chaptger 9: inventories learning objectives 1.the relationship between inventory valuation and cost...

Chaptger 9: InventoriesLearning objectives

1.The relationship between inventory valuation and cost of goods sold.

2.The two methods used to allocate the total inventory cost between the COGS and the ending inventories—perpetual and periodic.

3.What kinds of costs are included in inventory.4.What absorption costing is and how it

complicates financial analysis.5.The difference between inventory cost flow

assumptions—weighted average, FIFO and LIFO.

9-1

Learning objectives concluded

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

7. How LIFO affects firms’ income taxes.

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

9. Economic incentives guiding the choice of inventory methods.

9-2

Learning objectives concluded

10.How to apply the lower of cost or market method.

11.The key differences between GAAP and IFRS requirements for inventory accounting.

9-3

4

Main Types of Businesses Service Companies:

Travel agency, Entertainment, Internet, etc.

Merchandising Companies: Wholesalers and retailer: to buy and sell

ready-to-sell merchandise. Manufacturing Companies

Acquire and process raw materials into finished goods.

5

Main Types of Businesses

For both merchandising and manufacturing companies, inventories are important assets.

Therefore, inventory accounting is crucial to financial reporting.

6

Inventory types

Wholesaler or retailer: Manufacturer:

Manufacturer

Merchandise inventory

Customer

Raw materials

Work-in-process

Finished goods

Supplier

Customer

Includes other manufacturing costs ( Direct labor costs, direct materials, manufacturing overhead, etc.)

Firm

Firm

Gross Profit: Sales – Cost of Goods Sold

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:

9-7

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:

9-8

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

9-9

Overview of accounting issues: How to allocate total inventory between the

COGS and the ending inventory? What items should be included in ending

inventory? What costs should be included in inventory

purchases (and eventually in ending inventory)?

What different cost flow assumptions can be used in determine the COGS under each inventory method (i.e., perpetual vs. periodic)? 9-10

11

Learning Objective:

How to allocate total inventory between the COGS and the ending inventory?

12

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

13

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

14

Determining inventory quantities:Journal entries illustrated

Beginning Inv.(1,400) + Purchases (9,100) – Ending Inv. (3,500)=COGS (7,000)

15

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 or when continuous monitoring of inventory levels is essential.

Periodic inventory Perpetual inventory

16

Learning Objective:

What items should be included in ending inventory?

.

Items included in inventory In day-to-day operations, most firms record

inventory when they physically receive it. 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.

9-17

18

What is Included in Ending Inventory?

General Rule

All goods legally owned by the company on the All goods legally owned by the company on the inventory date, regardless of their location.inventory date, regardless of their location.

General Rule

All goods legally owned by the company on the All goods legally owned by the company on the inventory date, regardless of their location.inventory date, regardless of their location.

Goods in TransitGoods in Transit Goods on Consignment

Goods on Consignment

Depends on FOB shipping terms.

Depends on FOB shipping terms.

19

Goods in transit The party with the legal title during

transit will record the items as inventory.

FOB Shipping Point: the title transfers to the buyer at the shipping point (i.e., the seller’s facility). Thus, the buyer has the title during the transit.

FOB Destination: the title transfers to the buyer at the destination (i.e., buyer’s facility. Thus, the seller has the title during the transit.

20

Houston Corporation had the following inventory transactions in transit on 12/31/08. Indicate whether the inventory would be included in Houston’s ending inventory on 12/31/2010.

1. Purchased inventory “FOB Shipping Point”; shipped on 12/31/10.

2. Sold inventory “FOB Shipping Point”; shipped on 12/31/10.

3. Purchased inventory “FOB Destination”; shipped on 12/31/10.

4. Sold inventory “FOB Destination”; shipped on 12/31/10.

In Class Exercise :

21

Learning Objective:

What costs should be included in inventory purchases?

22

Costs included in inventory All costs necessary to obtain the

inventory and to make it saleable should be accounted for.

