Download Chapter 9 – Part 1: Inventories

Chaptger 9: Inventories
Learning 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
Main Types of Businesses

Service Companies:


Merchandising Companies:


Travel agency, Entertainment, Internet,
etc.
Wholesalers and retailer: to buy and sell
ready-to-sell merchandise.
Manufacturing Companies

Acquire and process raw materials into
finished goods.
4
Main Types of Businesses
For both merchandising and
manufacturing companies,
inventories are important assets.
 Therefore, inventory accounting is
crucial to financial reporting.

5
Inventory types
Wholesaler or retailer:
Manufacturer:
Manufacturer
Supplier
Firm
Firm
Merchandise
inventory
Raw materials
Work-in-process
Finished goods
Customer
Includes other
manufacturing
costs ( Direct
labor costs,
direct
materials,
manufacturing
overhead,
etc.)
Customer
Gross Profit: Sales – Cost of Goods Sold
6
Overview of accounting issues
Old unit
New unit
Issue: What kind of costs are
included in inventory?
Issue: How is the cost of
goods available for
sale split between the
balance sheet and the
income statement?
9-7
Overview of accounting issues:
Summary
 Three methods for allocating the
cost of goods available for sale:
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).
9-8
Overview of accounting issues:
Allocating the cost of goods available for sale
Weighted average approach:
Uses the
the average
average cost
cost of
of the
the two
two
Uses
units.
units.
First-in, first-out (FIFO) approach:
Oldest unit cost flows to income.
Last-in, last-out (LIFO) approach:
Newest unit cost flows to income.
FIFO
produces
a smaller
expense
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
Learning Objective:
How to allocate total inventory between the
COGS and the ending inventory?
11
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
12
Determining inventory quantities:
Periodic inventory system

This approach does NOT keep a running (or “perpetual”)
record of the amount of inventory on hand.
Entries are made as units are purchased
 Ending inventory and cost of goods sold must be determined by
physically counting the goods on hand at the end of the period.
13
Determining inventory quantities:
Journal entries illustrated
Beginning Inv.(1,400) + Purchases (9,100) – Ending Inv. (3,500)=COGS (7,000)
14
Periodic and perpetual compared
Periodic inventory
Perpetual inventory

Less recordkeeping means
lower cost to maintain.

More complicated and usually
more expensive.

Less management control
over inventory.

Does NOT eliminate the need
to take a physical inventory.
COGS is a “plug” figure and
there is no way to determine
the extent of inventory losses
(“shrinkage”).

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.


Typically used when inventory
volumes are high and per-unit
costs are low.
15
Learning Objective:
What items should be included in ending
inventory?
.
16
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
What is Included in Ending
Inventory?
General Rule
All goods legally owned by the company on
the inventory date, regardless of their
location.
Goods in Transit
Goods on
Consignment
Depends on FOB
shipping terms.
18
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.
19
In Class Exercise :
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.
20
Learning Objective:
What costs should be included in inventory
purchases?
21
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.
22
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.
23
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) .
24
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.
25
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.
26
Costs included in inventory:
Manufacturing industry ( FYI )
Two views on treatment of
manufacturing overhead costs:
Absorption and variable costing
27
Manufacturing Overhead:
Variable costing versus Absorption costing
Fixed
production
costs
Variable costs
will change in
proportion to
the level of
production.
Variable
production
costs
Variable
production
costs
Fixed overhead:
 Manufacturing rentals
and depreciation
 Property taxes
 Raw materials
 Direct labor
 Variable overhead, like
electricity
Variable costing
Absorption costing
of inventory (not
allowed by GAAP)
of inventory (required
by GAAP)
Costs are considered to be
Includable in inventory if they
provide future benefits to the firm.
The rationale for absorption costing is that
both variable and fixed production costs are
assets since both are needed to produce
a saleable product.
28
Manufacturing Overhead: Summary
This approach is not
allowed by GAAP.
These are never
included in inventory.
29
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
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.
33
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.
34
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.

9-35
Cost Flow Assumptions:
Allocating the cost of goods available for sale
Assumption: the cost of inventory is rising
Older inventory purchase: Unit price:$300
Most recent inventory purchase: Unit price ;$340
Weighted average
Uses the average cost of
the two units.
First-in, first-out (FIFO)
FIFO
produces
a smaller
expense
Oldest
unitunit
cost cost
flows to
income.
Oldest
flows
to
income.
Last-in, first-out (LIFO)
LIFO
produces
a larger
expense
Newest unit cost flows
to income.
36
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).
37
Cost flow assumptions:
What assumptions do firms use?(Accounting Trends and
Techniques)
38
Inventory Cost Flow Methods

Specific cost identification

Average cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)
39
Specific Cost Identification
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.


