Inventory Valuation

Lewis Corporation
Case: 6-2 Page: 173
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Lewis Corporation
Traditionally used inventory valuation method: FIFO Uses periodic inventory system

Inventory Transaction 2005-2007 No. of Cartons Price per Carton 2005 2006 2007 2005 2006 2007 Beginning balance 1840 1020 1040 $20.00 Purchases 600 700 1000 $20.25 $21.50 $22.50 800 700 700 $21.00 $21.50 $22.75 400 700 700 $21.25 $22.00 $23.00 200 1000 700 $21.50 $22.25 $23.50 Sales 2820 3080 2950 $34.00 $35.75 $35.75
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Discussion Question
Calculate the cost of goods sold and year-end inventory amounts for 2005, 2006, and 2007 using..,
FIFO LIFO Average cost method

Cartons 2005 Cost of goods sold 1840 600 380

FIFO Price $20.00 $20.25 $21.00

Value

Inventory Valuation LIFO Cartons Price 200 400 800 600 820 2820 1020 $21.50 $21.25 $21.00 $20.25 $20.00 $20.00

Value $4,300.00 $8,500.00 $16,800.00 $12,150.00 $16,400.00 $58,150.00 $20,400.00

Average Cost Cartons Price Value 2820 $20.46 $57,685.92

$36,800.00 $12,150.00 $7,980.00

Inventory

2820 420 400 200 1020 420 400 200 700 700 660 3080 40 1000 1040 40 1000 1000 700 210 2950 490 700 1190

$21.00 $21.25 $21.50

$56,930.00 $8,820.00 $8,500.00 $4,300.00 $21,620.00 $8,820.00 $8,500.00 $4,300.00 $15,050.00 $15,050.00 $14,520.00 $66,240.00 $880.00 $22,250.00 $23,130.00 $880.00 $22,250.00 $22,500.00 $15,925.00 $4,830.00 $66,385.00 $11,270.00 $16,450.00 $27,720.00

2820 1020

$20.46

$57,685.92 $20,865.12

1020 1000 700 700 680 $22.25 $22.00 $21.50 $21.50

$20,400.00 $22,250.00 $15,400.00 $15,050.00 $14,620.00

1020 3080 $21.51

$20,865.12 $66,247.72

2006 Cost of goods sold

$21.00 $21.25 $21.50 $21.50 $21.50 $22.00 $22.00 $22.25

Inventory

3080 20 1020 1040 700 700 700 850 2950 1020 20 150 1190

$21.50 $20.00

$67,320.00 $430.00 $20,400.00 $20,830.00 $16,450.00 $16,100.00 $15,925.00 $19,125.00 $67,600.00 $20,400.00 $430.00 $3,375.00 $24,205.00

3080 1040 1040 2950

$21.51

$66,247.72 $22,369.36 $22,369.36

2007 Cost of goods sold

$22.00 $22.25 $22.50 $22.75 $23.00 $23.00 $23.50

$23.50 $23.00 $22.75 $22.50

$22.55

$66,513.65

Inventory

$20.00 $21.50 $22.50

2950 1190

$22.55

$66,513.65 $26,830.93

1190

$26,830.93

FIFO vs. LIFO vs. Average Cost

Check on Calculation FIFO LIFO Cost of goods sold 2005 2006 2007 Inventory - 2007 $56,930.00 $66,240.00 $66,385.00 $27,720.00 $217,275.00 Average Cost

$58,150.00 $57,685.92 $67,320.00 $66,247.72 $67,600.00 $66,513.65 $24,205.00 $26,830.93 $217,275.00 $217,278.22
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Discussion Question
Lewis corporation is considering switching from FIFO to LIFO to reduce its income tax expense Assuming a corporate income tax rate of 40%, calculate the tax savings this would have made for 2005 to 2007 Would you recommend and Lewis make this change?
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Tax Expense Benefit

FIFO LIFO 2005 2006 2007 2005 2006 2007 Sales $95,880.00 $110,110.00 $105,462.50 $95,880.00 $110,110.00 $105,462.50 Cost of goods sold $56,930.00 $66,240.00 $66,385.00 $58,150.00 $67,320.00 $67,600.00 Gross margin $38,950.00 $43,870.00 $39,077.50 $37,730.00 $42,790.00 $37,862.50 Tax expense $15,580.00 $17,548.00 $15,631.00 $15,092.00 $17,116.00 $15,145.00 Net income $23,370.00 $26,322.00 $23,446.50 $22,638.00 $25,674.00 $22,717.50 Total tax expense savings $488.00 $432.00 $486.00 $1,406.00
COGS is $3515 * 40% = $1,406 Three-year COGS difference is equal to difference in 2007 year-end 9 inventories = $27,720 - $24,205 = $3,515