These costs include: Purchase cost or production costs Sales taxes and transportation costs (if

paid by the buyer). In-transit insurance costs (if paid by the

buyer). Storage costs.

23

Costs included in inventory In theory, costs such as the costs of the

purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory should also be included in the inventory costs(referred to as the “indirect” costs”).

However, most firms exclude these items.

24

Costs included in inventory : Non-manufacturing firms consider the

following items in the cost of inventories: Purchase costs ( invoice price) + Freight-in (transportation-in) - Purchase returns - Purchase allowances (reduce the

purchase price due to damages on goods).

- Purchase discounts (from early cash payments for the purchase) .

25

Costs included in inventory: Manufacturing firms

The inventory costs (i.e., product costs)of a manufacturer include:

Raw Material (variable) Direct Labor (variable) Overhead items:

Variable overhead: indirect labor, indirect material, electricity used for production, etc.

Fixed overhead: depreciation expense of machine, property taxes of factories, rent expense for the factories, etc.

26

Costs included in inventory: Manufacturing firms (contd.)The inventory costs are treated as assets

(in work-in-process account for any raw material, labor and overhead in production process and in finished goods account when the production process is complete) until finished goods are sold.When finished goods are sold, the carrying value of these finished goods is charged to cost of goods sold.

27

Costs included in inventory:Manufacturing industry ( FYI )

Two views on treatment ofmanufacturing overhead costs: Absorption and variable costing

28

Manufacturing Overhead:Variable costing versus Absorption 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)

Fixed overhead: Manufacturing rentals

and depreciation Property taxes

Raw materials Direct labor Variable overhead, like

electricity

Variable costs will change in proportion to the level of production.

Costs are considered to beIncludable in inventory if they provide future benefits to the firm.

The rationale for absorption costing is that both variable and fixed production costs areassets since both are needed to producea saleable product.

29

Manufacturing Overhead: 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 2011 to $130,000 in 2012 even though variable production costs and selling price are constant, and sales revenue has fallen.

9-30

Costs included in inventory:Absorption costing distortion

9-31

Costs included in inventory:Variable costing illustration

Under variable costing the gross margin falls

9-32

33

Absorption Costing and Earnings Management (source: RCJM Textbook)A research study found that firms in

danger of producing zero earnings resort to overproducing inventory to reduce sort of goods sold and thereby boost profits. The evidence suggests that absorption costing provides opportunities for firms to manipulate earnings.

34

Cost Flow Assumptions:

Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost

of goods sold.

9-35

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.

36

Cost Flow Assumptions:Allocating the cost of goods available for sale

Weighted average

Oldest unit cost flows to income.

First-in, first-out (FIFO)

Uses the average cost of the two units.

FIFO produces a smaller expense

Newest unit cost flows to income.

Last-in, first-out (LIFO)

LIFO produces a larger expense

Oldest unit cost flows to income.

Assumption: the cost of inventory is risingOlder inventory purchase: Unit price:$300Most recent inventory purchase: Unit price ;$340

37

Cost Flow Assumptions: Summary 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 amount assigned to the balance sheet and the income statement is the same (i.e., the amount of goods available for sale).

38

Cost flow assumptions:What assumptions do firms use?(Accounting Trends and Techniques)

39

Inventory Cost Flow Methods

Specific cost identification

Average cost



Specific cost identification

Average cost



40

The specific cost of each inventory item must be known.

By selecting specific items from inventory at the time of sale, income may be manipulated.

The specific cost of each inventory item must be known.

By selecting specific items from inventory at the time of sale, income may be manipulated.

Specific Cost Identification

Items are added to inventory at cost when they are purchased.

COGS for each sale is based on the specific cost of the item sold.

Items are added to inventory at cost when they are purchased.

COGS for each sale is based on the specific cost of the item sold.

Companies which can identify specific units sold can adopt the specific identification method to allocate costs of goods sold and cost of ending Inventory. Examples include jewelry stores and automobile dealerships.

