Tax Accounting: Valuation of Inventories: A Cost Basis Approach under GAAP

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1 Tax Accounting: Valuation of Inventories: A Cost Basis Approach under GAAP Adopted in part from Kieso, Weygandt, and Warfield s Intermediate Accounting and Originally prepared by Jep Robertson and Renae Clark New Mexico State University (altered by Thomas M. Brinker, Jr. for Tax Accounting)

2 Flow of Costs through Manufacturing and Merchandising Companies

3 Inventory Control Inventory control is important for: 1. Ensuring availability of inventory items 2. Preventing excessive accumulation of inventory items The perpetual system maintains a continuous record of inventory changes The periodic system updates inventory records only periodically

4 Inventory Systems Perpetual Method Purchases are debited to Inventory account Freight-in, Purch. R & A and Purch. Disc. are recorded in Inventory account. Debit COGS and credit Inventory account for each sale. Periodic Method Purchases are debited to Purchases account. Freight-in, Purch. R & A and Purch. Disc. are recorded in their respective accounts. COGS is computed only periodically: COGAS - Ending Inventory COGS

5 Guidelines for Determining Inventory Ownership

6 Effect of Inventory Errors Error in Effect on Effect on Ending Income Balance sheet Inventory Items Items Under- COGS (over) Inventory (under) stated Net income (under) Retained Earn (under) Overstated COGS (under) Inventory (over) Net income (over) Retained Earn (over)

7 Costs Included in Inventory Generally accounted for on a cost basis. Product costs (DM, DL, O/H) are inventoriable costs, whereas Period costs (S,G, & A) are not inventoriable costs

8 Cost Flow Assumptions The objective is to most clearly reflect periodic income. Cost flow assumptions need not be consistent with physical flow of goods. The cost flow assumptions are: 1 Specific Identification 2 Weighted Average Cost 3 First-in, First-out (FIFO) and 4 Last-in, First-out (LIFO)

9 Cost Flow Assumptions: Example Susieworld reports the following transactions for 2004: Date Purchases Purchase Cost May units $1,000 Aug units 2,200 Sep units 1, units $5,000 On December 31, the company had 20 units on hand and uses the periodic inventory system. What are the cost of goods sold and the cost of ending inventory?

10 Weighted Average Method Given Data: Date Purchases Cost May units $1,000 Aug units $2,200 Sep units $1, units $5,000 Steps: 1. Calculate per unit average cost: $5,000/420 = $ Apply this per unit average cost to units sold to get COGS: 400 x $ = $4, Apply the per unit average cost to units remaining in inventory to determine Ending Inventory: 20 x $11.91 = $238

11 First-In, First-Out (FIFO) Method Given data: Date Purchases Cost May $10 $1,000 Aug $11 $2,200 Sep $15 $1, $5,000 Cost of goods sold (FIFO) $1,000 (100 sold) $2,200 (200 sold) $1,500 (100 sold; 20 end inv) $4,700 Cost of goods available $5,000 Cost of Goods Sold $4,700 Ending Inventory 20 * $15 = $300

12 Last-In, First-Out (LIFO) Method Given data: Date Purchases Cost May $10 $1,000 Aug $11 $2,200 Sep $15 $1, $5,000 Cost of goods sold (LIFO) $ 800 (80 sold; 20, end inv) $2,200 (200 sold) $1,800 (120 sold) $4,800 Cost of goods available Cost of Goods Sold $4,800 $5,000 Ending Inventory 20 * $10 = $200

13 Cost Flow Assumptions: Notes The ending inventory in units is the same in all three methods: the cost is different. The cost of goods sold and the cost of ending inventory are different, but The cost of goods available is the same in all three methods. LIFO would result in the smallest reported net income (with rising prices).

14 Advantages of LIFO Method LIFO matches more recent costs with current revenues. With increasing prices, LIFO yields the lowest taxable income (assuming inventory does not decrease). With reduced taxes, cash flow is improved. Under LIFO, the need to write down inventory to market is lower.

15 Disadvantages of LIFO Method LIFO does not approximate the physical flow of goods except in special situations. LIFO yields the lowest net income and therefore reduced earnings (when prices rise). Under LIFO, the ending inventory is understated relative to current costs. LIFO involuntary liquidation may result in income that is detrimental from a tax view. LIFO Conformity rule for GAAP LCM does not apply for tax purposes