Module 6
Inventory & Cost of Sales
Choosing an Inventory Cost Flow Assumption: Trade-Offs
• Income and Asset Measurement
– How much does it cost?
– Valuation: Cost-original or replacement, Lower of
Cost or Market
• Economic Consequences
– Income Taxes and Liquidity
– Bookkeeping Costs
– LIFO Liquidation and Inventory Purchasing Practices
– Debt and Compensation Practices
– The Capital Market- Current ratio, Profit margin ratio
Coca Cola Inventory Disclosures
Income Statement:
Balance Sheet:
Coca Cola Inventory Disclosures continued
Footnotes:
Walmart Inventory Disclosures
• Income Statement:
• Balance Sheet
Walmart Inventory Disclosures continued
Footnotes:
Walmart Inventory Disclosures continued
Footnotes:
Inventory Cost Components
• Generally, the cost of inventory includes the
invoice price, plus freight-in, less returns and
allowances, less discounts received for quantity
purchase or early payment.
• Manufactured inventory cost includes the cost of
materials, direct labor, and overhead. Overhead
includes indirect materials and labor, plus all
other production related costs including the cost
of engineering, design, storage, handling,
maintenance, purchasing, and the salaries of
manufacturing management.
Accounting for Inventory: Two MethodsPerpetual
• Record increases and decreases in inventory as they
occur on a day-to-day basis. Typical entries are:
• Buy:
Dr. Inventory
Cr. Accounts payable
XX
XX
• Sell:
Dr. Accounts Receivable XX
Sales price
Cr. Sales
XX
Dr. Cost of goods sold XX
Cost determined by FIFO,
Cr. Inventory
XX LIFO, or Average methods
E7-2 Purchases under Perpetual
Using Gross Method, what are the journal entries?
• Nick’s Fish Market purchased Maine lobster on account
on October 10, 2011, for a gross price of $76,000. Terms:
2/15, n/30
• Nick also purchased Alaskan king crab on account on
October 11, 2011, for a gross price of $36,000. Terms:
2/15, n/30
• Nick paid for the lobster on October 20, 2011.
• Nick paid for the crab on October 30, 2011.
Accounting for Inventory: Two MethodsPeriodic
• Records only increases in inventory during the period as they
occur. Only at the end of the period are decreases for sales of
inventory computed and recorded. Typical entries are:
• Buy:
Dr. Purchases or Inventory
Cr. Accounts payable
• Sell:
At time of sale:
Dr. Accounts Receivable
Cr.
Sales
At end of period compute*, then
Dr. Cost of Goods Sold
Cr.
Inventory
XX
XX
XX
Sales price
XX
XX
XX
* (Beginning Inventory +Net Purchases ) - Ending Inventory = Cost of Goods Sold
E7-2 Purchases under Periodic
Using Gross Method, what are the journal entries?
• Nick’s Fish Market purchased Maine lobster on account
on October 10, 2011, for a gross price of $76,000. Terms:
2/15, n/30
• Nick also purchased Alaskan king crab on account on
October 11, 2011, for a gross price of $36,000. Terms:
2/15, n/30
• Nick paid for the lobster on October 20, 2011.
• Nick paid for the crab on October 30, 2011.
Accounting for Inventory: Two MethodsPeriodic
• The periodic ending inventory is determined by physical
count and cost of goods sold is computed as follows:
Beginning inventory (from prior period physical count)
+ Net Purchases
=Cost of Goods Available for Sale
- Ending Inventory (from physical count)
Cost of Goods Sold
Note: Many companies use a combination of perpetual and periodic
inventory methods—perpetual to track inventory changes day-to-day and
periodic to record changes in inventory values in the accounts at the end of
the period.
Cost Flow Assumptions
• Given: BB + Purchases (net) = EB + COGS
• How to assign costs of inflows [BB + P(net)] to EB
and COGS?
• Any time there are changes in the purchase price of
inventory purchased and on hand during the
period, it is necessary to make an assumption
about cost flow.
