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Chapter 7: Highlights
1.
The term "inventory" means a stock of goods or other items a firm owns and holds for
sale or for processing as part of a firm's business operations. Merchandise inventory
refers to goods held for sale by a retail or wholesale business. Finished goods denote
goods held for sale by a manufacturing company. The inventories of manufacturing
firms also include work in process (partially completed products) and raw materials
(materials which will become part of goods produced).
2.
Accounting for inventories includes the process of determining the proper assignment of
expenses to various accounting periods. Accounting must allocate the total cost of goods
available for sale or use during a period between the current period's usage (cost of goods
sold, an expense) and the amounts carried forward to future periods (the end of period
inventory, an asset now but an expense later).
3.
The following equation aids the understanding of the accounting for inventory:
Beginning Inventory + Additions - Withdrawals = Ending Inventory
Beginning Inventory + Additions equal goods available for use or sale. Slightly different
terminology applied to the same equation is Beginning Inventory + Purchases - Cost of
Goods Sold = Ending Inventory. The valuation for ending inventory will appear on the
balance sheet as the asset, merchandise inventory; the amount of cost of goods sold will
appear on the income statement as an expense of producing sales revenue.
4.
Financial statements report dollar amounts, not physical units such as pounds or cubic
feet. The accountant must transform physical quantities for beginning inventory,
additions, withdrawals, and ending inventory into dollar amounts in order to measure
income for the period as well as financial position at the beginning and end of the period.
5.
Some problems of inventory accounting are (a) the costs to be included in acquisition
costs, (b) the treatment of changes in the market value of inventories subsequent to
acquisition, and (c) the choice of cost flow assumptions used to trace the movement of
costs into and out of inventory.
6.
The amount on a balance sheet for inventory includes all costs incurred to acquire goods
and prepare them for sale. Acquisition cost includes the invoice price less any cash
discounts taken for prompt payment. Acquisition cost also includes the cost of
purchasing, transporting, receiving, unpacking, inspecting, and shelving as well as any
costs for recording purchases.
7.
The operating process for a typical manufacturing firm includes (a) acquiring plant and
equipment to provide the capacity to manufacture goods, (b) acquiring raw materials for
use in production, and (c) converting raw materials into a salable product. The firm holds
the finished product in inventory until it sells the goods. At the time the firm sells the
goods, it typically has identified a customer and agreed to a sales price. Thus the firm
recognizes revenue because it has substantially completed the production and sales
activities. Following the accrual basis, the manufacturing firm matches against the
revenue the expense for the manufacturing cost of the items sold.
8.
Manufacturing firms incur costs for direct materials, direct labor, and manufacturing
overhead to convert raw materials into finished products. Manufacturing overhead
includes a variety of indirect costs (depreciation, insurance, supervisory labor, factory
supplies) that firms cannot trace directly to products manufactured but which provide a
firm with productive capacity. Manufacturing costs are product costs (assets) and
accumulate in various inventory accounts. At the time of sale, the firm transfer the cost
of items sold from the asset account, Finished Goods Inventory, to the expense account,
Cost of Goods Sold.
9.
A manufacturing firm, like a merchandising firm, incurs various marketing and
administrative costs. Both merchandising and manufacturing firms treat selling and
administrative costs as period expenses.
10.
Manufacturing firms maintain separate inventory accounts for product costs incurred at
various stages of completion. The Raw Materials Inventory account includes the cost of
raw materials purchased but not yet transferred to production. The Work-in-Process
Inventory account accumulates the cost of raw materials transferred from the raw
materials storeroom, the cost of direct labor services used in production, and the
manufacturing overhead cost incurred. The balance in the Work-in-Process Inventory
account indicates the product costs incurred thus far on units not yet finished as of the
date of the balance sheet. The Finished Goods Inventory account includes the total
manufacturing cost of units completed but not yet sold.
11.
GAAP requires firms to record inventories initially at acquisition cost. GAAP does not
permit firms to revalue inventories above acquisition cost. The benefit of the increase in
market value affects net income in the period of sale when the firm realizes the benefit of
a higher selling price instead of recognizing the benefit during the periods while market
values increased. In contrast, GAAP requires firms to write down inventories when their
replacement cost, or market value, is less than acquisition cost. GAAP refers to this
valuation as the lower-of-cost-or-market valuation method.
