1. Inventory Chapter 11 Robinson, Munter, Grant

2. Grant, Munter & Robinson Chapter 112 Learning Objectives Understand the methods for determining inventory values and cost of goods sold Understand LIFO layers and liquidation Adjust statements for differences in inventory methods Explain the impact of capitalization of costs in inventory

3. Grant, Munter & Robinson Chapter 113 Inventory Basics Cost Flow Beginning Inventory Goods Purchased Goods Available For Sale Ending Inventory Cost of Goods Sold Balance SheetIncome Statement

4. Grant, Munter & Robinson Chapter 114 Inventory Basics Cost of Goods Sold Periodic Accounting System –Sales and purchases are recorded as they occur –COGS is recorded at the end of the period after a physical count of ending inventory has been taken –BI + Purchases (= COGAS) – EI = COGS Perpetual Accounting System –COGS is recorded at the time of the sale –BI + Purchases (= COGAS) – COGS = EI –Still take physical count to verify EI

5. Grant, Munter & Robinson Chapter 115 Inventory Basics Methods Specific Identification –Exactly identify which units were sold and which were still on hand at the end of the period –Large, expensive, easily identified items First-in-first-out (FIFO) –Assume oldest units (beginning inventory) are sold first –Most recent purchases are in ending inventory

6. Grant, Munter & Robinson Chapter 116 Inventory Basics Methods Last-in-first-out (LIFO) –Assume newest items are sold first –Oldest items remain in ending inventory –Increases COGS in periods of rising prices Average cost –Average cost of a unit sold = $COGAS/# units available for sale –Use when individual items are indistinguishable

7. Grant, Munter & Robinson Chapter 117 Inventory Basics Example Beginning inventory consists of 1,000 units at at cost of $5.00 each ($5,000 total) 10,000 units were purchased at a cost of $6.00 each 2,000 units remain in ending inventory 9,000 units were sold for $10.00 each

8. Grant, Munter & Robinson Chapter 118 Inventory Basics Example UnitsFIFOLIFOAverage cost Beginning Inventory 1,000$ 5,000 Purchases10,000 60,000 Goods Available 11,00065,000 Ending Inventory 2,00012,00011,00011,818 Goods Sold 9,00053,00054,00053,182

9. Grant, Munter & Robinson Chapter 119 Impact of FIFO on Financial Statements Ending inventory always consists of the company’s most recent purchases. FIFO COGS does not necessarily reflect current market conditions. Holding gains occur when older, lower cost items are sold at current prices. In industries with declining prices (technology) holding losses can occur.

10. Grant, Munter & Robinson Chapter 1110 Impact of LIFO on Financial Statements LIFO provides a matching of current revenues and current costs on the income statement. Inventory amount on balance sheet does not reflect current costs. LIFO layers are added (liquidated) in every period in which purchases exceed (are less than) sales.

11. Grant, Munter & Robinson Chapter 1111 Comparison of LIFO and FIFO In periods of rising (falling) prices, the LIFO method normally results in lower (higher) gross profit than FIFO. –Except when LIFO layers are liquidated The LIFO Conformity Rule requires companies using LIFO for tax purposes to use LIFO for financial reporting as well.

12. Grant, Munter & Robinson Chapter 1112 Comparison of LIFO and FIFO LIFO reserve = FIFO inventory value – LIFO inventory value. When prices are rising and LIFO layers are added, the LIFO reserve will increase. Similarly, layers will be depleted when the LIFO reserve decreases.

13. Grant, Munter & Robinson Chapter 1113 Implications of Inventory Methods for Financial Analysis Caution must be used when net income (plus depreciation) is used to estimate cash flow because it: Overstates operating cash flow when prices are rising and the company is using FIFO Not useful for either LIFO or FIFO when old inventory layers are depleted

14. Grant, Munter & Robinson Chapter 1114 Implications of Inventory Methods for Financial Analysis ROA is lower under LIFO when prices are rising and no LIFO layers have been depleted LIFO inventory turnover seems to improve when prices are rising; numerator is higher (more current COGS) while denominator is lower (reflecting older costs) –Can adjust ratio: COGS LIFO /Avg. Inventory FIFO

15. Grant, Munter & Robinson Chapter 1115 Financial Analysis Peer Comparisons If a company is using FIFO or average cost, there is no requirement to present comparable LIFO data. Adjustments should be made when subject company does not use the same inventory valuation methods as comparator firms or the industry. Using LIFO on the income statement and FIFO on the balance sheet can provide a clearer picture of operating performance.

