FINANCIAL ACCOUNTING Fourth Edition

FINANCIAL ACCOUNTING Fourth Edition Thomas R. Dyckman Robert P. Magee Glenn M. Pfeiffer CHAPTER 7 Reporting and Analyzing Inventory Learning Objective 1 Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs. 2 Expense Recognition Matching Principle Requires that expenses be recognized in the same period that the associated revenue is recognized Three Approaches Direct Association Immediate Recognition Systematic Allocation 3 Direct Association Expense Recognition Any cost directly associated with a specific source of revenue Recognize at the same time the related revenue is recognized Examples Cost of goods sold Warranty costs 4 Immediate Recognition Expense Recognition Costs that can be associated with the revenues of an accounting period, but not with any specific sales transaction Recognize in period incurred Examples Research and development costs Most marketing costs Most administrative costs including insurance, utilities, salaries, etc. 5 Systematic Allocation Expense Recognition Costs that benefit more than one accounting period that are not associated with specific revenues or assigned to one specific time period Capitalize as an asset and convert to an expense over its useful life Example Depreciation expense 6 1

Reporting Inventories BJ S Wholesale Club, Inc. reports the cost of its inventories sold on its income statements: Income Statements Years Ended (in thousands) January 29, 2011 January 30, 2010 Net sales 0,877,239 0,050,597 Cost of sales 9,697,014 8,950,774 Selling, general and administrative expenses 933,836 860,830 Operating income 246,389 238,993 Other expenses One of the largest single expenses in a company s income statement 7 Inventory A major asset for most manufacturers and merchandisers When inventory is purchased or produced, it is capitalized and carried on the balance sheet as an asset until it is sold. When the inventory item is sold, its cost is transferred to cost of goods sold on the income statement. Cost of goods sold is matched against sales revenue to yield gross profit: Sales revenue Cost of goods sold = Gross profit 8 often called Cost of Sales Inventory Purchasing (1) Phelp s, Inc., a startup company, purchases 60 pairs of swim goggles for resale at a cost of each. Transaction Purchase 60 goggles for cash for each Cash Asset 240 Cash + Noncash Asset Balance Sheet Contrib. = Liabilities + Capital + Earned Capital Income Statement Revenues Expenses = +240 Inventory = = (1) Inventory (+A) 240 Cash ( A) 240 Net Income 9 Inventory Sales (2) Phelp s sells 50 of the swim goggles previously purchased for 0 cash each. Transaction Sell 50 goggles for cash for 0 each Cash Asset +500 Cash + Noncash Asset 200 Inventory = Balance Sheet = Liabilities + Contrib. Capital + Earned Capital +500 & 200 Retained Earnings Income Statement Revenues Expenses = +500 Sales Revenue (2a) Cash (+A) 500 Sales revenue (+R, +SE) 500 (2b) Cost of goods sold (+E, SE) 200 Inventory ( A) 200 Net Income +200 +500 Cost of = 200 Goods Sold 10 Reporting Inventory Reported at cost which includes the cost To acquire For transportation In preparing goods for sale With consideration of incentives Volume discounts Early payment discounts Referred to as cash discounts 11 Reporting Inventory A company should recognize all inventories to which it holds legal title. Occasionally, that means the company will recognize items in inventory that are not on premise. If purchases are FOB shipping point, purchasing company receives title and recognizes inventory as soon as shipped by supplier. When a company ships its own product to a customer, but has not fulfilled its requirements for recognizing revenue, the product remains in sellers inventory until revenue can be recognized. 12 2

