Topics for Today: discuss inventory reporting discuss inventory analysis review & practice simple calculations

Inventories What do financial statement users want to know? (items owned by a company and held for sale, or processing before being sold, as part of ordinary business operations) Balance Sheet ASSETS Cash A/R Inventories Income Statement Sales revenues COGS Gross profit Etc. (other expenses/income) What do financial statement users want to know? 1. how much inventory is held by the company? 2. what is the value of the inventory? can it be sold for more than cost? 3. for how long does the company hold inventory?

Inventories What do the financial statements tell users? how much inventory is held by the company? the $$$ amount of inventory is reported on the B/S the number of units is not reported what is the value of the inventory? the $$$ amount represents the lower of cost and market look at gross profit on I/S for (historical) estimate of price mark-up for how long does the company hold inventory? can be determined using the $$$ amount of inventory and cost of goods sold inventory turnover ratio = Cost of Goods Sold / Average Inventory higher turnover means faster sales and less obsolescence risk

Accounting for Inventories Accounting Challenges What costs go into additions? What costs come out when goods are sold? What happens when the value of inventory drops below cost? How do we track inventory manufacturing costs? Inventories Opening Additions Available for Sale Goods Sold Ending OI + Additions – COGS = Ending Inventory

Inventories Opening Additions Available for Sale Goods Sold Ending Accounting Challenges What costs go into additions? Opening Additions Available for Sale Goods Sold Ending If purchased, include any costs related to “getting the inventory in a condition and location for sale.” If manufactured …. (we’ll talk about that later)

Inventories Opening Additions Available for Sale Goods Sold Ending Accounting Challenges What costs go into additions? Opening Additions What costs come out when goods are sold? Available for Sale Goods Sold Ending That depends … What cost flow assumption is adopted Is the accounting system perpetual or periodic

Cost Flow Assumptions What's the issue? Why is it an issue? what costs should be removed from inventory when goods are sold? OR ... what costs should remain in inventory after goods are sold? Why is it an issue? in most cases, the cost of inventory additions changes from time to time if the costs going into inventory are changing, how do we know which ones should be removed when goods are sold?

Cost Flow Assumptions Example: Possible Solutions Include: inventory includes 40 items, with the following costs: October: 10 units @ $13 each September: 10 units @ $12 each August: 10 units @ $11 each July: 10 units @ $10 each $460 total cost 40 units available Q: 10 units are sold in November ... what is the cost of goods sold? Possible Solutions Include: 1. whatever those 10 units cost 2. assume first-in, first-out (FIFO) 3. assume last-in, first-out (LIFO) 4. assume average cost of all (Weighted Average) (any of $120, $110, etc.) ($100) Assumptions Cost-Flow ($130) ($460 / 40 = $11.50 per unit x 10 units = $115) notice that COGS under LIFO > WA > FIFO because costs are rising

Example Income Statement Balance Sheet Inventories Specific Identification FIFO LIFO Weighted Average Sales COGS Gross Profit 150 (120) 30 (100) 50 (130) 20 (115) 35 Balance Sheet Specific Identification FIFO LIFO Weighted Average Current Assets Inventories 340 360 330 345

Cost Flow Assumptions 1. Specific Identification each specific unit's cost is identified and expensed as COGS used most often for expensive & separately identifiable products 2. First-in, First-Out (FIFO) cost of units acquired early are expensed until all of those units are gone, and then the cost of the next "oldest" units also are expensed, etc. the income statement (COGS) gets the old costs the balance sheet (inventory) gets the most recent costs (LISH) 3. Last-In, First-Out (LIFO) cost of units acquired most recently are expensed until all of those units are gone, and then the cost of the next most recent units are expensed the income statement (COGS) gets the most recent costs the balance sheet (inventory) gets the old costs (FISH) 4. Weighted Average for each product, the total units and costs are accumulated to determine an average unit cost per unit costs on the B/S and I/S are the same

Cost Flow Assumptions Notes the cost flow assumption need not match actual product flow the cost flow assumption must remain consistent over time costs calculated under LIFO and Weighted Average are affected by the use of perpetual vs. periodic systems

Perpetual vs. Periodic Systems What's the issue? when should costs be removed from inventory? - physically count the goods on hand at the end of the accounting period - assign costs to EI only at the end of the accounting period ("forces-out" the COGS = OI + Purchases - EI) cost information may not be timely cheap to monitor costs Periodic Perpetual - determine costs of inventory and goods sold after every sale cost information is more timely more expensive to monitor costs Why do we care about the issue? the choice of system is an important management decision the choice of system can affect which costs are assigned to inventories and to goods sold (under LIFO or Weighted Average)

Cost Flow Assumptions Notes the cost flow assumption need not match actual product flow the cost flow assumption must remain consistent over time costs calculated under LIFO and Weighted Average are affected by the use of perpetual vs. periodic systems Specific Identification is not affected by perpetual vs. periodic systems because the actual cost of each product is expensed when it is sold FIFO is not affected because the first goods in are assumed to be sold first, so it doesn't matter when the sale occurs or is recorded because it's always the first purchase that is expensed first

Cost Flow & Periodic/Perpetual assume 3 bricks are bought ... January 1 -- $10 and 1 brick is sold January 11 ... What is the COGS in January? January 10 -- $15 FIFO-periodic? $10 FIFO-perpetual? $10 LIFO-periodic? $20 January 30 -- $20 LIFO-perpetual? $15 WA-periodic? $15 WA-perpetual? $12.50

How do you compare a company that uses FIFO with a company that uses LIFO? You have to calculate the COGS and Inventory amounts using the SAME cost flow assumption. Most companies that use LIFO provide enough information to convert to FIFO – so, to compare, convert LIFO to FIFO. Remember that the cost flow assumption affects OI, COGS, and EI, but it does NOT affect the cost of inventory purchases (i.e., additions). Inventories Opening Purchases Goods Sold Ending

Inventories (LIFO) How to Convert LIFO to FIFO? Example Ford Motor Company recently reported cost of goods sold of $74,315 (million) in the current year, and total inventories of $6816 and $6638 in the current and prior years, respectively, using the LIFO cost flow assumption. Their f/s notes indicated that had they used FIFO, their current and prior year inventories would have been $1,235 and $1,246 higher. Inventories (LIFO) Opening Purchases Goods Sold Ending 6638 X = 74493 74315 6816

Inventories (LIFO) Inventories (FIFO) How to Convert LIFO to FIFO? Example Ford Motor Company recently reported cost of goods sold of $74,315 (million) in the current year, and total inventories of $6816 and $6638 in the current and prior years, respectively, using the LIFO cost flow assumption. Their f/s notes indicated that had they used FIFO, their current and prior year inventories would have been $1,235 and $1,246 higher. What is COGS using FIFO? Inventories (LIFO) Inventories (FIFO) Opening Purchases Goods Sold Ending 6638 6638+1246=7884 X = 74493 74315 74493 X=74326 6816 6816+1235=8051