Inventories
Revsine/Collins/Johnson: Chapter 9
Learning objectives
1. The two methods used to determine inventory quantities—
perpetual and periodic.
2. What kinds of costs are included in inventory.
3. What absorption costing is and how it complicates financial
analysis.
4. The difference between inventory cost flow assumptions—
weighted average, FIFO and LIFO.
5. How LIFO reserve disclosures can be used to estimate inventory
holding gains and to transform LIFO firms to a FIFO basis.
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Learning objectives concluded
6. How LIFO liquidations distort gross profit.
7. What research tells us about why some firms use LIFO and
others don’t.
8. How to eliminate realized holding gains from FIFO income.
9. How and when to use the lower of cost or market method.
10. How and why the dollar-value LIFO method is applied.
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Inventory types
Manufacturer:
Wholesaler or retailer:
Supplier
Manufacturer
Firm
Raw materials
Firm
Merchandise
inventory
Work-in-process
Includes other
manufacturing
costs
Finished goods
Customer
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Customer
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Overview of accounting issues
Old unit
New unit
Issue: What kind of costs are
included in inventory?
Issue: How is the cost of
goods available for
sale split between the
balance sheet and the
income statement?
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Overview of accounting issues:
Allocating the cost of goods available for sale
Weighted average approach:
Uses the
the average
average cost
cost of
of the
the two
two
Uses
units.
units.
FIFO
produces
a smaller
expense
First-in, first-out (FIFO) approach:
Oldest unit cost flows to income.
Last-in, last-out (LIFO) approach:
LIFO
produces
a larger
expense
Newest unit cost flows to income.
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Overview of accounting issues:
Summary
 Three methods for allocating the
cost of goods available for sale:
Weighted average
FIFO
LIFO
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 GAAP does not require the cost
flow assumption to correspond to
the actual physical flow of
inventory.
 If the cost of inventory never
changes, all three cost flow
assumptions would yield the same
financial statement result.
 No matter what assumption is
used, the total dollar amount
assigned to the balance sheet and
the income statement is the same
($640 in this example).
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Overview of accounting issues:
Unanswered questions
 How should physical quantities in inventory be determined?
 What items should be included in ending inventory?
 What costs should be included in inventory purchases (and
eventually in ending inventory)?
 What cost flow assumption should be used for allocating goods
available for sale between cost of goods sold and ending
inventory?
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Determining inventory quantities:
Perpetual inventory system
 This approach keeps a running (or “perpetual”) record of the
amount of inventory on hand.
 The inventory T-account under a perpetual inventory system looks
like this:
Entries are made as
units are purchased
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Entries are made as
units are sold
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Determining inventory quantities:
Periodic inventory system
 This approach does not keep a running (or “perpetual”) record of
the amount of inventory on hand.
Entries are made as units are purchased
 Ending inventory and cost of goods sold must be determined by
physically counting the goods on hand at the end of the period.
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Determining inventory quantities:
Journal entries illustrated
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Determining inventory quantities:
T-accounts illustrated
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Determining inventory quantities:
Periodic and perpetual compared
Periodic inventory
Perpetual inventory

Less recordkeeping means lower
cost to maintain.

More complicated and usually more
expensive.

Less management control over
inventory.

Does not eliminate the need to take
a physical inventory.

COGS is a “plug” figure and there is
no way to determine the extent of
inventory losses (“shrinkage”).

Better management control over
inventories including “stock outs”.

Typically used for low volume, high
unit cost items (e.g., automobiles)
or when continuous monitoring of
inventory levels is essential.

Typically used when inventory
volumes are high and per-unit costs
are low.
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Items included in inventory
 In day-to-day operations, most firms record inventory when they
physically receive it.
 However, when it comes to preparing financial statements, the
firm must determine whether all inventory items are legally owned.


Goods in transit may be “owned” by the buyer or the seller.
The party that has legal title during transit will record the items as
inventory.
 Consignment goods should not be counted as inventory for the
consignee.
Consignor
Owner
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consigned
goods
Consignee
Sale
Customer
Agent
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Costs included in inventory
 All costs required to obtain physical possession of the inventory
and to make it saleable.





