Chapter 5 Accounting for Inventories

Accounting for Inventories: Cost Flow Methods

Cost Flow vs. Physical Flow of Goods

Our discussions about inventory cost flow methods relate to the flow of costs through accounting records, not the actual physical flow of goods.
Cost flow can significantly differ from physical flow.
- For example, we might physically sell the first unit purchased (consistent with a FIFO physical flow), but recognize the cost of the last unit purchased in Cost of Goods Sold (COGS) for accounting purposes (consistent with a LIFO cost flow).

Inventory Cost Flow Methods Overview

When goods are sold, product costs are transferred from the Inventory account (a Balance Sheet asset) to the Cost of Goods Sold (COGS) account (an Income Statement expense).
U.S. GAAP recognizes four acceptable methods for determining the amount of cost to transfer:
1. Specific Identification
2. First-in, First-out (FIFO)
3. Last-in, First-out (LIFO)
4. Weighted Average

Specific Identification Method

Concept: Involves detailed record-keeping where the exact/actual cost of a specific item is assigned to COGS when that item is sold.
Application: Generally used only if inventory consists of high-priced, low-turnover items (e.g., auto dealerships, antique dealers) where sales are relatively infrequent and individual items are easily identifiable.
Disadvantages:
- Impracticality: The extensive record-keeping required is not practical for companies with many low-priced, high-turnover goods.
- Manipulation Potential: Allows managers to manipulate the income statement by choosing to sell higher-cost or lower-cost specific items from their inventory pool, thereby affecting reported COGS and net income.

FIFO, LIFO, and Weighted Average Methods

These methods are assumptions about cost flow, simplifying record-keeping, and do not need to mirror the actual physical flow of goods. GAAP requires consistency in method use over time and disclosure in financial statements.

First-in, First-out (FIFO)
- Cost Flow Assumption: Assumes the cost of the oldest goods (first-in) is assigned to COGS first.
- Inventory Valuation: The cost of the most recent purchases remains in the ending inventory balance.
Last-in, First-out (LIFO)
- Cost Flow Assumption: Assumes the cost of the most recent purchases (last-in) is assigned to COGS first.
- Inventory Valuation: The cost of the oldest goods remains in the ending inventory balance.
Weighted Average Method
- Cost Flow Assumption: Uses the average unit cost, calculated by dividing the total cost of goods available for sale (COGAS) by the total number of units available.
- Valuation: Both COGS and ending inventory are based on this same average cost per unit.

Example: Cortez Company Inventory Calculation

Cortez Company sells chairs. Here's how costs are allocated under each method:

Beginning Inventory: 100 ext{ units @ } \$60 ext{ ea} = \$6,000
Purchase #1: 150 ext{ units @ } \$68 ext{ ea} = \$10,200
Purchase #2: 200 ext{ units @ } \$72 ext{ ea} = \$14,400
Total Units Available for Sale: 100 + 150 + 200 = 450 ext{ units}
Total Cost of Goods Available for Sale (COGAS): \$6,000 + \$10,200 + \$14,400 = \$30,600
Units Sold During Year: 270 ext{ units}
Units in Ending Inventory: 450 - 270 = 180 ext{ units}

FIFO Calculation

COGS (270 units):
- 100 ext{ units from BI @ } \$60 = \$6,000
- 150 ext{ units from Pch #1 @ } \$68 = \$10,200
- 20 ext{ units from Pch #2 @ } \$72 = \$1,440 (270 - 100 - 150 = 20)
- Total FIFO COGS: \$6,000 + \$10,200 + \$1,440 = \$17,640
Ending Inventory (180 units):
- 180 ext{ units from Pch #2 @ } \$72 = \$12,960 (200 - 20 = 180)

LIFO Calculation

COGS (270 units):
- 200 ext{ units from Pch #2 @ } \$72 = \$14,400
- 70 ext{ units from Pch #1 @ } \$68 = \$4,760 (270 - 200 = 70)
- Total LIFO COGS: \$14,400 + \$4,760 = \$19,160
Ending Inventory (180 units):
- 100 ext{ units from BI @ } \$60 = \$6,000
- 80 ext{ units from Pch #1 @ } \$68 = \$5,440 (150 - 70 = 80)
- Total LIFO Ending Inventory: \$6,000 + \$5,440 = \$11,440

Weighted Average Calculation

Step 1: Determine Weighted Average Cost per Unit
- ext{Wtd Avg Cost per Unit} = rac{ ext{COGAS}}{ ext{# Units Avail. to Sell}} = rac{\$30,600}{450 ext{ units}} = \$68 ext{ per unit}
Step 2a: Calculate COGS
- ext{COGS} = ext{Wtd Avg Cost per Unit} imes ext{# Units Sold} = \$68 imes 270 ext{ units} = \$18,360
Step 2b: Calculate Ending Inventory
- ext{Ending Inventory} = ext{Wtd Avg Cost per Unit} imes ext{# Units NOT Sold} = \$68 imes 180 ext{ units} = \$12,240

Self-Check for Cost Flow Methods

ext{COGS} + ext{Ending Inventory} = ext{COGAS}
ext{# of Units in Ending Inventory} + ext{# of Units Sold} = ext{# of Units Available for Sale}

Effect of Cost Flow Method on Financial Statements

The inventory cost flow method determines how the Cost of Goods Available for Sale (COGAS) is allocated between Cost of Goods Sold (COGS) and Ending Inventory.

