CHAPTER 19
REPORTING
INVENTORY
1
Chapter Overview
 How does a company determine the costs
and amounts of inventory that it includes in
the inventory reported on its balance sheet?
 What alternative cost flow assumptions may
a company use for determining its cost of
goods sold and ending inventory?
 How do alternative cost flow assumptions
affect a company’s financial statements?
2
Chapter Overview
 How do a company’s inventory and cost of
goods sold disclosures help a user evaluate
the company?
 How does a company apply the lower-ofcost-or-market method to report the
inventory on its balance sheet?
 What methods may a company use to
estimate its cost of goods sold and
inventory?
3
Reporting Inventory on the
Balance Sheet
 A company using GAAP is required to base its
inventory reporting on two accounting concepts
we discussed in earlier chapters: historical cost
and matching.
 Historical cost states that a company records its
transactions on the basis of the dollars
exchanged; in other words, the cost of the
inventory purchased.
 Historical cost provides the most reliable value
and the most conservative value for inventory,
reflecting GAAP’s emphasis on conservatism.
4
Reporting Inventory on the
Balance Sheet
 The matching principle states that the cost of
producing revenues for an accounting period
must be deducted from the revenue earned.
 Therefore, a company reports inventory
expense, known as cost of goods sold, in the
period in which it sells inventory and reports
the revenue from the sale.
 Inventory is one of the most ideal illustration
of how the GAAP matching principle is
applied.
5
Computing Historical Cost
 The cost of each unit of inventory includes all
of the cost incurred to bring the item to its
existing condition and location.
 Cost includes the purchase price (less
purchase discounts), sales tax, applicable
transportation costs, insurance, custom duties
and similar costs.
 A company determines the cost of each unit
of inventory by reviewing the source
documents (i.e., invoices) used to record the
purchase.
6
Goods In Transit
 When a company takes a physical inventory,
the purpose is to determine the total cost of
goods on hand at the end of the accounting
period.
 Goods may be in transit at this time, both
from suppliers and to customers.
 A company can buy or sell inventory using
FOB shipping point or FOB destination terms.
Economic control transfers at the same time
legal ownership transfer.
7
Goods In Transit: FOB Shipping
Point
 FOB shipping point means that the title to the
goods transfers when the inventory is delivered to
the shipping agent.
 If a company purchases goods with these terms,
then title transfers when shipped. A company
must include the cost of the inventory in the yearend count even though it may not have physically
arrived.
 If goods are being sold with these terms, then title
transfers to the customer when shipped. A
company must exclude the cost of the inventory in
the year-end count even though it may not have
physically arrived at the customer’s location.
8
Goods In Transit: FOB
Destination
 FOB destination means that the title to the goods
transfers when the inventory arrives at the place
of delivery.
 If a company purchases goods with these terms,
then title transfers when they arrive. A company
must exclude the cost of the inventory in the yearend count if it has not physically arrived.
 If goods are being sold with these terms, then title
transfers to the customer when delivered. A
company must include the cost of the inventory in
the year-end count if it has not yet arrived at the
customer’s location.
9
Inventory Cost Flow Assumptions
 Once a company has determined the
number of units in its ending inventory and
the cost of the units it purchased during the
period, it must determine how to allocate the
total cost of these units between the ending
inventory and the balance sheet:
Cost of
Beginning
Inventory
=
+
Cost of
Purchases*
Cost
Goods
Available
for Sale
*or Cost of Goods Manufactured
Balance
Sheet
Cost of
Ending
Inventory
=
+
Cost of
Goods Sold
Income
Statement
10
Inventory Cost
Flow Assumptions
 If the cost of each unit of inventory is the
same during the period, a company simply
allocates these costs between inventory and
cost of goods sold according to how many
units it has left and how many were sold.
 Most of the time, costs in the inventory are
at various amounts and it becomes more
difficult to determine which costs a company
includes in cost of goods sold and which are
included in the ending inventory.
11
Inventory Cost
Flow Assumptions
 GAAP allows a company to choose one of
four alternative cost flow assumptions to
allocate its cost of goods available for sale
between ending inventory and cost of goods
sold.
1. Specific identification
2. First-in, First-out (FIFO)
3. Average Cost, and
4. Last-in, First-out (LIFO)
12
Granola Goodies Company: Inventory
Information: FIFO Calculation
FIFO Ending Inventory (Perpetual Inventory System):
200 units @$5.50/unit (from January 12 purchase) $ 1,100
900 units @$6.00/unit (from January 24 purchase) $ 5,400
$ 6,500
First goods in are the first goods out
13
Granola Goodies Company: Inventory
Information: LIFO Calculation
LIFO Ending Inventory (Perpetual Inventory System):
700 units @$6.00/unit (from January 24 purchase) $ 4,200
400 units @$5.00/unit (from beginning inventory) $ 2,000
$ 6,200
Last goods in are the first goods out
14
Effect of FIFO and LIFO on the
Financial Statements
The choice made to adopt FIFO
or LIFO affects both the balance
sheet and the income statement.
