)

The LIFO inventory costing method assumes that the last units purchased are the first to be sold

The costs of beginning inventory and earlier purchases go to ending inventory

Weighted average costing

This method assumes that the units are sold without regard to the order in which they are purchased

Instead, it computes COGS and ending inventories as a simple weighted average

Example

Summary Inventory Records No. of units $/unit Total cost

Inventory on January 1st, 2006 600 100 60,000

Inventory purchased in 2006 200 150 30,000

Cost of goods available for sale in 2006 800 90,000

Inventory sold in 2006 550 250 137,500

Calculate gross profit for the following methods of inventory valuation

a) FIFO

b) LIFO

c) Weighted Average Costing

Also show the Balance sheet and Income Statement Flow


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FIFO:

Calculation of gross profit

Balance Sheet Effect

LIFO:




$55,000 flowsthrough the IncomeStatement as expense

$55,000

cost of goods sold

FIFO

Sales 137,500

COGS (550 @ $100) (55,000)

Gross Profit 82,500

Inventory cost as on January 1st,2006 is taken

LIFO

Sales 137,500

COGS (200 units @ $150) (30,000)COGS (350 units @ $100) (35,000)

Gross Profit 72,500



$65,000

cost of goods sold

Last purchased inventory taken firstand the remaining from the

beginning of the year inventory


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Weighted Average Cost

Calculation of Weighted average cost



Summary



$61,875

cost of goods sold

Weighted average cost taken as per

calculation above

Total cost 90,000

Total units 800

Average cost 112.5

Weighted Average cost

Sales 137,500

COGS (550 @ $112.5) (61,875)

Gross Profit 75,625

Summary COGS Ending Inventory

FIFO Costing 55,000 35,000

LIFO Costing 65,000 25,000

Average Costing 61,875 28,125

FIFO:200*150+50*100 = $35,000

LIFO:=250*100 = $25,000

Average Costing: = 112.5 * 250 = $28,125


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In an environment of Stable Prices

All three inventory valuation methods (FIFO, LIFO and Weighted Average costs) will yield the sameresults for Inventory, COGS and Earnings

In an environment of Rising Prices and Increasing or Stable Inventory

Item LIFO FIFO

COGS Higher Lower

Ending Inventoryand Working Capital

Lower as inventory reflects the pricesof items purchased at lower prices

Higher as inventory reflects the mostrecently purchased items

Net WorthLower because earnings and inventory

is lowerHigher because earnings and inventory

is higher

Taxes Lower Taxes Higher Taxes

Earnings Lower because COGS is higher Higher because COGS is lower

Pre-tax Cash Flows Same Same

After-tax Cash flows Higher because of lower tax outgo Lower because of higher tax outgo


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LIFO /FIFO Conversion


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US GAAP requires that all companies that use LIFO to also report a LIFO reserve

LIFO reserve is the difference between what their ending inventory would have been underLIFO accounting and its value under LIFO

LIFO Reserve

Converting LIFO to FIFO (Quick Method)

Converting LIFO to FIFO (Long Method)

LIFO Reserves Inventory (FIFO) Inventory (LIFO)= -

COGS (FIFO) COGS (LIFO) LIFO Reserve (end)= - LIFO Reserve (begin)-

Change in LIFO Reserves

Purchases Ending Inv (LIFO) Beginning Inv (LIFO)= - COGS+

COGS (FIFO) Purchases Beginning Inv (FIFO)= + Ending Inv (FIFO)-

Ending Inv (FIFO) Ending Inv (LIFO) LIFO Reserve (end)= +

Begin Inv (FIFO) Begin Inv (LIFO) LIFO Reserve (begin)= +


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Example : LIFO to FIFO conversion

Kappa Corp. uses LIFO inventory accounting. The footnotes to 2007 financial statements contain the following

2006 2007

COGS 50,000 60,000

LIFO Inventory 400,000 460,000

Less LIFO Reserves 42,000 45,000

Calculate Kappa's 2007 COGS under FIFO

Long Method

Purhcases (2007) 120,000Ending Inv (2007,FIFO) 505,000

Beginning Inv (2007,FIFO) 442,000

COGS (2007,FIFO) 57,000

=-($45,000 - $42,000)

=Beginning Inv +Purchases Ending Inv

= $400,000 + $42,000

= $460,000 + $45,000

= $460,000 + $60,000 -$400,000

Quick Method

Change in LIFO Reserves (2007) (3,000)

COGS (2007, FIFO) 57,000


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FIFO /Weighted Average to LIFO Conversion

FIFO to LIFO Conversion

Use the following formula

Weighted Average to LIFO Conversion

Average cost method always reports inventory values and cost of goods sold between values reportedfrom FIFO and LIFO

Hence, the adjustment is done by a factor of 2

Inflation is calculated using two methods

Industry Statistics: Inflation rate of the appropriate industry and not a general inflation rate for the

economy Company Statistics:Increase in LIFO reserve for another company in the same industry divided by that

companys beginning inventory converted to FIFO accounting

COGS (LIFO) COGS (FIFO) Begin Inventory (FIFO) X Inflation= +

FIFOinvBeginning

reservesLIFOinchangeInflation

__

___

COGS (LIFO) COGS (Wgt Avg) (1/2) X Begin Inventory (Wgt Avg) X Inflation= +


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FIFO /LIFO Conversion

Estimating Inflation

Estimating COGS

COGS (LIFO) = COGS (FIFO) + Begin Inv X Inflation Rate COGS (LIFO) = $20,000 + $3,500 X 0.7% = $20,023

