Inventory Accounting Principles for Profit Maximization

1. Chapter 7 -- Inventories: The Source of Operating Profits FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil

2. Learning Objectives 1. Apply the principles of cost inclusions for assets to inventories. 2. Understand the effect of changes in valuation for inventory. 3. Understand why most firms make a cost flow assumption for inventories and cost of goods sold. 4. Compute cost of goods sold and ending inventories using FIFO, LIFO, and weighted average methods. 5. Understand the effects of using different cost flow assumptions. 6. Analyze the effect of inventories on assessments of profitability and risk.

3. Chapter Outline 1. Inventory terminology 2. Inventory equation 3. Issues in inventory accounting 4. International perspectives Chapter Summary Appendix 7.1 -- Effects on the Statement of Cash Flows of Inventory Transactions

4. 1. Inventory Terminology • Inventory is the stock of goods a firm holds for sale or for further processing. • Merchandise inventory denotes goods held for sale by a retail or wholesale business. • Finished goods inventory denotes goods held for sale by a manufacturing firm. • Raw materials inventory is the inventory of materials stored that are used in production. • Work-in-process is an inventory of partially completed goods. • To inventory is a verb meaning to list and count inventory items and assign them a unit price.

5. 2. Inventory Equation • Inventories fluctuate in size, growing by additions and shrinking by withdrawals. The following equations describe the change in inventory measured in physical units. Beginning Inv. + Additions - Withdrawals = Ending Inv. Goods available for Use or Sale Beginning Inv. + Additions - Ending Inv. = Withdrawals Goods available for Use or Sale

6. 3. Issues in Inventory Accounting 1. The costs included in acquisition cost of purchased inventory. 2. The costs included in acquisition cost of manufactured inventory. 3. The valuation basis used for items in inventory. 4. The frequency of carrying out inventory computations -- periodically or perpetually. 5. The cost flow assumption used to trace the movement of costs into and out of inventory. The cost flow assumption need not parallel the physical movement of goods.

7. 3.1. The Costs Included in Acquisition Cost of Purchased Inventory Inventory should include all costs incurred to acquire goods and prepare them for sale. • The purchase price includes ordering goods, receiving, inspecting and recording the purchase. • Recorded when title passes to the firm. • Merchandise purchase adjustments such as transportation and special handling, cash discounts, returns and other adjustments are part of costs included in inventory. • Adjustments may be made directly to the inventory account or made to contra or supplemental accounts provided the balance sheet amount includes these.

8. 3.2. The Costs Included in Acquisition Cost of Manufactured Inventory • Accrual basis for manufacturers • Because expenses must be matched against the revenue they produce, a manufacturer does not incur costs of production until the goods are sold. Before that time, the costs are capitalized, that is, part of inventory as an asset. • Inventories of manufactured goods should include all costs incurred to manufacturer and prepare them for sale, including: • Materials used in the manufacturing process, • Labor of manufacturing workers, and • A portion of overhead that related to manufacturing.

9. Figure 7.2 -- Flow of Manufacturing Costs Through the Accounts Raw Materials Inv.(A) Cost of Raw matl’s raw costs materials incurred purchases in manuf. Work-in-Proc. Inv.(A) Raw matl’s costs incurred in manuf. Finished Goods Inv. (A) Manuf. Manuf. costs of cost of units units completed sold and moved to store- room Cost of Goods Sold (SE) Manuf. cost of units sold Manuf. costs of units completed and moved to store- room Cash(A) or Wages Payable (L) Direct labor costs incurred in manuf. Direct labor costs incurred in manuf. A = Asset L = Liability SE = Shareholders’ Equity XA = Contra Asset Matl’s = Materials Manuf. = Manufacturing Cash(A) , Accumulated Deprec. (XA), other Overhead costs incurred in manuf. Overhead costs incurred in manuf.

10. 3.2. The Costs Included in Acquisition Cost of Manufactured Inventory (Cont.) • A manufacturing firm incurs three types of costs to convert raw materials into finished goods. • Direct materials such as raw materials that can easily be identified in the finished product • Direct labor of workers who work on the product, and • Manufacturing overhead, costs which are not easily identified with the product but are easily identified with the production facility • The manufacturing firm can trace (or match) direct material and direct labor costs to the units or production. • Manufacturing overhead includes a variety of indirect manufacturing costs (depreciation on manuf. equipment, insurance and taxes on manuf. facilities) that do not match to specific units.