12.
The lower-of-cost-or-market basis for inventory valuation is a conservative accounting
policy. Conservatism in accounting tends to result in higher quality of earnings figures
because (a) it recognizes losses from decreases in market value before the firm sells
goods, but does not record gains from increases in market value before a sale takes place,
and (b) inventory figures on the balance sheet are never greater, but may be less, than
acquisition costs. In other words, the lower-of-cost-or-market basis results in reporting
unrealized holding losses on inventory items currently in the financial statements through
lower net income amounts but delays reporting unrealized holding gains until the firm
sells the goods.
13.
An inventory valuation problem arises because of two unknowns in the inventory
equation. The values of beginning inventory and purchases are known; the values of
cost of goods sold and ending inventory are not known. Accountants can base the
valuation of the ending inventory on the most recent costs, the oldest costs, the average
costs, or some other choice. Once the accountant assigns an amount to one unknown,
then the equation automatically determines the amount of the other. The relation between
the two unknowns in the inventory equation, cost of goods sold and ending inventory, is
such that the higher the value assigned to one of them, the lower must be the value
assigned to the other.
14.
If a firm cannot specifically identify the cost of items sold, it must make some
assumption as to the flow of cost in order to estimate the acquisition costs applicable to
the units remaining in the inventory and to the units sold. Even if a firm finds specific
identification feasible, it may choose to make a cost flow assumption. Three principal
cost flow assumptions are first-in, first-out (FIFO), last-in, first-out (LIFO), and
weighted-average.
15.
The first-in, first-out (FIFO) cost flow assumption assigns the costs of the earliest units
acquired to the withdrawals and the cost of the most recent acquisitions to the ending
inventory.
16.
The last-in, first-out (LIFO) cost flow assumption assigns the costs of the most recent
acquisitions to the withdrawals and the costs of the oldest units to the ending inventory.
17.
The weighted-average method assigns costs to both inventory and withdrawals based
upon a weighted average of all merchandise available for sale during the period.
18.
When purchase prices change, no acquisition cost-based accounting method for costing
inventory and cost of goods sold allows the accountant to show up-to-date costs on both
the income statement and the balance sheet. Financial statements can present current cost
amounts in the income statement or the balance sheet but not both.
19.
Of the three cost flow assumptions, FIFO results in balance sheet figures that are the
closest to current cost. The cost of goods sold expense tends to be out-of-date because
the earlier purchase prices of beginning inventory and the earliest purchases during the
period become expenses. When purchase prices rise, FIFO usually leads to the highest
reported net income of the three methods and when purchase prices fall, it leads to the
smallest.
20.
When purchase prices have been rising and inventory amounts increasing, LIFO produces
balance sheet figures usually much lower than current costs. LIFO’s cost of goods sold
figure closely approximates current costs. LIFO usually results in the smallest net
income when purchase prices are rising and the largest when purchase prices are falling.
21.
The weighted-average cost flow assumption resembles FIFO more than LIFO in its effect
on the financial statements. When inventory turns over rapidly, the weighed-average
inventory cost flow provides amounts virtually identical to FIFO’s amounts.
22.
Differences in cost of goods sold and inventories under the cost flow assumptions relate
in part to (a) the rate of change in the acquisition costs of inventory items, and (b) the rate
of inventory turnover.
23.
As the rate of price change increases, the effect of using older versus more recent price
increases results in larger differences in cost of goods sold and inventories between FIFO
and LIFO.
24.
As the rate of inventory turnover increases, purchases during the period make up an
increasing proportion of the cost of goods available for sale. Because purchases are the
same regardless of the cost flow assumption, cost of goods sold amounts will not vary as
much with the choice of cost flow assumptions.
25.
LIFO generally results in the deferral of income taxes. If a firm uses LIFO for income
tax reporting purposes, it must also use LIFO in its financial report to shareholders. This
“LIFO conformity rule” results from the restrictions placed by the Internal Revenue
Service on firms using LIFO for income tax reporting.
