1. 1 Chapter 6,Part 2: Inventory Capitalization of Inventor Primary accounts: Inventory and Cost of Goods Sold (COGS). Capitalize: add to an asset (inventory) account at the time of acquisition. What costs to capitalize? Cost to acquire, including transportation costs to facility (transportation-in or freight-in). What items or units to include? – General rule: (1) held for sale and (2) complete and unrestricted ownership.

2. 2 Formulas for COGS and Inventory For Income Statement To calculate COGS: BI + Purchases (net) - EI = COGS To calculate Gross Profit (GP): Sales (net) - COGS = GP Alternative: BI + P(net) = EI + COGS

3. 3 Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS? Methods: Specific identification: used internally by many companies now, because of unique ID tags. Average: used internally and externally by some manufacturing companies with large volume of identical inventories. FIFO - (first-in, first-out) for COGS – and LISH (last-in, still here) for EI LIFO - (last-in, first-out) for COGS – and FISH (first-in, still here) for EI FIFO and LIFO are the two primary techniques used for external financial reporting.

4. 4 Class Problem - Cost Flows Given the following activity for January: Cost Total Units per Unit Cost Begin Inventory 20 $ 9.00 $180 Purchase 1/10 40 10.00 400 Purchase 1/22 30 11.00 330 Total available 90 units $910 Sales - 55 units Ending inventory 35 units

5. 5 FIFO(LISH) FIFO for COGS (top down) 55 units 20 @ $9 = $180 35 @ $10 = $350 Total = $530 LISH for EI (bottom up) 35 units 30 @ $11 = $330 5 @ $10 = $ 50 Total $380

6. 6 LIFO(FISH) LIFO for COGS (bottom up) 55 units 30 @ $11 = $330 25 @ $10 = $250 Total =$580 FISH for EI (top down) 35 units 20 @ $ 9 = $180 15 @ $10 = $150 Total = $330

7. 7 Average First calculate average: Goods available cost = $910 Goods available units = 90 units Avg. = $10.11 per unit Now COGS: 55 units x $10.11 per unit = $ 556 Now EI: 35 units x $10.11 per unit = $354

8. 8 Comparison of FIFO, LIFO, and Average In times of rising prices: highest COGS lowest COGS highest EI lowest EI highest Net Income lowest Net Income LIFO FIFO

9. 9 Additional LIFO issues: LIFO and taxes – Why use LIFO for taxes? – Why use LIFO for financial statements? LIFO and market valuation – Should market value a company higher or lower if they use LIFO? LIFO liquidation – What happens to net income with liquidation of an old LIFO layer? LIFO reserve – what information is contained in this disclosure? Cash flow savings. Required, if used for tax purposes. Generally: higher Increases FIFO EI, LIFO EI and difference (reserve)

10. 10 LIFO Reserve For companies that use LIFO for tax and external financial reporting, a financial statement disclosure is required that indicates the calculated inventory(ies) at FIFO. The difference between the FIFO and LIFO inventories is called the LIFO Reserve. This number may be used to convert LIFO Inventory and COGS and Net Income to a FIFO basis, to allow for comparison to other companies. It also facilitates the calculation of the cash flow savings from reduced taxes.

11. 11 LIFO Reserve Calculations for ending inventory (EI): FIFO EI = LIFO EI + LIFO Reserve Calculation for COGS: FIFO COGS = LIFO COGS - Increase in LIFO Reserve ( or +Decrease in LIFO Reserve) Calculation for tax saving (assuming LIFO Reserve increased during the year): Tax Savings = Increase in LIFO Reserve x tax rate

12. 12 Ending Inventory:Applying the Lower-of-Cost-or-Market Rule Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. Problem: because it is an estimate, overestimation of the write-down can create hidden “reserves”. – Recognizes value decreases immediately – Lower EI, lower COGS means higher net income next period, when the inventory is sold.

13. 13 Ratios Relating to Inventory Activity Inventory Turnover: COGS Average Inventory Indicates how often we “turn over” or sell our inventory. High factor is a positive indicator. Average Days Outstanding: Inventory COGS/365 Indicates how many days Inventory is outstanding. Shorter periods are desirable. Gross profit percentage = GP/Sales Changes in GP% indicate changes in profit from product sales.