Discussion Question
Dollar sales for 2008 are expected to drop by approximately 8%, as a recession in Lewiss market is forecasted to continue at least through the first three quarters of the year Total sales are forecasted to be 2,700 cartons Lewis will be unable to raise its selling price from the 2007 level of $35.75 However, costs are expected to increase to $24 per carton for the whole year Due to these cost/price pressures, the corporation wishes to lower its investment in inventory by holding only the essential inventory of 400 cartons at any time during the year What is the effect of remaining on FIFO, assuming Lewis had adopted FIFO in 2008? What is the effect of remaining on LIFO, assuming Lewis adopted LIFO in 2008? What method would you recommend now?
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FIFO No. of Cartons 490 700 1510 Rate $23.00 $23.50 $24.00 Value $11,270.00 $16,450.00 $36,240.00 $63,960.00 $9,600.00 No. of Cartons 1910 150 20 620 2700 400 $96,525.00 $62,045.00 $34,480.00 $13,792.00 $20,688.00

LIFO Rate $24.00 $22.50 $21.50 $20.00 $20.00 Value $45,840.00 $3,375.00 $430.00 $12,400.00 $62,045.00 $8,000.00

Cost of goods sold

Inventory 2008 Sales (2,700 @ $35.75) Cost of goods sold Gross margin Tax expense Net income

2700 400 $24.00 $96,525.00 $63,960.00 $32,565.00 $13,026.00 $19,539.00

Purchase for 2008 forecasted at 1910 x Cartons @ 24.00 In 2008, LIFO would cause an increase in tax expense of $766
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Invasion of LIFO layers

Discussion Question
What is the LIFO reserve in 2005? What is the LIFO reserve in 2006? What is the significance of the LIFO reserve number? How much did the LIFO reserve increase in 2006? What is the significance of this increase?

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LIFO Reserve
2005 2006 FIFO Inventory $21,620 $23,130 LIFO Inventory $20,400 $20,830 LIFO Reserve $1,220 $2,300

LIFO reserve: cumulative difference between LIFO cost of goods sold LIFO reserve 2005 = LIFO COGS - FIFO COGS = $58,150 - $56930 = $1220 LIFO reserve 2006 = LIFO COGS - FIFO COGS = $67,320 - $66,240 = $2,300 FIFO inventory = LIFO inventory + LIFO reserve FIFO COGS = LIFO COGS - [LIFO reserve year x - LIFO reserve year x-1]*Tax savings year x FIFO COGS = [LIFO reserve year x - LIFO reserve year x-1]*(1-tax rate)

LIFO reserve is noted in the inventory footnote

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Discussion Question
Despite continuing inflation in the US in the 1980s and the early 1990s, many companies continued to use FIFO for all or part of their domestic inventories. Why do you believe this was the case?

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Using FIFO
Some companies use FIFO in circumstances when LIFO would improve cash flows is that their managements do not believe that EMH premise that the lower reported earnings from LIFO would not diminish shareholder value

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Importance of Inventory Valuation

Affects net income and net working capital Forms the major assets of many firms Have significant impact on financial results State of a firms inventories is often a good indicator of its economic health Significant problem in inventory valuation..,
Difficulties involved in allocating costs between periods and products Failure of selling prices and costs to move together
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Inventory
All tangible items held for sale or consumption in the normal course of business Company holds title, wherever they might be located Inventory value = quantity of inventory of hand x price per unit Categories..,
Finished goods Goods in process Raw materials Manufacturing supplies

Types of inventory system

Periodic inventory system Perpetual inventory system
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Periodic Inventory System

Involves a periodic determination of..,
Beginning inventory Purchases for the period Ending inventory

Total are determined by actual count Cost of goods sold = Beginning inventory + purchases ending inventories
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Perpetual Inventory System

Involves keeping a running record of all the additions to and subtractions from the inventory

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Pricing Bases
Pricing on inventories based various circumstances may be of..,
Cost Cost or market [which ever is lower] Selling price

Objective in basis selection: fairest determination of periodic income

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Pricing Bases Cost

Principal basis Cost = sum of applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location Cost of Inventory of manufacturing companies includes..,
Cost of raw materials Direct labor Factory overhead Storage and receiving costs [if the company is using tax accounting for book purposes]

Cost of Inventory of merchandising companies includes..,

Prices it paid for the products it sells Storage and receiving costs [if the company is using tax accounting for book 21 purposes]

