Transcript Chapter 7 Instructor

Chapter 6,Part 2: Inventory
Capitalization of Inventory
 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 Statement
To calculate COGS:
BI + Purchases (net) - EI = COGS
Alternative: BI + P(net) = EI + COGS
To calculate Gross Profit (GP):
Sales (net) - COGS = GP
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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 Flows
Given 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?
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FIFO(LISH)

FIFO for COGS (top down)

LISH for EI (bottom up)
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LIFO(FISH)

LIFO for COGS (bottom up)

FISH for EI (top down)
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Average

First calculate average:
Goods available cost =
Goods available units =

Now COGS:

Now EI:
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Comparison of FIFO, LIFO, and
Average

In times of rising prices:
highest COGS
lowest COGS
highest EI
lowest EI
highest Net Income
lowest Net Income
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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?


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LIFO Reserve
For 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 Reserve
Calculations 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 Activity

Inventory Turnover:
COGS
Average 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/Sales
Changes in GP% indicate changes in profit from
product sales.
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