CHAPTER 9 INVENTORIES

1. CHAPTER9INVENTORIES

2. Roadmap • Components of inventories • Two inventory system • Allocate Fixed Overhead costs: variable costing vs. absorption costing • Three cost flow assumptions • LIFO reserve and LIFO liquidations • Adjusting FIFO • Lower of cost or market • Dollar value of LIFO

3. I. An Overview of Inventory Accounting Issues • A. Inventoriesare assets held for sale. • 1.Inventory includes • a. Raw materials inventory • b. Work-in-process inventory • c. Finished goods inventory

4. Two Inventory Systems • Perpetual inventory system • Periodic inventory system

5. II. Determining Inventory Quantities • A. A perpetual inventory system keeps a running (or “perpetual”) record of the amount in inventory.1. Purchases are debited to the inventory account.2. Cost of units sold is removed from the inventory account as sales are made.3. No need to close accounts

6. II. Determining Inventory Quantities • B. A periodic inventory system does not keep a running record of the amount of inventory on hand. • 1. Purchases are accumulated in a separate purchases account. • 2. No entry is made at the time of sale to reflect cost of goods sold. • 3. Closing entry is needed and ending inventory is determined by a physical count.

7. IV. Costs Included in Inventory • A. The carrying cost of inventory should include all costs required to obtain physical possession and to put the merchandise in saleable condition. • B. The inventory costs of a manufacturer include raw material, labor, and certain overhead items (i.e., product costs). • C. General administrative costs and selling costs are expensed in the period in which they are incurred (i.e., period costs).

8. V. To allocate fixed overhead costs • Variable costs are those that change in proportion to the level of production, such as raw materials cost, direct labor, and certain overhead items. • Fixed costs of production are costs that do not change as production levels changes, such as production facilities rental, depreciation of production equipment, property taxes, etc. • A. Variable costing includes in inventory only variable costs of production.Fixed overhead costs are not included as part of the inventory cost, but are treated as period costs. • B. Absorption costing include both variable costs and fixed costs.

9. V. Absorption Costing Versus Variable Costing • B. Under absorption costing, all production costs are inventoried. • 1. Fixed production costs are not written-off to expense as incurred, rather they are treated as product costs. • 2. The rationale is that both variable and fixed production costs are assets since both are needed to produce a saleable product.

10. V. Absorption Costing Versus Variable Costing • D. Generally accepted accounting principals do not allow variable costing to be used in external financial statements. • 1. Absorption costing makes it difficult to interpret year-to-year changes in reported income when inventory levels change. • 2. As the number of units being produced increases, under absorption costing, the amount of fixed cost assigned to each unit decreases and the profit margin goes up.

11. III. Cost Flow Assumptions: The Concepts • A. Under specific identification, the cost of goods sold (ending inventory) can be measured by reference to the known cost of the actual units sold (still on hand).1. This method is used by businesses that sell a small number of high value items. 2. This method makes it relatively easy to manipulate income.3. This method is usually not feasible for most businesses, so one of the following cost flow assumptions is required to allocate the cost of goods available for sale between ending inventory and cost of goods sold.

12. Cost Flow Assumptions: The Concepts • B. FIFO cost flow: • 1. This method presumes that sales are made from the oldest available goods and that ending inventory is comprised of the most recently acquired goods. • 2. FIFO charges the oldest costs against revenues on the income statement. • a. This characteristic is often viewed as a deficiency since current costs of replacing the units sold are not being matched with current revenues.b. However, on the balance sheet, FIFO inventory represents the most recent purchases and will usually approximate current replacement costs.

13. Cost Flow Assumptions: The Concepts • C. LIFO cost flow: • 1. This method presumes that sales are made from the most recently acquired units and that ending inventory is comprised of the oldest available goods. • 2. This method seldom corresponds to the actual physical flow of goods.

14. Cost Flow Assumptions: The Concepts • C. LIFO cost flow • 3. LIFO matches the most recently incurred costs against revenues. • a. This characteristic is often viewed as an advantage since current costs of replacing the units sold are being matched with current revenues. • b. However, on the balance sheet, LIFO inventory represents the oldest available costs, which usually do not approximate current replacement costs. • c. For firms that have used LIFO for many years, the LIFO inventory amount may reflect only a small fraction of what it would cost to replace this inventory at today’s prices.

15. Cost Flow Assumptions: The Concepts • D. Frequency of inventory cost flow assumptions. • 1. FIFO is the most popular method, followed closely by LIFO. • 2. Most firms use a combination of inventory costing methods. • 3. Few firms use LIFO exclusively, largely because LIFO is prohibited in most countries outside of the United States.

16. Example • 1. Facts:a. Retailer started the year with a beginning inventory of one refrigerator that cost $300.b. The retailer purchases another identical refrigerator for a cost of $340 during the year.c. At the end of the year, the retailer sells one of the refrigerators for $500.2. The total cost of goods available for sale equals beginning inventory plus purchases ($640 in this example).

17. Example (Cont’d) • The first-in, first-out (FIFO) method of inventory costing method assumes that the first unit purchased is the first unit sold. Therefore, cost of goods sold in this example is $300. • The last-in, first-out (LIFO) method of inventory costing method assumes that the last unit purchased is the first unit sold. Therefore, cost of goods sold in this example is $340.

18. Cost Flow Assumptions: The Concepts • E. FIFO, LIFO, and inventory holding gains: • 1. Inventory holding gains and losses are the input cost changes that occur following the purchase of inventory. • a. These holding gains are treated as a component of net income when the unit is sold.b. One alternative is to recognize this “unrealized holding gain” as an owners’ equity increase that is part of comprehensive income.