41

Weighted Average Cost Method

42

Weighted Average Method – Periodic system

Begin Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 400Purchase 1/22 30 @ 11.00 330Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40 + 30 - 55=35 units

Average unit cost: $ of Goods available cost( 180+400+330 ) = $10.11per unit Units of Goods available ( 20+40+30 ) Ending Inventories:

35 units x $10.11 = $354 Cost of Goods Sold: $180+ (400+330)– 354 = $556

43

Weighted Average Method – Perpetual systemBegin Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 400Purchase 1/22 30 @ 11.00 330Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40+ 30 – 55 = 35 units

Calculate weighted average unit cost on 1/10: Goods available cost ( 180+400 ) = $580 = $9.67 per unit Goods available units ( 20+40 ) 60 Cost of Goods sold on 1/13:

55 units x $9.67 per unit = $ 531.85 Calculate weighted average unit cost on1/22: Goods available cost ( 5*9.67+30*11) = $378 = $10.81 Goods available units ( 20+40-55+30 ) 35 Cost of ending inventory on 1/31:

35 units x $10.81 per unit = $378.35

44

First-In, First-Out The FIFO method assumes that items are

sold in the chronological order of their acquisition.

The cost of the oldest inventory items are charged to COGS when goods are sold.

The cost of the newest inventory items remain in ending inventory.

The COGS and ending inventory cost are the same under periodic and perpetual approaches regardless their differences in the timing of adjustments to inventory.

45

First-in, First-out (FIFO)

Oldest units assumed sold

Newest units assumed still

on hand

46

First-in, First-out (FIFO) illustrated

The computations are:

47

Practice Problem: FIFO - Periodic systemBeginning Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 Units Ending Inventory: 20+40+30-55 = 35 units

FIFO of cost of ending units (bottom up) : 35 units 30 @ $11 = $330

5 @ $10 = $ 50 Total = $380

FIFO for COGS (top down) 55 units 20 @ $ 9 = $180

35 @ $10 = $350 Total = $530

Alternatively (recommended), COGS = beg. Inv. + net pur. – end. Inv. = $180 + (400+330) – 380 = $530.

48

Practice Problem: FIFO -Perpetual systemBeginning Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 Units Ending Inventory: 20 + 40+ 30 - 55 = 35 units FIFO COGS for 1/13 Sale FIFO Inventory on 1/13 55 units 20 @ $ 9 = $180 5 @ $10 = $50

35 @ $10 = $350 Total = $530

Inventory on 1/22 (same as inventory on 1/31 due to no other transactions after 1/22 in January)

35 units 5 @ $10 = $ 50 30 @ $11 = $330

Total = $380

49

Last-In, First-Out The LIFO method assumes that the newest

items are sold first, leaving the older units in inventory.

The cost of the newest inventory items are charged to COGS when goods are sold.

The cost of the oldest inventory items remain in inventory.

Unlike FIFO, using the LIFO method may result in COGS and ending inventory Cost that differ under the periodic and perpetual approaches.

50

Last-in, First-out (LIFO)

Newest units assumed sold

Oldest units assumed still

on hand

51

Last-in, First-out (LIFO) illustrated

The computations are:

52

Practice Problem: LIFO - Periodic systemBeginning Inventory 20 @ $ 9.00 $180

Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 Units Ending Inventory: 20+40+30-55 = 35 units

LIFO of cost of ending inventory (top down) : 35 units 20 @ $9 = $180

15 @ $10 = $150 Total = $330

FIFO for COGS (bottom up) 55 units 30 @ $11 = $330

25 @ $10 = $250 Total = $580

Alternatively (recommended), COGS = beg. Inv. + net pur. – end. Inv. = $180 + (400+330) – 330 = $580.

