Financial Reporting and Analysis 6e Inventories
CHAPTER 9
INVENTORIES
CHAPTER OVERVIEW
This chapter is designed to allow users to understand existing GAAP inventory methods and
disclosures; it can also help users conduct informed comparisons and analysis of profitability and
net asset positions across firms with varying inventory methods. The chapter also highlights the
key differences between GAAP and IFRS requirements for inventory accounting.
Financial reporting rules allow firms latitude in selecting a cost flow assumption for the
purpose of determining the cost of goods sold reported on the income statement and the inventory
values reported on the balance sheet. Firms use first in, first out (FIFO), last in, first out (LIFO),
and weighted average or a combination of these methods. This diversity in practice can severely
hinder both interfirm and intrafirm comparability when inventory purchase costs are changing
over time. For a reasonable comparison, LIFO amounts should first be transformed to the FIFO
basis. The use of absorption costing is required under GAAP.
Reported FIFO income merges sustainable operating profits and potentially unsustainable
realized holding gains. Analysts must disentangle these elements when preparing earnings and
cash flow forecasts. Similarly, LIFO gross margins can be distorted when LIFO liquidations
occur because “old” costs are matched with current selling prices. To address inventory
obsolescence, GAAP requires that inventory be carried at lower of cost or market. Even though
absorption costing is required by GAAP, it may lead to potentially misleading period–to-period
income changes when inventories increase or decrease sharply.
IFRS accounting for inventory is similar to the accounting under GAAP although LIFO
method is not allowed under IFRS. Additionally, when applying lower of cost or market,
market is defined as net realizable value and write-downs may be reversed. Reversals are not
permitted under U.S. GAAP.
The LIFO conformity rule requires firms to use LIFO for financial reporting if they use it for
tax reporting. LIFO accounting gives firms significant tax deferrals. These deferrals may go
away soon because of deficit pressures and conversions to IFRS, which does not allow LIFO.
Most firms use some form of dollar-value LIFO. Dollar-value LIFO essentially converts FIFO
inventory amounts to LIFO inventory amounts.
CHAPTER OUTLINE
I. AN OVERVIEW OF INVENTORY ACCOUNTING ISSUES
A. Inventories are assets held for sale.
1. A manufacturing firm makes a final product from different inputs.
a. Raw materials inventory consists of components that will eventually be
used in the
completed product.
b. Work-in-process inventory contains the aggregate cost of units that
have been
started, but not completed at the balance sheet date.
c. Finished goods inventory represents the total costs incorporated in
completed, but
Financial Reporting and Analysis 6e Inventories
unsold units.
2. Inventories are usually a significant asset, both in absolute size and in proportion
to all
other assets.
3. Selling inventory for a price greater than its cost represents the main source of a
firm’s
total long-run income.
B. Retail example:
1. Important facts:
a. Retailer started the year with a beginning inventory of one refrigerator
that cost
$300.
b. The retailer purchases another identical refrigerator for a cost of $340 during
the
year.
c. At the end of the year, the retailer sells one of the refrigerators for $500.
2. The total cost of goods available for sale equals beginning inventory plus
purchases ($640 in this example).
3. The total cost of goods available for sale must be allocated between ending
inventory
and cost of goods sold.
4. The choice of the method for making this allocation between ending inventory
and
cost of goods sold represents the major issue in inventory accounting.
a.
Weighted average inventory costing method assumes that the item sold
should
reflect the average cost of the goods available for sale ($320 in this example).
b. The first-in, first-out (FIFO) method of inventory costing method assumes
that the
first unit purchased is the first unit sold. Its cost becomes the cost of goods
sold. Therefore, cost of goods sold in this example is $300. The cost of
ending inventory would be $340 in this case.
c. The last–in, first-out (LIFO) method of inventory costing method assumes
that the
last unit purchased is the first unit sold. Therefore, cost of goods sold in this
example is $340. The cost of ending inventory would therefore be $300.
5. Cost of goods sold equals the cost of goods available for sale less ending
inventory.
C. GAAP does not require the cost flow assumption to correspond to the physical flow of
goods.
D. If the cost of inventory never changed, all three cost flow assumptions would yield the
same result.