Purchase cost
Sales taxes and transportation paid by the buyer
Insurance costs
Storage costs
Production costs (labor and overhead) for a manufacturer
 In theory, inventory costs should also include the (indirect) costs
of the purchasing department and other general and
administrative costs associated with the acquisition and
distribution of inventory.
 However, most firms exclude these items and limit inventory costs
to direct acquisition and processing costs.
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Costs included in inventory:
Manufacturing costs
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Costs included in inventory:
Absorption costing versus variable costing
Fixed
production
costs
 Manufacturing rentals
and depreciation
 Property taxes
Variable
production
costs
Variable
production
costs
 Raw materials
 Direct labor
 Variable overhead, like
electricity
Variable costing of
inventory (not
allowed by GAAP)
Absorption costing
of inventory
(required by GAAP)
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Costs included in inventory:
Summary
This approach is not
allowed by GAAP.
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These are never
included in inventory.
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Costs included in inventory:
How absorption costing can distort profitability
Selling prices and
costs are constant
 As we shall see, the GAAP gross margin increases from $110,000 in 2005
to $130,000 in 2006 even though variable production costs and selling
price are constant, and sales revenue has fallen.
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Costs included in inventory:
Absorption costing distortion
Variable cost (given): $3.00/unit
Variable cost (given): $3.00/unit
Fixed cost,
$400,000/100,000:
$4.00/unit
Fixed cost,
$400,000/125,000:
$3.20/unit
Total cost:
$7.00/unit
Total cost:
$6.20/unit
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Costs included in inventory:
Variable costing illustration
Under variable costing the gross margin falls
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Cost flow assumptions:
The concepts
 In a few industries, it is possible to identify which particular units
have been sold. Examples include jewelry stores and automobile
dealerships. These firms use specific identification inventory
costing.
 For most firms, however, a cost flow assumption is required.
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Cost flow assumptions:
What assumptions firms use
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Cost flow assumptions:
First-in, First-out (FIFO) illustrated
The computations are:
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Cost flow assumptions:
First-in, First-out (FIFO)
Newest units
assumed still
on hand
Oldest
units
assumed
sold
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Cost flow assumptions:
Last-in, First-out (LIFO) illustrated
The computations are:
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Cost flow assumptions:
Last-in, First-out (LIFO)
Newest units
assumed sold
Oldest units
assumed still
on hand
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Cost flow assumptions:
Inventory holding gains
 LIFO and FIFO are historical cost methods and they overlook
inventory holding gains:
 Current cost accounting records holding gains as they arise (but it
is not permitted under GAAP).
To record inventory holding gain under current cost accounting (not GAAP).
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Cost flow assumptions:
Inventory holding gains (continued)
 Once the holding gains entry has been made:
 When the unit is sold for $500:
Both now shown
at current cost but this is not
GAAP!
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Cost flow assumptions:
Inventory holding gains summary
Holding gain still
on balance sheet
Holding gain
flows to income
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Cost flow assumptions:
LIFO and inventory holding gains
Holding gain remains
on balance sheet
Usually (but not always) the same; however balance sheets
are very different.
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Cost flow assumptions:
FIFO and inventory holding gains
FIFO automatically includes the holding gain on units that are sold.
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Cost flow assumptions:
The LIFO reserve disclosure
Amount
shown on
balance sheet
if FIFO had
been used
Amount
actually
shown on
balance sheet
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Cost flow assumptions:
Converting from LIFO to FIFO
If FIFO had
been used
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Cost flow assumptions:
Partial LIFO use
Ending
LIFO
reserve
Beginning
LIFO
reserve
 So, the LIFO reserve decreased $4,538 during the year.
COGS LIFO  $4,538  COGS FIFO
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Cost flow assumptions:
Another LIFO footnote
LIFO reserve
at Finlay
Enterprises
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LIFO and inflation:
LIFO reserve
Magnitude of
LIFO Reserves
Modest inflation
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Percentage
Change in
Consumer Prices
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LIFO and inflation:
LIFO earnings effect
Modest inflation
Percentage
Change in
Consumer Prices
Magnitude of
LIFO Earnings
Effect
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LIFO liquidation
 When a LIFO firm liquidates old LIFO layers, the net income
number under LIFO can be seriously distorted.
Current
purchases
45 units at $600 each
3rd layer
30 units at $500 each
2rd layer
20 units at $400 each
1st layer
10 units at $300 each
45 units at $600 each
80 units
30 units at $500 each
were sold
5 units at $400 each
How old
LIFO cost
distorts
COGS
LIFO cost of goods sold
Goods available
 Old LIFO layers that are liquidated are “matched” against sales
dollars that are stated at higher current prices.
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LIFO liquidation:
Illustration
Old LIFO
layers
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LIFO liquidation:
Calculation of LIFO liquidation profits
What the per unit
COGS would have
been without the
liquidation
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LIFO liquidation disclosures
Income tax effect ($910,000) was the difference.
From footnote
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LIFO liquidation:
Gross profit distortion
Improving gross margin
was reported
But the improvement
was due to LIFO
liquidation
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LIFO liquidation:
Frequency and earnings impact
Percentage of manufacturing
and merchandising firms
using LIFO and experiencing
a LIFO liquidation
Percentage of firms with
LIFO liquidations
experiencing a positive,
negative, or immaterial effect
on pre-tax earnings
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LIFO liquidation:
Percentage impact on pre-tax earnings
Pre-tax earnings effect of LIFO liquidations with positive
effects on earnings
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Eliminating LIFO ratio distortions:
Current ratio example
Understated
because of LIFO
LIFO reserve adjustment
restates inventory to
approximate current cost.
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Eliminating LIFO ratio distortions:
Inventory turnover example
Distorted by LIFO liquidation
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Tax implications of LIFO
 U.S. tax rules specify that if LIFO is used for tax purposes, LIFO must also
be used in external financial statements.
 This LIFO conformity rule explains why so many firms use LIFO for financial
reporting purposes.
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Eliminating realized holding gains
for FIFO firms
 Reported income for FIFO firms always includes some realized
holding gains during periods of rising inventory costs.
 The size of the FIFO realized holding gain depends on:


How fast input costs are changing.
How fast inventory turns over during the period.
x 10% cost increase
Replacement COGS = 7,900,000
= 8,000,000
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+
100,000
Realized FIFO
holding gain
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Inventory errors
 Due to a miscount in 1995, ending inventory is overstated by $1
million. Here’s the effect:
 If not detected and corrected, here’s how the 2005 error will effect
2006 results:
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Analytical insights:
LIFO dangers
 LIFO makes it possible to “manage” earnings when inventory costs
are rising!
 How?


Accelerate inventory purchases toward the end of a “good” earnings
year so that COGS increases.
Delay inventory purchases toward the end of a “bad” earnings year so
that COGS decreases when old LIFO layers are liquidated.
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Reasons why some companies do
not use LIFO
 The estimated tax savings is too small.
 Business cycles may cause extreme fluctuations in physical
inventory levels.
 The rate of inventory obsolescence is high.
 Managers may want to avoid reporting lower profits because they
believe doing so will lead to:



Lower stock price
Lower compensation from earnings-based bonuses
Loan covenant violations
 Small firms may not find LIFO economical because of high recordkeeping costs.
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Summary
 Absorption costing can lead to potentially misleading trend
comparisons.
 GAAP allows firms latitude in selecting a cost flow assumption.
Some firms use FIFO, others use LIFO, and still others use
weighted-average.
 This diversity can hinder comparisons across firms, thus its often
useful to convert LIFO firms to a FIFO basis.
 Reported FIFO income includes potentially unsustainable realized
holding gains.
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Summary concluded
 Similarly, LIFO liquidations produce potentially unsustainable
realized holding gains.
 Old, out-of-date LIFO layers can distort various ratio comparisons.
 Users must understand these inventory accounting differences
and know how to adjust for them. Only then can valid
comparisons be made across firms and over time.
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Appendix B:
Lower of cost or market
 Inventory is presumed to be impaired when its replacement cost
falls below its carrying value.
 When this occurs, GAAP requires inventory to be carried on the
balance sheet at the lower of its cost or “market” value.
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Appendix B:
Lower of cost or market example
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Appendix B:
LCM and inventory aggregates
 The lower of cost or market LCM method can be applied to:



Individual inventory items
Classes of inventory—say, fertilizers versus weed-killers
The inventory as a whole
Three different answers
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Appendix B:
Criticisms of the LCM method
 Write-downs may initially be conservative, but the resulting higher margin
in the period following the write-down can lead to earnings management.
 Because LCM is conservative, it violates the neutrality posture that
financial reporting rules are designed to achieve.
Insert Exhibit
9.18
 LCM relies on an implicit relationship
between
input and output prices
that may not prevail.
But selling
price and profit
potential hasn’t
changed
LCM rule would
require write-down
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Appendix C:
Dollar-value LIFO
 The standard LIFO method requires data on each separate
product or inventory item.
 This approach has two drawbacks:


Item-by-item inventory records are costly to maintain.
The likelihood of liquidating a LIFO layer is greatly increased.
 The dollar-value LIFO method overcomes these drawbacks:


Much of the detailed recordkeeping required under standard LIFO is
eliminated.
Inventory items are combined into a common pool, which reduces the
likelihood of LIFO liquidation.
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Appendix C:
Overview of dollar-value LIFO
 Here are the inventory amounts before dollar-value LIFO is
applied:
$100,00
$140,00
Beginning inventory
(price index = 1.00)
Ending inventory
(price index = 1.12)
 Under dollar-value LIFO, ending inventory becomes:
$140,00
Ending inventory
at period-end
price
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÷
1.12
1.00
$25,000
X 1.12
$28,000
$100,000
X 1.00
$100,000
Ending inventory
at base-period
price
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Newest LIFO
layer
LIFO Ending
inventory
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Appendix C:
Example continued
2006 beginning inventory:
2006 year-end inventory
Dollar-value LIFO ending inventory for 2006:
$124,600 = 100,000 x 1.00 + ($25,000 -$3,000) x 1.12
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From the
newest
layer
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Appendix C:
Example concluded
2007 year-end inventory
New layer added
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Appendix C:
Steps to computing dollar-value LIFO
1. Ending inventory is initially computed in terms of year-end costs.
2. Restate ending inventory
tobottom
base-period
Insert
panel, p. 482 costs to find out whether
inventory quantities have increased or decreased.
3. Inventory changes determined from step 2 are then costed as:
Insert top panel, p. 483
 New LIFO layers are valued using costs of the year in which the
layer was added.
 Decreases in old LIFO layers are removed using costs in effect when
the layer was originally formed.
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