11. 3.2. The Costs Included in Acquisition Cost of Manufactured Inventory (Cont.) • The work-in-process inventory accumulates the costs of production. It is debited with costs of raw materials, direct labor and manufacturing overhead. These costs are combined to compute a total cost of manufactured units. • The finished goods inventory includes the total cost of manufactured units that is transferred from work-in-process upon completion of a set of units. The goods remain here until sold when the finished goods inventory account is reduced by the total cost of the unit (credited) and cost of goods sold (an expense) is debited with the same.

12. Full Absorption Costing or Variable Costing • The costing system just described is called full absorption costing because the inventory accounts absorb (include) all of the costs that relate directly to manufacturing. • GAAP and most tax laws require this method. It gives a total cost which is useful for computing profits. • It does not necessarily mean that additional units will cost the same amount because some costs do not increase proportionately with the number of units (such as the president’s salary). • Variable or direct costing may provide better information for planning purposes. In this method, attempts are made to estimate the costs of new units given the current level of production. This is similar to an economist’s definition of marginal cost. • In variable costing, certain costs (like the president’s salary) would not be included because they would not vary with the additional units.

13. 3.3. The Valuation Basis Used forItems in Inventory • Acquisition cost basis or historical cost basis -- goods are valued at the value of assets given in exchange. These costs do not include any market fluctuations that may occur after the acquisition. This is the cost of goods acquired and may not be a good estimate of the cost of additional goods. • Current cost basis is an attempt to estimate the cost of new goods rather the the cost of goods acquired. This may be more useful for planning purposes. • Replacement cost (entry value) -- goods are valued at the cost of a new purchase. • Net realizable value (exit value) -- goods are value at the price that someone would pay. Lower-of-cost-or-market basis. • Lower-of-cost-or-market basis -- This basis is the same as the acquisition cost basis but goods may be written down to a market price if the market for the good drops. • Standard costs -- are budgeted costs or engineering estimates of what the good should cost. Differences between actual cost and standard cost are variances and are watched closely as warning signs.

14. 3.3. The Valuation Basis Used for Items in Inventory (Cont.) • Writing inventory down to a market value, a credit, results in an offsetting debit which is interpreted as a loss. This loss is not supported by an actual sale, so it is distinguished by being called an unrealized loss. • An unrealized loss reduces net income. • When the good is sold, cost of sales will reflect the new lower cost of the good. • For inventory, increases in market value are not recognized. To do so would recognized an unrealized gain. Instead, the gain is delayed until the good is sold.

15. 3.4. Timing of Computations -- Periodic versus Perpetual Inventory Systems • Adjustments to the inventory accounts do not necessarily have to be made at the time of physical changes in the goods. Two more efficient systems are in general use: 1. Periodic inventory systems • Purchases are recorded to a purchase account but withdrawals are not recorded. Instead, physical counts of inventory are made at the end of an accounting period and the inventory value is adjusted to that figure after adding in purchases. • Less costly method. 2. Perpetual inventory systems • Purchases and withdrawals are made directly to inventory during the period. • This method provides more timely information about inventory.

16. 3.4.1. Periodic Inventory Systems • Since withdrawals are not recorded, cost of goods sold must be computed at the end of the period after the physical count of inventory. • We can rearrange the basic inventory equation to give this computation: Beginning Inv. + Purchases - Ending Inv. = Cost of Goods Sold Goods available for Use or Sale • Ending inventory comes from the physical count. • Beginning inventory is from the last period. • Purchases are recorded. • So we can compute cost of goods sold.

17. 3.4.2. Perpetual Inventory Systems • A perpetual system records with additions (purchases) and withdrawals (cost of goods sold) so there is no need to compute cost of goods sold. • A current balance of inventory can be estimated by the basic inventory equation. Beginning Inv. + Purchases - Cost of Goods Sold = Ending Inv. Goods available for Use or Sale • A count of inventory may be made at the end of the period to confirm this estimated value. • Many firms that use perpetual inventory systems do not count all inventories at the end of all periods thus saving some costs.

18. Choosing between Periodic and Perpetual • The periodic inventory system costs less because there are fewer recordings. • The perpetual inventory system provides more timely information about cost of goods sold and estimates of the amount of inventory, but at a higher cost. • Some savings may be had from doing fewer physical counts of inventory. • Inventory shrinkage (lost inventory that was not sold) can only be measured with a physical count, however, • Since periodic systems do not record withdrawals, shrinkage is hidden in the cost of goods sold and is not available as a separate number. • A perpetual system can only record shrinkage when there has been a physical count.

