1 - New York University
Accounting choices – Inventory
1 Real world
1 Too costly for firms to keep track of the cost of each sale item
2 Choices have no impact on inflows into the account (purchases)
3 Impact solely on timing of outflows from the account
4 Outflows impact expenses, income, assets and owners’ equity
2 FIFO accounting
1 CGS based on per unit cost of oldest goods in inventory
2 Inventory based on per unit cost of newest goods in inventory
3 Actual item sold likely to differ from item assumed sold
3 LIFO accounting
1 CGS based on per unit coast of newest goods in inventory
2 Inventory based on per unit cost of oldest goods in inventory
3 Actual item sold likely to differ from item assumed sold
4 Weighted average
1 Items sold, CGS & inventory based on averages
2 Average never matches to the actual item sold
5 Many companies use a mix of inventory methods
1 Different industries may use different methods
1 Retailers tend to use LIFO
2 Technology industries tend to use FIFO
2 Due to mergers – accumulate multiple approaches
3 LIFO prohibited in most countries outside U.S.
Physical counting of inventory
1 Periodic
1 Physical count of inventory done at end of the period
2 Use LIFO or FIFO to assign costs to inventory
3 CGS is beginning inventory + purchases – ending inventory
4 Don’t actually know how much was sold or ‘lost’
2 Perpetual
1 Done with each sale
2 More costly
3 Get CGS directly
4 Beginning inventory + purchases – CGS = ending inventory
5 Confirmed by inventory count at end of period
6 Differences due to shrinkage
3 Impact of periodic v perpetual measurement
1 No impact under FIFO
2 Impact under LIFO
1 always take the newest acquired inventory as CGS
2 Perpetual inventory method uses most recently acquired inventory for each sale
3 Periodic inventory method uses most recently acquired inventory starting with purchases made at end of the year
Impact of prices
1 Level prices – choice has no impact on balance sheet or on income
2 Continually rising prices
1 LIFO has highest CGS, FIFO lowest, weighted average in the middle
2 LIFO CGS & income closest to income at current prices
1 LIFO CGS higher, income lower
2 Best measure of current earning power
3 Periodic comes closest to current costs
3 LIFO has lowest inventory, FIFO has highest inventory, weighted average in the middle
4 FIFO inventory closest to inventory at current prices
1 Current assets, total assets higher
2 Best measure of asset values
5 Weighted average doesn’t have the extremes – or current prices
3 Reporting Inventory
1 Companies that report FIFO report only FIFO
2 Companies that report LIFO report both
1 Balance sheet has mix of FIFO & LIFO inventory
2 Difference between FIFO inventory & balance sheet inventory
1 Called LIFO reserve or adjustment to LIFO
2 Represents reduced value of inventory
3 Reserve increases each year due to inflation
4 Decreases with deflation
5 Decreases if the company liquidates inventory
6 Changes in reserve = ending cum – beginning cum
7 Change is the impact on CGS for the current year
1 Increase in reserve means higher LIFO CGS & lower LIFO income
2 Decrease in reserve means lower LIFO CGS & higher LIFO income
8 LIFO Reserve can fall for three reasons
1 Divestitures of inventory
2 Deflation
3 LIFO liquidation - Sale of more inventory than was purchased
Converting LIFO to FIFO
1 Rationale
1 Companies using FIFO report only FIFO
2 Companies using LIFO report LIFO and FIFO
3 Comparison of companies helped by having a common reporting method
2 Converting LIFO to FIFO inventory
1 Companies mixing LIFO and other inventory techniques are typically referred to as LIFO companies
1 FIFO inventory = LIFO inventory + LIFO reserve
2 FIFO CGS = LIFO CGS – period change in LIFO reserve.
3 Purchases of inventory from all sources = LIFO (FIFO) CGS + change in the LIFO (FIFO) inventory account. (Purchases are not affected by the accounting method.)
4 Purchases of inventory due to operations = LIFO (FIFO) CGS + change in the LIFO (FIFO) inventory account reported in the cash flow statement.
5 Negative change in inventory account in the cash flow statement reflects increase the inventory account due to operations.
3 Converting LIFO to FIFO for comparison
1 Have current value income & current value inventory
Inventory Reserve
Owners' Equity Reserve ( (1 – t)
Deferred tax Reserve ( t
1 Owners’ equity is always after tax
2 Use marginal tax rate
4 Impact on financial ratios
1 Under inflation reduced income, reduced assets, reduced equity, increased cash flow - assume taxes are paid
2 Lower current ratio (CA/CL)
3 Higher turnover ratio (CGS/Avg Inv)
4 Higher leverage (Debt/Equity)
5 Lower TIE (Operating Income/Interest Expense)
6 Higher CFO/Interest Paid
7 Return questionable after first year (lower income/lower equity)
5 Inventory & Income Management
1 LIFO – can increase or decrease income by year-end purchases
2 Income too high – purchase more
3 Income too low – purchase less
Costs in inventory
1 Costs included in inventory
1 Manufacturing costs that becomes CGS
1 Raw materials
2 Direct manufacturing labor
3 Overhead (depreciation, indirect labor)
1 Variable overhead costs (some electricity & support)
2 Fixed overhead costs (depreciation, rental, property tax)
2 Other period costs excluded
1 Advertising
2 Selling
3 Administrative
4 Interest
2 Variable costing not allowed under GAAP
1 Gives better estimate of production costs per unit
2 Fixed overhead costs would go to expenses
3 CGS contains only raw materials and direct costs
4 Production cost per unit constant over wide range
5 Income always based on variable costs per unit plus all fixed overhead costs
3 Absorption costing used under GAAP
1 Includes all manufacturing overhead costs
2 If production climbs cost per unit falls
3 If inventory climbs then some fixed overhead costs remain in inventory
4 Income tends to be overstated
5 If inventory falls then extra fixed overhead costs get into CGS
6 Income tends to be understated
4 Analysis of depreciation expense
1 Amount in income statement based on allocation going through inventory
2 Depreciation component of CGS
1 Amount assigned to goods in inventory at beginning of year and sold this year
2 Amount assigned to production this year and sold this year
3 Amount assigned to production this year and still in inventory is NOT in CGS
3 Impact of increased production
1 Spreads out fixed costs
2 Reduces per unit costs
3 Reduces unit cost of CGS
4 Increases income
4 Amount reported in cash flow statement is full amount of depreciation for period (like variable costing)
5 Lower of Cost or Market
1 Tax accounting not quite the same as LIFO financial accounting
1 Can writedown losses for financial reporting
2 Not for tax reporting
1 Companies get advantage of lower income with rising taxes
2 Can’t let companies do the same with falling prices
2 Tax reporting permits the losses under FIFO accounting
3 Mechanics of the cost or market approach
1 Cost is known
2 Replacement cost of product is known
3 Or can be known from the manufacturing process
4 Net realizable value is selling price less costs to complete
5 Net realizable value less normal profit
6 Three different possible values
7 Take the middle value
8 Details
1 If replacement cost > net realizable value, take net realizable value
2 If replacement cost between NRV & NRV-(, take NRV
3 Hard to believe NRV-( > replacement cost (markets out of order)
Using estimation in inventory
1 Goal is to simplify & estimate
1 Focus on one item (base year or costs or sales)
2 Use it to develop estimates of inventory
3 Cost effective, but an estimate
2 Dollar Value LIFO
1 Approach
1 All inventory analysis is based on prices in a base year
2 Determination of new layers are based on base year prices
3 New layers repriced to appropriate price levels
4 Dependent on general price indexes
2 Basics
1 Layers of inventory are associated with different price levels
2 Each layer can represent a year and an associated average price level
3 Use price index to convert inventory value to base year value
4 Know base year value of each year's purchases remaining in inventory
5 Split out layers based on base year values
6 Adjust each year's inventory layer to price levels for that year
7 Add everything up
3 Gross profit method
1 Know beginning inventory at cost
2 Know purchases
3 Know sales
4 Know profit margin percent
5 Calculate sales based on costs
6 Subtract sales at cost from beginning inventory at cost and purchases to get ending inventory
4 Retail Inventory Method
1 Fundamental approach
1 Avoid counting everything
2 Know cost & sales value of beginning inventory & purchases
3 Convert costs to sales value of costs
4 Know net sales
5 Use sales values to estimate sales value of ending inventory
6 Reconvert back to costs
2 Basics
1 Know normal markup used to get sale price
2 Know cost and normal retail values of beginning inventory
3 Know cost and normal retail values of new purchases
4 Know normal retail sales during period
5 Use average ratio of cost to sales
6 (Estimate cost of remaining inventory
3 Adjustments - markups
1 Include special markups
2 Include markup cancellations
3 Gives maximum retail sales during period
4 Use ratio including markup adjustments only
5 Ratio is lower then if markdowns are included
6 (Gives lower of cost or market estimate of inventory
7 Eliminates losses that company should expense
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