978-0078025679 Chapter 9 Lecture Note Part 2

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Financial Reporting and Analysis 6e Inventories

LIFO adopters.

D. The market perceives LIFO earnings to be of higher quality than FIFO earnings.

E. The market response to earnings news is greater after LIFO adoption.

XII. LOWER OF COST OR MARKET METHOD

A. Whenever the replacement cost of inventory declines below its original cost, the

presumption is that the service potential value of the inventory has been impaired and a

write-down is warranted.

1. The implication is that inventory cost and eventual selling price move together.

2. Carrying value is reduced under the lower of cost or market method.

B. The Contracting Origins of the Lower of Cost or Market Method

1. Was widely practiced before 1920s and evolved to satisfy the information needs of the

most important external group then – commercial lenders.

2. The lower of cost or market rule presumably evolved to satisfy the information

needs of commercial lenders, protecting them from lower than expected collateral

values.

B. Evaluation of the Lower of Cost or Market Rule:

1. The lower of cost or market rule reflects conservatism.

2. The lower of cost or market constitutes GAAP but it does not hold a secure place in

accounting theory.

3. Conservative rules designed to systematically understate asset amounts favor

lenders and equity purchasers over borrowers and equity sellers.

4. The lack of neutrality plaguing the lower of cost or market has troubled various

financial reporting experts and has become the basis for repeated criticisms of this

method.

5. The inherent conservatism of this rule may hurt other users:

a. The assumption that input costs and output prices move together may favor

lenders and equity purchasers over borrowers and equity sellers.

b. “Losses” are recognized even though they are unrealized, but “gains” are

recognized only after they are realized.

c. The lower of cost or market method has received criticism due to the absence

of neutrality.

6. The relevant comparison is between historical cost and replacement cost.

7. However, the use of replacement cost as the relevant market value is subject to

two constraints:

a. Ceiling.

i. “Market” should not exceed the net realizable value NRV—that is, the

estimated selling price in the ordinary course of business less reasonably

predictable costs of completion and disposal.

ii. Therefore, if replacement cost exceeds the ceiling (i.e., NRV), then

inventory must be written down to NRV, assuming that NRV is less than

historical cost.

Teaching Tip The ceiling constraint simply requires that any expected loss be recorded in

its entirety when the expected loss becomes known. In other words, writing down

inventory to replacement cost that exceeds NRV results in a loss recognized in the current

period, with additional loss recorded in the period of sale. This is a direct contradiction to

conservatism, which encourages managers to anticipate losses in the period in which they

become known.

Financial Reporting and Analysis 6e Inventories

b. Floor.

i. “Market” should not be less than net realizable value reduced by an

allowance for an approximately normal profit margin.

ii. Therefore, if replacement cost is less than the floor, then inventory

must be written down to the floor, assuming that he floor is less than

historical cost.

Teaching Tip: The floor constraint discourages managers from overstating losses in the

current period, only to overstate profit in the period of sale. For example, if replacement

cost is less than the floor, writing down inventory to replacement increases the loss

recognized in the current period, only to result in a sale of goods at greater than normal

profit margins in the year of sale. This provides a signal to the market that contradicts the

decline in replacement cost that led to the application of the lower of cost or market rule in

the first place.

8. These constraints mean that the market value used to compare to cost in applying

the lower of cost or market rule is the middle value of (1) replacement cost, (2) net

realizable value, and (3) net realizable value less a normal profit margin.

XIII. GLOBAL VANTAGE POINT – Comparison of IFRS and GAAP Inventory Accounting

A. IAS 2, “Inventories” provides the guidance for inventory accounting under IFRS. Most

IFRS rules for inventory are similar to those under U.S. GAAP. Absorption costing is

required. Some differences include:

1. LIFO is not permitted under IAS 2. FIFO or weighted average methods are

acceptable.

2. Lower of cost or market is applied differently. Market, for IFRS, is defines as net

realizable value while for U.S. GAAP, replacement cost, net realizable value, and net

realizable value less normal markup are all used to capture “market”.

3. IFRS allows inventory reductions to be reversed if the market recovers (not to exceed

the original cost). U.S. GAAP does not allow such reversal.

4. Future Directions: If U.S. firms move to adopt IFRS, they will incur large tax

liabilities although the U.S. Congress could remove the conformity rule and/or grant

firms an extended period over which firms must pay the additional tax.

