inventories revsine/collins/johnson: chapter 9. rcj: chapter 9 © 2005 2 learning objectives 1.the...

Inventories

Revsine/Collins/Johnson: Chapter 9

2RCJ: Chapter 9 © 2005

Learning objectives

1. The two methods used to determine inventory quantities—perpetual and periodic.

2. What kinds of costs are included in inventory.

3. What absorption costing is and how it complicates financial analysis.

4. The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO.

5. How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis.


Learning objectives concluded

6. How LIFO liquidations distort gross profit.

7. What research tells us about why some firms use LIFO and others don’t.

8. How to eliminate realized holding gains from FIFO income.

9. How and when to use the lower of cost or market method.

10.How and why the dollar-value LIFO method is applied.


Inventory types

Wholesaler or retailer: Manufacturer:

Manufacturer

Merchandise inventory

Customer

Raw materials

Work-in-process

Finished goods

Supplier

Customer

Includes other manufacturing costs

Firm

Firm


Overview of accounting issues

What kind of costs are included in inventory?

How is the cost of goods available for sale split between the balance sheet and the income statement?

Old unit New unit

Issue:

Issue:


Overview of accounting issues:Allocating the cost of goods available for sale

Weighted average approach:Uses the average cost of the two units.

Oldest unit cost flows to income.First-in, first-out (FIFO) approach:

Uses the average cost of the two units.

FIFO produces a smaller expense

Newest unit cost flows to income.

Last-in, last-out (LIFO) approach:

LIFO produces a larger expense

Oldest unit cost flows to income.


Overview of accounting issues:Summary

Weighted average

FIFO

LIFO

GAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory.

If the cost of inventory never changes, all three cost flow assumptions would yield the same financial statement result.

No matter what assumption is used, the total dollar amount assigned to the balance sheet and the income statement is the same ($640 in this example).

Three methods for allocating the cost of goods available for sale:


Overview of accounting issues:Unanswered questions

How should physical quantities in inventory be determined?

What items should be included in ending inventory?

What costs should be included in inventory purchases (and eventually in ending inventory)?

What cost flow assumption should be used for allocating goods available for sale between cost of goods sold and ending inventory?


Determining inventory quantities:Perpetual inventory system

This approach keeps a running (or “perpetual”) record of the amount of inventory on hand.

The inventory T-account under a perpetual inventory system looks like this:

Entries are made as units are purchased

Entries are made as units are sold


Determining inventory quantities:Periodic inventory system

This approach does not keep a running (or “perpetual”) record of the amount of inventory on hand.

Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period.

Entries are made as units are purchased


Determining inventory quantities:Journal entries illustrated


Determining inventory quantities:T-accounts illustrated


Determining inventory quantities:Periodic and perpetual compared

Less recordkeeping means lower cost to maintain.

Less management control over inventory.

COGS is a “plug” figure and there is no way to determine the extent of inventory losses (“shrinkage”).

Typically used when inventory volumes are high and per-unit costs are low.

More complicated and usually more expensive.

Does not eliminate the need to take a physical inventory.

Better management control over inventories including “stock outs”.

Typically used for low volume, high unit cost items (e.g., automobiles) or when continuous monitoring of inventory levels is essential.

Periodic inventory Perpetual inventory


Items included in inventory

In day-to-day operations, most firms record inventory when they physically receive it.

However, when it comes to preparing financial statements, the firm must determine whether all inventory items are legally owned.

Goods in transit may be “owned” by the buyer or the seller. The party that has legal title during transit will record the items as

inventory.

Consignment goods should not be counted as inventory for the consignee.

Consignor Consignee Customerconsigned

goods SaleOwner Agent


Costs included in inventory All costs required to obtain physical possession of the inventory

and to make it saleable. Purchase cost Sales taxes and transportation paid by the buyer Insurance costs Storage costs Production costs (labor and overhead) for a manufacturer

In theory, inventory costs should also include the (indirect) costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory.

However, most firms exclude these items and limit inventory costs to direct acquisition and processing costs.


Costs included in inventory:Manufacturing costs


Costs included in inventory:Absorption costing versus variable costing

Variable production

costs

Fixed production

costs

Variable production

costs

Variable costing of inventory (not

allowed by GAAP)

Absorption costing of inventory (required by

GAAP)

Manufacturing rentals and depreciation

Property taxes

Raw materials Direct labor Variable overhead, like

electricity


Costs included in inventory:Summary

These are never included in inventory.

This approach is not allowed by GAAP.


Costs included in inventory:How absorption costing can distort profitability

As we shall see, the GAAP gross margin increases from $110,000 in 2005 to $130,000 in 2006 even though variable production costs and selling price are constant, and sales revenue has fallen.

