Beruflich Dokumente
Kultur Dokumente
Learning objectives
1. The relationship between inventory valuation and cost of goods sold. 2. The two methods used to allocate the total inventory cost between the COGS and the ending inventoriesperpetual and periodic. 3. What kinds of costs are included in inventory. 4. What absorption costing is and how it complicates financial analysis. 5. The difference between inventory cost flow assumptionsweighted average, FIFO and LIFO.
9-1
6. How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis. 7. How LIFO affects firms income taxes. 8. How to eliminate realized holding gains from FIFO income.
10.How to apply the lower of cost or market method. 11.The key differences between GAAP and IFRS requirements for inventory accounting.
9-3
Service Companies:
Travel agency, Entertainment, Internet, etc. Wholesalers and retailer: to buy and sell ready-to-sell merchandise. Acquire and process raw materials into finished goods.
4
Merchandising Companies:
Manufacturing Companies
Inventory types
Wholesaler or retailer: Manufacturer
Firm
Manufacturer:
Supplier
Firm
Merchandise inventory
Customer
Gross Profit: Sales Cost of Goods Sold
Includes other manufacturing costs ( Direct labor costs, direct materials, manufacturing overhead, etc.)
Customer
Issue: How is the cost of goods available for sale split between the balance sheet and the income statement?
9-7
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).
FIFO
LIFO
9-8
How to allocate total inventory between the COGS and the ending inventory? What items should be included in ending inventory? What costs should be included in inventory purchases (and eventually in ending inventory)? What different cost flow assumptions can be used in determine the COGS under each inventory method (i.e., perpetual vs. periodic)?
9-10
Learning Objective:
How to allocate total inventory between the COGS and the ending inventory?
11
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:
This approach does NOT keep a running (or perpetual) record of the amount of inventory on hand.
Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period.
13
14
Perpetual inventory
Less recordkeeping means lower cost to maintain. Less management control over inventory.
More complicated and usually more expensive. Does NOT eliminate the need to take a physical inventory. Better management control over inventories including stock outs. Typically used for low volume, high unit cost items or when continuous monitoring of inventory levels is essential.
COGS is a plug figure and there is no way to determine the extent of inventory losses (shrinkage). Typically used when inventory volumes are high and per-unit costs are low.
15
Learning Objective:
16
In day-to-day operations, most firms record inventory when they physically receive it. 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.
All goods legally owned by the company on the inventory date, regardless of their location.
Goods in Transit
Goods on Consignment
Goods in transit The party with the legal title during transit will record the items as inventory.
FOB Shipping Point: the title transfers to the buyer at the shipping point (i.e., the sellers facility). Thus, the buyer has the title during the transit. FOB Destination: the title transfers to the buyer at the destination (i.e., buyers facility. Thus, the seller has the title during the transit.
19
In Class Exercise :
Houston Corporation had the following inventory transactions in transit on 12/31/08. Indicate whether the inventory would be included in Houstons ending inventory on 12/31/2010. 1. Purchased inventory FOB Shipping Point; shipped on 12/31/10. 2. Sold inventory FOB Shipping Point; shipped on 12/31/10. 3. Purchased inventory FOB Destination; shipped on 12/31/10. 4. Sold inventory FOB Destination; shipped on 12/31/10.
20
Learning Objective:
21
All costs necessary to obtain the inventory and to make it saleable should be accounted for. These costs include: Purchase cost or production costs Sales taxes and transportation costs (if paid by the buyer). In-transit insurance costs (if paid by the buyer). Storage costs.
22
In theory, costs such as the costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory should also be included in the inventory costs(referred to as the indirect costs).
23
Non-manufacturing firms consider the following items in the cost of inventories: Purchase costs ( invoice price) + Freight-in (transportation-in) - Purchase returns - Purchase allowances (reduce the purchase price due to damages on goods). - Purchase discounts (from early cash payments for the purchase) .
24
inventory costs (i.e., product costs)of a manufacturer include: Raw Material (variable) Direct Labor (variable) Overhead items: Variable overhead: indirect labor, indirect material, electricity used for production, etc. Fixed overhead: depreciation expense of machine, property taxes of factories, rent expense for the factories, etc.
25
inventory costs are treated as assets (in work-in-process account for any raw material, labor and overhead in production process and in finished goods account when the production process is complete) until finished goods are sold. finished goods are sold, the carrying value of these finished goods is charged to cost of goods sold.
26
When
Two views on treatment of manufacturing overhead costs: Absorption and variable costing
27
Absorption costing
of inventory (required by GAAP)
Costs are considered to be Includable in inventory if they provide future benefits to the firm.
The rationale for absorption costing is that both variable and fixed production costs are assets since both are needed to produce a saleable product.