53

Practice Problem: LIFO -Perpetual systemBeginning Inventory 20 @ $ 9.00 $180Purchase 1/10 40 @ 10.00 $400Purchase 1/22 30 @ 11.00 $330Sales on 1/13: 55 Units Ending Inventory: 20 + 40+ 30 - 55 = 35 units LIFO COGS for 1/13 Sale LIFO Inventory on 1/13 55 units 40 @ $10 = $400 5 @ $9 = $40

15 @ $9 = $135 Total = $535

Inventory on 1/22 (same as inventory on 1/31 due to no other transactions after 1/22 in January)

35 units 5 @ $9 = $ 45 30 @ $11 = $330

Total = $375

54

Learning Objective

LIFO Reserve and LIFO Effect

5555

LIFO Reserve Many companies use LIFO for external

reporting and income tax purposes but maintain internal records using FIFO or average cost.

The difference in the value of inventory between the inventory method used for internal reporting purposes (i.e., FIFO) and LIFO is reported in an account referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO .

5656

LIFO Reserve The change in the balance of LIFO

Reserve account from one period to another is referred as the LIFO Effect, which reflects the impact on income from using LIFO vs. FIFO.

The SEC required the LIFO reserve disclosure since 1974 for firms adopting LIFO costing.

Cost flow assumptions:The LIFO reserve disclosure

Amount actually

shown on balance sheet

Amount shown on balance sheet if FIFO had been used

9-57

5858

LIFO Reserve (contd.) The LIFO Reserve decreased by $655,000 in

2005.

This difference is the same as the 2005 COGS difference between LIFO and FIFO.

A decreased LIFO Reserve indicates a smaller LIFO COGS than FIFO COGS, an indication of either deflation or a LIFO liquidation (discussed later).

When LIFO Reserve increases, it indicates a greater LIFO COGS than FIFO COGS, an indication of inflation.

5959

LIFO Reserve (contd.) The proof of LIFO effect equals the COGS impact of FIFO

vs. LIFO:

COGS = BI + Pur –EI (BI=beg. Inv; EI=ending Inv.)

COGS FIFO – COGS LIFO

=(BI FIFO – BI LIFO) – (EI FIFO – EI LIFO)

=LIFO Reserve of BI – LIFO Reserve of EI

Thus, a positive LIFO effect indicates COGS FIFO > COGS LIFO

(see the example in Exhibit 9.6 on p57)

Conversely, a negative LIFO effect indicates COGS FIFO < COGS LIFO

LIFO and inflation:LIFO reserve

Figure 9.4 Magnitude of Inventory and LIFO Reserve relative to CPI and Oil Prices

9-60

6161

LIFO Reserve and Inflation (contd.) When inflation heats up, the disparity between LIFO inventory and FIFO inventory increases.

Why did the LIFO reserve increase through 2007 and then decrease? Firms reduce inventory levels as they

downsize, restructure, or adopt just-in-time inventory management.

Oil price was $16.75 per barrel at the end of 2001. It was $85.52 per barrel at the end of 2007 before dropped to $31.84 by the end of 2008.

62

Learning Objective:

Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income.

63

LIFO Liquidation

LIFO inventory costs on the balance sheet are “out of date” because they reflect

old purchase transactions.

LIFO inventory costs on the balance sheet are “out of date” because they reflect

old purchase transactions.

When prices rise . . .

If inventory declines, these “out of date” costs

may be charged to current COGS, and

earnings.

If inventory declines, these “out of date” costs

may be charged to current COGS, and

earnings.

This LIFOliquidation results in

“paper profits.”

This LIFOliquidation results in

“paper profits.”

64

LIFO liquidation LIFO Liquidation occurs when a firm

experiences significant inventory shortage, and therefore, liquidate some layers in beginning inventory.

This results in costs from preceding periods being matched against current year’s revenues.

This leads to a distortion in net income and a substantial increase in tax payment in the current period.

65

LIFO liquidation: Illustration

Old LIFO layers

If recent inventory purchase is sufficient, gross margin will be $32,000

66

LIFO liquidation:Calculation of LIFO liquidation profits

What the per unit COGS would have been without the liquidation

The LIFO Reserve on 12/31/2005= 10 x $100+15x

$200 = $6000.LIFO effect of 2005 is (6,000-

10,000= -4,000)

67

LIFO liquidation disclosures

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

From footnote

The buildup of the LIFO inventory creates the reserve, and the decline in inventory--known as LIFO dipping--is a liquidation of the reserve.

