1Inventory Valuation

2Lewis Corporation

Case: 6-2Page: 173

3Lewis Corporation

Traditionally used inventory valuation method: FIFOUses periodic inventory system

42005 2006 2007 2005 2006 2007Beginning balance 1840 1020 1040 $20.00Purchases 600 700 1000 $20.25 $21.50 $22.50

800 700 700 $21.00 $21.50 $22.75400 700 700 $21.25 $22.00 $23.00200 1000 700 $21.50 $22.25 $23.50

Sales 2820 3080 2950 $34.00 $35.75 $35.75

Inventory Transaction 2005-2007No. of Cartons Price per Carton

5Discussion Question

Calculate the cost of goods sold and year-end inventory amounts for 2005, 2006, and 2007 using..,

FIFO LIFO Average cost method

6Cartons Price Value Cartons Price Value Cartons Price Value2005Cost of goods sold 1840 $20.00 $36,800.00 200 $21.50 $4,300.00 2820 $20.46 $57,685.92

600 $20.25 $12,150.00 400 $21.25 $8,500.00380 $21.00 $7,980.00 800 $21.00 $16,800.00

600 $20.25 $12,150.00820 $20.00 $16,400.00

2820 $56,930.00 2820 $58,150.00 2820 $57,685.92Inventory 420 $21.00 $8,820.00 1020 $20.00 $20,400.00 1020 $20.46 $20,865.12

400 $21.25 $8,500.00200 $21.50 $4,300.00

1020 $21,620.00 1020 $20,400.00 1020 $20,865.122006Cost of goods sold 420 $21.00 $8,820.00 1000 $22.25 $22,250.00 3080 $21.51 $66,247.72

400 $21.25 $8,500.00 700 $22.00 $15,400.00200 $21.50 $4,300.00 700 $21.50 $15,050.00700 $21.50 $15,050.00 680 $21.50 $14,620.00700 $21.50 $15,050.00660 $22.00 $14,520.00

3080 $66,240.00 3080 $67,320.00 3080 $66,247.72Inventory 40 $22.00 $880.00 20 $21.50 $430.00 1040 $21.51 $22,369.36

1000 $22.25 $22,250.00 1020 $20.00 $20,400.001040 $23,130.00 1040 $20,830.00 1040 $22,369.36

2007Cost of goods sold 40 $22.00 $880.00 700 $23.50 $16,450.00 2950 $22.55 $66,513.65

1000 $22.25 $22,250.00 700 $23.00 $16,100.001000 $22.50 $22,500.00 700 $22.75 $15,925.00

700 $22.75 $15,925.00 850 $22.50 $19,125.00210 $23.00 $4,830.00

2950 $66,385.00 2950 $67,600.00 2950 $66,513.65Inventory 490 $23.00 $11,270.00 1020 $20.00 $20,400.00 1190 $22.55 $26,830.93

700 $23.50 $16,450.00 20 $21.50 $430.00150 $22.50 $3,375.00

1190 $27,720.00 1190 $24,205.00 1190 $26,830.93

LIFO Average CostInventory Valuation

FIFO

7FIFO vs. LIFO vs. Average Cost

FIFO LIFO Average CostCost of goods sold

2005 $56,930.00 $58,150.00 $57,685.922006 $66,240.00 $67,320.00 $66,247.722007 $66,385.00 $67,600.00 $66,513.65

Inventory - 2007 $27,720.00 $24,205.00 $26,830.93$217,275.00 $217,275.00 $217,278.22

Check on Calculation

8Discussion Question

Lewis corporation is considering switching from FIFO to LIFO to reduce its income tax expenseAssuming a corporate income tax rate of 40%, calculate the tax savings this would have made for 2005 to 2007Would you recommend and Lewis make this change?

9Tax Expense Benefit

2005 2006 2007 2005 2006 2007Sales $95,880.00 $110,110.00 $105,462.50 $95,880.00 $110,110.00 $105,462.50Cost of goods sold $56,930.00 $66,240.00 $66,385.00 $58,150.00 $67,320.00 $67,600.00Gross margin $38,950.00 $43,870.00 $39,077.50 $37,730.00 $42,790.00 $37,862.50Tax expense $15,580.00 $17,548.00 $15,631.00 $15,092.00 $17,116.00 $15,145.00Net income $23,370.00 $26,322.00 $23,446.50 $22,638.00 $25,674.00 $22,717.50Total tax expense savings $488.00 $432.00 $486.00 $1,406.00

