BUS312A/612A
Financial Reporting I
Homework
Inventory
Chapter 8
Chapter 8
Inventory & Cost of
Sales
Objectives
Chapter 8
 You should be able to
• Discuss the relevance of inventory methods
• Compare the periodic and perpetual inventory systems
• Identify the effects of inventory errors on financial statements
• Identify the items included as inventory costs
• Compare FIFO, LIFO, Average cost, specific identification, Dollar
Value LIFO, and pooling methods)
• Extract inventory information from financial statements
• Convert COGS and inventory from LIFO to FIFO using information
in the financial statements
Valuation
• Cost-Flow Assumptions: Physical flow versus FIFO, LIFO, Average
cost, Dollar Value LIFO, specific identification and pooling methods
• Lower of Cost of Market
• Periodic vs. Perpetual
Inventory Valuation and Consequences
 Same total $$ amount over the life of the company is allocated differently to
cost of goods sold and ending inventory.
•
•
Is Cost of Goods Sold Correct?
Is Ending Inventory Correct?
•
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
P8-4 (FIFO, LIFO, and Average Cost-Periodic and Perpetual)
Purchases
April 1 (balance on hand)
4
11
18
26
30
100 @ $5.00
400 @ 5.10
300 @ 5.30
200 @ 5.35
600 @ 5.60
200 @ 5.80
Sales
April 5
12
27
28
300
200
800
150
(a) Compute the inventory (kept in units only) at 04/30.
1.
FIFO
2.
LIFO
3.
Average Cost.
(b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each
withdrawal, what amount would be shown as ending inventory in 1, 2, and 3 above?
Problem 8-4 FIFO-periodic
Problem 8-4 FIFO-periodic
Problem 8-4 LIFO-periodic
Problem 8-4 LIFO-periodic
Problem 8-4 Average Cost
-periodic
Problem 8-4 Average Cost
-periodic
P8-4 Recap
Periodic
Inventory
Method
Cost of Goods Sold
Balance Sheet Inventory
Cost of Goods Sold
Balance Sheet Inventory
Weighted
Average
FIFO
LIFO
Perpetual
Inventory
Method
Weighted
Average
FIFO
LIFO
Problem 8-4 FIFO-perpetual
Problem 8-4 FIFO-perpetual
Problem 8-4 LIFO-perpetual
Problem 8-4 LIFO-perpetual
Problem 8-4 Average Cost
-perpetual
Problem 8-4 Average Cost
-perpetual
Cost-Flow Assumptions
Periodic
Perpetual
No
difference
FIFO
LIFO
Vs.
COGS: Last units purchased
this period.
Average
EB: Last units purchased
prior to sale.
COGS: Average across the
EB: Average across the part of whole period.
of the period prior to the sale.
---------------------------------------------------------------------------------------------------------------------------------------Rising cost implications for IS: COGS & NI
BS: Current Assets
FIFO
LIFO
Average cost
Summary of LIFO, FIFO, Average cost
• 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, Average cost
• 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).
FIFO V. LIFO
General Electric uses LIFO inventory cost
flow assumption, reporting inventories on its
2012 balance sheet of $15.4 billion and a
LIFO reserve of approximately $398 million.
What would be GE’s 2012 inventory balance
if it used FIFO assumption instead?
Why is disclosure of the LIFO reserve useful
to financial statement users?
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.
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.”
Disclosure
 Method(s) used
 If using LIFO, LIFO reserve information
(LIFO reserve=difference between LIFO inventory balances and balances if
either FIFO or current costs had been used)
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:
Dollar-value LIFO
 Lose verifiability
• BUT
 Reduce cost of measurement
Dollar-value LIFO
 Periodic
• Determine ending inventory (EI)
• Use EI to determine COGS
 Ending Inventory
• Need ‘units’
 Inventory in base-year dollars
• Need ‘cost’ per ‘unit’
 Price index
P8-8 (Dollar-Value LIFO) Norman’s Televisions produces television sets in three categories: portable,
midsize, and flat screen. On January 1, 2014, Norman adopted dollar-value LIFO and decided to use a
single inventory pool. The company’s January 1 inventory consists of:
Category
Quantity Cost per Unit
Total Cost
Portable
6,000
$100
$ 600,000
Midsize
8,000
250
2,000,000
Flat screen
3,000
400
1,200,000
17,000
$3,800,000
During 2014, the company had the following purchases and sales:
Category No. Purchased Cost per Unit No. Sold
Sales Price/Unit
Portable
15,000
$110
14,000
$150
Midsized
20,000
300
24,000
405
Flat screen 10,000
500
6,000
600
45,000
44,000
(a) Compute ending inventory, cost of goods sold, and gross profit.
P8-8 (Dollar-Value LIFO) Norman’s Televisions produces television sets in three categories: portable,
midsize, and flat screen. On January 1, 2014, Norman adopted dollar-value LIFO and decided to use a
single inventory pool. The company’s January 1 inventory consists of:
Category
Quantity Cost per Unit
Total Cost
Portable
6,000
$100
$ 600,000
Midsize
8,000
250
2,000,000
Flat screen
3,000
400
1,200,000
17,000
$3,800,000
During 2014, the company had the following purchases and sales:
Category No. Purchased Cost per Unit No. Sold
Sales Price/Unit
Portable
15,000
$110
14,000
$150
Midsized
20,000
300
24,000
405
Flat screen 10,000
500
6,000
600
45,000
44,000
(b) Assume the company uses three inventory pools instead of one. Compute ending inventory, cost of
goods sold, and gross profit.