Accounting for Inventory

Transcription

1 Accounting for Inventory There are a lot of accounting issues relating to inventory. Manufacturing inventories (Raw materials, work in process, finished goods). Perpetual vs. periodic inventory systems Inventory costs (goods in transit, freight costs, purchase discounts). Cost allocation (specific identification, FIFO, LIFO, average cost). Lower of cost or market Inventory estimation (Dollar value LIFO, Gross profit method, retail inventory method Change in inventory method Inventory errors

2 For our purposes, we will focus on two aspects of accounting for inventories. LIFO reserve/liquidation We will focus less on the details of the calculations and more on the implications of the LIFO reserve. The LIFO reserve represents the difference between a FIFO and LIFO inventory valuation. We will also discuss the income effects of LIFO liquidation. LIFO liquidation occurs when firms have declining levels of inventory and as a result, charge expenses with "old" costs. Lower of cost or market We will discuss the calculations as well as the implications We will discuss why there is an asymmetric treatment of gains and losses Note that this is a basic concept that will appear again when we discuss long-term assets

3 Basic Idea: Example from the Text page 349 Periodic inventory basis: Beginning inventory $22,000 Purchases: (7,000 units) 49,500 Less: ending inventory (4,500 units) (25,000) Cost of Goods Sold (6,500 units) $46,500 Note that under the Last in First Out concept, the most recent costs are included in cost of goods sold. The oldest costs are therefore in ending inventory. Therefore, it is often easiest to determine the cost of goods sold by starting with the ending inventory. In this case, the ending inventory consists of 4,500 units. The first 4,000 came from beginning inventory (the oldest The next 500 come from the first purchase during the year (which turns out to be the 500 units purchased on January Therefore the ending inventory is valued at (4,000 x $5.50) + (500 x $6.00) = $25,000.

4 Assume that the next year the company purchases 8,000 units and sells 7,000 units. Purchases were made as follows: January 31 March 31 July 31 October 31 2,000 2,000 2,000 2,000 Beginning + 500@6) $25,000 Purchases: (8,000 units) 56,000 Less: ending inventory (5,500 units) (31,500) Cost of Goods Sold (7,000 units) $49,500 Ending inventory is therefore: $25,000 + (1,000 x $6.50) = $31,500. Now the ending inventory consists of 3 layers: $6.00; $6.50 We can now use this example to illustrate the LIFO reserve and the liquidation of the LIFO layers.

5 Under the First-In-First-Out method, all of the old costs are allocated to cost of goods sold, and the most recent costs are allocated to ending inventory. Therefore ending inventory consists of $7.50 and $7.00 = $39,500. The difference between the ending inventory of $39,500 under FIFO and the $31,500 ($8,000) is called the "LIFO Reserve". Most firms will report a FIFO inventory of $39,500 less a LIFO reserve of $8,000 to obtain the balance sheet value of $31,500.

6 LIFO LIQUIDATION As long as the firm continues to increase its inventory (units purchased exceeds units sold), additional LIFO layers are created. However, what happens if the firm begins to reduce its inventory? Consider the next year. Assume the following data: ABC purchases 5,000 units at $8.00 and sells 8,000 units at $ Then the gross profit is: 5,000 x ($10-$8) = $10,000 1,000 x ($10-$6.50) = 3, x ($10 - $6) = 2,000 1,500 x ($ ) = 6,750 $22,250 On the other hand, if ABC purchases 8,000 units at $8 then the gross profit is: 8,000 x (10-8) = $16,000. Note that under LIFO liquidation, some very "old" costs are matched against current revenues. Also note that LIFO allows managers to adjust their gross profit by adjusting the timing of their purchases.

7 Inventory Method Choice Most US firms use LIFO because of the LIFO conformity rule: If firms use LIFO to compute taxable income, they must also use LIFO for financial reporting income. In times of rising prices, LIFO provides higher COGS and lower income. Assignment for Thursday, October 26 P8-8, Discussion Case Examine the financial statements for your company and answer the following questions: What inventory method does your firm use? Compute the LIFO reserve as a proportion of the FIFO inventory value.