1. Revsine/Collins/Johnson: Chapter 9
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 Wholesaler or retailer: Manufacturer: Supplier
Firm
Firm
Raw materials
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. Overview of accounting issues: Allocating the cost of goods available for sale
Weighted average approach:
Uses the average cost of the two units.
Oldest unit cost flows to income.
First-in, first-out (FIFO) approach:
Uses the average cost of the two units.
FIFO produces a smaller expense
Newest unit cost flows to income.
Last-in, last-out (LIFO) approach:
LIFO produces a larger expense
Oldest unit cost flows to income.

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. Determining inventory quantities: Periodic and perpetual compared
Periodic inventory
Perpetual inventory
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.

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
goods
Sale
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
Selling prices and costs are constant
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.

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

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 flows to income
Holding gain still on balance sheet

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

35. Cost flow assumptions: Partial LIFO use
Ending LIFO reserve
Beginning 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
30 units at $500 each
80 units
30 units at $500 each
3rd layer
How old LIFO cost distorts COGS
were sold
20 units at $400 each
5 units at $400 each
2rd layer
10 units at $300 each
LIFO cost of goods sold
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. LIFO liquidation disclosures
Income tax effect ($910,000) was the difference.
From footnote

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

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
= 8,000,000
Realized FIFO holding gain

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

51. Analytical insights: LIFO dangers
LIFO makes it possible to “manage” earnings when inventory costs are rising!
How?
Accelerate inventory purchases toward the end of a “good” earnings year so that COGS increases.
Delay inventory purchases toward the end of a “bad” earnings year so that COGS decreases when old LIFO layers are liquidated.

52. Reasons why some companies do not use LIFO
The estimated tax savings is too small.
Business cycles may cause extreme fluctuations in physical inventory levels.
The rate of inventory obsolescence is high.
Managers may want to avoid reporting lower profits because they believe doing so will lead to:
Lower stock price
Lower compensation from earnings-based bonuses
Loan covenant violations
Small firms may not find LIFO economical because of high record-keeping costs.

53. Summary
Absorption costing can lead to potentially misleading trend comparisons.
GAAP allows firms latitude in selecting a cost flow assumption. Some firms use FIFO, others use LIFO, and still others use weighted-average.
This diversity can hinder comparisons across firms, thus its often useful to convert LIFO firms to a FIFO basis.
Reported FIFO income includes potentially unsustainable realized holding gains.

54. Summary concluded
Similarly, LIFO liquidations produce potentially unsustainable realized holding gains.
Old, out-of-date LIFO layers can distort various ratio comparisons.
Users must understand these inventory accounting differences and know how to adjust for them. Only then can valid comparisons be made across firms and over time.

55. Appendix B: Lower of cost or market
Inventory is presumed to be impaired when its replacement cost falls below its carrying value.
When this occurs, GAAP requires inventory to be carried on the balance sheet at the lower of its cost or “market” value.

56. Appendix B: Lower of cost or market example

57. Appendix B: LCM and inventory aggregates
The lower of cost or market LCM method can be applied to:
Individual inventory items
Classes of inventory—say, fertilizers versus weed-killers
The inventory as a whole
Three different answers

58. Appendix B: Criticisms of the LCM method
Write-downs may initially be conservative, but the resulting higher margin in the period following the write-down can lead to earnings management.
Because LCM is conservative, it violates the neutrality posture that financial reporting rules are designed to achieve.
LCM relies on an implicit relationship between input and output prices that may not prevail.
Insert Exhibit 9.18
But selling price and profit potential hasn’t changed
LCM rule would require write-down

59. Appendix C: Dollar-value LIFO
The standard LIFO method requires data on each separate product or inventory item.
This approach has two drawbacks:
Item-by-item inventory records are costly to maintain.
The likelihood of liquidating a LIFO layer is greatly increased.
The dollar-value LIFO method overcomes these drawbacks:
Much of the detailed recordkeeping required under standard LIFO is eliminated.
Inventory items are combined into a common pool, which reduces the likelihood of LIFO liquidation.

60. Appendix C: Overview of dollar-value LIFO
Here are the inventory amounts before dollar-value LIFO is applied:
$100,00
$140,00
Beginning inventory (price index = 1.00)
Ending inventory (price index = 1.12)
Under dollar-value LIFO, ending inventory becomes:
$28,000
$25,000
$140,00
Ending inventory at period-end price ÷
$100,000
X 1.12
X 1.00
Ending inventory at base-period price
LIFO Ending inventory
1.12
1.00
Newest LIFO layer

61. Appendix C: Example continued
2006 beginning inventory:
2006 year-end inventory
$124,600 = 100,000 x ($25,000 -$3,000) x 1.12
Dollar-value LIFO ending inventory for 2006:
From the newest layer

62. Appendix C: Example concluded
2007 year-end inventory
New layer added

63. Appendix C: Steps to computing dollar-value LIFO
Ending inventory is initially computed in terms of year-end costs.
Restate ending inventory to base-period costs to find out whether inventory quantities have increased or decreased.
Inventory changes determined from step 2 are then costed as:
New LIFO layers are valued using costs of the year in which the layer was added.
Decreases in old LIFO layers are removed using costs in effect when the layer was originally formed.
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