13 14 Inventories for Manufacturers Cisco Systems Inventories Raw Materials Inventory Work-in- Process Inventory Finished Goods Inventory Parts and materials purchased from suppliers for use in the production process Inventory of partially completed goods; includes materials, labor, and overhead cost Completed products ready for delivery to customers Cisco reports inventory totaling.486 million in its July 30, 2011 balance sheet: 15 16 Learning Objective 2 Calculating Cost of Goods Sold The inventory account decreases when goods are sold. Account for inventory and cost of goods sold using different costing methods. The ending inventory in the current period becomes the beginning inventory for the subsequent period. Inventory Cost Flows to Financial Statements 17 Inventory Costing Methods Three commonly used inventory methods.. First-in, First-out (FIFO) Assumes the oldest costs recorded in inventory are the first costs transferred to cost of goods sold 18 Last-in, First-out (LIFO) Assumes the most recent costs recorded in inventory are the first costs transferred out Unsold goods Includes the amount of beginning inventory plus current period inventory purchases Costs of items sold during the period Average Cost (AC) Assumes the cost of goods sold is the average of the cost to purchase all of the inventories available during the period Physical inventory flow need not match the cost flow. 3

19 20 FIFO Costing Method Example Phelps, Inc. had 100 goggles costing each in inventory at June 1, and incurred the following inventory transactions during June: Purchased 400 goggles at.50 each Sold 460 goggles at 2.00 each LIFO Costing Method Example Phelps, Inc. had 100 goggles costing each in inventory at June 1, and incurred the following inventory transactions during June: Purchased 400 goggles at.50 each Sold 460 goggles at 2.00 each Cost of goods sold during June 100 goggles at.00 each $ 400 360 goggles at.50 each 1,620 Cost of goods sold $2,020 Cost of goods sold during June 400 goggles at.50 each,800 60 goggles at.00 each 240 Cost of goods sold $2,040 Ending inventory 40 goggles at.50 each 80 Ending inventory 40 goggles at.00 each 60 Inventory Costing and Price Changes 21 Recent cost trends of producers 22 LIFO and FIFO Are both historical cost methods Allocate costs of inventory differently Differences arise when costs of inventory change over time Average Cost Method Example 23 Comparing the Costing Methods 24 Phelps, Inc. had 100 goggles costing each in inventory at June 1, and incurred the following inventory transactions during June: Purchased 400 goggles at.50 each Sold 460 goggles at 2.00 each Average cost = [(100 ) + (400.50)]/500 =.40 Cost of goods sold during June 460 goggles at.40 each $2,024 Ending inventory 40 goggles at.40 each 76 FIFO LIFO AC Ending inventory 40 @.50 each $ 180 40 @.00 each $ 160 40 @.40 each $ 176 Cost of goods sold 100 @.00 and 360 @.50 2,020 400 @.50 and 60 @.00 2,040 460 @.40 each 2,024 Total cost of goods available $2,200 $2,200 $2,200 The total cost of goods available for sale of $2,200 is divided differently between the cost of the goods sold and the inventory that remains on hand for each of the three methods. 4

Learning Objective 3 25 Lower of Cost or Market Inventory is reported on the balance sheet at lower of cost of market (LCM) 26 Apply the lower of cost or market rule to value inventory. If market value of inventory is less than inventory cost If market value of inventory is greater than inventory cost Company must write-down inventory to market Inventory cost remains on the balance sheet Writedown No writedown Market value = Replacement cost Inventory Write-Downs Under LCM Inventory book value is written down to current market value, reducing total assets Inventory write-down is reflected as an expense on the income statement, reducing current period gross profit, income, and equity 27 IFRS Reporting Insight Write-down of inventory cost can be reversed under IFRS if market value increases May be reversed up to the acquisition cost Revaluation results as a debit to Inventory and credit to Cost of Goods Sold 28 Included as part of Cost of Goods Sold Inventory Disclosures BJ s Wholesale Club s note disclosure: 1) Average cost method 2) LCM valuation 3) Physical inventory is taken Merchandise Inventories Inventories are stated at the lower of cost, determined under the average cost method, or market. We recognize the write-down of slow-moving or obsolete inventory in cost of sales when such write-downs are probable and estimable. We recognize a reserve for inventory shrinkage for the period between physical inventories based on historical results of previous physical inventories, shrinkage trends or other judgments management believes to be reasonable under the circumstances. 29 Reasons for Inventory Disclosures The magnitude of a company s investment in inventory is often very large Impacts the income statement and balance sheet Risks of inventory losses are often high Tied to technological obsolescence and consumer tastes Can provide insight into future performance Both good and bad High inventory levels result in substantial costs for a company such as financing costs to purchase, storage, handling, and insurance costs 30 5