FIFO LIFO

COGS is $3515 * 40% = $1,406Three-year COGS difference is equal to difference in 2007 year-end inventories = $27,720 - $24,205 = $3,515

10

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 yearTotal sales are forecasted to be 2,700 cartonsLewis will be unable to raise its selling price from the 2007 level of $35.75However, costs are expected to increase to $24 per carton for the whole yearDue 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 yearWhat 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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No. of Cartons Rate Value

No. of Cartons Rate Value

Cost of goods sold 490 $23.00 $11,270.00 1910 $24.00 $45,840.00700 $23.50 $16,450.00 150 $22.50 $3,375.00

1510 $24.00 $36,240.00 20 $21.50 $430.00620 $20.00 $12,400.00

2700 $63,960.00 2700 $62,045.00Inventory 400 $24.00 $9,600.00 400 $20.00 $8,000.00

2008 Sales (2,700 @ $35.75) $96,525.00 $96,525.00Cost of goods sold $63,960.00 $62,045.00Gross margin $32,565.00 $34,480.00Tax expense $13,026.00 $13,792.00Net income $19,539.00 $20,688.00

In 2008, LIFO would cause an increase in tax expense of $766

FIFO LIFO

Purchase for 2008 forecasted at 1910 x Cartons @ 24.00

Invasion of LIFO layers

12

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?

13

LIFO ReserveFIFO

InventoryLIFO

InventoryLIFO

Reserve2005 $21,620 $20,400 $1,2202006 $23,130 $20,830 $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 reserveFIFO 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

14

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 capitalForms the major assets of many firmsHave significant impact on financial resultsState of a firms inventories is often a good indicator of its economic healthSignificant 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 businessCompany holds title, wherever they might be locatedInventory value = quantity of inventory of hand x price per unitCategories..,

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 countCost 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 basisCost = sum of applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and locationCost 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

purposes]

22

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 beassigned..,

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 priceSimple average method

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

Weighted average methodMoving average method

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

FIFOLIFO

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

Over statementof profits

In rising prices

Over statementof profits

In falling prices

NoYesTimeliness in reporting

LowHighCOGS

HighLowInventory

FIFOLIFO

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LIFO vs. FIFO

NoYesFollows EMH

Not all the timeAcceptance under law

High during inflationTax advantages

Recognizes partiallyPrice level changes

Improper matching on revenues and costs

Argument against

FIFOLIFO

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Cost or Market, Whichever is Lower

Inventory losses should be recognized currently to the extent that they can be determinedMarket pricing is required for inventory when; utility of goods < inventory costIf 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

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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 methodAn approximation of the cost-or-market methods by retailerInventory record kept on selling price basisShows 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 manipulativeBad and nonsaleable units may be counted as inventoryLIFO goes in hand with inflation; if relation is vague, theres possibility of some accounting changes or manipulationsCompanies ship inventory as premature deliveryExtending 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 cyclesIntegration of vendor and customer production plansOptimum inventory lot size schedulingReceipt of vendor shipments as close to use as possibleFavorable vendor payment termsInfrequent stockoutsReliable 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 recognizedExceptions 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

41

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 costsAbnormal amounts of wasted materials, labor, and other production costsStorage costsAdministrative overheads not forming part of bringing the inventories to present location and conditionSelling and distribution costs

43

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 increasedWritten down to net realizable value on item-by-item basisAn assessment of net realizable value is made at each balance sheet date

46

Inventory

Recorded on the B/S at the lower of the cost or the market value of the inventory

47

Inventory

Cost of inventory includes all costs necessary to bring the inventory to saleable conditionBeginning inventory + purchases = COGAS = COGS +Ending inventoryInventory costs include..,

Costs to acquire, manufacture, prepare Shipping costs for retailers Overheads cost for manufacturers

48

Ending Inventory

49

Incentives to Overstate Inventory

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

50

Discussion Question

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

51

Discussion Question

Who owns goods in transit?

52

Discussion Question

How do we know how much has been sold?

53

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

54

Inventory Accounting

Actual physical flow of inventory need not correspond to the assumptions of inventory accounting

55

Goods Available for Sale

56

FIFO Conveyer Belt

57

FIFO Conveyer Belt

58

LIFO Cookie Jar

59

LIFO

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

Old costs are on the balance sheetIn increasing inventory costs = tax savingsUsing LIFO can reduce political visibilityLIFO reserve = inventory value under FIFO inventory value under LIFOCOGSLIFO - COGSFIFO = (End InvFIFO End InvLIFO) (Beg InvFIFO - (Beg InvLIFO) + ( End LIFO reserve Beg. LIFO reserve)

60

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)