Inventories Revsine/Collins/Johnson/Mittelstaedt: Chapter 9 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives 1.The relationship between inventory valuation and cost of goods sold. 2.The two methods used to determine inventory quantities—perpetual and periodic. 3.What kinds of costs are included in inventory. 4.What absorption costing is and how it complicates financial analysis. 5.The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO. 6.How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis. 9-2

Learning objectives concluded 7.How LIFO liquidation distorts cost of goods sold. 8.How LIFO affects firms’ income taxes. 9.Economic incentives guiding the choice of inventory methods. 10.How to apply the lower of cost or market method. 11.The key differences between GAAP and IFRS requirements for inventory accounting. 12.How to eliminate realized holding gains from FIFO income. 13.How and why the dollar-value LIFO method is applied. 9-3

Overview of accounting issues What kind of costs are included in inventory? How is the cost of goods available for sale split between the balance sheet and the income statement? Old unitNew unit Issue: 9-4

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 9-5

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 9-6

Determining inventory quantities: Periodic inventory system  This approach does not keep a running (or “perpetual”) record of the amount of inventory on hand.  Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period. Entries are made as units are purchased 9-7

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. ConsignorConsigneeCustomer consigned goods Sale Owner Agent 9-8

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. 9-9

Cost flow assumptions: First-in, First-out (FIFO) illustrated 9-10

Cost flow assumptions: First-in, First-out (FIFO) illustrated Figure 9.1 FIFO Cost Flow 9-11

Cost flow assumptions: Last-in, First-out (LIFO) illustrated 9-12

Cost flow assumptions: Last-in, First-out (LIFO) illustrated Figure 9.2 LIFO Cost Flow 9-13

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

 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. LIFO liquidation 10 units at $300 each 20 units at $400 each 30 units at $500 each 45 units at $600 each 5 units at $400 each 30 units at $500 each 45 units at $600 each Current purchases 3 rd layer 2 rd layer 1 st layer Goods available LIFO cost of goods sold 80 units were sold How old LIFO cost distorts COGS 9-15

Lower of Cost or Market Method If the market value of inventory falls below its cost, the carrying value must be reduced. Market value is subject to two constraints: Ceiling – Net Realizable Value Floor – Net Realizable Value less normal profit margin CeilingFloor Figure

Lower of Cost or Market Method  The journal entry when inventory with a cost of $1,000,000 is written down to a market value of $970,000 would be (assuming the use of the perpetual inventory method):  The lower of cost or market method can be applied to: Individual inventory items Classes of inventory The inventory as a whole 9-17

Global Vantage Point Comparison of IFRS and GAAP Inventory Accounting  IFRS guidelines for inventory are similar to U.S. GAAP  Two important differences LIFO is not permitted under IAS 2 Lower of cost or market is applied differently. Market is net realisable value (no ceiling or floor). IAS 2 allows inventory reductions to be reversed if the market recovers, but the inventory carrying amount cannot exceed the original cost. 9-18

Summary  Absorption costing is required by GAAP but 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 it’s often useful to convert LIFO firms to a FIFO basis.  Reported FIFO income includes potentially unsustainable realized holding gains.  Similarly, LIFO liquidations distort reported margins.  Old, out-of-date LIFO layers can distort various ratio comparisons. 9-19

Summary concluded  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.  To address inventory obsolescence, GAAP requires inventory to be carried at lower of cost or market (LCM).  IFRS accounting for inventory is very similar to GAAP, but LIFO is not allowed.  The LIFO conformity rules requires firms to use LIFO for financial reporting if they use it for tax reporting.  Most LIFO firms use some form of dollar-value LIFO. 9-20