Tài chính doanh nghiệp - Chapter 9: Inventories

InventoriesRevsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 9 Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill EducationLearning objectivesThe relationship between inventory valuation and cost of goods sold.The two methods used to determine inventory quantities—perpetual and periodic.What types of costs are included in inventory.What absorption costing is and how it complicates financial analysis.The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO.How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis.9-*Learning objectives concludedHow LIFO liquidation distorts cost of goods sold.How LIFO affects firms’ income taxes.Economic incentives guiding the choice of inventory methods.How to apply the lower of cost or market method.The key differences between GAAP and IFRS requirements for inventory accounting.How to eliminate realized holding gains from FIFO income.How and why the dollar-value LIFO method is applied.9-*Inventory typesIncludes other manufacturing costsWholesaler or retailer:ManufacturerMerchandise inventoryCustomerFirmManufacturer:Raw materialsWork-in-processFinished goodsSupplierCustomerFirm9-*Overview of accounting issuesOld unitNew unitWhat costs are included in inventory?Issue:How is the cost of goods available for sale split between the balance sheet and the income statement?Issue:9-*Overview of accounting issues:SummaryWeighted averageFIFOLIFOGAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory. If the cost of inventory never changes, all three cost flow assumptions would yield the same financial statement result.No matter what assumption is used, the total dollar amount assigned to the balance sheet and the income statement is the same ($640 in this example).Three methods for allocating the cost of goods available for sale:9-*Overview of accounting issues:Allocating the cost of goods available for sale Uses the average cost of the two units.Oldest unit cost flows to income.First-in, first-out (FIFO) approach:Weighted average approach:Uses the average cost of the two units.Newest unit cost flows to income.Last-in, last-out (LIFO) approach:FIFO produces a smaller expenseLIFO produces a larger expense9-*Overview of accounting issues:Unanswered questionsHow should physical quantities in inventory be determined?What items should be included in ending inventory?What costs should be included in inventory purchases (and eventually in ending inventory)?What cost flow assumption should be used for allocating goods available for sale between cost of goods sold and ending inventory?9-*Determining inventory quantities:Perpetual inventory systemThis approach keeps a running (or “perpetual”) record of the amount of inventory on hand.The inventory T-account under a perpetual inventory system looks like this:Entries are made as units are purchasedEntries are made as units are sold9-*Determining inventory quantities:Periodic inventory systemThis approach does not keep a running (or “perpetual”) record of the amount of inventory on hand.Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period.Entries are made as units are purchased9-*Determining inventory quantities:Periodic and perpetual compared9-*Determining inventory quantities:Periodic and perpetual comparedLess recordkeeping means lower cost to maintain.Less management control over inventory.COGS is a “plug” figure and there is no way to determine the extent of inventory losses (“shrinkage”).Typically used when inventory volumes are high and per-unit costs are low.More complicated and usually more expensive.Does not eliminate the need to take a physical inventory.Better management control over inventories including “stock outs”.Typically used for low volume, high unit cost items (e.g., automobiles) or when continuous monitoring of inventory levels is essential.Periodic inventoryPerpetual inventory9-*Items included in inventoryIn day-to-day operations, most firms record inventory when they physically receive it.However, when it comes to preparing financial statements, the firm must determine whether all inventory items are legally owned.Goods in transit may be “owned” by the buyer or the seller.The party that has legal title during transit will record the items as inventory.Consignment goods should not be counted as inventory for the consignee.ConsignorConsigneeCustomerconsignedgoodsSaleOwnerAgent9-*Costs included in inventoryAll costs required to obtain physical possession of the inventory and to make it saleable.Purchase costSales taxes and transportation paid by the buyerInsurance costsStorage costsProduction costs (labor and overhead) for a manufacturerIn theory, inventory costs should also include the (indirect) costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory.However, most firms exclude these items and limit inventory costs to direct acquisition and processing costs.9-*Costs included in inventory:Manufacturing costs9-*Costs included in inventory:Absorption costing versus variable costingVariable production costsFixed production costsVariable productioncostsVariable costing of inventory (not allowed by GAAP)Absorption costing of inventory (required by GAAP)Manufacturing rentals and depreciationProperty taxesRaw materialsDirect laborVariable overhead, like electricity9-*Costs included in inventory:SummaryThese are never included in inventory.This approach is not allowed by GAAP.9-*Costs included in inventory:How absorption costing can distort profitabilityAs we shall see, the GAAP gross margin