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.

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.
40
Weighted Average Cost Method
Periodic average cost uses a
weighted-average unit cost:
Weightedaverage
unit cost
Cost of
goods
=
available for
sale
÷
Quantity
available for
sale
Perpetual average cost uses a moving
average unit cost that is recomputed
each time a new purchase is made.
41
Weighted Average Method – Periodic
system
Begin Inventory
20
@ $ 9.00
$180
Purchase 1/10
40 @ 10.00
400
Purchase 1/22
30 @ 11.00
330
Sales 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
42
Weighted Average Method – Perpetual system
Begin Inventory
20 @ $ 9.00
$180
Purchase 1/10
40 @ 10.00
400
Purchase 1/22
30 @ 11.00
330
Sales 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
43
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.
44
First-in, First-out (FIFO)
Newest units
assumed still
on hand
Oldest
units
assumed
sold
45
First-in, First-out (FIFO) illustrated
The computations are:
46
Practice Problem: FIFO - Periodic system
Beginning Inventory
20 @ $ 9.00
Purchase 1/10
40 @ 10.00
Purchase 1/22
30 @ 11.00
Sales on 1/13: 55 Units
Ending Inventory: 20+40+30-55 = 35 units

$180
$400
$330
FIFO of cost of ending units (bottom up) :
30 @ $11 = $330 Alternatively
5 @ $10 = $ 50 (recommended),
Total = $380 COGS
= beg. Inv. + net pur.
FIFO for COGS (top down) – end. Inv.
55 units
20 @ $ 9 = $180 = $180 + (400+330)
35 @ $10 = $350 – 380 = $530.
Total = $530
35 units

47
Practice Problem: FIFO -Perpetual system
Beginning Inventory
20 @ $ 9.00
$180
Purchase 1/10
40 @ 10.00
$400
Purchase 1/22
30 @ 11.00
$330
Sales 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
48
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.
49
Last-in, First-out (LIFO)
Newest units
assumed sold
Oldest units
assumed still
on hand
50
Last-in, First-out (LIFO) illustrated
The computations are:
51
Practice Problem: LIFO - Periodic system
Beginning Inventory
20 @ $ 9.00
Purchase 1/10
40 @ 10.00
Purchase 1/22
30 @ 11.00
Sales on 1/13: 55 Units
Ending Inventory: 20+40+30-55 = 35 units

$180
$400
$330
LIFO of cost of ending inventory (top down) :
20 @ $9 = $180 Alternatively
15 @ $10 = $150 (recommended),
Total = $330 COGS
= beg. Inv. + net pur.
FIFO for COGS (bottom up) – end. Inv.
55 units
30 @ $11 = $330 = $180 + (400+330)
25 @ $10 = $250 – 330 = $580.
Total = $580
35 units

52
Practice Problem: LIFO -Perpetual system
Beginning Inventory
20 @ $ 9.00
$180
Purchase 1/10
40 @ 10.00
$400
Purchase 1/22
30 @ 11.00
$330
Sales 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
53
Learning Objective
LIFO Reserve and LIFO Effect
54
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 .
55
55
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.
56
56
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
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.
58
58
LIFO Reserve (contd.)

The proof of LIFO effect equals the COGS impact of FIFO
vs. LIFO:

COGS = BI + Pur –EI

COGS FIFO – COGS LIFO
(BI=beg. Inv; EI=ending Inv.)
=(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
59
59
LIFO and inflation:
LIFO reserve
Figure 9.4 Magnitude
of Inventory and LIFO
Reserve relative to CPI
and Oil Prices
9-60
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.
61
61
Learning Objective:
Understand supplemental LIFO disclosures and
the effect of LIFO liquidations on net income.
62
LIFO Liquidation
When prices rise . . .
LIFO inventory costs on the balance
sheet are “out of date” because they reflect
old purchase transactions.
If inventory declines,
these “out of date” costs
may be charged to
current COGS, and
earnings.
This LIFO
liquidation
results in
“paper profits.”
63
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.