Learning Objective 4 Evaluate how inventory costing affects management decisions and outsiders interpretation of financial statements. 31 LIFO Reserve What is LIFO reserve? Difference between LIFO cost and the current value of inventory Must be reported by companies using LIFO LIFO reserve = FIFO ending inventory cost LIFO ending inventory cost Estimating FIFO cost of goods sold FIFO cost of goods sold = LIFO cost of goods sold Change in LIFO reserve Useful for comparing gross profits of a company using FIFO with another company using LIFO 32 Income Statement Effects of LIFO versus FIFO Function of two factors Speed and direction of inventory cost changes If costs increase more slowly, difference between LIFO and FIFO will decrease If costs decrease, difference between LIFO and FIFO will reverse Length of time inventory is held Differences increase with longer holding periods Effects of changing costs Management may change selling prices Lower income taxes result with LIFO when prices are rising 33 Income Statement Effects of Inventory Costing In a period of rising prices FIFO yields the highest gross profit and net income In a period of rising prices LIFO yields the lowest gross profit and net income FIFO LIFO AC Sales (460 2),520,520,520 Cost of goods sold 2,020 2,040 2,024 Gross profit $3,500 $3,480 $3,496 34 Balance Sheet Effects of Inventory Costing In a period of rising prices, LIFO yields ending inventories that are often much lower than FIFO. Current Assets FIFO LIFO AC Cash $ xxx $ xxx $ xxx Accounts receivable xxx xxx xxx Inventories 180 160 176 LIFO does not accurately represent the cost that a company would incur to replace its current investment in inventories. 35 Balance Sheet Effects of LIFO versus FIFO FIFO costing on the balance sheet Approximates current value More likely to require lower of cost or market adjustments Periods of rising prices LIFO ending inventories are understated compared to FIFO Does not represent replacement cost LIFO reserve can be viewed as an unrealized holding gain A gain that results from holding inventory as prices are rising 36 6

Cash Flow Effects of LIFO versus FIFO 37 Financial Statement Effects of Inventory Costing 38 FIFO in periods of rising prices Higher pretax income Higher income taxes Less cash available LIFO in periods of rising prices Lower pretax income Lower income taxes More cash available Increased cash flow from tax savings is often cited as a compelling reason for management to adopt LIFO FIFO LIFO AC Sales (460 2),520,520,520 Cost of goods sold 2,020 2,040 2,024 Gross profit $3,500 $3,480 $3,496 Using FIFO Increased gross profit results in higher pretax income causing higher taxes payable Using LIFO Results in a reduced tax liability, so cash flows are higher Opposite effects occur in deflationary periods Adjusting from LIFO to FIFO Adjust the balance sheet to FIFO FIFO inventory = LIFO reserve + LIFO inventory Adjust the income statement to FIFO FIFO cost of goods sold = LIFO cost of goods sold increase in LIFO reserve OR FIFO cost of goods sold = LIFO cost of goods sold + decrease in LIFO reserve Enhances comparability between companies using FIFO versus LIFO 39 LIFO reserve During the year, account for inventory using FIFO At year-end, record an adjusting entry to adjust inventory and to LIFO Dr. Cr. LIFO reserve FIFO Inventory (A) BI Purch. FIFO xxx xxx LIFO Reserve (XA) Beg Bal Adjustment = xxx End Bal Disclosure of LIFO reserve Conversion to FIFO Inventories Inventories are valued using the last-in, first-out (LIFO) method. This method provides a better matching of current costs against sales revenue. If the first-in, firstout method had been used, reported inventory balances would have been $7,845 (,679) higher than those reported in the 2014 (2013) balance sheet. LIFO Inventory (A) Beg Inv Purch LIFO End Inv LIFO Reserve (XA) Beg End FIFO Inventory (A) Beg Inv Purch FIFO End Inv LIFO LIFO Reserve = FIFO LIFO Inv + LIFO Reserve = FIFO Inv 7

