Grant, Munter & Robinson
Chapter 11 2
Learning Objectives
• Understand the methods for determining inventory values and cost of goods sold
• Understand LIFO layers and liquidation
• Adjust statements for differences in inventory methods
• Explain the impact of capitalization of costs in inventory
Grant, Munter & Robinson
Chapter 11 3
Inventory BasicsCost Flow
BeginningInventory
GoodsPurchased
GoodsAvailable
ForSale
EndingInventory
Cost ofGoods Sold
Balance Sheet Income Statement
Grant, Munter & Robinson
Chapter 11 4
Inventory BasicsCost of Goods Sold
• Periodic Accounting System– Sales and purchases are recorded as they occur
– COGS is recorded at the end of the period after a physical count of ending inventory has been taken
– BI + Purchases (= COGAS) – EI = COGS
• Perpetual Accounting System– COGS is recorded at the time of the sale
– BI + Purchases (= COGAS) – COGS = EI
– Still take physical count to verify EI
Grant, Munter & Robinson
Chapter 11 5
Inventory BasicsMethods
• Specific Identification– Exactly identify which units were sold and
which were still on hand at the end of the period
– Large, expensive, easily identified items
• First-in-first-out (FIFO)– Assume oldest units (beginning inventory) are
sold first– Most recent purchases are in ending inventory
Grant, Munter & Robinson
Chapter 11 6
Inventory BasicsMethods
• Last-in-first-out (LIFO)– Assume newest items are sold first– Oldest items remain in ending inventory– Increases COGS in periods of rising prices
• Average cost– Average cost of a unit sold = $COGAS/# units
available for sale– Use when individual items are indistinguishable
Grant, Munter & Robinson
Chapter 11 7
Inventory BasicsExample
• Beginning inventory consists of 1,000 units at at cost of $5.00 each ($5,000 total)
• 10,000 units were purchased at a cost of $6.00 each
• 2,000 units remain in ending inventory
• 9,000 units were sold for $10.00 each
Grant, Munter & Robinson
Chapter 11 8
Inventory BasicsExample
Units FIFO LIFO Average cost
Beginning Inventory
1,000 $ 5,000 $ 5,000 $ 5,000
Purchases 10,000 60,000 60,000 60,000
Goods Available
11,000 65,000 65,000 65,000
Ending Inventory
2,000 12,000 11,000 11,818
Goods Sold 9,000 53,000 54,000 53,182
Grant, Munter & Robinson
Chapter 11 9
Impact of FIFO on Financial Statements
• Ending inventory always consists of the company’s most recent purchases.
• FIFO COGS does not necessarily reflect current market conditions.
• Holding gains occur when older, lower cost items are sold at current prices.
• In industries with declining prices (technology) holding losses can occur.
Grant, Munter & Robinson
Chapter 11 10
Impact of LIFO on Financial Statements
• LIFO provides a matching of current revenues and current costs on the income statement.
• Inventory amount on balance sheet does not reflect current costs.
• LIFO layers are added (liquidated) in every period in which purchases exceed (are less than) sales.
Grant, Munter & Robinson
Chapter 11 11
Comparison of LIFO and FIFO
• In periods of rising (falling) prices, the LIFO method normally results in lower (higher) gross profit than FIFO.– Except when LIFO layers are liquidated
• The LIFO Conformity Rule requires companies using LIFO for tax purposes to use LIFO for financial reporting as well.
Grant, Munter & Robinson
Chapter 11 12
Comparison of LIFO and FIFO
• LIFO reserve = FIFO inventory value – LIFO inventory value.
• When prices are rising and LIFO layers are added, the LIFO reserve will increase.
• Similarly, layers will be depleted when the LIFO reserve decreases.
Grant, Munter & Robinson
Chapter 11 13
Implications of Inventory Methods for Financial Analysis
• Caution must be used when net income (plus depreciation) is used to estimate cash flow because it:
• Overstates operating cash flow when prices are rising and the company is using FIFO
• Not useful for either LIFO or FIFO when old inventory layers are depleted
Grant, Munter & Robinson
Chapter 11 14
Implications of Inventory Methods for Financial Analysis
• ROA is lower under LIFO when prices are rising and no LIFO layers have been depleted
• LIFO inventory turnover seems to improve when prices are rising; numerator is higher (more current COGS) while denominator is lower (reflecting older costs)– Can adjust ratio: COGSLIFO/Avg. InventoryFIFO
Grant, Munter & Robinson
Chapter 11 15
Financial AnalysisPeer Comparisons
• If a company is using FIFO or average cost, there is no requirement to present comparable LIFO data.
• Adjustments should be made when subject company does not use the same inventory valuation methods as comparator firms or the industry.