Pricing Bases Cost

Costs may be collected and recorded on the basis of either of..,
Individual jobs (job cost system) Production process (process cost system)

Costs assigned to various finished and partially finished products may be..,
Predetermined standard costs
If std cost used, difference between actual and std cost will be assigned..,
Difference is small: COGS Difference if large: allocate variance between COGS and ending inventory accounts

Actual costs

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Pricing Bases Cost

Methods of allocating overhead costs to inventories..,
Standard manufacturing overhead rate
Allocates fixed amount of overhead per unit to finished or partially finished goods based on eg. amount of direct labor embodied in the inventory

Based machine-hours Based on direct labor hours Based on no. of transactions or setups ABC method
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Pricing Bases Cost

Methods of allocating overhead costs to inventories..,
Direct costing method
Includes in inventory price only variable manufacturing costs Fixed manufacturing costs are treated as period costs and charged against income during period in which they are incurred Can be used for internal accounting purposes

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Pricing Bases Cost

Methods of allocating overhead costs to inventories on the join product [common product or by-products]..,
Allocated among products based on relative sales value By-product cost method also can be used
By-product is initially valued at selling price less disposition costs Profit and losses of the company are recorded on the sale of primary product
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Inventory Valuation Methods

Specific identification
Associates actual costs with particular item in inventory

Last invoice price Simple average method

= [sum of invoice prices per unit / no. of invoices] x No. of units in ending inventory

Weighted average method Moving average method

Computes average unit price of the inventory after each purchase Used in perpetual inventory system

FIFO LIFO
Firms can adopt LIFO method for income taxes purposes only if it also uses this method in its published financial statements Can be used for raw materials, finished goods, or some component of finished goods
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LIFO vs. FIFO

LIFO Inventory COGS In rising prices In falling prices Over statement of profits Low High High Low No Over statement of profits FIFO

Timeliness in reporting Yes

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LIFO vs. FIFO

LIFO Argument against Improper matching on revenues and costs Recognizes partially High during inflation Yes No
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FIFO

Price level changes Tax advantages Follows EMH

Acceptance under law Not all the time

Cost or Market, Whichever is Lower

Inventory losses should be recognized currently to the extent that they can be determined Market pricing is required for inventory when; utility of goods < inventory cost If utility of goods < inventory cost in ordinary course of business should be recognized as loss..,
Physical deterioration Obsolescence Changes in price levels Other causes

Cost = cost of replacing inventory in hand by..,

Purchase in open market
All costs incurred to bring the products to their usual location

Reproduction in companys own factories

Includes all direct and indirect costs associated with manufacturing the goods 29

Cost or Market, Whichever is Lower

Market refers to current replacement costs with two provisions..,
Market should not exceed realizable value (estimated selling price costs of completion and disposal) Market should not be less than net realizable value reduced by an allowance for an ~normal profit margin Cost =
Net realizable value is lower: market Replacement cost is lower: market
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Retail Method
Also called retail inventory method An approximation of the cost-or-market methods by retailer Inventory record kept on selling price basis Shows records..,
Purchases from and returns to manufactures: costs and selling prices Customer sales and returns: selling prices
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Retail Method
Estimation of cost of ending inventory..,
Purchases during the period at cost + opening inventory at cost ---A Purchases at retail + opening inventory at retail---B Cumulative mark-on in rupee = B - A Mark on percentage = [B A] / B Inventory at retail = total retail price of goods available for sale actual sales Inventory at cost = Inventory at retail - [ending inventory at retail x mark on percentage]
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Retail Method
Estimation of cost of ending inventory [using LIFO]

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Inventory at Selling Price

Allowed if..,
Precious metal having fixed monetary value No substantial cost for marketing Production as the critical business activity rather than selling Inability to determine appropriate ~cost Immediate marketability at quoted market price Characteristics of unit interchangeability

Cost of disposition should be deducted

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Inventory Analysis
Turnover ratios..,
Inventory turnover = annual cost of sales / average FIFO inventory for the period Average inventory period = 365 days / inventory turnover Average age of inventory = Average inventory period / 2 Ideal ratio limits..,
Based on best comparable firm Highest is also bad.., Stockouts Excessive production costs due to short production runs

Component wise percentage

= RM / total inventory = WIP / total inventory = finished goods / total inventory
Increase in this ratio mean.., Poor sales forecasting Slowdown in customer orders Failure to react promptly to downturn in business

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Inventory Related Accounting Manipulations

COGS in interim reports may be manipulative Bad and nonsaleable units may be counted as inventory LIFO goes in hand with inflation; if relation is vague, theres possibility of some accounting changes or manipulations Companies ship inventory as premature delivery Extending generous credit to customers to ship inventory unusual buildup of receivables towards the end of accounting period
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Actions Leading to Effective Inventory Management