Conversion to FIFO Conversion to FIFO LIFO FIFO Beg Inv + Beg. LIFO Reserve = Beg Inv + Purch + Purch = GAS = GAS End Inv + End LIFO Reserve = End Inv = + Δ LIFO Reserve * = = * Beg LIFO Res End LIFO Res = LIFO Reserve The change in the LIFO Reserve will generally be negative because the ending reserve includes a new LIFO layer. Inventories Inventories are valued using the last-in, first-out (LIFO) method. This method provides a better matching of current costs against sales revenue. If the first-in, firstout method had been used, reported inventory balances would have been $7,845 (,679) higher than those reported in the 2014 (2013) balance sheet. Assume inventories reported using LIFO were 5,000 in 2014 and $37,000 in 2013. Also assume cost of goods sold was reported at $200,000 for 2014. Conversion to FIFO Conversion to FIFO LIFO Inventory (A) 37,000 208,000 45,000 200,000 LIFO Reserve (XA) 5,679 2,166 7,845 LIFO LIFO Reserve = FIFO 200,000 2,166= 197,834 LIFO Inv + LIFO Reserve = FIFO Inv Beg: 37,000+ 5,679= 42,679 End: 45,000+ 7,845= 52,845 FIFO Inventory (A) 42,679 208,000 52,845 197,834 LIFO FIFO 37,000 + 5,679 = 42,679 + 208,000 + 208,000 = 245,000 = 250,679 45,000 + 7,845 = 52,845 = 200,000 + (2,166) = = 197,834 Beg LIFO Res End LIFO Res = LIFO Reserve 5,679 7,845 = (2,166) IFRS Reporting Insight 47 Learning Objective 5 48 LIFO not allowed by IFRS This is one of the major impediments to the conversion of US GAAP and IFRS. Due to the LIFO conformity rule, US taxpayers will not be able to keep using LIFO for their taxes if they adopt IFRS. This will result in a potentially huge onetime tax bill for companies as they switch from LIFO to FIFO. Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios. 8

Gross Profit Margin Important because it is monitored by external users and management Gross profit margin = Sales revenue - Cost of good sold Sales revenue BJ s Wholesale Club, Inc. s Gross Profit Income Statements Years Ended January 29, January 30, (in thousands) 2011 2010 Net sales 0,877,239 0,050,597 Cost of sales 9,697,014 8,950,774 Gross profit,180,225,099,823 Gross profit margin 10.85% 10.94% Gross profit margin decreased slightly 49 Gross Profit Analysis Causes of a changing gross profit margin Product line is stale Change in product mix New competitors enter the market General decline in economic activity Inventory is overstocked Change in pricing Likely cause of BJ s Wholesale Club s decrease in gross profit margin Change in product mix or product pricing 50 Gross Profit Margin Comparison 51 Tools for Inventory Analysis 52 Gross profit margins of Home Depot and Lowe s: Gross profit margins among retailers: Inventory turnover Indicates how quickly inventory is being sold Inventory turnover = Cost of goods sold Average inventory Average inventory days outstanding Indicates how long inventories are held before being sold Average inventory days outstanding = 365 Inventory Turnover 53 54 Tools for Inventory Analysis BJ s Inventory Turnover Inventory days on hand Indicates how many days of inventory are on hand at the end of the year. Inventory days on hand = Ending inventory Average daily cost of goods sold BJ s Wholesale Club, Inc. s inventory turnover for its year ending January 29, 2011: = Inventory turnover = Cost of goods sold Average inventory $9,697,014,000 [$981,576,000 + $930,289,000] 2 = 10.14 times BJ s Wholesale Club sells its entire inventory about 10.14 times per year, on average. 9