increases from $110,000 in 2014 to $130,000 in 2015 even though variable production costs and selling price are constant, and sales revenue has fallen.9-*Costs included in inventory:Absorption costing distortion9-*Costs included in inventory:Variable costing illustrationUnder variable costing the gross margin falls9-*Cost flow assumptions:The conceptsIn a few industries, it is possible to identify which particular units have been sold. Examples include jewelry stores and automobile dealerships. These firms use specific identification inventory costing.For most firms, however, a cost flow assumption is required.9-*Cost flow assumptions:First-in, First-out (FIFO) illustrated9-*FIFOCost flow assumptions:First-in, First-out (FIFO) illustratedFigure 9.1 FIFO Cost Flow9-*Cost flow assumptions:Last-in, First-out (LIFO) illustrated9-*LIFOCost flow assumptions:Last-in, First-out (LIFO) illustratedFigure 9.2 LIFO Cost Flow9-*Cost flow assumptions:Inventory holding gains summaryHolding gain flows to incomeHolding gain still on balance sheetFigure 9.39-*Cost flow assumptions:LIFO and inventory holding gainsUsually (but not always) the same; however balance sheets are very different.Holding gain remains on balance sheet9-*Cost flow assumptions:FIFO and inventory holding gainsFIFO automatically includes the holding gain on units that are sold.9-*Cost flow assumptions:The LIFO reserve disclosure9-*Amount shown on balance sheet if FIFO had been usedAmount actually shown on balance sheetLIFO and inflation:LIFO reserveFigure 9.4 Magnitude of Inventory and LIFO Reserve relative to CPI and Oil Prices9-*When a LIFO firm liquidates old LIFO layers, the net income number under LIFO can be seriously distorted.Old LIFO layers that are liquidated are “matched” against sales dollars that are stated at higher current prices.LIFO liquidation10 units at $300 each20 units at $400 each30 units at $500 each45 units at $600 eachCurrent purchases3rd layer2rd layer1st layerGoods availableHow old LIFO cost distorts COGS5 units at $400 each30 units at $500 each45 units at $600 eachLIFO cost of goods sold80 unitswere sold9-*LIFO liquidation disclosuresIncome tax effect ($910,000) was the difference.9-*Tax implications of LIFOU.S. tax rules specify that if LIFO is used for tax purposes, LIFO must also be used in external financial statements.This LIFO conformity rule explains why so many firms use LIFO for financial reporting purposes.9-*Eliminating realized holding gains for FIFO firmsReported income for FIFO firms always includes some realized holding gains during periods of rising inventory costs.The size of the FIFO realized holding gain depends on:How fast input costs are changing.How fast inventory turns over during the period.x 10% cost increaseRealized FIFO holding gainReplacement COGS = 7,900,000 + 100,000 = 8,000,0009-*Reasons why some companies do not use LIFOThe estimated tax savings is too small.Business cycles may cause extreme fluctuations in physical inventory levels.The rate of inventory obsolescence is high.Managers may want to avoid reporting lower profits because they believe doing so will lead to:Lower stock priceLower compensation from earnings-based bonusesLoan covenant violationsSmall firms may not find LIFO economical because of high record-keeping costs.9-*Lower of Cost or Market MethodIf the market value of inventory falls below its cost, the carrying value must be reduced. Market value is subject to two constraints: Ceiling – Net Realizable Value Floor – Net Realizable Value less normal profit marginCeilingFloorFigure 9.59-*Lower of Cost or Market MethodThe journal entry when inventory with a cost of $1,000,000 is written down to a market value of $970,000 would be (assuming the use of the perpetual inventory method):The lower of cost or market method can be applied to:Individual inventory itemsClasses of inventoryThe inventory as a whole9-*Global Vantage PointComparison of IFRS and GAAP Inventory AccountingIFRS guidelines for inventory are similar to U.S. GAAPTwo important differencesLIFO is not permitted under IAS 2Lower of cost or market is applied differently. Market is net realisable value (no ceiling or floor). IAS 2 allows inventory reductions to be reversed if the market recovers, but the inventory carrying amount cannot exceed the original cost.Something to consider: LIFO conformity rule. Firms would incur large tax liabilities if they eventually move to IFRS which does not allow LIFO. 9-*SummaryAbsorption costing is required by GAAP but can lead to potentially misleading trend comparisons.GAAP allows firms latitude in selecting a cost flow assumption. Some firms use FIFO, others use LIFO, and still others use weighted-average.This diversity can hinder comparisons across firms, thus it’s often useful to convert LIFO firms to a FIFO basis.Reported FIFO income includes potentially unsustainable realized holding gains.Similarly, LIFO liquidations distort reported margins.Old, out-of-date LIFO layers can distort various ratio comparisons.9-*Summary concludedUsers must understand these inventory accounting differences and know how to adjust for them. Only then can valid comparisons be made across firms and over time.To address inventory obsolescence, GAAP requires inventory to be carried at lower of cost or market (LCM).IFRS accounting for inventory is very similar to GAAP, but LIFO is not allowed.The LIFO conformity rules requires firms to use LIFO for financial reporting if they use it for tax reporting.Most LIFO firms use some form of dollar-value LIFO.9-*