Accounting for Inventory
There are a lot of accounting issues relating to inventory.
• Manufacturing inventories (Raw materials, work in
process, finished goods).
• Perpetual vs. periodic inventory systems
• Inventory costs (goods in transit, freight costs, purchase
discounts).
• Cost allocation (specific identification, FIFO, LIFO,
average cost).
• Lower of cost or market
• Inventory estimation (Dollar value LIFO, Gross profit
method, retail inventory method
• Change in inventory method
• Inventory errors
For our purposes, we will focus on two aspects of
accounting for inventories.
• LIFO reserve/liquidation
• We will focus less on the details of the calculations
and more on the implications of the LIFO reserve.
• The LIFO reserve represents the difference between a
FIFO and LIFO inventory valuation.
• We will also discuss the income effects of LIFO
liquidation. LIFO liquidation occurs when firms have
declining levels of inventory and as a result, charge
expenses with "old" costs.
• Lower of cost or market
• We will discuss the calculations as well as the
implications
• We will discuss why there is an asymmetric treatment
of gains and losses
• Note that this is a basic concept that will appear again
when we discuss long-term assets
Basic Idea: Example from the Text page 349
Periodic inventory basis:
Beginning inventory (4,000 @5.50)
Purchases: (7,000 units)
Less: ending inventory (4,500 units)
Cost of Goods Sold (6,500 units)
$22,000
49,500
(25,000)
$46,500
Note that under the Last in First Out concept, the most
recent costs are included in cost of goods sold. The oldest
costs are therefore in ending inventory. Therefore, it is
often easiest to determine the cost of goods sold by starting
with the ending inventory. In this case, the ending
inventory consists of 4,500 units. The first 4,000 came
from beginning inventory (the oldest costs) @$5.50. The
next 500 come from the first purchase during the year
(which turns out to be the 500 units purchased on January
17 @$6.00). Therefore the ending inventory is valued at
(4,000 x $5.50) + (500 x $6.00) = $25,000.
Assume that the next year the company purchases 8,000
units and sells 7,000 units. Purchases were made as
follows:
January 31
March 31
July 31
October 31
2,000 units @$6.50
2,000 units @$7.00
2,000 units @$7.00
2,000 units @$7.50
Beginning (4,000 @5.50 + 500@6)
Purchases: (8,000 units)
Less: ending inventory (5,500 units)
Cost of Goods Sold (7,000 units)
$25,000
56,000
(31,500)
$49,500
Ending inventory is therefore:
$25,000 + (1,000 x $6.50) = $31,500.
Now the ending inventory consists of 3 layers:
4,000 @$5.50; 500 @ $6.00; 1,000 @ $6.50
We can now use this example to illustrate the LIFO reserve
and the liquidation of the LIFO layers.
Under the First-In-First-Out method, all of the old costs are
allocated to cost of goods sold, and the most recent costs
are allocated to ending inventory. Therefore ending
inventory consists of 2,000 @ $7.50 and 3,500 @ $7.00 =
$39,500.
The difference between the ending inventory of $39,500
under FIFO and the $31,500 ($8,000) is called the "LIFO
Reserve".
Most firms will report a FIFO inventory of $39,500 less a
LIFO reserve of $8,000 to obtain the balance sheet value of
$31,500.
LIFO LIQUIDATION
As long as the firm continues to increase its inventory
(units purchased exceeds units sold), additional LIFO
layers are created.
However, what happens if the firm begins to reduce its
inventory? Consider the next year. Assume the following
data: ABC purchases 5,000 units at $8.00 and sells 8,000
units at $10.00. Then the gross profit is:
5,000 x ($10-$8) =
1,000 x ($10-$6.50) =
500 x ($10 - $6) =
1,500 x ($10 - 5.50) =
$10,000
3,500
2,000
6,750
$22,250
On the other hand, if ABC purchases 8,000 units at $8 then
the gross profit is: 8,000 x (10 - 8) = $16,000.
Note that under LIFO liquidation, some very "old" costs are
matched against current revenues.
Also note that LIFO allows managers to adjust their gross
profit by adjusting the timing of their purchases.
Inventory Method Choice
Most US firms use LIFO because of the LIFO conformity
rule: If firms use LIFO to compute taxable income, they
must also use LIFO for financial reporting income. In
times of rising prices, LIFO provides higher COGS and
lower income.
Assignment for Thursday, October 26
P8-8, Discussion Case 8-3. 8-4
Examine the financial statements for your company and
answer the following questions:
What inventory method does your firm use?
Compute the LIFO reserve as a proportion of the FIFO
inventory value.