28
29
As we shall see, the GAAP gross margin increases from $110,000 in 2011 to $130,000 in 2012 even though variable production costs and selling price are constant, and sales revenue has fallen.
9-30
9-31
9-32
research study found that firms in danger of producing zero earnings resort to overproducing inventory to reduce sort of goods sold and thereby boost profits.
The
evidence suggests that absorption costing provides opportunities for firms to manipulate earnings.
33
Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold.
34
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.
9-35
Cost Flow Assumptions: Allocating the cost of goods available for sale
Assumption: the cost of inventory is rising Older inventory purchase: Unit price:$300 Most recent inventory purchase: Unit price ;$340
Weighted average
Uses the average cost of the two units.
FIFO produces a smaller expense
income.
36
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 amount assigned to the balance sheet and the income statement is the same (i.e., the amount of goods available for sale).
37
Cost flow assumptions: What assumptions do firms use?(Accounting Trends and Techniques)
38
39
which can identify specific units sold can adopt the specific identification method to allocate costs of goods sold and cost of ending Inventory. Examples include jewelry stores and automobile dealerships.
COGS for each sale is based on the specific cost of the item sold.
Perpetual average cost uses a moving average unit cost that is recomputed each time a new purchase is made.
41
Begin Inventory 20 @ $ 9.00 $180 Purchase 1/10 40 @ 10.00 400 Purchase 1/22 30 @ 11.00 330 Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40 + 30 - 55=35 units
Ending Inventories:
35 units x $10.11 = $354 Cost of Goods Sold: $180+ (400+330) 354 = $556
42
First-In, First-Out
The FIFO method assumes that items are sold in the chronological order of their acquisition. The cost of the oldest inventory items are charged to COGS when goods are sold. The cost of the newest inventory items remain in ending inventory. The COGS and ending inventory cost are the same under periodic and perpetual approaches regardless their differences in the timing of adjustments to inventory.
44
45
46
Last-In, First-Out
The LIFO method assumes that the newest items are sold first, leaving the older units in inventory. The cost of the newest inventory items are charged to COGS when goods are sold. The cost of the oldest inventory items remain in inventory. Unlike FIFO, using the LIFO method may result in COGS and ending inventory Cost that differ under the periodic and perpetual approaches.
49
51
Learning Objective
54
LIFO Reserve
Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost.
The difference in the value of inventory between the inventory method used for internal reporting purposes (i.e., FIFO) and LIFO is reported in an account referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO .
55
55
LIFO Reserve
The change in the balance of LIFO Reserve account from one period to another is referred as the LIFO Effect, which reflects the impact on income from using LIFO vs. FIFO.
The SEC required the LIFO reserve disclosure since 1974 for firms adopting LIFO costing.
56
56
9-57
The LIFO Reserve decreased by $655,000 in 2005. This difference is the same as the 2005 COGS difference between LIFO and FIFO.
A decreased LIFO Reserve indicates a smaller LIFO COGS than FIFO COGS, an indication of either deflation or a LIFO liquidation (discussed later).
When LIFO Reserve increases, it indicates a greater LIFO COGS than FIFO COGS, an indication of inflation.
58
58
The proof of LIFO effect equals the COGS impact of FIFO vs. LIFO:
COGS = BI + Pur EI
COGS FIFO COGS LIFO
Thus, a positive LIFO effect indicates COGS (see the example in Exhibit 9.6 on p57)
FIFO
Conversely, a negative LIFO effect indicates COGS FIFO < COGS LIFO
59
59
9-60
LIFO inventory and FIFO inventory increases. Why did the LIFO reserve increase through 2007 and then decrease?
Firms reduce inventory levels as they downsize, restructure, or adopt just-in-time inventory management. Oil price was $16.75 per barrel at the end of 2001. It was $85.52 per barrel at the end of 2007 before dropped to $31.84 by the end of 2008.
61
61
Learning Objective:
Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income.
62
LIFO Liquidation
When prices rise . . .
LIFO inventory costs on the balance sheet are out of date because they reflect old purchase transactions.
If inventory declines, these out of date costs may be charged to current COGS, and earnings.
LIFO liquidation
LIFO Liquidation occurs when a firm experiences significant inventory shortage, and therefore, liquidate some layers in beginning inventory.
This results in costs from preceding periods being matched against current years revenues. This leads to a distortion in net income and a substantial increase in tax payment in the current period.
64
65
LIFO liquidation:
Calculation of LIFO liquidation profits
The LIFO Reserve on 12/31/2005= 10 x $100+15x $200 = $6000. LIFO effect of 2005 is (6,00010,000= -4,000)
What the per unit COGS would have been without the liquidation
66
From footnote
The buildup of the LIFO inventory creates the reserve, 67 and the decline in inventory--known as LIFO dipping--is a liquidation of the reserve.
