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Chapter 6,Part 2: InventoryChapter 6,Part 2: InventoryCapitalization of Inventor Primary accounts: Inventory and Cost of Goods

Sold (COGS). Capitalize: add to an asset (inventory) account at

the time of acquisition. What costs to capitalize? Cost to acquire,

including transportation costs to facility (transportation-in or freight-in).

What items or units to include?– General rule: (1) held for sale and (2) complete

and unrestricted ownership.

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Formulas for COGS and Inventory

For Income StatementTo calculate COGS: BI + Purchases (net) - EI = COGS

To calculate Gross Profit (GP):Sales (net) - COGS = GP

Alternative: BI + P(net) = EI + COGS

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Cost Flow Assumptions Given: BI + P (net) = EI + COGS How to assign costs of inflows [BI + P(net)] to EI and COGS?Methods: Specific identification: used internally by many

companies now, because of unique ID tags. Average: used internally and externally by some

manufacturing companies with large volume of identical inventories.

FIFO - (first-in, first-out) for COGS– and LISH (last-in, still here) for EI

LIFO - (last-in, first-out) for COGS– and FISH (first-in, still here) for EI

FIFO and LIFO are the two primary techniques used for external financial reporting.

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Class Problem - Cost FlowsGiven the following activity for January:

Cost Total

Units per Unit Cost

Begin Inventory 20 $ 9.00 $180

Purchase 1/10 40 10.00 400

Purchase 1/22 30 11.00 330

Total available 90 units $910

Sales - 55 units

Ending inventory 35 units

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FIFO(LISH)FIFO for COGS (top down)

55 units20 @ $9 = $18035 @ $10 = $350

Total = $530LISH for EI (bottom up)

35 units30 @ $11 = $330 5 @ $10 = $ 50

Total $380

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LIFO(FISH)LIFO for COGS (bottom up)

55 units30 @ $11 = $33025 @ $10 = $250

Total = $580FISH for EI (top down)

35 units20 @ $ 9 = $18015 @ $10 = $150

Total = $330

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AverageAverageFirst calculate average:

Goods available cost = $910

Goods available units = 90 units

Avg. = $10.11 per unitNow COGS:

55 units x $10.11 per unit = $ 556Now EI:

35 units x $10.11 per unit = $354

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Comparison of FIFO, LIFO, and Comparison of FIFO, LIFO, and AverageAverage

In times of rising prices:highest COGS

lowest COGS

highest EI

lowest EI

highest Net Income

lowest Net Income

LIFO

LIFO

LIFO

FIFO

FIFO

FIFO

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Additional LIFO issues:Additional LIFO issues: LIFO and taxes

– Why use LIFO for taxes? – Why use LIFO for financial statements?

LIFO and market valuation– Should market value a company higher or lower if

they use LIFO? LIFO liquidation

– What happens to net income with liquidation of an old LIFO layer?

LIFO reserve– what information is contained in this disclosure?

Cash flow savings.

Required, if used for tax purposes.

Generally: higher

Increases

FIFO EI, LIFO EI and difference (reserve)

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LIFO ReserveFor companies that use LIFO for tax and

external financial reporting, a financial statement disclosure is required that indicates the calculated inventory(ies) at FIFO. The difference between the FIFO and LIFO inventories is called the LIFO Reserve.

This number may be used to convert LIFO Inventory and COGS and Net Income to a FIFO basis, to allow for comparison to other companies.

It also facilitates the calculation of the cash flow savings from reduced taxes.

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LIFO ReserveCalculations for ending inventory (EI):FIFO EI = LIFO EI + LIFO Reserve

Calculation for COGS:FIFO COGS = LIFO COGS

- Increase in LIFO Reserve ( or +Decrease in LIFO Reserve)

Calculation for tax saving (assuming LIFO Reserve increased during the year):

Tax Savings = Increase in LIFO Reserve x tax rate

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Ending Inventory:Applying the Lower-of-Cost-or-Market Rule

Based on conservatism, ending inventory is valued at cost or market value, whichever is lower.

Problem: because it is an estimate, overestimation of the write-down can create hidden “reserves”.– Recognizes value decreases immediately– Lower EI, lower COGS means higher net

income next period, when the inventory is sold.

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Ratios Relating to Inventory ActivityRatios Relating to Inventory Activity

Inventory Turnover: COGSAverage Inventory

Indicates how often we “turn over” or sell our inventory. High factor is a positive indicator.

Average Days Outstanding: Inventory COGS/365

Indicates how many days Inventory is outstanding. Shorter periods are desirable.

Gross profit percentage = GP/SalesChanges in GP% indicate changes in profit from product sales.