BJ s Average Inventory Days Outstanding BJ s Wholesale Club, Inc. s average inventory days outstanding for its year ending January 29, 2011: Average inventory Average inventory days outstanding = Average daily cost of goods sold [$981,576,000 + $930,289,000] 2 = = 35.98 $9,697,014,000 365 days BJ s has its inventories on its shelves about 35.98 days. 55 BJ s Inventory Days On hand BJ s Wholesale Club, Inc. s inventory days on hand for its year ending January 29, 2011: Inventory days on hand = Ending inventory Average daily cost of goods sold $981,576,000 = = 36.95 $9,697,014,000 365 days BJ s has on its shelves about 36.95 days of inventory. 56 Turnover Factors - Inventory Quality Inventory turnover can be compared with prior periods and competitors Higher turnover is favorable Turnover level may imply Change in product mix to higher or lower margin products Excessive purchases or production Missed trends or technological advances Increased competition Change in promotion policies Improvement in manufacturing efficiency 57 Turnover Factors Asset Utilization Optimizing inventory investment Too much inventory is expensive Too little inventory causes stock-outs, lost sales Operational changes to reduce inventory Improved manufacturing processes to eliminate bottlenecks and work-in-process buildup Just-in-time deliveries from suppliers to reduce raw material inventories Demand-pull production in which raw materials are released to production when final goods are demanded by customers 58 Comparing Inventory Turnover 59 Adjusting Turnover Ratios 60 Inventory turnover of Home Depot and Lowe s Inventory turnover of various retail companies Advisable to adjust before calculating turnover ratios Potential mismatch LIFO causes the cost of goods sold value per unit to differ from inventory amount per unit Solution Update beginning and ending inventory values using the LIFO reserve information Adjusted inventory = turnover LIFO cost of goods sold Average FIFO inventory 10

61 62 Adjusting Turnover Ratios Learning Objective 6 This gives a more accurate inventory turnover, but cannot be compared to FIFO firms because FIFO cost of goods sold cannot be converted to LIFO To compare to FIFO companies, both the numerator and denominator must be converted to FIFO Appendix 7A Analyze LIFO liquidations and the impact they have on the financial statements. Adjusted inventory = turnover FIFO cost of goods sold Average FIFO inventory LIFO Liquidation Occurs when the quantity sold exceeds the quantity purchased Old inventory costs from the older cost layers are transferred to cost of goods sold Creates larger than normal profits because older layers are usually less costly per unit when prices are rising Prevention Keep purchases equal or greater than the quantity sold, so that older cost layers remain in inventory 63 LIFO Liquidation Example Under LIFO, all units purchased at the same price are referred to as a layer of inventory Purchases cause new layers to be added LIFO assumes that the most recent layers added are the first to be sold Old layers stay in inventory as long as purchases are greater than or equal to sales When exceeds purchases, old cost layers are liquidated, distorting and income LIFO liquidation illustration LIFO liquidation illustration = =$20 =$25 = =$20 =6 =$2 =$6 =1 =$2 =$6 =$0 YEAR 1 YEAR 2 YEAR 3 YEAR 1 YEAR 2 YEAR 3a 11

68 LIFO liquidation illustration = =$20 =$25 =6 LIFO Liquidation Disclosure LIFO liquidation gain The amount by which net income would be increased if the liquidation had not occurred Must be disclosed in financial statement footnotes =$2 =$6 =1 =$0 YEAR 1 YEAR 2 YEAR 3 YEAR 3a 69 70 LIFO Liquidation Implications LIFO Liquidation Implications continued LIFO liquidation boosts gross profit Because older, lower costs are matched against revenues based on current sales prices Can be Intentional, such as Efforts to lower costs Efforts to improve efficiency Earnings management Involuntary, such as Supply disruption due to natural disasters Tax implications An incentive to avoid LIFO liquidations Financial reporting An incentive to create LIFO liquidations for earnings management purposes The End 71 12