Methods:
• Specific identification
• Average for both COGS and EB
• FIFO - (first-in, first-out) for COGS
– and LISH (last-in, still here) for EB
• LIFO - (last-in, first-out) for COGS
– and FISH (first-in, still here) for EB
E7-10 Inventory Cost Flows
Watkins Corporation began operations on January 1, 2010. The 2010 and
2011 schedules of inventory purchases and sales are as follows:
2010:
Purchase 1
10 units @ $10
$100
Purchase 2
20 units @ $12
$240
Total Purchases
$340
Sales
15 units @ $30
$450
2011:
Purchase 1
Purchase 2
Total Purchases
Sales
10 units @ $13
15 units @ $15
20 units @ $35
$130
$225
$355
$700
Compare the COGS, Gross profit, and Ending inventory 2010 and 2011
results when using FIFO, Weighted Average, or LIFO periodic.
E7-10 Periodic Recap
Inventory
Costing
Method
Revenue
Cost of Goods
Sold
Gross Margin
Balance Sheet
Inventory
Revenue
Cost of Goods
Sold
Gross Margin
Balance Sheet
Inventory
Weighted
Average
FIFO
LIFO
Inventory
Costing
Method
Weighted
Average
FIFO
LIFO
E7-10 Inventory Cost Flows
Watkins Corporation began operations on January 1, 2010. The
2010 and 2011 schedules of inventory purchases and sales are
as follows:
2010:
Purchase 1
10 units @ $10
$100
Sales
5 units @ $30
Purchase 2
20 units @ $12
$240
Sales
10 units @ $30
2011:
Purchase 1
10 units @ $13
$130
Sales
10 units @ $35
Purchase 2
15 units @ $15
$225
Sales
10 units @ $35
Compare the COGS, Gross profit, and Ending inventory 2010
and 2011 results when using FIFO, or LIFO perpetual.
E7-10 Perpetual Recap
Inventory
Costing
Method
Revenue
Cost of Goods
Sold
Gross Margin
Balance Sheet
Inventory
Revenue
Cost of Goods
Sold
Gross Margin
Balance Sheet
Inventory
FIFO
LIFO
Inventory
Costing
Method
FIFO
LIFO
Summary of LIFO, FIFO, Weighted Average
• Managers have wide latitude in inventory cost flow
decisions. Specific identification is generally
considered appropriate where items of inventory are
unique (low volume, high cost items) because of the
potential for income manipulation.
• LIFO is generally used when prices are rising because of
the tax advantages and the requirement that it be used
in the financial statements if it is used for tax purposes.
• The only theoretical defense for LIFO is that in times of
extreme inflation, it minimizes the inflationary
distortions in the income statement by matching
current dollars of revenues and expenses. However,
the LIFO method, over time, misrepresents the balance
sheet by understating inventory values.
Summary of FIFO, LIFO, Weighted Average
• If a company adopts LIFO, it must disclose in its footnotes
the “LIFO reserve” which is the difference between
ending inventory ‘s FIFO value and LIFO value.
• FIFO’s advantage is that it provides a valuation for ending
inventory that more closely approximates its current
replacement cost. FIFO’s disadvantage is that it does not
provide a good match of revenues and expenses in
current dollars during periods of changing prices.
• Weighted average is a good compromise in that it
generally provides a fairly good match of revenues and
expenses as long as inventory is turning over fairly fast
which keeps inventory levels fairly low. In such cases, it
will tend to give an inventory value on the balance sheet
that is closer to FIFO, since current purchases normally
have more influence than beginning inventories on
determining the average cost.
LIFO to FIFO Inventory Conversion
• The difference between LIFO and FIFO inventory values
is called the “LIFO Reserve.”
• Assuming prices rise over time, the effect on the
balance sheet of using LIFO is that assets and
shareholders’ equity (Retained Earnings) are lower
than they would be under FIFO.
• The reduction is not equal to the LIFO reserve because
of tax consequences. Inventory values may be lower
but cash is higher by the amount of the LIFO reserve
times the tax rate.
• Thus, total assets are lower by the LIFO reserve times
(1-tax rate) and Retained Earnings is lower by the LIFO
reserve times (1-tax rate).
BE7-3 FIFO V. LIFO
General Electric uses LIFO inventory cost flow
assumption, reporting inventories on its 2008
balance sheet of $13.7 billion and a LIFO reserve
of approximately $706 million.
What would be GE’s 2008 inventory balance if it
used FIFO assumption instead?
Why is disclosure of the LIFO reserve useful to
financial statement users?
Ending Inventory: Applying the Lower-of-Cost-or-Market Rule
• U.S. GAAP says that inventory, like most assets, should be
carried at original cost (aka historical cost). For inventory,
under the conservatism principle, a departure is
appropriate if the replacement cost is less than the
historical cost. So if inventory can be replaced for less than
its original cost, then the difference between the original
and replacement cost should be recognized as a loss.