26.
Under LIFO, in any year purchases exceed sales, the quantity of units in inventory
increases. This increase is called a LIFO inventory layer.
27.
If under LIFO, a firm must reduce end-of-period physical inventory quantities below
what they were at the beginning of the period, cost of goods sold will include the current
period's purchases plus a portion of the older and lower costs in the beginning inventory.
Such a firm will have larger reported income and income taxes in that period than if the
firm had maintained its ending inventory at beginning-of-period levels. LIFO results in
firms deferring taxes as long as they do not dip into LIFO layers.
28.
Because firms often control whether inventory quantities increase or decrease through
their purchase or production decisions, LIFO affords firms an opportunity to manage
their earnings in a particular year. Analysts view firms who dip into LIFO layers to
manage their earnings as having a lower quality of earnings than firms that use FIFO.
GAAP requires firms that dip into LIFO layers during the period to indicate the effect of
the dip on cost of goods sold.
29.
Managers of LIFO inventories often face difficult decisions relative to the use of this
inventory method. Managers must weigh the purchase decisions at year end with the
effect these decisions will have on reported income and income taxes. LIFO can induce
firms to manage LIFO layers and cost of goods sold in a way that would be unwise in the
absence of tax effects. LIFO also gives management the opportunity to manage income.
Under LIFO, end-of-year purchases, which the firm can manage, affect net income for
the year.
30.
The valuation of inventory on the balance sheet under LIFO understates the current
replacement cost of the inventory. The inventory understatement results in an
understatement of the firm’s current ratio. The computed current ratio tends to
underestimate the firm’s liquidity and the firm’s computed inventory turnover is
overstated. Because the Securities and Exchange Commission is concerned that this outof-date information might mislead the readers of financial statements, it requires firms
using LIFO to disclose, in notes to the financial statements, the amounts by which
inventories based on FIFO or current cost exceed their amounts as reported on a LIFO
basis.
31.
In general, the reported net income under FIFO exceeds that under LIFO during periods
of rising prices. The higher reported net income results from including a larger realized
holding gain in reported net income under FIFO than under LIFO.
32.
The conventionally reported gross margin (sales minus cost of goods sold) consists of (a)
an operating margin and (b) a realized holding gain (or loss).
33.
Operating margin denotes the difference between the selling price of an item and its
replacement cost at the time of sale.
34.
The realized holding gain is the difference between the current replacement cost of an
item at the time of sale and its acquisition cost. The term inventory profit sometimes
denotes the realized holding gain on inventory. The amount of inventory profit varies
from period to period as the rate of change in the purchase price of inventories varies.
The larger the inventory profit, the less sustainable are earnings and therefore the lower
the quality of earnings.
35.
The unrealized holding gain is the difference between the current replacement cost of the
ending inventory and its acquisition cost. Unrealized holding gains on ending inventory
do not appear in a firm’s income statement as presently prepared under GAAP.
36.
The unrealized holding gain under LIFO is larger than under FIFO since LIFO assumes
that earlier purchases with lower costs remain in ending inventory.
37.
The sum of the operating margin plus all holding gains (both realized and unrealized) is
the same under FIFO and LIFO. Most of the holding gain under FIFO is included in net
income each period, whereas most of the holding gain under LIFO is not currently
recognized in the income statement. Under LIFO, the unrealized holding gain remains
unreported as long as the older acquisition costs appear on the balance sheet as ending
inventory.
38.
Statement No. 2 of the International Accounting Standards Board supports the use of the
lower of cost or market method for the valuation of inventories, with market value based
on net realizable value. All major industrialized countries require the lower-of-cost-ormarket method in the valuation of inventories. Firms in most countries use FIFO and
weighted-average cost flow assumptions. Few countries except the United States and
Japan allow LIFO as an acceptable cost flow assumption.
39.
All transactions involving inventory affect the operations section of the statement of cash
flows. An increase in inventory during the year is subtracted from net income in
computing cash flows from operations. A decrease in inventory during the year is added
to net income in computing cash flows from operations.