19. Cost Flow Assumptions: The Concepts • 2. Current cost accounting records unrealized holding gains on financial statements as they arise. • a. Inventory is debited and “unrealized holding gains” is credited for the input cost changes. • b. As a result, current costs are recorded both in cost of goods sold and in ending inventory. • c. The current cost operating profit reflects the expected ongoing profitability of current operations at current levels of costs and selling prices.

20. Cost Flow Assumptions: The Concepts • 3. The primary difference between FIFO and LIFO is that each method makes a different choice regarding which element is shown at the out-of-date cost. • a. FIFO shows inventory at approximately current cost, but is then forced to reflect cost of goods sold at historical cost. • b. LIFO shows cost of goods sold at approximately current cost, but is then forced to reflect inventory on the balance sheet at historical cost. • c. By charging the oldest costs to the income statement, FIFO automatically includes in income the holding gain on the unit that was sold.

21. Cost Flow Assumptions: The Concepts • F. The LIFO reserve disclosure: • 1. The LIFO reserve is a mandated disclosure that shows the dollar magnitude of the difference between LIFO and FIFO inventory costs. • 2. By adding the reported LIFO reserve to the balance sheet LIFO inventory number, one can estimate FIFO inventory.

22. Cost Flow Assumptions: The Concepts • F. The LIFO reserve disclosure: • 3. The LIFO reserve disclosure also allows the analyst to convert reported LIFO cost of goods sold amounts to FIFO amounts.(Exhibit 8.5 Page 390) • a. LIFO cost of goods sold – Increase in LIFO reserve = FIFO cost of goods sold. • b. LIFO cost of goods sold + Decrease in LIFO reserve = FIFO cost of goods sold.

23. Cost Flow Assumptions: The Concepts • A. LIFO liquidation can seriously distort reported net income. • 1. LIFO liquidation results when there is a decline in inventory quantities, I.e, you sold more than what you bought in current period. • 2. The older costs in the LIFO layer liquidated are matched with current sales dollars. In other words, previously ignored holding gains are included in income as old layers are liquidated. • 3. This results in inflated or illusory profit margins.

24. Cost Flow Assumptions: The Concepts • A. LIFO liquidation can seriously distort reported net income. • 4. LIFO liquidation profit is calculated as (Current cost – LIFO layer cost)  Quantity liquidated. • 5. When LIFO liquidation profits are material, the SEC requires that its income effect be reported. • 6. LIFO liquidationresults in an (unsustainable) increase in the gross margin percentage.

25. V. Eliminating LIFO Ratio Distortions • A. To adjust the current ratio, we should the LIFO reserve to the numerator, converting LIFO inventory to FIFO inventory. • B. To adjust the inventory turnover ratio: • 1. LIFO liquidation profits should be added to the numerator. • 2. The denominator should be adjusted to reflect FIFO inventory instead of LIFO inventory.

26. VI. Tax Implications of LIFO • A. The LIFO conformity rule requires that if LIFO is used for income tax purposes, the financial statements must also use LIFO.

27. VI. Tax Implications of LIFO • B. LIFO’s tax advantage is that it provides a lower income number than FIFO, thus lowering the immediate tax liability. 1. This benefit can be reversed if LIFO layers are liquidated or if future purchase costs fall. 2. These cash flow benefits can induce undesirable managerial behavior. a. This may happen if a firm has depleted its inventories during the year and it wants to avoid the tax liability associated with the LIFO liquidation. b. A manager can avoid taxes by simply purchasing a large amount of inventory at the end of the year to bring it back up to beginning-of-year levels.

28. VII.  Eliminating Realized Holding Gains for FIFO Firms • A. Reported income for FIFO firms always includes some realized holding gains during periods of rising inventory costs. • B. Since holding gains are potentially unsustainable, analysts try to remove them from reported FIFO income. • 1. The greater the amount of cost change, the larger the divergence between FIFO and replacement cost of goods sold. • 2. The slower that inventory turns over, the larger the divergence between FIFO and replacement cost of goods sold.

29. VII.  Eliminating Realized Holding Gains for FIFO Firms • C. The adjustment procedure comprises three steps: • 1. Determine FIFO cost of goods sold. • 2. Adjust the beginning inventory for one full year of specific price change. • 3. Replacement cost of goods sold is the sum of the amounts in step 1 and the amount in step 2.

30. X. Appendix B—Lower of Cost or Market Method • Lower of cost or market method: • 1. The relevant comparison is between historical cost and replacement cost.

31. X. Appendix B—Lower of Cost or Market Method • The market value used to compare to cost in applying the lower of cost or market rule is the middle value of (1) replacement cost, (2) net realizable value, and (3) net realizable value less a normal profit margin.

32. XI. Dollar Value LIFO • A. The LIFO inventory method requires data on each separate product or inventory item. • 1. This system necessitates considerable clerical work and cost. • 2. The likelihood of liquidating a LIFO layer is greatly increased when LIFO records are kept by individual item.

33. XI. Dollar Value LIFO • B. The steps involved in computing dollar value LIFO are summarized as follows: • a. Ending inventory is initially computed in term of year-end costs. • b. To determine whether a new LIFO layer has been added or liquidated, the ending inventory is restated to base-period cost and compared to the beginning inventory at base-year cost. • i. This eliminates the effect of cost changes. • ii. The comparison indicates whether quantities have changed.

34. XI. Dollar Value LIFO • c. Any inventory change is costed as follows: • i. New LIFO layers are valued using cost of the year in which the layer was added. • ii. Decreases in old layers are removed using costs that were in effect when the layer was originally formed.

35. Summary • Components of inventories • Two inventory system • Allocate Fixed Overhead costs: variable costing vs. absorption costing • Three cost flow assumptions • LIFO reserve and LIFO liquidations • Adjusting FIFO • Lower of cost or market • Dollar value of LIFO