Inventories

1. Inventories Revsine/Collins/Johnson: Chapter 9

2. Learning objectives • The two methods used to determine inventory quantities—perpetual and periodic. • What kinds of costs are included in inventory. • What absorption costing is and how it complicates financial analysis. • The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO. • How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis.

3. Learning objectives concluded • How LIFO liquidations distort gross profit. • What research tells us about why some firms use LIFO and others don’t. • How to eliminate realized holding gains from FIFO income. • How and when to use the lower of cost or market method. • How and why the dollar-value LIFO method is applied.

4. Inventory types Manufacturer: Wholesaler or retailer: Manufacturer Supplier Firm Raw materials Firm Includes other manufacturing costs Merchandise inventory Work-in-process Finished goods Customer Customer

5. 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?

6. Uses the average cost of the two units. FIFO produces a smaller expense First-in, first-out (FIFO) approach: Oldest unit cost flows to income. Oldest unit cost flows to income. LIFO produces a larger expense Last-in, last-out (LIFO) approach: Newest unit cost flows to income. Overview of accounting issues:Allocating the cost of goods available for sale Weighted average approach: Uses the average cost of the two units.

7. Overview of accounting issues:Summary • Three methods for allocating the cost of goods available for sale: • 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). Weighted average FIFO LIFO

8. Overview of accounting issues:Unanswered questions • How should physical quantities in inventory be determined? • What items should be included in ending inventory? • What costs should be included in inventory purchases (and eventually in ending inventory)? • What cost flow assumption should be used for allocating goods available for sale between cost of goods sold and ending inventory?

9. Determining inventory quantities:Perpetual inventory system • This approach keeps a running (or “perpetual”) record of the amount of inventory on hand. • The inventory T-account under a perpetual inventory system looks like this: Entries are made as units are purchased Entries are made as units are sold

10. 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.

11. Determining inventory quantities:Journal entries illustrated

12. Determining inventory quantities:T-accounts illustrated

13. Less recordkeeping means lower cost to maintain. Less management control over inventory. COGS is a “plug” figure and there is no way to determine the extent of inventory losses (“shrinkage”). Typically used when inventory volumes are high and per-unit costs are low. More complicated and usually more expensive. Does not eliminate the need to take a physical inventory. Better management control over inventories including “stock outs”. Typically used for low volume, high unit cost items (e.g., automobiles) or when continuous monitoring of inventory levels is essential. Determining inventory quantities:Periodic and perpetual compared Periodic inventory Perpetual inventory

14. Items included in inventory • In day-to-day operations, most firms record inventory when they physically receive it. • However, when it comes to preparing financial statements, the firm must determine whether all inventory items are legally owned. • Goods in transit may be “owned” by the buyer or the seller. • The party that has legal title during transit will record the items as inventory. • Consignment goods should not be counted as inventory for the consignee. consigned Consignor Consignee Customer Sale goods Owner Agent

15. Costs included in inventory • All costs required to obtain physical possession of the inventory and to make it saleable. • Purchase cost • Sales taxes and transportation paid by the buyer • Insurance costs • Storage costs • Production costs (labor and overhead) for a manufacturer • In theory, inventory costs should also include the (indirect) costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory. • However, most firms exclude these items and limit inventory costs to direct acquisition and processing costs.

16. Costs included in inventory:Manufacturing costs

17. Costs included in inventory:Absorption costing versus variable costing Fixed production costs • Manufacturing rentals and depreciation • Property taxes Variable production costs Variable production costs • Raw materials • Direct labor • Variable overhead, like electricity Variable costing of inventory (not allowed by GAAP) Absorption costing of inventory (required by GAAP)

18. Costs included in inventory:Summary This approach is not allowed by GAAP. These are never included in inventory.

19. Costs included in inventory:How absorption costing can distort profitability • As we shall see, the GAAP gross margin increases from $110,000 in 2005 to $130,000 in 2006 even though variable production costs and selling price are constant, and sales revenue has fallen. Selling prices and costs are constant

20. Costs included in inventory:Absorption costing distortion Variable cost (given): Fixed cost, $400,000/100,000: Total cost: $3.00/unit Variable cost (given): Fixed cost, $400,000/125,000: Total cost: $3.00/unit $4.00/unit $3.20/unit $7.00/unit $6.20/unit

21. Costs included in inventory:Variable costing illustration Under variable costing the gross margin falls

22. 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.