68

LIFO liquidation Disclosures (contd.) Aral’s 2005 LIFO effect ($655,000

decrease) is attributable to LIFO liquidation profit in the amount of

$2,600,000, reducing LIFO Reserve, and an inflation effect in 2005 in the amount of

$1,945,000, increasing LIFO Reserve. Reconciliation of Changes in LIFO Reserve:Rising input costs increased LIFO cost of goods sold by $1,945,000LIFO dipping undercharged expense and thus, reduced COGS by (2,600,000)Result: LIFO COGS is less than LIFO by $ 655,000(=Changes in LIFO Reserve)

69

The Frequency of LIFO liquidation and Its Contribution to Pre-Tax Earnings LIFO liquidation is not uncommon:

Figure 9.5 of the textbook indicates that during the period of 1985 to 2001, on average, about 10% to 20% of firms using LIFO experiencing LIFO liquidation.

The contribution of LIFO liquidation to pre-tax earnings ranges from 10.4% in 1991 to 2% in 2000.

To avoid being misled by transitory LIFO liquidation profit, LIFO inventory footnote should be studied to see whether LIFO liquidation occurred and its impact to profits.

70

Learning Objective:

Remove LIFO dipping, a non-sustainable factor from gross margin analysis.

71

LIFO liquidation: Gross profit distortion

Improving gross margin was reported

But the improvement was due to LIFO liquidation

72

Current ratio example

Understated because of LIFO

LIFO reserve adjustment restates inventory to approximate current cost.

Eliminating LIFO ratio distortions : Current Ratio

73

Distorted by LIFO liquidation

Eliminating LIFO Distortion: Inventory Turnover Rate

74

Partial LIFO use

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

FIFOLIFO COGS538,4$COGS

Ending LIFO

reserve

Beginning LIFO

reserve

Most companies use a combination ofInventory cost flow assumptions. The LIFO to FIFO adjustment is identical to the method used in Exhibit 9.8.

9-75

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.

9-76

Tax implications of LIFO

9-77

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

9-78

Reasons why some companies do not use LIFO The estimated tax savings is too

small (academic research confirms that LIFO firms have higher tax savings) .

Business cycles may cause extreme fluctuations in physical inventory levels.

The rate of inventory obsolescence is high.

9-79

Reasons why some companies do not use LIFO 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.

9-80

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.

9-81

Summary (contd.) 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.

82

Learning Objective:

Discuss the factors affecting a company’s choice of inventory method.

83

Decision Makers’ Perspective

What factors motivate companies to select one inventory method over another?

How accurate is the timing of reported

incomeand income taxes?

How closely do reported

costs reflect actualflow of inventory?

How well are costs matched against

related revenues?

84

FIFO vs. LIFO:

Comparison of FIFO and LIFO

85

Comparison of FIFO and LIFO When Prices Are Rising . . .

LIFO Matches high (newer)

costs with current (higher) sales.

Inventory is valued based on low (older) cost basis.

Results in lower taxable income and higher COGS.

Is not allowed by the IASC.

LIFO Matches high (newer)


Inventory is valued based on low (older) cost basis.

Results in lower taxable income and higher COGS.

Is not allowed by the IASC.

FIFO Matches low (older)


Inventory is valued at approximate replacement cost.

Results in higher taxable income and lower COGS.

FIFO Matches low (older)


Inventory is valued at approximate replacement cost.

Results in higher taxable income and lower COGS.

86

Advantage and Disadvantage of FIFO Disadvantage

a. Bad matches of sales revenue and CGS; match current sales revenue with old cost (earnings contains the holding gains and therefore, have lower quality than LIFO earnings)

b. Producing higher income during an inflation period results in paying more income tax.

Disadvantage

a. Bad matches of sales revenue and CGS; match current sales revenue with old cost (earnings contains the holding gains and therefore, have lower quality than LIFO earnings)

b. Producing higher income during an inflation period results in paying more income tax.