• Using LIFO on the income statement and FIFO on the balance sheet can provide a clearer picture of operating performance.
Grant, Munter & Robinson
Chapter 11 16
Financial AnalysisManagement Decisions
• To avoid liquidation of LIFO layers – and the corresponding higher income tax payment – managers may purchase excess inventory.– Inventory could become obsolete.
• If earnings estimates will not be met, managers may defer inventory purchases, causing a LIFO liquidation and artificially inflating profits.– Income tax payments will also increase.
– May lose sales as a result of insufficient inventory.
Grant, Munter & Robinson
Chapter 11 17
Financial AnalysisMultiple Methods
• Neither LIFO nor FIFO needs to be used exclusively.
• LIFO can be applied to those portions of inventory where the company expects to derive benefits from doing so.
• LIFO may be applied to pools of different items or to individual items of inventory.
• LIFO liquidations are less likely to occur when firms pool inventory.
Grant, Munter & Robinson
Chapter 11 18
Adjusting Financial Statement DataLIFO
Beginning Inventory BI LIFO
Plus: Purchases Purchases
Goods Available for Sale BI LIFO + Purchases
Less: Ending Inventory EI LIFO
COGS BI LIFO+Purchases-EI LIFO
Grant, Munter & Robinson
Chapter 11 19
Adjusting Financial Statement DataConvert LIFO to FIFO
Beginning Inventory BI LIFO+Beginning LIFO Reserve
Plus: Purchases Purchases
Goods Available for Sale BI LIFO + Beginning LIFO Reserve + Purchases
Less: Ending Inventory EI LIFO+Ending LIFO Reserve
COGS BI LIFO+Purchases-EI LIFO -Ending LIFO Reserve+ Beginning LIFO Reserve
Grant, Munter & Robinson
Chapter 11 20
Adjusting Financial Statement Datafrom LIFO to FIFO
• Starting with LIFO data
• EI FIFO = EI LIFO + Ending LIFO Reserve
• COGS FIFO=
BI LIFO
+ Purchases
- EI LIFO
± Decrease/(Increase) in LIFO Reserve
• Or, COGS LIFO ± Decrease/(Increase) in LIFO Reserve
Grant, Munter & Robinson
Chapter 11 21
Adjusting Financial Statement Datafrom LIFO to FIFO
• The following accounts will be adjusted
• Cost of goods sold
• Gross profit
• Income taxes
• Net income (and Retained earnings)
• Inventory (Current and Total assets)
• Deferred income taxes
Grant, Munter & Robinson
Chapter 11 22
Why use LIFO?
• Improve cash flow in periods of rising prices.– Tax deferral
• Better matching of current operating costs to revenues.
• No benefit from LIFO if– No tax due
– Immaterial, rapidly turning or declining prices of inventory
– LIFO is costly to maintain
Grant, Munter & Robinson
Chapter 11 23
Inventory Method Changes
• Tax regulations restrict changes– May require IRS approval
• If adopting LIFO, existing inventory value becomes first LIFO layer
• If switching from LIFO all periods in the financial statements must be restated
Grant, Munter & Robinson
Chapter 11 24
Costs to Capitalize
• IAS No. 2: Cost of inventories can include:• All costs of purchase
– Including taxes, transportation, discounts…
• Costs of conversion– Direct labor and direct overhead
• Other costs incurred in bringing inventories to their present location and condition– Indirect overhead, product design costs
Grant, Munter & Robinson
Chapter 11 25
Do Not Capitalize
• IAS No. 2: Cost of inventories exclude:
• Abnormal waste (materials, labor and OH)
• Storage costs except as part of production
• Administrative overhead
• Selling expenses
• Note: US GAAP is similar to IAS regarding capitalization of inventory costs
Grant, Munter & Robinson
Chapter 11 26
Service Firms
• Capitalize as inventory:
• Labor and other costs directly related to providing services– Including supervisory personnel
• Accumulate costs in inventory
• Expense when related revenues are reported
Grant, Munter & Robinson
Chapter 11 27
Tax Rules
• In the US, tax rules (§263A) require additional capitalization of indirect costs
• Storage and warehousing
• Depreciation
• Quality control
• A portion of General and Administrative costs
Grant, Munter & Robinson
Chapter 11 28
Inventory Overstatement
• Overstating ending inventory will overstate earnings– Include obsolete or nonexistent inventory– MiniScribe Corp. shipped bricks instead of disk
drives
• Firms may capitalize costs that should be expensed
Grant, Munter & Robinson
Chapter 11 29
Declines in Inventory Cost
• Inventory is reported at the lower of cost or market value
• When current market values fall below cost, the adjustment is to inventory and cost of goods sold
• Can lead to managerial manipulation