XIV. APPENDIX A—ELIMINATING REALIZED HOLDING GAINS FROM FIFO INCOME

A. To eliminate realized holding gains from FIFO income, we must estimate the percentage

change in inventory purchase costs.

B. The formula: Change in LIFO Reserve/ [Beg. LIFO Inv. + Beg. LIFO Reserve] produces

a rate of inventory input cost change.

C. Professor: It might be a great idea for you to walk students through equations 9.1

through9.6

XV. APPENDIX B — DOLLAR-VALUE LIFO

A. Cost: The traditional LIFO inventory method requires data on each separate product

or inventory item. This system necessitates considerable clerical work and cost.

B. Liquidation: The likelihood of liquidating a LIFO layer is greatly increased when

LIFO records are kept by individual item.

C. Dollar value LIFO is intended to overcome both of these problems above.

1. Inventory is initially determined in terms of year-end prices, just as under FIFO.

2. The ending inventory at end-of-year prices is then adjusted by a price index to

Financial Reporting and Analysis 6e Inventories

estimate LIFO inventory.

a. The index must reflect price changes for the specific inventory, eliminating the

use of general price indices except in unusual cases.

b. The price index relates current costs to base year costs (i.e., the time of initial

LIFO adoption).

3. The steps involved in computing dollar value LIFO are summarized as follows:

a. Ending inventory is initially computed in term of year-end costs.

b. To determine whether a new LIFO layer has been added or liquidated, the

ending inventory is stated in base-period cost and compared to the beginning

inventory at base-year cost.

i. This eliminates the effect of cost changes.

ii. The comparison indicates whether quantities have changed.

c. Any inventory change is costed as follows:

i. New LIFO layers are valued using cost of the year in which the layer

was added.

ii. Decreases in old layers are removed using costs that were in effect when

the layer was originally formed.

e. The LIFO reserve is computed as the difference between FIFO inventory and

LIFO inventory. The change in the reserve represents the difference between

FIFO and LIFO and cost of goods sold.

XVI. APPENDIX C—INVENTORY ERRORS

A. Errors in computing inventory are rare and almost always accidental.

B. Ending inventory one year is the beginning inventory the next year.

1. Overstated ending inventory leads to understated cost of goods sold,

overstated gross profit, and overstated net income.

2. Understated ending inventory leads to overstated cost of goods sold,

understated gross profit, and understated net income.

C. Since inventory errors correct themselves over a two-year period, beginning

inventory errors have the opposite reporting effect that ending inventory errors have.

Teaching Tip: Of particular concern is the effect that inventory errors have on reported

earnings. Overstating (understating) ending inventory overstates (understates) gross margin.

In addition, ending inventory of one period becomes the beginning inventory of the next

period. Therefore, an error this period carries over to the next period, having the opposite

effect on gross margin. For this reason, inventory errors “correct” themselves at the end of

the second period.

Financial Reporting and Analysis 6e Inventories

CHAPTER QUIZ

1. Swiss Corporation overstated its ending inventory by $14,000 at December 31, 2014. At

December 31, 2015, ending inventory was understated by $24,000. Assume that there were

no other errors in any of the years. Calculate the (before-tax) impact that these errors have on

the income statement for the year ended December 31, 2016.

a. Cost of goods sold is overstated by $24,000.

b. Cost of goods sold is understated by $24,000.

c. Gross profit is understated by $24,000.

d. Gross profit is neither understated nor overstated.

2. The following was taken from Driver-Harris Company’s 1990 Annual Report: We would like

to call your attention to a major effect caused by inflation. Our results are significantly

affected by the use of LIFO accounting. We believe that this method better reflects the

results of operations in inflationary times, even though, had the FIFO method been used for

inventory valuation, our 1990 results before income taxes would have been approximately

$1,800,000 better. Unfortunately, some of our competitors throughout the world are still

using the FIFO method, and thus tend to offer unrealistically low sales prices, based on

outdated costs. Which of the following is true?

a. The FIFO inventory costing method reports higher quality earnings in inflationary

times.

b. The LIFO reserve is $1,800,000 at the end of 1990.

c. FIFO firms tend to offer unrealistic sales prices based on outdated costs.

d. The accounting method for inventory should have nothing to do with a company’s

pricing

strategy.