FIFO
FIFO
$ 16,900
LIFO
LIFO
$ 16,900
Sales
Cost of goods available for sale $ 13,150
$ 13,150
Ending inventory
$ (6,500)
$ (6,200)
Cost of goods sold
$ (6,650)
$ (6,950)
Gross profit
$ 10,250
$ 9,950
When costs are rising, cost of goods sold will
be lower under FIFO because the first cost
moved into cost of goods sold are the earlier
(lower) costs. Gross profit, net income and
ending inventory are higher.
When costs are rising, cost of goods sold will be
higher under LIFO because the first cost moved
into cost of goods sold are the later (higher) costs.
Gross profit, net income, and ending inventory are
lower.
15
Income Measurement Issues
 LIFO may seem counter-intuitive – it assumes an
illogical cost flow that results in lower gross profit,
net income and an ending inventory valuation on
the balance sheet. Why would a company use
this?
 Many users of financial statement argue that LIFO
presents a more accurate picture of profitability
when costs are rising because it matches current
costs with revenues.
 While FIFO results in higher profits, an argument
against this method is that it creates artificial
profits from holding inventory at historical costs
which is less than its current replacement value.
16
Impact of Tax Rules
 In general, a company is not bound to use the
same accounting method for tax purposes
that is used for financial reporting purposes.
 There are many difference between financial
reporting and tax basis profits and inventory
is among them, except when it comes to
LIFO.
 LIFO is an attractive choice for tax purposes
because lower financial profits produce lower
taxes. Lower taxes result in less cash
outflow.
17
Impact of Tax Rules
 However, to use LIFO for tax purposes, a
company must have “book/tax conformity.” This
means that LIFO must be used for financial
reporting purposes as well as for tax purposes.
 The cash deferral from tax savings is usually very
significant and is sufficient for many companies to
choose LIFO for financial reporting purposes.
 For instance, ExxonMobil, General Motors, and
General Electric together have saved over $3
billion in taxes by using LIFO instead of FIFO.
18
Choosing a Cost Flow Method
 If managers of a company expect that the
costs of inventory will increase in the future,
then we should expect them to select LIFO
because of the lower taxes that the company
will have to pay.
 Reporting lower net income, however, does
not mean the the company’s stock price goes
down.
 Since cash is being saved and the company
is matching current revenues and costs, it is
more likely that investors will favorably react
to the adoption of LIFO.
19
Choosing a Cost Flow Method
 Regardless of the method chosen, once a
company selects a method, GAAP requires
that it be applied consistently from period to
period.
 A company can’t choose LIFO one year and
FIFO the next.
 A company can change is method of cost-flow
assumption but there must be a valid
underlying reasons for the change. GAAP
requires that the effect of the change be
highlighted and explained in a company’s
annual report.
20
Financial Statement Disclosure
When inventory is paid
for, it reduces operating
cash flows on the
statement of cash flows.
Cost of goods sold is deducted
from net sales to arrive at
gross profit on the income
statement.
A company must disclose its
inventory cost flow
assumption, method of
inventory valuation, and
components of inventory (if a
manufacturer).
Inventory is
usually reported
right after
receivables, in
order of liquidity.
21
Lower of Cost or
Market Valuation
 The GAAP requirement that companies report
inventories at historical cost (under one of the
cost-flow assumptions) is modified in one
situation.
 When the market value of a company’s
inventory falls below its cost, the company is
required to reduce, or “write down” the
inventory to market value.
 This rule is called the lower-of-cost-or-market
(LCM) method.
22
Lower of Cost or
Market Valuation
 For the LCM rule, market value means
replacement value of the inventory, not selling
price.
 Assume Cane Candy Corporation has 100
boxes of Candy for which it paid $50 a box
but the replacement cost is $40 per box.
What must the company do?
 Under the LCM rule, the company writes
down the inventory $10 per box (taking a loss
on its income statement) and reports the
value of the inventory at $40 on the balance
sheet.
23
Lower of Cost or
Market Valuation
 The LCM rule is a good example of how the
concept of conservatism is applied in GAAP.
 The conservatism principle states that a
company should apply GAAP in a way that
there is little chance that it will overstate
assets or income. Therefore, companies
record losses when evidence of loss exists
but only record gains when they arise as a
result of transactions.
 Conservatism does not mean that a company
can intentionally understates assets or
revenues.
24
Lower of Cost or
Market Valuation
 While conservatism may bias reporting, the
rational for the LCM rule makes sense if one
thinks about the marketplace.
 If a company can replace its current inventory
by paying a lower amount, then it is equally
as likely that the price at which it ultimately
sells the merchandise to customers will also
be less.
 This is further validated by the fact that there
is usually a constant relationship between
selling price and cost in companies.