23. Cost flow assumptions:What assumptions firms use

24. The computations are: Cost flow assumptions:First-in, First-out (FIFO) illustrated

25. Cost flow assumptions:First-in, First-out (FIFO) Newest units assumed still on hand Oldest units assumed sold

26. Cost flow assumptions:Last-in, First-out (LIFO) illustrated The computations are:

27. Cost flow assumptions:Last-in, First-out (LIFO) Newest units assumed sold Oldest units assumed still on hand

28. Cost flow assumptions:Inventory holding gains • LIFO and FIFO are historical cost methods and they overlook inventory holding gains: • Current cost accounting records holding gains as they arise (but it is not permitted under GAAP). To record inventory holding gain under current cost accounting (not GAAP).

29. Cost flow assumptions:Inventory holding gains (continued) • Once the holding gains entry has been made: • When the unit is sold for $500: Both now shown at current cost -but this is not GAAP!

30. Cost flow assumptions:Inventory holding gains summary Holding gain still on balance sheet Holding gain flows to income

31. Cost flow assumptions:LIFO and inventory holding gains Holding gain remains on balance sheet Usually (but not always) the same; however balance sheets are very different.

32. Cost flow assumptions:FIFO and inventory holding gains FIFO automatically includes the holding gain on units that are sold.

33. Cost flow assumptions:The LIFO reserve disclosure Amount shown on balance sheet if FIFO had been used Amount actually shown on balance sheet

34. If FIFO had been used Cost flow assumptions:Converting from LIFO to FIFO

35. Cost flow assumptions:Partial LIFO use Beginning LIFO reserve Ending LIFO reserve • So, the LIFO reserve decreased $4,538 during the year.

36. Cost flow assumptions:Another LIFO footnote LIFO reserve at Finlay Enterprises

37. LIFO and inflation:LIFO reserve Magnitude of LIFO Reserves Percentage Change in Consumer Prices Modest inflation

38. LIFO and inflation:LIFO earnings effect Percentage Change in Consumer Prices Modest inflation Magnitude of LIFO Earnings Effect

39. LIFO liquidation • When a LIFO firm liquidates old LIFO layers, the net income number under LIFO can be seriously distorted. • Old LIFO layers that are liquidated are “matched” against sales dollars that are stated at higher current prices. Current purchases 45 units at $600 each 45 units at $600 each 80 units 30 units at $500 each 30 units at $500 each 3rd layer How old LIFO cost distorts COGS were sold 5 units at $400 each 20 units at $400 each 2rd layer LIFO cost of goods sold 10 units at $300 each 1st layer Goods available

40. LIFO liquidation:Illustration Old LIFO layers

41. LIFO liquidation:Calculation of LIFO liquidation profits What the per unit COGS would have been without the liquidation

42. From footnote LIFO liquidation disclosures Income tax effect ($910,000) was the difference.

43. But the improvement was due to LIFO liquidation LIFO liquidation:Gross profit distortion Improving gross margin was reported

44. LIFO liquidation:Frequency and earnings impact Percentage of manufacturing and merchandising firms using LIFO and experiencing a LIFO liquidation Percentage of firms with LIFO liquidations experiencing a positive, negative, or immaterial effect on pre-tax earnings

45. LIFO liquidation:Percentage impact on pre-tax earnings Pre-tax earnings effect of LIFO liquidations with positive effects on earnings

46. Eliminating LIFO ratio distortions:Current ratio example Understated because of LIFO LIFO reserve adjustment restates inventory to approximate current cost.

47. Eliminating LIFO ratio distortions:Inventory turnover example Distorted by LIFO liquidation

48. 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.

49. 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 = 8,000,000 Realized FIFO holding gain

50. If not detected and corrected, here’s how the 2005 error will effect 2006 results: Inventory errors • Due to a miscount in 1995, ending inventory is overstated by $1 million. Here’s the effect: