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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