Module 5
Reporting and
Analyzing Operating
Assets
Inventory Issues



What is inventory?
What costs are included in inventory?
How do we separate COGS from End. Inv?
Inventory Cost Flows to
Financial Statements
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
Purchases
3
Sales
4@20
3
6
6
10
10
10
12
12
13
13
Year 2
Purchases
10
Sales
5@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
In Class Case

Joe’s TV