Accounting for Inventory

Accounting for Inventory Objectives Understand • Cost-flow assumptions are necessary to determine ending inventory and cost of goods sold (COGS) • LIFO and FIFO are two cost-flow assumptions • How the COGS and ending inventory numbers differ under LIFO and FIFO? • How to convert LIFO COGS and ending inventory to FIFO COGS and ending inventory (understand the LIFO reserve) • How inventory assumptions affect taxes 1 Accounting for Inventory Inventory accounting has two fundamental components: 1) Product Costing Decision (This component is discussed in managerial accounting) What costs flow into each product's inventory account? 2) Cost Flow & Valuation Decisions Once costs are in the inventory account (i.e., on the Balance sheet), when are costs transferred to the Income Statement? 2 Accounting for Inventory Freight in Goods available for sale Beginning Inventory Purchases The “ins” of inventory accounting Ending inventory Cost of goods sold The “outs” of inventory accounting 3 Accounting for Inventory Year 1 Year 2 Beg. Units 0 4 + Units produced 7 5 = Units available 7 9 - Units sold 3 4 = End. Units 4 5 First-year production Second-year production 4 Accounting for Inventory Circuit City, Inc. (Retail operations) vs. CarMax Auto Superstore 5 Accounting for Inventory A Comparison of LIFO and FIFO Income Statement Balance Sheet LIFO FIFO 6 Accounting for Inventory Cost of goods sold and ending inventory: LIFO vs. FIFO Product 1 Units at start of year Units produced Units available for sale Units sold Units at end of year Year 1 Year 2 0 4@$8 7@$8 5@$10 7@$8 9 3@$8 4 4@$8 5 In year 2.... LIFO cogs LIFO ei LIFO cogs + ei FIFO cogs FIFO ei FIFO cogs + ei ? 7 Accounting for Inventory BSE Entries •Inputs for product 1 purchased for cash, year 2 • 4 units sold for $20 each in cash. LIFO cost used for matching • 4 units sold for $20 each in cash, but FIFO used for matching 8 Accounting for Inventory LIFO vs. FIFO over time •Different “cost layers” of inventory LIFO 1@$10 4@$8 FIFO 5@10 Cumulative difference: EInvFIFO-EInvLIFO = “LIFO Reserve”pretax • Under increasing input prices, Year 2: EInvLIFO $42 < EInvFIFO $50 Are FIFO firms’ inventories more valuable? 9 Accounting for Inventory LIFO vs. FIFO over time Under increasing input prices and continuous buildup of cost layers, Year 2: Gross profitLIFO $40 < Gross profitFIFO $48 Are FIFO firms more profitable? 10 Accounting for Inventory LIFO vs. FIFO over time •Inventory turnover: units sold per average units in inventory Based on physical units : Based on FIFO $: Based on LIFO $: 4/[(4+5)/2)] = 0.89 32/[(32+50)/2] = 0.78 40/[(32+42)/2] = 1.08 • Under increasing input prices and continuous buildup of cost layers, ITOLIFO > ITOFIFO Year 2: 1.08 0.78 Are LIFO firms more efficient? 11 0 median catalog, mail-order houses eating places family clothing stores womens clothing stores drugs and proprietary whsl electronic parts whsl natural gas distribution sporting&athletic gds games,toys,chld veh,ex dolls photographic equip&suppl electromedical appar ortho,prosth,surg appl,suply surgical,med instr, appart lab analytical instr elec measu&test instr indl measurement instr motor vehicle parts communications equip tele&telegraph appartus special indl machinery plastics products petroleum refining pharmaceutical preps indl inorganic chemicals newspaper:pubg, pubg&print btld&can soft drinks, water operative builders gold ores Inventory Turnover by Industry 45 40 35 30 25 20 15 10 5 12 Circuit City v. Best Buy 2002 Gross profit % Best Buy 21% Circuit City 25% 2002 ROE 26% 8% 2002 I--Turn 6.9× 4.2× 13 Accounting for Inventory EInvFIFO = BInvFIFO + Inputs - COGSFIFO EInvLIFO = BInvLIFO + Inputs - COGSLIFO The amount of input does not depend upon the choice of LIFO/FIFO. EInvFIFO - EInvLIFO = BInvFIFO - BInvLIFO + COGSLIFO - COGSFIFO Change in LIFO Reserve = COGSLIFO-COGSFIFO The change in LIFO Reserve tells us the difference in cost between LIFO and FIFO. 14 Accounting for Inventory Intel ITO 2002 USX ITO 2002 Adj. USX ITO 2002 COGS = 13,446 COGS = Beg Inv = 2,253 Beg Inv = 870 “FIFO” Beg Inv = 1,280 End Inv = 2,276 End Inv = 1,030 “FIFO” End Inv = 1,340 ITO = 5.9 ITO = 6,158 6.5 “FIFO” COGS = “FIFO” ITO 6,258 = 4.8 15 Accounting for Inventory Suppose no inventory is acquired at start of year 2 (sales = 4) • FIFO COGS = 4 x $8 • LIFO COGS = 4 x $8 = $32 (as before) = $32 (same) Liquidating LIFO layers, if multiple layers exist • Decrease LIFO COGS (possibly less than FIFO) • Increase profitability • Decrease LIFO reserve • Decrease turnover ratio Earnings manipulation? 17 Accounting for inventory: Tax considerations LIFO conformity rule: if a firm uses LIFO for tax purposes, it must also use LIFO for financial reporting purposes Choice should minimize the present value of tax payments Given the tax effects, what types of firms would you expect to choose each inventory method? 18 Summary •Matching principle requires a “cost flow” assumption, leading to different accounting methods (e.g. LIFO/FIFO) • Computation/record-keeping trivial, but implications not: LIFO and FIFO produce temporary differences in accounting numbers. • No accounting method is innately superior: choice depends upon business environment, incentives of users, possibility of manipulation, etc. • Disclosures available to make numbers comparable across firms. 19