Example : FIFO to LIFO conversion

Gamma is in the same industry as Kappa. Gamma uses FIFO accounting and has COGS of $20,000, ending inventory

of $5,000 and beginning inventory of $3,500

Kappa Corp 2006 2007

COGS 50,000 60,000

LIFO Inventory 400,000 460,000

Less LIFO Reserves 42,000 45,000

Calculate Gamma's COGS under LIFO

%7.0442000

3000

)42000400000(

)42000000,45(

__

___

FIFOinvBeginning

reservesLIFOinchangeInflation


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Analytical adjustments


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Analytical adjustments

Profitability

LIFO produces higher COGS balances and are better measure of true economic costs

In an environment of rising prices, LIFO produces income that are lower than FIFO

Gross margins and profit margins are lower due to lower income under LIFO

For FIFO firms, profitability ratios should be recalculated using estimates of what COGS wouldhave been under FIFO

Liquidity FIFO produces inventory figures that are higher and are a better measure of economic value

LIFO, however, uses prices that are outdated (in an environment of rising prices)

Liquidity ratios such as current ratios are higher under FIFO than in LIFO

For LIFO firms, Liquidity ratios should be recalculated using inventory balances that have beenrestated using LIFO reserve

Solvency

Solvency ratio like debt ratio, debt-to-equity ratio will be lower under FIFO because of higher denominator

For firms that use LIFO, ratios should be calculated using asset and equity figures restated byusing LIFO reserve


LIFO Reserve LIFO Reservex Tax Rate

LIFO Reservex (1-Tax Rate)


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Analytical treatment of Inventory

Take care of all theanalyst specific

adjustments whilecalculating the ratios

Balance Sheet 2006 2007

Cash 7,500 8,750

Accounts Receivables 10,000 12,500

Inventories 17,500 13,750

Plants and Equipments 36,250 37,500

Total Assets 71,250 72,500

Short-term Debt 6,250 5,000

Long-term Debt 25,000 25,000

Common Stock 6,250 6,250Additional Paid-in Capital 12,500 12,500

Retained Earnings 21,250 23,750

Total Liabilities & Capital 71,250 72,500

Income Statement 2006 2007

Sales 68,750 75,000

COGS (51,250) (53,750)

Interest Expense (1,875) (1,875)

Pretax Income 15,625 19,375

Income Taxes (40%) (6,250) (7,750)

Net Income 9,375 11,625

Note: a) Company uses LIFO inventory method

b) LIFO reserves for 2002 and 2003 is $500 and $650, resp

Calculate the following

a) FIFO Inventory for 2006 and 2007 and COGS for 2007 into FIFO

b) Calculate the net profit margin, current ratio, inventory turnover, and long term debt-to-equity

ratio using the accounting figures that are most appropriate to compare to industry

Example : Inventory Adjustments


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Analytical treatment of Inventory

FIFO Inventory

Calculating COGS

Calculating Ratios

FIFO inventory (2006) 18,000

FIFO inventory (2007) 14,400

Quick method

COGS 53,750

change in LIFO reserves (150)

COGS (FIFO) 53,600

Long method

Purchases 50,000

Ending Inv (FIFO) 14,400

Beginning Inv (FIFO) 18,000

COGS (FIFO) 53,600 = $11,625/$75,000

= ($8,750 + $12,500+$13,750+ $650)/5000

= ($53,750/($18,000+$14,400)/2)

= $25,000/($23,750 +$650*(1-40%))

Profit Margin (2007) Net Income under LIFO / Sales

Profit Margin (2007) 15.5%

Current Ratio (2007) Current assets under FIFO/Current liabilities

Current Ratio (2007) 7.1

Inventory turnover (2007) COGS under LIFO/Avg. inventory under FIFO

Inventory turnover (2007) 3.3

Debt-to-equity (2007) Long term debt / (equity under FIFO)

Debt-to-equity (2007) 103.6%


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Please analyze the Caterpillar (CAT) 2003 10K for Inventory adjustments

Answer the following:

Which method of inventory valuation does CAT follow?

Determine COGS using LIFO and FIFO for 2003?

Find the analyst adjusted profit margin?

Find the analyst adjusted current ratio?

Find the analyst adjusted inventory turnover?

Find the analyst adjusted Debt-to-Equity ratio?


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Other Important Topics


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LIFO Reserve Declines

Usually LIFO Reserves increases from year to year due to an increasing volumes of inventory

and rising price levels

However, sometimes LIFO reserves may decline and COGS sold will be lower and Net Incomewill be higher

Interpretation would depend on the reason why the LIFO reserve declined

There could be two reasons of such a decline

Inventory Liquidation

If there is a physical inventory liquidation, we should restate COGS and Income to eliminate the impact ofdecline in LIFO reserves

Reported results are distorted due to inclusion of low cost-LIFO inventory

LIFO liquidations occurs mostly in times of economic distress

Strike or Recession might cut production faster than sales are decreasing to reduce inventories

Footnotes generally carry information regarding LIFO liquidation so that we can eliminate excess profits

Declining Prices

If LIFO reserve declines because the prices of the inventory items are declining, we do not adjust thereported COGS or Net Income

LIFO will produce higher profits than FIFO and cash flow will be affected by higher tax outgo


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Changes in Inventory Accounting Methods

Change from FIFO to LIFO

The change is only made prospectively

A retrospective restatement or disclosure of cumulative effect are not required

The firm is only required to disclose in its footnotes the effect on current period net income and netincome before extraordinary items

Change from LIFO to FIFO

All reported prior financial data must be restated retroactively to reflect FIFO accounting

Cumulative effect of the accounting change on prior periods must be credited to retained earnings atthe beginning of the earliest restated year

All reserves become taxable immediately at the time the change is made

Negative impact on net after-tax cash flow


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Sum up..


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