Inventories Inventory costs either are reported on the balance sheet or they are transferred to the income statement as an expense (cost of goods sold) to match against sales revenues. The process for which costs are removed from the balance sheet is important.
Capitalization Costs “Capitalization” means that a cost is recorded on the balance sheet and is not immediately expensed on the income statement. Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as expense. If costs are capitalized rather than expensed, then assets, current income, and current equity are all greater.
Cost of Goods Sold When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is then matched against sales revenue to yield gross profit: Sales revenue - COGS Gross profit
When Do You Transfer From Inventory To COGS? Every so often when you count the remaining inventory. Periodic COGS = Beginning Inventory + Purchases – Ending Inventory A Plug figure At time of the sale Perpetual
Effects of errors Common source of manipulation Often difficult for the auditor to catch Affects two years Example
Inventory Costing Methods First-In. First-Out (FIFO). This method assumes that the first units purchased are the first units sold. Last-In, First-Out (LIFO). The LIFO inventory costing method assumes that the last units purchased are the first to be sold. Average cost. The average cost method assumes that the units are sold without regard to the order in which they are purchased. Instead, it computes COGS and ending inventories as a simple weighted average. Specific identification. Uniquely identified items.
Inventory Costing Effects on Cash Flows One reason frequently cited for using LIFO is the reduced tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO for tax purposes also use it for financial reporting. This is the LIFO conformity rule. Companies using LIFO are also required to disclose the amount at which inventories would have been reported had it used FIFO. The difference between these two amounts is called the LIFO reserve.
LIFO vs FIFO Compute gross profit, ending inventory, and LIFO reserve for years 1 and 2 Year 1 Purchases336610 Sales4@20 Year 2 Purchases10 12 13 Sales5@20
Impairment of Inventories Companies are required to write down the carrying amount of inventories on the balance sheet if, at the statement date, the reported cost exceeds their market value (determined as the current replacement cost). This is called reporting inventories at the lower of cost or market. Inventory book value is written down to market value. Inventory write-down is reflected as an expense (part of cost of goods sold) on the income statement.
Inventory Turnover Rates for Selected Companies