Teaching Tip: A greater emphasis that inventory costing is a cost flow assumption
and is NOT the actual physical flow of goods may be very important for student
learning. Consider mentioning the Kroger illustration and why a LIFO physical flow
would lead to spoiled goods since the most recent purchases would be the first sold.
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II. DETERMINATION OF INVENTORY QUANTITIES
A. A perpetual inventory system keeps a running (or “perpetual”) record of the
amount of inventory on hand.
1. Purchases are debited to the inventory account.
2. Cost of units sold is removed from the inventory account as sales are made.
3. In theory, the amount of inventory on hand at any point in time should correspond
to the
unit balance in the inventory account.
Teaching Tip: Most students are familiar with the perpetual inventory system. For
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E. Errors may occur under either type of system. Accounting for various types of
inventory errors is discussed in Appendix C.
III. ITEMS INCLUDED IN INVENTORY
A. All items to which the firm has legal title should be included in the inventory account.
B. Legal title to goods in transit may transfer to purchaser when the goods are shipped
(FOB Shipping Point), when the goods are received (FOB Destination), or when the
goods arrive at a particular place (FOB Boston).
C. Consigned goods are physically in the possession of the firm, but not legally
owned by the firm. They should appear in the consignor’s reported inventory but not
in the consignee’s reported inventory.
IV. COSTS INCLUDED IN INVENTORY
A. The carrying cost of inventory should include all costs required to obtain physical
possession
and to put the merchandise in saleable condition.
B. Manufacturing Costs: The inventory costs of a manufacturer include raw material,
labor, and certain overhead items
(i.e., product costs).
C. General administrative costs and selling costs are expensed in the period in which they
are
incurred (i.e., period costs).
D. Absorption Costing versus Variable Costing:
A. Variable costing includes in inventory only variable costs of production.
1. Variable costs change in proportion to the level of production, such as raw
materials cost, direct labor, and certain overhead items.
2. Fixed costs of production do not change as production levels changes, such
as production facilities rental, depreciation of production equipment,
property taxes
3. When variable costing is used, fixed overhead costs are not included as
part of the inventory cost, but are treated as period costs.
B. Under absorption costing (full costing), all production costs are inventoried.
1. Fixed production costs are not written off to expense as incurred, rather they
are treated as product costs.
2. The rationale is that both variable and fixed production costs are assets since
both are needed to produce a salable product. Exclusion of fixed costs
would understate the carrying value of inventory on the balance sheet.
3. Management may manipulate production to absorb additional fixed items in
the inventory calculation.
C. Absorption costing and variable costing each treat all selling, general, and
administrative costs as period costs.
1. Exhibit 9.2 in the text summarizes the cost treatment by category
under variable and absorption costing.
2. The variable and absorption costing alternatives provide statement
readers with potentially very different pictures of year–to-year
changes in performance.
3. Generally accepted accounting principles do not allow variable costing to be
used in
external financial statements.
Financial Reporting and Analysis 6e Inventories
4. Absorption costing makes it difficult to interpret year-to–year changes in
reported income when inventory levels change (production quantity does not
equal sales quantity)
5. As inventory levels increase under absorption costing, the amount of fixed
cost assigned to inventory increases, leaving less fixed cost charged to the
income statement.
6. The allocation of fixed costs between product and period cost may distort the
quality of earnings for a manufacturing company.
7. GAAP requires that normal capacity be used to allocate fixed overhead. The definition
of normal capacity is very broad and subjective making it unlikely to affect the
computation of fixed overhead in inventory.
8. Absorption costing facilitates comparability when firms differ in the percentage of
components that they buy versus manufacture themselves.
D. Vendor Allowances: These are common practices such as providing cash payments and/or
credits to customers. A common type is a slotting fee. [ you may choose to discuss this using
the example in the text]
V. COST FLOW ASSUMPTIONS: THE CONCEPTS
A. Under specific identification, the cost of goods sold (ending inventory) can be
measured by
reference to the known cost of the actual units sold (still on hand).
1. This method is used by businesses that sell a small number of high-value items.
2. This method makes it relatively easy to manipulate income.
3. This method is usually not feasible for most businesses, so one of the following
cost flow
assumptions is required to allocate the cost of goods available for sale between
ending
inventory and cost of goods sold.