Short manufacturing cycles Integration of vendor and customer production plans Optimum inventory lot size scheduling Receipt of vendor shipments as close to use as possible Favorable vendor payment terms Infrequent stockouts Reliable sales forecasts
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Valuation of Inventories (AS 2)

Value at which inventories are carried in the financial statements until the related revenues are recognized Exceptions to AS 2..,
WIP in..,
Construction contracts Service contracts Shares Debentures Financial instruments Inventories measured at net realizable value through forward contract, a govt. guarantee, when homogeneous market exists, or negligible risk of failure to sell..,
Livestock Agriculture and forest products Mineral oils, ores and gases

Machinery spares to be used with an item of fixed assets and whose use is expected to be irregular

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Valuation of Inventories (AS 2)

Inventories are assets..,
Held for sale
Goods held for sale Computer software held for sale Land and other property held for sale

In the process of production In the form of material or supplies to be consumed in the production process or rendering of services
Materials Maintenance supplies consumables

Net realizable value

= estimated selling price estimated costs of completion estimated costs necessary to make the sale
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Valuation of Inventories (AS 2)

Inventories should be valued at lower of..,
Cost of inventories Net realizable value

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Cost of Inventories
Costs of purchase
Includes..,
Duties and taxes Freight inwards Expenditures directly attributable to acquisition

Less..,
Trade discounts Rebates Duty drawbacks

Costs of conversion
Direct labor Systematic allocation of fixed and variable production overheads based on normal capacity

Costs incurred in bringing inventories to present location and condition

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Exclusion from Cost of Inventories

Interests and borrowing costs Abnormal amounts of wasted materials, labor, and other production costs Storage costs Administrative overheads not forming part of bringing the inventories to present location and condition Selling and distribution costs
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Cost of Inventories
Cost to be assigned by using..,
FIFO
Assumption: inventory purchased or produced first is consumed or sold first

Weighted average cost

Weighted average of cost at the beginning cost of items purchased during the period WA may be calculated on periodic basis or as each additional shipment is received

Formula used should reflect the fairest possible approximation to cost incurred
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Techniques for Measurement of Cost

Standard cost method
Considers normal levels of..,
Consumption of materials and supplies Labor Efficiency and capacity utilization

Regularly reviewed and revised if necessary

Retail method
Used
In retail trade When large no. of rapidly changing items having similar margins

Cost = sales value appropriate gross margin

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Net Realizable Value

Reduces when..,
Become partially or wholly obsolete Declined selling price

Cost of inventories may not be also recoverable if; estimated costs of completion has increased Written down to net realizable value on item-by-item basis An assessment of net realizable value is made at each balance sheet date
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Inventory
Recorded on the B/S at the lower of the cost or the market value of the inventory

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Inventory
Cost of inventory includes all costs necessary to bring the inventory to saleable condition Beginning inventory + purchases = COGAS = COGS +Ending inventory Inventory costs include..,
Costs to acquire, manufacture, prepare Shipping costs for retailers Overheads cost for manufacturers
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Ending Inventory

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Incentives to Overstate Inventory

Overstatement increases income and improves the balance sheet Reversal in the following period: Payback time

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Discussion Question

Which costs are expensed in COGS and which cost remain in ending Inventory?

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Discussion Question

Who owns goods in transit?

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Discussion Question

How do we know how much has been sold?

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Inventory System
Perpetual system
More accurate More timely Potentially more costly

Periodic system
Harder to detect inventory Impossible to trace..,
Shrinkages Theft Spoilage Management fraud
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Inventory Accounting
Actual physical flow of inventory need not correspond to the assumptions of inventory accounting

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Goods Available for Sale

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FIFO Conveyer Belt

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FIFO Conveyer Belt

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LIFO Cookie Jar

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LIFO
Recent costs are on the income statement
LIFO matches current costs with current revenues

Old costs are on the balance sheet In increasing inventory costs = tax savings Using LIFO can reduce political visibility LIFO reserve = inventory value under FIFO inventory value under LIFO COGSLIFO - COGSFIFO = (End InvFIFO End InvLIFO) (Beg InvFIFO - (Beg InvLIFO) + ( End LIFO reserve Beg. LIFO reserve)
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LIFO and FIFO Inventory Turnover

Inventory turnover = COGS / Average Inv.
= FIFO = COGS / Average Inv. = old / new = LIFO = COGS / Average Inv. = new / old

New inventory turnover = COGS (LIFO) / Average Inventory (FIFO)

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