LIFO liquidation profit in the amount of $2,600,000, reducing LIFO Reserve, and an inflation effect in 2005 in the amount of $1,945,000, increasing LIFO Reserve.
Reconciliation of Changes in LIFO Reserve: Rising input costs increased LIFO cost of goods sold by $1,945,000 LIFO dipping undercharged expense and thus, reduced COGS by (2,600,000) Result: LIFO COGS is less than LIFO by $ 655,000 (=Changes in LIFO Reserve)
68
Figure 9.5 of the textbook indicates that during the period of 1985 to 2001, on average, about 10% to 20% of firms using LIFO experiencing LIFO liquidation.
The contribution of LIFO liquidation to pre-tax earnings ranges from 10.4% in 1991 to 2% in 2000. To avoid being misled by transitory LIFO liquidation profit, LIFO inventory footnote should be studied to see whether LIFO liquidation occurred and its impact to profits.
69
Learning Objective:
70
71
72
73
Most companies use a combination of Inventory cost flow assumptions. The LIFO to FIFO adjustment is identical to the method used in Exhibit 9.8.
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.
9-75
9-76
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.
= 8,000,000
The estimated tax savings is too small (academic research confirms that LIFO firms have
higher tax savings) .
Business cycles may cause extreme fluctuations in physical inventory levels. The rate of inventory obsolescence is high.
9-78
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.
9-79
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.
9-80
Summary (contd.)
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.
9-81
Learning Objective:
82
84
FIFO Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher taxable income and lower COGS.
LIFO
Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income and higher COGS. Is not allowed by the IASC.
85
b. Producing higher income during an inflation period results in paying more income tax.
Disadvantage a. Inventory cost presented on the B/S is not fair. b. Subject to management manipulation.
.
87
Earnings Quality
Manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.
88
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.
89
Inventory Errors
90
Inventory Errors
Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods. Due to the ending inventory will be the beginning inventory of next year, the errors will be corrected by the end of the second year.
91
under a over b
over under
a. either understating the units or the value b. either overstatingInventories: the Measurement units or the value
92
Due to a miscount in 2008, ending inventory is overstated by $1 million. Heres the effect:
If not corrected, heres how the 2008 error will affect 2009 results:
9-93
Assume that, at the end of 2001, Xeron Corporation neglected to include $1,000 of goods in transit to the company when it performed the annual inventory count. This error went undetected through 2002. How would this inventory error affect the financial statements for 2001 and 2002? Assume the cost flow assumption is FIFO.
94
95
BI + P - EI
= COGS | NI
A = L + SE
01: 02: U
O U
U O
U X
U X
LCM
97
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.
98
Net realizable value: The amount that would be received if the assets were sold in the (used) asset market.
99
The lower of cost or market LCM method can be applied to: Individual inventory items Classes of inventorysay, fertilizers versus weed-killers The inventory as a whole
100
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. LCM relies on an implicit relationship between input and output prices that may not prevail.
But selling price and profit potential hasnt changed LCM rule would require write-down 101
IFRS guidelines for inventory are similar to U.S. GAAP Two important differences
LIFO is not permitted under IAS 2 Lower of cost or market is applied differently. Market is net realisable value (no ceiling or floor). IAS 2 allows inventory reductions to be reversed if the market recovers, but the inventory carrying amount cannot exceed the original cost.
9-102
Estimate ending inventory and cost of goods sold using the gross profit method.
103
NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.
105
106
2.
Sales x (1 - Estimated Gross Margin %) = Estimated COGS Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS)
3.
4.
NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.
109
If the gross margin has historically been 30 percent of sales, calculate the estimated ending inventory at March 31.
110
Solution
First, estimate COGS: If GM% = 30%, then COGS = 70% So Sales x 70% = COGS Then, estimate EI: BI + P (net) - EI = COGS
Summary
Absorption costing is required by GAAP but 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.
9-112
Summary
Reported FIFO income includes potentially unsustainable realized holding gains. Similarly, LIFO liquidations distort reported margins and produce unsustainable realized
holding gains.
9-113
Summary concluded
To address inventory obsolescence, GAAP requires inventory to be carried at lower of cost or market (LCM). IFRS accounting for inventory is very similar to GAAP, but LIFO is not allowed. The LIFO conformity rules requires firms to use LIFO for financial reporting if they use it for tax reporting. Most LIFO firms use some form of dollar-value LIFO.
9-114
Summary concluded
Users must understand these inventory accounting differences and know how to adjust for them. Valid comparisons can only be made across firms and over time after adequate adjustments.
9-115