Selling prices and costs are constant


Costs included in inventory:Absorption costing distortion

Variable cost (given):

Fixed cost, $400,000/100,000:

Total cost:

$3.00/unit

$4.00/unit

$7.00/unit

Variable cost (given):

Fixed cost, $400,000/125,000:

Total cost:

$3.00/unit

$3.20/unit

$6.20/unit


Costs included in inventory:Variable costing illustration

Under variable costing the gross margin falls


Cost flow assumptions:The concepts

In a few industries, it is possible to identify which particular units have been sold. Examples include jewelry stores and automobile dealerships. These firms use specific identification inventory costing.

For most firms, however, a cost flow assumption is required.


Cost flow assumptions:What assumptions firms use


Cost flow assumptions:First-in, First-out (FIFO) illustrated

The computations are:


Cost flow assumptions:First-in, First-out (FIFO)

Oldest units assumed sold

Newest units assumed still

on hand


Cost flow assumptions:Last-in, First-out (LIFO) illustrated

The computations are:


Cost flow assumptions:Last-in, First-out (LIFO)

Newest units assumed sold

Oldest units assumed still

on hand


Cost flow assumptions:Inventory holding gains

LIFO and FIFO are historical cost methods and they overlook inventory holding gains:

Current cost accounting records holding gains as they arise (but it is not permitted under GAAP).

To record inventory holding gain under current cost accounting (not GAAP).


Cost flow assumptions:Inventory holding gains (continued)

Once the holding gains entry has been made:

When the unit is sold for $500:

Both now shown at current cost -but this is not GAAP!


Cost flow assumptions:Inventory holding gains summary

Holding gain flows to income

Holding gain still on balance sheet


Cost flow assumptions:LIFO and inventory holding gains

Usually (but not always) the same; however balance sheets are very different.

Holding gain remains on balance sheet


Cost flow assumptions:FIFO and inventory holding gains

FIFO automatically includes the holding gain on units that are sold.


Cost flow assumptions:The LIFO reserve disclosure

Amount actually

shown on balance sheet

Amount shown on balance sheet if FIFO had been used


Cost flow assumptions:Converting from LIFO to FIFO

If FIFO had been used


Cost flow assumptions:Partial LIFO use

So, the LIFO reserve decreased $4,538 during the year.

FIFOLIFO COGS538,4$COGS

Ending LIFO

reserve

Beginning LIFO

reserve


Cost flow assumptions:Another LIFO footnote

LIFO reserve at Finlay Enterprises


LIFO and inflation:LIFO reserve

Magnitude of LIFO Reserves

Modest inflation

Percentage Change in Consumer Prices


LIFO and inflation:LIFO earnings effect

Magnitude of LIFO Earnings Effect

Percentage Change in Consumer PricesModest inflation


When a LIFO firm liquidates old LIFO layers, the net income number under LIFO can be seriously distorted.

Old LIFO layers that are liquidated are “matched” against sales dollars that are stated at higher current prices.

LIFO liquidation

10 units at $300 each






45 units at $600 eachCurrent purchases

3rd layer

2rd layer

1st layer

Goods available

LIFO cost of goods sold

80 units

were soldHow old LIFO cost distorts COGS


LIFO liquidation:Illustration

Old LIFO layers


LIFO liquidation:Calculation of LIFO liquidation profits

What the per unit COGS would have been without the liquidation


LIFO liquidation disclosures

Income tax effect ($910,000) was the difference.

From footnote


LIFO liquidation:Gross profit distortion

Improving gross margin was reported

But the improvement was due to LIFO liquidation


LIFO liquidation:Frequency and earnings impact

Percentage of manufacturing and merchandising firms using LIFO and experiencing a LIFO liquidation

Percentage of firms with LIFO liquidations experiencing a positive, negative, or immaterial effect on pre-tax earnings


LIFO liquidation:Percentage impact on pre-tax earnings

Pre-tax earnings effect of LIFO liquidations with positive effects on earnings


Eliminating LIFO ratio distortions:Current ratio example

Understated because of LIFO

LIFO reserve adjustment restates inventory to approximate current cost.


Eliminating LIFO ratio distortions:Inventory turnover example

Distorted by LIFO liquidation


Tax implications of LIFO U.S. tax rules specify that if LIFO is used for tax purposes, LIFO must also

be used in external financial statements.

This LIFO conformity rule explains why so many firms use LIFO for financial reporting purposes.


Eliminating realized holding gains for FIFO firms

Reported income for FIFO firms always includes some realized holding gains during periods of rising inventory costs.

