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Inventories and CGS

Inventories and CGS. RCJ Chapter 9. Key Issues. Effect of LIFO on financial statements  LIFO layers LIFO reserve Change in LIFO reserve Price vs. quantity effects LIFO and earnings management LIFO footnote LIFO tax savings LIFO  FIFO switch Dollar Value LIFO. Cost Flow Assumptions.

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Inventories and CGS

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  1. Inventories and CGS RCJ Chapter 9

  2. Key Issues • Effect of LIFO on financial statements  • LIFO layers • LIFO reserve • Change in LIFO reserve • Price vs. quantity effects • LIFO and earnings management • LIFO footnote • LIFO tax savings • LIFO  FIFO switch • Dollar Value LIFO Paul Zarowin

  3. Cost Flow Assumptions BI + Pur = Cost of Goods Available for Sale • GAAP does not require specific identification of the cost of each unit sold to its acquired cost. • Allocation of the “Cost of Goods Available for Sale” between EI and CGS based on assumptions like FIFO & LIFO. Cost of Goods Sold (CGS) Ending Inventory (EI) + Paul Zarowin

  4. Illustrative Example • Use of FIFO vs. LIFO makes a difference when prices change. Paul Zarowin

  5. Illustrative Example (cont’d) Paul Zarowin

  6. Reporting Trade-offs • FIFO vs. LIFO: • Inventories closer to replacement (current) cost under FIFO – reliable B/S • CoGS closer to replacement cost under LIFO – High quality of earnings operating margin (economic profit) Independent of inventory method Holding gain(influences only accounting earnings) Dependent on use of LIFO or FIFO Paul Zarowin

  7. Reporting Trade-offs (cont’d) • I/S perspective (CoGS): LIFO vs. FIFO Example continued: • 400 units were sold. • At replacement cost ((i.e., the 4th quarter unit cost of $14) the CoGS equals 400 x $14 = $5,600 FIFO $4,300 LIFO $5,150 replacement cost $5,600 < < EX. P. 93 W/O LR Paul Zarowin

  8. Reporting Trade-offs (cont’d) • B/S perspective (Inventory): FISH vs. LISH • Ending inventory 300 units • At replacement cost ($14 per unit) inventory has carrying value of: 300 x $14 = $4,200 Replacement cost $4,200 FIFO/LISH $3,950 LIFO/FISH $3,100 > > Ex. P. 93 w/o LR Paul Zarowin

  9. LIFO Reserve (LR) B/S perspective: LIFO layers: LR =LQL*(RC - HCL) L=layer Q=quantity (# of units) RC=replacement cost (current price per unit) HC=historical cost per unit Approximates replacement cost Paul Zarowin

  10. LIFO Layers $350 Dip $125 $75 $25 $25 Paul Zarowin

  11. LIFO Reserve (cont’d) I/S perspective: (pre-tax earnings) i.e. cumulative difference in CGS. Why? Paul Zarowin

  12. Why do we care about  in LIFO Reserve? • Note: FIFO CGS can be > LIFO CGS • Key assumption: same purchases. Reasonable? Incentives? • Do LIFO vs. FIFO firms differ in inventory management? Ex. P9-3; P9-8; P9-13 • Adjust B/S by LR • Adjust I/S by LR Paul Zarowin

  13. Why do we care about  in LIFO Reserve? (cont’d) Remember: LR =LQL*(RC - HCL) So LR means  Q and/or RC (HC is fixed) Example: • LRB=100($1.5 - $1) = $50 Consider there 2 alternative scenarios: • Q 100  150 : LRE=150($1.5 - $1) =$75 • RC  $1.5  $2 : LRE=100($2 - $1) =$100 In general, both Q and RC may change. Paul Zarowin

  14. LR: Price Effect and Quantity Effect • What makes LIFO CGS > or < FIFO CGS? • i.e., What makes LR + or - ? • LIFO disclosures: must disclose quantity effect if material. Why? Ex. ARAL CO, pg. 454-462, P.9-15 Paul Zarowin

  15. LIFO and Earnings Management • What is under management’s control?  Q? RCE ? HC? QB ? RCB? • LIFO liquidations • What about FIFO firms? P9-5 Paul Zarowin

  16. LIFO Tax Savings (conservative: assumes 0% interest) Remember: LR = cumulative difference in LIFO CGS vs. FIFO CGS C 9-2, 3 Paul Zarowin

  17. Switch FIFO  LIFO • Switch from FIFO to LIFO: just go forward, since can’t replicate layers (i.e., don’t know cumulative effect) • Switch from LIFO to FIFO: DR Inventory (LR) CR Cash/taxes payable (LR*tax rate) CR R/E LR* (1-tax rate) Remember: cumulative effect accounting change Note: pay no interest on tax savings Paul Zarowin C 9-5 Weldotron

  18. DVL: Dollar Value LIFO • How firms do LIFO • Keep records FIFO (replacement cost) • Convert to LIFO using annual price index • Ease of record keeping Paul Zarowin

  19. DVL Example • Firm begins at 1-1-1992 • FIFO CGS = 100,000 every year DVL = LIFO @ BOY + (Q * Price)   Qty = RC ÷ Price 1993: • DVL: 86,800 = 70,000 BI + 16,000*1.05 new layer • LR: 13,500 = 90,300 - 86,800 • P effect: 70,000 units * (1.05 - 1.00) • Q effect: zero, because RC = HC for new units • LIFO CGS = FIFO CGS + LR Paul Zarowin

  20. LIFO Correction J.E. Put LIFO firm on FIFO: DR Inventory (LR) CR Cash or taxes/payable (LR*tax rate%)CR R/E (LR* 1-T%) [same as slide #17] Paul Zarowin

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