Advantagea. Less likely to be subject

to management manipulation;

b. Produce higher income during an inflation period;

c. Inventory cost reported on the B/S is close to the replacement cost.

.

Advantagea. Less likely to be subject

to management manipulation;

b. Produce higher income during an inflation period;

c. Inventory cost reported on the B/S is close to the replacement cost.

.

87

Advantage and Disadvantage of LIFO

Disadvantage

a. Inventory cost presented on the B/S is not fair.

b. Subject to management manipulation.

Disadvantage

a. Inventory cost presented on the B/S is not fair.

b. Subject to management manipulation.

Advantagea. Good match of sales

revenue with CGS(thus, higher earnings quality than FIFO earnings).

b. Produce lower income during an inflation period; result in tax savings.

.

Advantagea. Good match of sales

revenue with CGS(thus, higher earnings quality than FIFO earnings).

b. Produce lower income during an inflation period; result in tax savings.

.

88

Earnings QualityManipulating income reduces earnings quality because it can mask permanent earnings.

Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

Manipulating income reduces earnings quality because it can mask permanent earnings.

Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

89

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.

90

Inventory Errors

91

Inventory Errors Inventory errors are unique in financial

reporting because they involve multiple accounts and multiple periods.

Due to the ending inventory will be the beginning inventory of next year, the errors will be corrected by the end of the second year.

Inventories: Measurement 92

The Impact of Valuation of Ending Inventory on The CGS & IncomeYear 1

Income COGS = Beg. Inv. + Net . - End. Inv.

under over under a

over under over b

Year 2

over under underunder over over

a. either understating the units or the valueb. either overstating the units or the value

9-93

Inventory Errors: An Example

Due to a miscount in 2008, ending inventory is overstated by $1 million. Here’s the effect:

If not corrected, here’s how the 2008 error will affect 2009 results:

94

Class Practice Problem Assume that, at the end of 2001, Xeron

Corporation neglected to include $1,000 of goods in transit to the company when it performed the annual inventory count.

This error went undetected through 2002. How would this inventory error affect the

financial statements for 2001 and 2002? Assume the cost flow assumption is FIFO.

95

Class Practice Problem To analyze, use the inventory formula and

the balance sheet formula. Note that the asset account in inventory

error analysis is ending inventory, and the equity effect is retained earnings, specifically the effect on net income.

96

Class Practice ProblemAnalysis : BI: Beginning Inventory P: Net Purchase EI: Ending Inventory

COGS: Cost of goods sold NI: Net income A: Assets L: Liabilities

SE: Stockholder’s equity

BI + P - EI = COGS | NI | A = L + SE01: O U U U

02: U U O X XWhy is there no effect on 2002 ending stockholder’s equity?

NI 2001 understated by $1,000NI 2002 overstated by $1,000

Both closed to RE, so no net effect at the end.SE in last year is understated, but SE balance is offset by overstated of year 2002. Thus, no effect on 2002 ending Stockholder’s Equity.

U

97

LCM

Understand and apply the lower-of-cost-or-market rule used to value inventories.

98

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.

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Lower of cost or market example

Net realizable value: The amount that would be received if the assets were sold in the (used) asset market.

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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

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Criticisms of the LCM method 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

Global Vantage PointComparison of IFRS and GAAP Inventory Accounting IFRS guidelines for inventory are similar to

U.S. GAAP Two important differences

LIFO is not permitted under IAS 2 Lower of cost or market is applied differently.

Market is net realisable value (no ceiling or floor). IAS 2 allows inventory reductions to be reversed if the market recovers, but the inventory carrying amount cannot exceed the original cost.

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Estimate ending inventory and cost ofgoods sold

Estimate ending inventory and cost ofgoods sold using the gross profit method.

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Inventory Estimation Techniques Estimate instead of taking

physical inventory Less costly Less time consuming

Two popular methods are . . .1.1. Gross Profit MethodGross Profit Method2.2. Retail Inventory MethodRetail Inventory Method

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Gross Profit Method

Useful when . . .Useful

when . . .