25
Inventory Estimation Methods
 Sometimes a company needs to estimate the
cost of its inventory. If there is a fire or theft,
or if records are destroyed, it may need to
estimate its loss.
 Also, if a company uses the periodic inventory
method, estimation methods can be used at
interim reporting periods without incurring the
cost or time of a physical inventory.
 Companies use the gross profit method for
the reasons set forth above, whereas retail
merchandisers routinely use the retail
inventory method for financial reporting.
26
Gross Profit Method
 Assume the following information: Beginning
inventory for Watson Company is $12,000,
net purchases are $48,000, and net sales are
$70,000.
 The historic rate of gross profit is 40%.
 Using this information, we can estimate the
company’s ending inventory using four steps.
27
Gross Profit Method: Step 1
 The first step is to estimate the current gross
profit based on the historical information.
 Estimated Gross Profit (Estimated GP) = Net
Sales X Historical Gross Profit Percentage
(GP%).
$70,000
X 40%
=
$28,000
Net Sales
X G.P. % = Estimated GP
28
Gross Profit Method: Step 2
 The second step is to determine the cost of
goods sold.
 Cost of Goods Sold (COGS) = Net Sales Gross Profit (GP).
$70,000
- $28,000
Net Sales -
G.P.
=
$42,000
=
COGS
29
Gross Profit Method: Step 3
 The third step is to determine the actual cost
of goods available for sale.
 Cost of Goods Available for Sale (COGAS ) =
Beginning Inventory (Beg. Inv.) + Net
Purchases (NP).
$12,000 + $48,000 = $60,000
Beg. Inv. + NP
= COGAS
30
Gross Profit Method: Step 4
 The fourth and last step is to estimate the
ending inventory.
 Ending Inventory (End. Inv.) = Cost of Goods
Available for Sale (COGAS) – Cost of Goods
Sold (COGS)
$60,000 - $42,000 = $18,000
COGAS - COGS = End. Inv.
31
Summary of Gross Profit
Relationships
 We can illustrate the results of steps 1- 4 using the
starting information and the information calculating
through the four gross profit estimation steps:
Net sales
Cost of goods sold:
Step 3: Cost of
Beginning inventory goods available $
for sale calculated
Net purchases
$
Cost of goods available for sale
(3) $
Less. Ending inventory (estimated) (4) $
Cost of goods sold
Step 1: gross
Gross Profit (estimated)
profit calculated
Step 4: Ending inventory estimated
$ 70,000 100%
12,000 Step 2: Cost
48,000 of goods sold
calculated
60,000
(18,000)
(2) $ (42,000) 60%
(1) $ 28,000 40%
32
Retail Inventory Method
 Retail companies find it easier and less
expensive to based their inventory accounting
system on the retail value of their inventory.
 The main reason for this is that the inventory
is marked and on display at the retail price.
 During the physical inventory, it is easier to
count the inventory at retail prices than to go
back and identify the cost of every item.
33
Retail Inventory Method – Step 1
 A company calculates its ending inventory
based on a cost-to-retail ratio using four
steps. The first step is to compute the total
goods available for sale at both cost and retail
prices.
Beginning inventory
Purchases (net)
Goods available for sale
Cost
Retail
$ 12,000 $ 20,000
$ 48,000 $ 80,000
$ 60,000 $ 100,000 (1)
34
Retail Inventory Method – Step 2
 The second step is to compute a cost-toretail ratio by dividing the cost of goods
available for sale by the retail value of the
goods available for sale.
Beginning inventory
Purchases (net)
Goods available for sale
Cost-to-retail ratio:
Cost
Retail
$ 12,000 $ 20,000
$ 48,000 $ 80,000
$ 60,000 $ 100,000 (1)
$60,000 = 60%
$100,000
(2)
35
Retail Inventory Method – Step 3
 The third step is to compute the ending inventory at
retail by subtracting the net sales for the period from
the retail value of the goods available for sale.
Beginning inventory
Purchases (net)
Goods available for sale
Cost-to-retail ratio:
Cost
Retail
$ 12,000 $ 20,000
$ 48,000 $ 80,000
$ 60,000 $ 100,000 (1)
$60,000 = 60%
$100,000
Less: Sales (net)
Ending inventory at retail
(2)
$
(70,000) (3)
$30,000
36
Retail Inventory Method – Step 4
 The fourth and last step is to compute the ending
inventory at cost by multiplying the ending inventory at
retail by the cost-to-retail ratio.
Cost
Retail
$ 12,000 $ 20,000
$ 48,000 $ 80,000
$ 60,000 $ 100,000 (1)
Beginning inventory
Purchases (net)
Goods available for sale
Cost-to-retail ratio:
$60,000
$100,000
= 0.60
(2)
Less: Sales (net)
$ (70,000) (3)
Ending inventory at retail
$30,000
Ending inventory at cost (0.60 X $30,000) $18,000
(4)
37