B. FIFO Cost Flow:
1. This method presumes that sales are made from the oldest available goods and that
ending
inventory is comprised of the most recently acquired goods.
2. FIFO charges the oldest costs against revenues on the income statement.
a. This characteristic is often viewed as a deficiency since current costs of
replacing the
units sold are not being matched with current revenues.
b. However, on the balance sheet, FIFO inventory represents the most recent
purchases
and will usually approximate current replacement costs.
C. LIFO Cost Flow:
1. This method presumes that sales are made from the most recently acquired units
and that
ending inventory is comprised of the oldest available goods.
2. This method seldom corresponds to the actual physical flow of goods.
3. LIFO matches the most recently incurred costs against revenues.
a. This characteristic is often viewed as an advantage since current costs of
replacing
the units sold are being matched with current revenues.
b. However, on the balance sheet, LIFO inventory represents the oldest available
Financial Reporting and Analysis 6e Inventories
costs, which usually do not approximate current replacement costs.
c. For firms that have used LIFO for many years, the LIFO inventory amount
may reflect only a small fraction of what it would cost to replace this
inventory at today’s prices.
D. 1. FIFO is the most popular method (about 50% of firms), followed by LIFO (24% of
firms).
2. Most firms use a combination of inventory costing methods.
3. GAAP does not require the cost flow assumption to conform to the actual physical
flow
of the goods.
4. Few firms use LIFO exclusively, largely because LIFO is prohibited in most
countries
outside of the United States – IAS permits the use of FIFO or weighted average
and in certain circumstances specific identification, but prohibits the use of LIFO.
E. FIFO, LIFO, and Inventory Holding Gains:
1. Inventory holding gains and losses are the input cost changes that occur
following the purchase of inventory.
a. These holding gains are treated as a component of net income when the unit is
sold.
b. One alternative is to recognize this “unrealized holding gain” as an owners’
equity increase that is part of comprehensive income.
2. Current cost accounting, also called replacement cost accounting, records unrealized
holding gains on financial statements as they arise.
a. Inventory is debited and “unrealized holding gains on inventory” is credited
for the input cost changes.
b. As a result, current costs are recorded both in cost of goods sold and in
ending inventory.
c. The current cost operating profit reflects the expected ongoing
profitability of current operations at current levels of costs and selling
prices.
d. Current cost accounting is a departure from historical cost and not
permitted in the basic financial statements under GAAP although
voluntary supplemental disclosure is allowed.
3. The primary difference between FIFO and LIFO is that each method makes a
different choice regarding which element is shown as the out–of–date cost.
a. FIFO shows inventory at approximately current cost, but is then forced to
reflect cost of goods sold at historical cost.
b. LIFO shows cost of goods sold at approximately current cost, but is then
forced to reflect inventory on the balance sheet at historical cost.
c. When input costs are rising, LIFO income will be lower than FIFO income as
long as inventory quantities remain constant or increase.
d. By charging the oldest costs to the income statement, FIFO
automatically
includes in income the holding gain on the unit that was sold.
F. The LIFO Reserve Disclosure:
1. The LIFO reserve is a mandated disclosure that shows the dollar magnitude of
the difference between LIFO and FIFO inventory costs.
2. By adding the reported LIFO reserve to the balance sheet LIFO inventory number,
one can estimate FIFO inventory.
3. The LIFO reserve disclosure also allows the analyst to convert reported LIFO
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cost of goods sold amounts to FIFO amounts.
a. LIFO cost of goods sold – Increase in LIFO reserve = FIFO cost of goods
sold.
b. LIFO cost of goods sold + Decrease in LIFO reserve = FIFO cost of goods
sold.
Teaching Tip: Emphasize that the change in the LIFO reserve represents the difference
between LIFO and FIFO gross margin for that period. The level of the LIFO reserve
represents the cumulative, before-tax difference between LIFO and FIFO income since the
firm adopted the LIFO inventory costing method.
VI. INFLATION AND LIFO RESERVES
A. LIFO liquidation can seriously distort reported net income.
1. LIFO liquidation results when there is a decline in inventory quantities.
2. The older costs in the LIFO layer liquidated are matched with current sales dollars.
In other words, previously ignored holding gains are included in income as old
layers are liquidated.