Estimating inventory & COGS for interim

reports.

Estimating inventory & COGS for interim

reports.

Determining the cost of inventory

lost, destroyed, or stolen.

Determining the cost of inventory

lost, destroyed, or stolen.

Auditors are testing the overall

reasonableness of client inventories.

Auditors are testing the overall

reasonableness of client inventories.

Preparing budgets and forecasts.

Preparing budgets and forecasts.

NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.

NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.

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Gross Profit Method

This method assumes that the historical gross margin rate is reasonably constant in the short run.

We need to know:1. Net sales for the period.2. Cost of beginning inventory.3. Historical gross margin rate.4. Net purchases for the period.

This method assumes that the historical gross margin rate is reasonably constant in the short run.

We need to know:1. Net sales for the period.2. Cost of beginning inventory.3. Historical gross margin rate.4. Net purchases for the period.

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Steps to the Gross Profit Method1.1. Estimate Historical Gross Margin %.Estimate Historical Gross Margin %.

2.2. Sales x (1 - Estimated Gross Margin %) = Sales x (1 - Estimated Gross Margin %) = Estimated COGSEstimated COGS

3.3. Beg. Inventory + Net Purchases = Cost of Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) Goods Available for Sale (COGAS)

The above information needs to be availableThe above information needs to be available

4.4. COGAS - Estimated COGS = Estimated COGAS - Estimated COGS = Estimated Cost of Ending InventoryCost of Ending Inventory

1.1. Estimate Historical Gross Margin %.Estimate Historical Gross Margin %.

2.2. Sales x (1 - Estimated Gross Margin %) = Sales x (1 - Estimated Gross Margin %) = Estimated COGSEstimated COGS

3.3. Beg. Inventory + Net Purchases = Cost of Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) Goods Available for Sale (COGAS)

The above information needs to be availableThe above information needs to be available

4.4. COGAS - Estimated COGS = Estimated COGAS - Estimated COGS = Estimated Cost of Ending InventoryCost of Ending Inventory

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Gross Profit Method

Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data:

•Net sales for May = $1,213,000

•Net purchases for May = $728,300•Inventory at May 1 = $237,400 •Gross margin = 43% of sales

Estimate Inventory at May 31.Estimate Inventory at May 31.

Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data:

•Net sales for May = $1,213,000

•Net purchases for May = $728,300•Inventory at May 1 = $237,400 •Gross margin = 43% of sales

Estimate Inventory at May 31.Estimate Inventory at May 31.

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Gross Profit Method

NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.NOTE: The key to successfully applying this

method is a reliable Gross Margin Percentage.

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Class Practice Problem - Inventory Estimation

Given the following information from the general ledger:

Sales, January-March $600,000

Inventory, January 1 50,000

Purchases, January-March 450,000

If the gross margin has historically been 30 percent of sales, calculate the estimated ending inventory at March 31.

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SolutionFirst, estimate COGS:

If GM% = 30%, then COGS = 70%

So Sales x 70% = COGS

Then, estimate EI:

BI + P (net) - EI = COGS

600,000 x .7 = COGS = 420,000

50,000 + 450,000 - EI = 420,000 80,000 = EI

Summary

Absorption costing is required by GAAP but 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 it’s often useful to convert LIFO firms to a FIFO basis.

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Summary

Reported FIFO income includes potentially unsustainable realized holding gains.

Similarly, LIFO liquidations distort reported margins and produce unsustainable realized holding gains.

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

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Summary concluded

To address inventory obsolescence, GAAP requires inventory to be carried at lower of cost or market (LCM).

IFRS accounting for inventory is very similar to GAAP, but LIFO is not allowed.

The LIFO conformity rules requires firms to use LIFO for financial reporting if they use it for tax reporting.

Most LIFO firms use some form of dollar-value LIFO.

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Summary concluded

Users must understand these inventory accounting differences and know how to adjust for them.

Valid comparisons can only be made across firms and over time after adequate adjustments.

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