• Applying the lower-of-cost-or-market rule to ending
inventory is accomplished by comparing the cost allocated
to ending inventory with the market (replacement) value of
the inventory. If the market value exceeds the cost, no
adjustment is made and the inventory remains at cost. If the
market value is less than the cost, the inventories are
written down to market value with an adjusting journal
entry. The typical entry is:
Dr. Cost of goods sold (or Loss on inventory write down) XX
Cr.
Inventory
XX
ID7-4 LCOM and Recognition of Loss/Income
TII Industries makes over-voltage protectors, power systems, and electronic
products primarily for the communications industry. Several years ago, the
company reported that it took “a substantial inventory write-down,”
resulting in a loss for its third quarter ending June 24. The write-down was
estimated to be $12 million and stems from customers’ changes in product
specifications.
a. Provide the journal entry to record the write-down.
b.
Assume the original cost of the inventory was $52 million and that it
was written down to its market value of $40 million. If TII sells it for
$48 million cash in the following period, what journal entries would be
recorded? Assume that TII uses the perpetual inventory method.
ID7-4 continued
c. Applying the lower-of-cost-or-market rule in
this case would cause TII to recognize a loss in
the period of the write-down and income in
the subsequent period. Does such recognition
seem appropriate? Why or why not?
International Perspective – Cost Flow
Assumptions
• Under IFRS the LIFO method is prohibited.
• This poses an important potential impediment to the
adoption of IFRS in the US. Most LIFO users in the US
have chosen LIFO because it results in an income tax
savings.
• DuPont, for example, has saved over $150 million in
income taxes because it uses LIFO.
• A shift to IFRS could impose a huge and immediate
tax burden on LIFO users in the US.
The Lower-of-Cost-or-Market Rule
and Hidden Reserves
• Based on conservatism, ending inventory is
valued at cost or market value, whichever is
lower.
• Problem: can create hidden reserves
– Recognizes price decreases immediately
– Defers price increase recognition until sold
• US GAAP and IFRS use different market values
when applying the lower-of-cost-or-market rule.
Under US GAAP the market value is usually the
replacement cost. Under IFRS it is normally the
realizable value.
ID7-3 LIFO Liquidation and Hidden Reserves
In the early 1980s, an oil glut caused Texaco, a
LIFO user, to delay drilling, which cut it oil
inventory levels by 16%. The LIFO cushion (i.e.,
the difference between LIFO and FIFO inventory
values) that was built into those barrels over the
year amounted to $454 million and transformed
what would have been a drop in net income to a
modest gain.
Explain how using LIFO could be interpreted as
building “hidden reserves.”
P7-10 Avoiding LIFO Liquidations
IBT has used the LIFO inventory cost flow assumption for five years. As of
December 31, 2010, IBT had 700 items in its inventory, and the $9,000 inventory
dollar amount reported on the balance sheet consisted of the following costs:
When
purchased
Number of
items
Cost per item
Total
2007
500
$12
$6,000
2009
200
$15
$3,000
Total
700
$9,000
During 2011, IBT sold 900 items for $75 each and purchased 350 items at $30
each. Expenses other than cost of goods sold totaled $20,000, and the federal
income tax rate is 30% of taxable income.
a. Prepare the 2011 income statement.
b. Assume that IBT purchased an additional 550 items on December 20, 2011
for $30 each. Prepare the 2011 income statement.
c. Compare the two income statements. Discuss the advantages to the
12.20.11 purchase. Discuss the disadvantages of such a strategy.
Operating Cycle Ratios
Inventory:
Inventory Turnover = COGS/Average inventory
Average inventory = (Beginning + Ending)/2
Days Inventory on Hand = 365 days/Inventory turnover
Accounts Receivable:
A/R Turnover=Net Credit Sales/Average A/R
Average A/R= (Beginning + Ending)/2
Days Sales= 365/A/R Turnover
Operating Cycle= Days Inventory on Hand + Days Sales
Is there a Financing Gap?
Accounts Payable:
Accounts Payable Turnover = COGS/Average A/P
Average A/P = (Beginning + Ending)/2
Days Payables = 365 days/Accounts Payable Turnover
Financing Gap?
Operating Cycle - Days Payables= Financing Gap…
BORROW SHORT TERM
OR
Days Payables – Operating Cycle= No Gap…
Free Financing from Suppliers