3. The Walker Company uses the LIFO inventory method. In 2014, anticipating a downturn in

demand, the company decided not to replenish inventory levels at year end. The ensuing

LIFO liquidation increased pretax income by $150,000 over what it would have been had

Walker replaced units of inventory sold during the year. Ending inventory on December 31,

2014, was $1,000,000, a reduction of $350,000 from the level at January 1, 2014. Compute

the additional purchases that would have been required to avoid the 2014 LIFO liquidation.

a. $150,000.

b. $200,000.

c. $350,000.

d. $500,000.

4. The following table contains inventory and cost of goods sold data for Amerada Hess, a

major oil producer and refiner. The firm uses the FIFO method.

Inventories at year end ($ in millions) 2014 2015

Crude Oil 299 250

Refined and other finished products 436 583

735 833

Cost of products sold 4,287 4,450

Calculate Amerada’s current cost of goods sold assuming that U.S. Commerce Department

statistics indicate prices of oil products increased by 10% during 2015.

a. $4,360.50.

Financial Reporting and Analysis 6e Inventories

b. $4,370.30.

c. $4,523.50.

d. $4,533.30.

5. The FIFO/LIFO choice impacts reported profitability, liquidity, activity, and leverage ratios.

What general guideline would you recommend that analysts make to financial statements to

“correct” ratios for a firm’s choice of accounting method?

a. The general guideline is to use LIFO numbers for ratio components that are income-

related.

b. The general guideline is to use FIFO-based data for components that are balance-sheet

related.

c. Both a. and b.

d. Neither a. nor b.

6. When calculating gross profit percentages, adjustments are made for the total LIFO effects

(i.e., both liquidations and declining prices). Which of the following statements is true?

a. The adjustments for both effects provide percentages that are directly comparable to

FIFO firms.

b. The adjustments will always result in higher gross profit percentages.

c. The effects of declining prices on current purchases are nonoperating in nature.

d. The results, adjusted for LIFO liquidation effects, do not better reflect the firm’s

ability to mark up the current cost of inputs.

7. The original cost of an inventory item is below both the replacement cost and net realizable

value. The net realizable value minus normal profit margin is below the original cost. Under

the lower of cost or market method, the inventory item should be valued at

a. Original cost.

b. Replacement cost.

c. Net realizable value.

d. Net realizable value minus normal profit margin.

8. Brock Co. uses the dollar-value LIFO inventory method as of January 1, 2014. A single

inventory pool and an internally computed price index are used to compute Brock’s LIFO

inventory layers. Information about Brock’s inventory follows:

Date At Base-Year Cost At Current-Year

Cost

12/1/2013 40,000 40,000

2014 Layer 5,000 _____

12/31/2014 45,000 54,000

2009 Layer 15,000 _____

12/31/2015 60,000 80,000

What was Brock’s dollar-value LIFO inventory at December 31, 2015?

a. $60,000.

b. $66,000.

c. $74,000.

Financial Reporting and Analysis 6e Inventories

d. $80,000.

9. Urban Company was formed on January 2, 2014 to sell a single product. Over a two-year

period, Urban’s costs steadily increased. Inventory quantities equaled three months’ sales at

December 31, 2014, and zero at December 31, 2015. Assume that Urban uses a periodic

inventory system and uses either FIFO, LIFO, or average cost for both years. Which

inventory costing method will result in the highest (dollar amount of) cost of goods sold for

2015?

a. FIFO.

b. LIFO.

c. Average cost.

d. All three methods will result in the same cost of goods sold.

10. Troy reports that 2014 FIFO gross profit was higher because of (realized) inventory holding

gains that amounted to $3,700 in 2014. If 2014 beginning inventory was $114,509; 2014 ending

inventory was $88,991; and 2014 cost of goods sold was $2,290,134, estimate the current cost of

Troy’s 2014 ending inventory.

a. $88,991.

b. $89,135.

c. $92,691.

d. $92,835.

Essay Question

Absorption costing requires accounting estimates and allocations to value inventory.

Transfer pricing includes all the variable costs in the product being transferred and may

include various fixed costs allocated as a result of absorption costing theory. Describe the

various earnings management schemes that have resulted because of absorption and

transfer pricing decisions.

QUIZ ANSWERS:

1. b. In 2016, only beginning inventory is incorrect. As a result, cost of goods sold is

understated by $24,000 and gross profit is overstated by $24,000. Since there are

no other errors, ending inventory is properly stated. Finally, retained earnings is

properly stated since all errors have reversed themselves by the end of 2016.

2. d. The last sentence in the statement is incorrect. The accounting method for inventory

should have nothing to do with a company’s pricing strategy. Pricing should be based on

current market conditions. Companies that ignore the cost of replacing inventory when

setting prices will suffer from poor cash flows, and in some cases, will fail.

3. d. To maintain its inventory balance at $2,700,000, Walker would have had to increase its

purchases by $350,000 + $150,000 = $500,000. The $150,000 is the difference between

the LIFO and FIFO cost of the inventory. The choice of inventory method does not affect

purchases as they reflect actual prices paid.

4. c. If the increase in specific price index for oil products was 10% in 2015, then the addition to

FIFO

COGS would be $73.5 million (10% x 735 million), where the latter is the inventory balance

Financial Reporting and Analysis 6e Inventories

at the beginning of 2015. This $73.5 million, it should be noted, is the holding gain portion

of the income reported under the FIFO method. Removing the holding gain from income

(adding it to COGS) results in a better measure of reported income ($ in millions):

COGS (reported) $4,450.0

Adjustment for holding gain 73.5

COGS (approximate LIFO) $4.523.5

5. c. The general guideline is to use LIFO numbers for ratio components that are

income- related and FIFO-based data for components that are balance-sheet-

related.

6. a. Adjusting gross profit percentages for LIFO liquidations effects provides a better

measure of current (and future) operating performance, even though the adjusted

percentages are likely to be lower. This adjustment yields gross margins that better

reflect the firm’s ability to mark up the current cost of inputs. While removing the

LIFO liquidation effectively adjusts reported LIFO COGS to a current cost basis, the

effects of declining prices on current purchases and sales, which are operating in nature,

are not removed. For purposes of comparison with firms using FIFO, adjustment

should be made for the total LIFO effect (liquidations and declining prices).

7. a. The ceiling and floor constraints mean that the market value used to compare to cost in

applying the lower of cost or market rule is the middle value of (1) replacement cost, (2)

net realizable value, and (3) net realizable value less a normal profit margin. In this

example, the floor is less than the cost, which is less than both the ceiling and

replacement cost. It is not important to know the relationship between the ceiling and the

replacement cost, since either one, as the middle value, exceeds cost. Therefore, the

inventory should remain on the books at cost.

8. b. The index at the end of 2014 is 1.20 ($54,000 ÷ $45,000). The index at the end of 2015 is

1.3333 (80,000 ÷ $60,000). Therefore, ending inventory consists of the base layer and the

two layers added in 2014 and 2015. Computationally, ending inventory is $66,000

($40,000 + $5,000 x 1.20 + $15,000 x 1.3333).

9. a. FIFO. Given zero inventory at December 31, 2015, the units sold in 2015 must have

equaled the sum of 2015 purchases and beginning inventory. Because beginning

inventory for 2015 would be reported at a higher amount under FIFO (because of rising

prices) than LIFO, the result is a higher cost of goods sold under FIFO.

10. b. CGS ÷ CGAFS = $2,290,134 ÷ ($2,290,134 + $88,991) = 96.26% = Percentage of

goods available that were sold. Therefore, $3,700 realized holding gain is

approximately 96.26% of the total holding gain. So, total holding gain is $3,700 ÷

96.26% = $3,844. Then, unrealized holding gain is $144 ($3,844 – $3,700). Finally,

current cost of ending inventory is $88,991 + $144 = $89,135.

Recommended Exhibits

Exhibit 9.1—Flow of Product Costs for Manufacturing Businesses.

Exhibit 9.2—Summary of Cost Treatment by Category under Variable and Absorption Costing.

Exhibit 9.4—Absorption versus Variable Costing Statements: Contrasting the Outcomes

Exhibit 9.5—Frequency of inventory cost flow assumptions (1995-1998).

Figure 9.1— FIFO Cost Flow.

Figure 9.2— LIFO Cost Flow.

Exhibit 9.6 – Adjusting Cost of Goods Sold from LIFO to FIFO.

Figure 9.4 – Magnitude of Inventory and LIFO Reserve Relative to CPI and Oil Prices.

Figure 9.5 – Lower of Cost or Market Rule for Inventories.

Financial Reporting and Analysis 6e Inventories