Definition
Inventory is the term used to describe the assets of a company that are intended for sale in the ordinary course of business, are in the process of being produced for sale, or are to be used currently in producing goods to be sold.
Kinds of Inventory
Wholesaler or Retailer
Typically has only one kind of inventory-merchandise
Manufacturer
Typically has three kinds of inventory
• Raw materials
• Work-in-process
• Finished goods
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Goods Available for Sale
Goods available for sale represents the aggregate historical cost of beginning inventory and inventory purchases during the period.
Goods Available for Sale
The amount of goods available for sale must be allocated between ending inventory and cost of goods sold.
Goods Available for Sale
The choice of method of making this allocation - called the cost flow assumption - represents the major issue in accounting for inventories.
– F I F O
– A v e r a g e C o s t
– L I F O
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Determining Inventory
Quantities
• A perpetual inventory system keeps a running record of the amount in inventory--both dollars and units.
• A periodic inventory system keeps a dollars only record of the amount of inventory purchases.
Manufacturing Costs
• The costs of production include:
– R a w M a t e r i a l s
– Direct Labor
– Manufacturing Overhead
• These costs flow through the inventory accounts to the income statement.
Variable vs. Absorption
Costing
• Under variable costing raw materials, direct labor and variable overhead are inventoried
– Fixed overhead is treated as a period e x p e n s e
• Under absorption costing all production costs are inventoried.
• Current GAAP required absorption costing
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Variable vs. Absorption
Costing
Absorption costing complicates financial analysis when there are differences between sales and production. The increase in income arising from an increase in sales will be masked if the sales are from existing inventory rather than production.
Variable vs. Absorption
Costing
On the other hand, when inventory increases under absorption costing the amount of fixed cost assigned to inventory increases. As inventory absorbs more fixed cost, less fixed cost gets charged to the income statement and income goes up.
Cost Flow Assumptions
It is important to understand that GAAP does not require the cost flow assumptions to conform to the actual physical flow of the goods.
– First-in, First-out (FIFO
– Last-in, First-out (LIFO)
• Dollar Value LIFO
– A v e r a g e c o s t
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Inventory Holding Gains
• Inventory holding gains and losses are the input cost changes that occur following the purchase of inventory.
• The primary difference between FIFO and LIFO is that each method makes a different choice regarding the allocation of more current costs.
LIFO Reserve Disclosure
• The SEC requires firms to disclose the difference between LIFO and FIFO ending inventory costs.
• Analysts can use this LIFO reserve to adjust a LIFO based system to a FIFO based one.
LIFO Layer Liquidation
• When a firm dips into LIFO layers, a profit distortion occurs as inventory holding gains ignored in previous years are shifted to the income statement.
• The SEC requires disclosure of material
LIFO layer liquidations.
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LIFO Conformity Rule
• U. S. tax laws specify that if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting purposes.
• Because of the short term cash flow tax benefits of LIFO, managers may be motivated into undesirable purchasing decisions in order to avoid LIFO layer liquidations.
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