Analysis of Inventories
Inventory: Asset or Expense?
ƒ Inventories normally considered assets held
for sale
ƒ Comprised of:
– Raw materials inventory
– Work-in-process inventory
– Finished goods inventory
ƒ Question:
– Asset or expense?
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What’s in Inventory?
ƒ Inventory:
– Consists of material, labor, and certain
overhead items
– GS&A expenses excluded
» Period costs
ƒ As an asset, it is a deferred expense
– Once sold, call it an expense
– Until then, call it an asset.
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COGS Equation
Beginning inventory
+ Production (or purchases)
= Goods available for sale
- Ending inventory
= Cost of goods sold
Note:
Must allocate “goods
available for sale”
between “ending
inventory” and “cost
of goods sold”.
Choice represents a
major accounting
issue.
Inventory is the only account that appears on both the
balance sheet and the income statement
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Allocation Choices
ƒ Balance sheet, income statement, and cash
flow statement affected by inventory
accounting
– FIFO, LIFO, average
» FIFO: more correctly states the balance sheet
» LIFO: more correctly states the income statement
» Average: between FIFO and LIFO
– If prices constant, value same.
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FIFO versus LIFO
Beginning inventory (2,000
units @ $5)
+ Production (1,000 units @
$6)
= Available for sale
- Ending inventory (500 units)
= Cost of goods sold
FIFO
$10,000
LIFO
$10,000
6,000
6,000
$16,000
3,000
$16,000
2,500
$13,000
$13,500
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LIFO/FIFO Example:
Increasing Prices
Day 1
Day 2
Day 3
Day 4
Day 5
Purchases
Units Price
1
$5
1
$6
1
$7
1
$8
1
$9
Total sales: 3 units
FIFO Accounting
1 x $5 + 1 x $6 + 1 x $7
= $18 cost of sales
1 x $8 + 1 x $9
= $17 ending inventory
Prices
rising LIFO Accounting
1 x $9 + 1 x $8 + 1 x $7
= $24 cost of sales
1 x $5 + 1 x $6
= $11 ending inventory
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LIFO/FIFO Example:
Falling Prices
Day 1
Day 2
Day 3
Day 4
Day 5
Purchases
Units Price
1
$9
1
$8
1
$7
1
$6
1
$5
Total sales: 3 units
Prices
falling
LIFO Accounting
1 x $5 + 1 x $6 + 1 x $7
= $18 cost of sales
1 x $8 + 1 x $9
= $17 ending inventory
FIFO Accounting
1 x $9 + 1 x $8 + 1 x $7
= $24 cost of sales
1 x $5 + 1 x $6
= $11 ending inventory
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FIFO/LIFO Summary
ƒ Period of increasing prices
– LIFO produces:
» Highest cost of sales
» Lower income taxes/higher cash flow
» Lowest inventory value in balance sheet
» Higher turnover ratios
ƒ Opposite result when prices falling
ƒ LIFO cost of sales approximates
replacement cost.
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FIFO/LIFO Summary...
ƒ If LIFO used:
– For taxes, it must be used for financial
reporting — but not vice versa
– Must show LIFO reserve in the annual report
» Converts investment to FIFO value
ƒ Liquidation of LIFO layers can generate profits
– Releases lower cost inventory to cost of sales &
increases profits.
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LIFO Reserve
ƒ Dollar difference between LIFO and FIFO
inventory costs
ƒ Change in LIFO reserve
» Represents the difference between LIFO & FIFO
gross margin for the period
» Level of LIFO reserve represents the cumulative,
before-tax difference between LIFO & FIFO
income since LIFO adopted.
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More Reserve...
ƒ LIFO balance sheet amount + LIFO reserve
approximates FIFO balance sheet amount
ƒ Cost of goods sold
LIFO COGS - increase LIFO reserve
= FIFO COGS
LIFO COGS + decrease LIFO reserve
= FIFO COGS.
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Why is the Reserve Interesting?
ƒ LIFO reserve is the cumulative excess of
LIFO COGS over what would have been
COGS using FIFO
ƒ Increase in reserve x tax rate = taxes saved
this year using LIFO
ƒ Total reserve x rate rate = cumulative tax
savings using LIFO.
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Example of Benefit ($ millions)
Company
Exxon
GM
Caterpillar
Ford
GE
’98 LIFO
Reserve
Est. Cumulative
Tax Benefit
$2,673
$2,268
$2,067
$1,397
$1,098
$1,069
$907
$827
$559
$439
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The End
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