The size of the FIFO realized holding gain depends on: How fast input costs are changing. How fast inventory turns over during the period.

x 10% cost increase

Replacement COGS = 7,900,000 + 100,000

= 8,000,000Realized FIFO holding gain


Inventory errors

Due to a miscount in 1995, ending inventory is overstated by $1 million. Here’s the effect:

If not detected and corrected, here’s how the 2005 error will effect 2006 results:


Analytical insights:LIFO dangers

LIFO makes it possible to “manage” earnings when inventory costs are rising!

How? Accelerate inventory purchases toward the end of a “good” earnings

year so that COGS increases.

Delay inventory purchases toward the end of a “bad” earnings year so that COGS decreases when old LIFO layers are liquidated.


Reasons why some companies do not use LIFO

The estimated tax savings is too small.

Business cycles may cause extreme fluctuations in physical inventory levels.

The rate of inventory obsolescence is high.

Managers may want to avoid reporting lower profits because they believe doing so will lead to:

Lower stock price Lower compensation from earnings-based bonuses Loan covenant violations

Small firms may not find LIFO economical because of high record-keeping costs.


Summary

Absorption costing can lead to potentially misleading trend comparisons.

GAAP allows firms latitude in selecting a cost flow assumption. Some firms use FIFO, others use LIFO, and still others use weighted-average.

This diversity can hinder comparisons across firms, thus its often useful to convert LIFO firms to a FIFO basis.

Reported FIFO income includes potentially unsustainable realized holding gains.


Summary concluded

Similarly, LIFO liquidations produce potentially unsustainable realized holding gains.

Old, out-of-date LIFO layers can distort various ratio comparisons.

Users must understand these inventory accounting differences and know how to adjust for them. Only then can valid comparisons be made across firms and over time.


Appendix B:Lower of cost or market

Inventory is presumed to be impaired when its replacement cost falls below its carrying value.

When this occurs, GAAP requires inventory to be carried on the balance sheet at the lower of its cost or “market” value.


Appendix B:Lower of cost or market example


Appendix B:LCM and inventory aggregates

The lower of cost or market LCM method can be applied to: Individual inventory items Classes of inventory—say, fertilizers versus weed-killers The inventory as a whole

Three different answers


Appendix B:Criticisms of the LCM method

Insert Exhibit 9.18

Write-downs may initially be conservative, but the resulting higher margin in the period following the write-down can lead to earnings management.

Because LCM is conservative, it violates the neutrality posture that financial reporting rules are designed to achieve.

LCM relies on an implicit relationship between input and output prices that may not prevail.

LCM rule would require write-down

But selling price and profit potential hasn’t changed


Appendix C:Dollar-value LIFO

The standard LIFO method requires data on each separate product or inventory item.

This approach has two drawbacks: Item-by-item inventory records are costly to maintain. The likelihood of liquidating a LIFO layer is greatly increased.

The dollar-value LIFO method overcomes these drawbacks: Much of the detailed recordkeeping required under standard LIFO is

eliminated. Inventory items are combined into a common pool, which reduces the

likelihood of LIFO liquidation.


Appendix C:Overview of dollar-value LIFO

Here are the inventory amounts before dollar-value LIFO is applied:

$100,00 $140,00

Beginning inventory (price index = 1.00)

Ending inventory (price index =

1.12) Under dollar-value LIFO, ending inventory becomes:

$28,000$25,000$140,00

Ending inventory at period-end

price

÷$100,000 $100,000

X 1.12

X 1.00

Ending inventory at base-period

price

LIFO Ending inventory

1.12 1.00

Newest LIFO layer


Appendix C:Example continued

2006 year-end inventory

$124,600 = 100,000 x 1.00 + ($25,000 -$3,000) x 1.12 Dollar-value LIFO ending inventory for 2006:

From the newest layer

2006 beginning inventory:


Appendix C:Example concluded

New layer added

2007 year-end inventory


Appendix C:Steps to computing dollar-value LIFO

Insert bottom panel, p. 482

Insert top panel, p. 483

1. Ending inventory is initially computed in terms of year-end costs.

2. Restate ending inventory to base-period costs to find out whether inventory quantities have increased or decreased.

3. Inventory changes determined from step 2 are then costed as: New LIFO layers are valued using costs of the year in which the

layer was added. Decreases in old LIFO layers are removed using costs in effect when

the layer was originally formed.

inventories revsine/collins/johnson: chapter 9. rcj: chapter 9 © 2005 2 learning objectives 1.the...

Documents

cost of inventory

inventory purchases

average cost

inventory quantities

perpetual inventory

periodic inventory system

cost of goods available

lower of cost