64
LIFO liquidation: Illustration
Old LIFO
layers
If recent inventory purchase is sufficient, gross margin will be $32,000
65
LIFO liquidation:
Calculation of LIFO liquidation profits
The LIFO Reserve on
12/31/2005= 10 x $100+15x
$200 = $6000.
LIFO effect of 2005 is (6,00010,000= -4,000)
What the per unit
COGS would have
been without the
liquidation
66
LIFO liquidation disclosures
Income tax effect ($910,000) was the difference.
From footnote
The buildup of the LIFO inventory creates the reserve,
67
and the decline in inventory--known as LIFO dipping--is a liquidation of the reserve.
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
$1,945,000
LIFO 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)
68
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.
69
Learning Objective:
Remove LIFO dipping, a non-sustainable factor
from gross margin analysis.
70
LIFO liquidation: Gross profit distortion
Improving gross margin
was reported
But the improvement
was due to LIFO
liquidation
71
Current
ratio example
Eliminating
LIFO ratio distortions :
Current Ratio
Understated
because of LIFO
LIFO reserve adjustment
restates inventory to
approximate current cost.
72
Eliminating LIFO Distortion: Inventory
Turnover Rate
Distorted by LIFO liquidation
73
Partial LIFO use
Most companies use a combination of
Inventory cost flow assumptions. The
LIFO to FIFO adjustment is identical to the
method used in Exhibit 9.8.

Ending
LIFO
reserve
Beginning
LIFO
reserve
So, the LIFO reserve decreased $4,538 during the year.
COGS LIFO  $4,538  COGS FIFO
74
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.
9-75
Tax implications of LIFO
9-76
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
+
= 8,000,000
100,000
Realized FIFO
holding gain
9-77
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.

9-78
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 recordkeeping costs.
9-79
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.
9-80
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.
9-81
Learning Objective:
Discuss the factors affecting a company’s choice
of inventory method.
82
Decision Makers’ Perspective
What factors motivate companies to
select one inventory method over another?
How closely do
reported
costs reflect actual
flow of inventory?
How well are costs
matched against
related revenues?
How accurate is the
timing of reported
income
and income taxes?
83
FIFO vs. LIFO:
Comparison of FIFO and LIFO
84
Comparison of FIFO and LIFO
When Prices Are Rising . . .



FIFO
Matches low (older)
costs with current
(higher) sales.
Inventory is valued at
approximate
replacement cost.
Results in higher
taxable income and
lower COGS.
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.
85
Advantage and Disadvantage of FIFO
Advantage
a. 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.
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.
.
86
Advantage and Disadvantage of LIFO
Advantage
a. 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.
.
Disadvantage
a. Inventory cost
presented on the B/S
is not fair.
b. Subject to
management
manipulation.
87
Earnings Quality
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.
88
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.
89
Inventory Errors
90
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.

91
The Impact of Valuation of Ending
Inventory on The CGS & Income
Year 1
Income COGS = Beg. Inv. + Net . - End. Inv.
under
over
under a
over b
over
under
Year 2
over
under
under
over
under
over
a. either understating the units or the value
b. either overstating the units or the value
Inventories: Measurement
92
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:
9-93
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.
94
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.
95
Class Practice Problem
Analysis : 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
01:
02: U
U
= COGS | NI
O
U
U
O
|
A = L + SE
U
X
U
X
Why is there no effect on 2002 ending stockholder’s equity?
NI 2001 understated by $1,000
NI 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.
96
LCM
Understand and apply the lower-of-costor-market rule used to value inventories.
97
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.
98
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.
99
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
100
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.
But selling
price and profit
potential hasn’t
changed
LCM rule would
require write-down
101
Global Vantage Point
Comparison 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.
9-102
Estimate ending inventory and cost of
goods sold
Estimate ending inventory and cost of
goods sold using the gross profit method.
103
Inventory Estimation Techniques

Estimate instead of taking
physical inventory



Less costly
Less time consuming
Two popular methods are . . .
1.
2.
Gross Profit Method
Retail Inventory Method
104
Gross Profit Method
Auditors are testing
the overall
reasonableness of
client inventories.
Estimating inventory
& COGS for interim
reports.
Useful
when . . .
Determining the
cost of inventory
lost, destroyed, or
stolen.
Preparing budgets
and forecasts.
NOTE: The Gross Profit Method is not acceptable
for use in annual financial statements.
105
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.
106
Steps to the Gross Profit Method
1.
Estimate Historical Gross Margin %.
2.
Sales x (1 - Estimated Gross Margin %) =
Estimated COGS
3.
Beg. Inventory + Net Purchases = Cost of
Goods Available for Sale (COGAS)

4.
The above information needs to be available
COGAS - Estimated COGS = Estimated
Cost of Ending Inventory
107
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.
108
Gross Profit Method
Beginning Inventory
Plus: Net Purchases
= Goods Available for Sale
Less: Estimated COGS*
= Estimated Ending Inventory
$
$
* COGS = Sales x (1 - GM%) = $
= $
237,400
728,300
965,700
(691,410)
274,290
1,213,000 x ( 1 - 43% )
691,410
NOTE: The key to successfully applying this
method is a reliable Gross Margin Percentage.
109
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.
110
Solution
First, 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
111
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.
9-112
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.
9-113
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.
9-114
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.
9-115