16. Grant, Munter & Robinson Chapter 1116 Financial Analysis Management Decisions To avoid liquidation of LIFO layers – and the corresponding higher income tax payment – managers may purchase excess inventory. –Inventory could become obsolete. If earnings estimates will not be met, managers may defer inventory purchases, causing a LIFO liquidation and artificially inflating profits. –Income tax payments will also increase. –May lose sales as a result of insufficient inventory.

17. Grant, Munter & Robinson Chapter 1117 Financial Analysis Multiple Methods Neither LIFO nor FIFO needs to be used exclusively. LIFO can be applied to those portions of inventory where the company expects to derive benefits from doing so. LIFO may be applied to pools of different items or to individual items of inventory. LIFO liquidations are less likely to occur when firms pool inventory.

18. Grant, Munter & Robinson Chapter 1118 Adjusting Financial Statement Data LIFO Beginning Inventory BI LIFO Plus: Purchases Purchases Goods Available for Sale BI LIFO + Purchases Less: Ending Inventory EI LIFO COGS BI LIFO +Purchases-EI LIFO

19. Grant, Munter & Robinson Chapter 1119 Adjusting Financial Statement Data Convert LIFO to FIFO Beginning InventoryBI LIFO +Beginning LIFO Reserve Plus: PurchasesPurchases Goods Available for SaleBI LIFO + Beginning LIFO Reserve + Purchases Less: Ending InventoryEI LIFO +Ending LIFO Reserve COGSBI LIFO +Purchases-EI LIFO -Ending LIFO Reserve+ Beginning LIFO Reserve

20. Grant, Munter & Robinson Chapter 1120 Adjusting Financial Statement Data from LIFO to FIFO Starting with LIFO data EI FIFO = EI LIFO + Ending LIFO Reserve COGS FIFO = BI LIFO + Purchases - EI LIFO ± Decrease/(Increase) in LIFO Reserve Or, COGS LIFO ± Decrease/(Increase) in LIFO Reserve

21. Grant, Munter & Robinson Chapter 1121 Adjusting Financial Statement Data from LIFO to FIFO The following accounts will be adjusted Cost of goods sold Gross profit Income taxes Net income (and Retained earnings) Inventory (Current and Total assets) Deferred income taxes

22. Grant, Munter & Robinson Chapter 1122 Why use LIFO? Improve cash flow in periods of rising prices. –Tax deferral Better matching of current operating costs to revenues. No benefit from LIFO if –No tax due –Immaterial, rapidly turning or declining prices of inventory –LIFO is costly to maintain

23. Grant, Munter & Robinson Chapter 1123 Inventory Method Changes Tax regulations restrict changes –May require IRS approval If adopting LIFO, existing inventory value becomes first LIFO layer If switching from LIFO all periods in the financial statements must be restated

24. Grant, Munter & Robinson Chapter 1124 Costs to Capitalize IAS No. 2: Cost of inventories can include: All costs of purchase –Including taxes, transportation, discounts… Costs of conversion –Direct labor and direct overhead Other costs incurred in bringing inventories to their present location and condition –Indirect overhead, product design costs

25. Grant, Munter & Robinson Chapter 1125 Do Not Capitalize IAS No. 2: Cost of inventories exclude: Abnormal waste (materials, labor and OH) Storage costs except as part of production Administrative overhead Selling expenses Note: US GAAP is similar to IAS regarding capitalization of inventory costs

26. Grant, Munter & Robinson Chapter 1126 Service Firms Capitalize as inventory: Labor and other costs directly related to providing services –Including supervisory personnel Accumulate costs in inventory Expense when related revenues are reported

27. Grant, Munter & Robinson Chapter 1127 Tax Rules In the US, tax rules (§263A) require additional capitalization of indirect costs Storage and warehousing Depreciation Quality control A portion of General and Administrative costs

28. Grant, Munter & Robinson Chapter 1128 Inventory Overstatement Overstating ending inventory will overstate earnings –Include obsolete or nonexistent inventory –MiniScribe Corp. shipped bricks instead of disk drives Firms may capitalize costs that should be expensed

29. Grant, Munter & Robinson Chapter 1129 Declines in Inventory Cost Inventory is reported at the lower of cost or market value When current market values fall below cost, the adjustment is to inventory and cost of goods sold Can lead to managerial manipulation

30. Grant, Munter & Robinson Chapter 1130 Summary Inventory valuation methods –LIFO, FIFO, Average cost, Specific identification Differences between methods Adjustments necessary for financial statement analysis Costs capitalized in inventory