19. 3.4. Cost Flow Assumptions • In addition to valuation, inventory is subject to a cost flow assumption. This issue is the “which one” issue. • When goods have different costs due to changing economic conditions (inflation or rapid technological changes), inventory may represent a set of goods with different costs. When one good is sold, the flow assumption issue is a set of rules for assigning one of the costs to that good. • In general, there are four methods: 1. Specific identification 2. First-in-first-out (FIFO) 3. Last-in-first-out (LIFO) 4. Weighted average

20. 3.4.1. Specific Identification • For large value items that have unique properties, the firm may choose to identify each good so that the actual costs can be traced. • Each item will require an identifying number. • For example, an automobile dealership knows which car they have just sold because of the vehicle identification number. Their records should give the exact cost of that car. • So there is no real flow assumption for these cases. • Flow assumptions are needed in cases where the items do not have large individual values and each item is a perfect substitute for other items (fungible items). For example, a hardware store sells nails. • In these cases, it may be more efficient to assume a flow than to trace each individual item.

21. 3.4.2. First-in-First-out (FIFO) • FIFO assumes that the first goods acquired are the first to be sold. This is a natural assumption and many physical systems work this way; for example, the waiting line at a restaurant. • Since the costs of the oldest goods are matched to sales, the newest costs are the ones that remain in inventory. • Recall that the accounting flow assumption does not have to reflect any physical flows of goods. • When costs are stable, this method works fine. • However, if costs are rising rapidly, FIFO may result in very old and low costs being matched against revenue. Of course, inventory is fine because the most recent costs remain there.

22. 3.4.3. Last-in-First-out (LIFO) • LIFO assumes that the last goods acquired are the first to be sold. This is an unusual assumption and has its roots in attempts to deal with inflation. • Since the costs of the newest goods are matched to sales, the oldest costs are the ones that remain in inventory. • Recall that the accounting flow assumption does not have to reflect any physical flows of goods. • When costs are rising rapidly, LIFO does match the most recent costs against revenue resulting in timely information about income. However, inventory remains with the oldest and lowest costs and this may give rise to problems in interpreting its value.

23. LIFO Layers • Under LIFO, the oldest costs remain in inventory. These form the bottom layer. Sales are assumed to be made from higher layers. • This may result in part of inventory being costed at very old values. This would cause two problems: 1. Inventory may be undervalued as compared to current costs and 2. If inventory ever goes to such a low level that this costs are matched against revenues, income will show a rapid increase that has nothing to do with economics. This is called dipping into the LIFO layers.

24. 3.4.4. Weighted Average • Weighted average assumes that all of beginning inventory and all purchases are mixed and that the average cost is matched against revenues. • This means that the average cost also remains in ending inventory to be averaged with new costs of the next period. • Weighted average takes a little more complex computation but less record keeping. • It does not reflect current costs in the income statement as quickly as LIFO.

25. 4. An International Perspective • Statement #2 of the International Accounting Standards Committee supports the use of lower of cost or market with market values based on net realizable values. • Statement #2 also states a preference for FIFO and weighted average over LIFO. • Few countries allow LIFO. • The exceptions are U.S. and Japan. • Even in Japan, few firms elect to use LIFO.

26. Chapter Summary • This chapter has introduced many concepts relating to the accounting for inventories. • An inventory method has many dimensions: • Inclusion: full absorption or variable costing. • Basis: acquisition cost, lower-of-cost-or-market, current cost or standard cost. • Frequency of computation: periodic or perpetual. • Flow assumption: specific identification, FIFO, LIFO or weighted average. • Many analysts support LIFO with lower-of-cost-or-market as providing a high quality of earnings. Of course, this may result in problems on the balance sheet and the problem of dipping into LIFO layers.

27. Appendix 7.1 -- Effects on the Statement of Cash Flows of Inventory Transactions • All transactions involving inventory affect the operations sections of the cash flow statement. • Recognizing cost of goods sold in a period inventory system recognized an expense that does not use cash, however, the current asset inventory account is also reduced. Since a change in inventory in part of the operating cash sections, these two cancel leaving cash from operations unchanged. • Purchases of inventory on credit also does not involve cash, however changes to both inventories and accounts payable are part of the operating cash section, so no additional adjustment is needed.