3. This results in inflated or illusory profit margins.
4. LIFO liquidation profit is calculated as (Current cost — LIFO layer cost) x Quantity
liquidated.
5. When LIFO liquidation profits are material, the SEC requires that its income effect
be reported.
6. LIFO dipping results in an (unsustainable) increase in the gross margin
percentage.
B. Exhibit 9.12 illustrates the potential gross profit effect of LIFO dipping.
C. LIFO liquidations occur frequently and often have a large effect on reported earnings.
D. Reconciliation of Changes in LIFO reserve provides auditors and analysts
information about the direction of input costs and is valuable when linked to other cost
information.
E. Improved Trend Analysis – To avoid being misled by transitory LIFO liquidation
profits, users should carefully scrutinize the LIFO inventory footnote in order to
determine whether a LIFO liquidation occurred during the period and, if so, what
impact it had on reported profits for the period.
VII. ELIMINATING LIFO RATIO DISTORTIONS
A. The current ratio increases after adding the LIFO reserve to the numerator, converting
LIFO inventory to FIFO inventory.
B. The inventory turnover ratio:
1. LIFO liquidation profits should be added to the numerator.
2. The denominator should be adjusted to reflect FIFO inventory instead of LIFO
inventory.
VIII. TAX IMPLICATIONS OF LIFO
A. The LIFO conformity rule requires that if LIFO is used for income tax purposes, the
Financial Reporting and Analysis 6e Inventories
financial statements must also use LIFO. This is one of the few areas where tax law
requires consistency with choices allowed within GAAP.
B. LIFO’s tax advantage is that it provides a lower income number than FIFO, thus
lowering the
immediate tax liability.
1. The cumulative dollar amount of the tax advantage is the LIFO reserve multiplied
by an average, or marginal, tax rate.
2. This benefit can be reversed if LIFO layers are liquidated or if future purchase
costs fall.
3. These cash flow benefits can induce undesirable managerial behavior.
a. This may happen if a firm has depleted its inventories during the year and it
wants to avoid the tax liability associated with the LIFO liquidation.
b. A manager can avoid taxes by simply purchasing a large amount of inventory
at the end of the year to bring it back up to beginning-of–year levels.
IX. ELIMINATING REALIZED HOLDING GAINS FOR FIFO FIRMS
A. Reported income for FIFO firms always includes some realized holding gains during
periods of rising inventory costs.
B. Since holding gains are potentially unsustainable, analysts try to remove them from
reported FIFO income.
1. The greater the amount of cost change, the larger the divergence between
FIFO and replacement cost of goods sold.
2. The slower that inventory turns over, the larger the divergence between FIFO
and replacement cost of goods sold.
C. The adjustment procedure comprises three steps:
1. Determine FIFO cost of goods sold.
2. Adjust the beginning inventory for one full year of specific price change.
3. Replacement cost of goods sold is the sum of the amounts in step 1 and step 2.
X. ANALYTICAL INSIGHTS: LIFO DANGERS
A. LIFO makes it possible to manage earnings since it is applied using periodic
inventory method and firms wait till the end of the year to compute cost of goods sold. If
managers buy “unneeded” higher cost inventory, this will raise the cost of goods sold,
lower income, and drive EPS down. This increases inventory carrying costs and risk of loss
from obsolescence and spoilage. When managers reduce inventory to appropriate levels the
following year, a LIFO liquidation occurs.
B. Intentional or Unintentional: Research evidence is not sufficient to offer definitive
conclusions. If management bonus contracts do not subtract out LIFO liquidation “profits”,
there is an incentive for deliberate actions.
XI. EMPIRICAL EVIDENCE ON INVENTORY POLICY CHOICE
A. The tax savings for LIFO adopters is much higher (when costs are rising) than the
potential savings for firms not using LIFO.
B. Non-LIFO firms generally have significantly larger tax loss carry forwards than LIFO
firms, therefore there is not a need to adopt LIFO to save on tax payments.
C. LIFO adopters have lower levels of inventory fluctuations and lower leverage than non-