Impact on Income Statement (Under a Period of Rising Prices)

Assume sales price per chair is \$100 and Other Operating Expenses are \$5,000. Sales Revenue = \$100 imes 270 = \$27,000

Item	FIFO	LIFO	Weighted Avg
Sales Revenue	\$27,000	\$27,000	\$27,000
Less: Cost of Goods Sold	\$17,640	\$19,160	\$18,360
Gross Margin	\$9,360	\$7,840	\$8,640
Other Operating Expenses	\$5,000	\$5,000	\$5,000
Net Income	\$4,360	\$2,840	\$3,640

When inventory costs are rising (inflationary period):
- FIFO yields the highest net income (because it assigns older, lower costs to COGS).
- LIFO yields the lowest net income (because it assigns newer, higher costs to COGS).
- Weighted Average yields a net income between FIFO and LIFO.

Impact on Balance Sheet (Ending Inventory Under Rising Prices)

Item	FIFO	LIFO	Weighted Avg
Ending Inventory Bal	\$12,960	\$11,440	\$12,240

When inventory costs are rising (inflationary period):
- FIFO results in the highest ending inventory balance (because newer, higher costs remain in inventory).
- LIFO results in the lowest ending inventory balance (because older, lower costs remain in inventory).
- Weighted Average yields an ending inventory balance between FIFO and LIFO.
Important Note: The inventory cost flow method does NOT affect the actual number of units of inventory (available, sold, remaining) at any point; it only affects the cost recorded for them.

Income Taxes and Cash Flow Implications

Income Statement Structure with Taxes:
- ext{Sales Revenue} - ext{COGS} = ext{Gross Margin}
- ext{Gross Margin} - ext{Operating Expenses} = ext{Income Before Taxes (Taxable Income)}
- ext{Income Before Taxes} imes ext{Tax Rate %} = ext{Income Tax Expense}
- ext{Income Before Taxes} - ext{Income Tax Expense} = ext{Net Income}
Effect on Cash Flow Statement:
- Payments for inventory purchases (an operating activity outflow) are not directly affected by the choice of cost flow method.
- However, differences in COGS generated by different methods lead to differences in taxable income, and consequently, income taxes paid (also an operating activity outflow).
- Therefore, the choice of cost flow method indirectly affects cash flows due to varying income tax payments.
Strategic Choice Under Rising Prices:
- Given that FIFO produces higher net income (and thus higher taxes) and LIFO produces lower net income (and thus lower taxes) in inflationary periods, companies often prefer LIFO for tax purposes to reduce their tax liability and preserve cash.
- Lower taxes result in lower cash outflows, which can be reinvested in the company or paid as dividends, potentially increasing company value.
LIFO Conformity Rule (IRS Requirement):
- To prevent companies from using FIFO for financial reporting (to show higher income) and LIFO for tax reporting (to lower taxes), the IRS imposes the LIFO Conformity Rule.
- If a company uses LIFO for tax purposes, it MUST ALSO use LIFO for financial reporting purposes (GAAP statements).
- This rule does not apply the other way around; a company can use FIFO for tax reporting and FIFO for financial reporting.

Avoiding Fraud Through Inventory Control

Significance of Inventory and COGS: Inventory is often the largest single asset on the balance sheet, and COGS is frequently the largest expense on the income statement.
Fraud Risk: Their substantial size, importance, and the high volume of transactions make these accounts prime targets for concealing fraud and misstatement.
Ramifications of Misstatement: Any misstatement of COGS (whether fraudulent or accidental) has far-reaching effects, impacting gross margin, taxable income, net income, and ending inventory.
Fraud Prevention & Detection:
- Perpetual Inventory System Discrepancies: Large or frequent differences between physical inventory counts and accounting records (in a perpetual system) serve as red flags for potential issues, including fraud.
- Separation of Duties: A key internal control involves separating the duties of employees who record inventory transactions from those who have physical custody of inventory (e.g., responsible for counting it).
  - This makes fraud more difficult as it would require collusion between at least two employees.
- Gross Margin Method (Detection Tool): This method can be used to estimate ending inventory and COGS, acting as a detection mechanism to identify potential fraud or significant errors in inventory records.

Gross Margin Method to Estimate Ending Inventory

Purpose: The Gross Margin Method is used to estimate COGS and ending inventory, particularly useful in situations like inventory loss (e.g., due to a natural disaster) or for verifying recorded inventory amounts.
Underlying Assumption: The company's Gross Margin Percentage (GM%) is relatively constant over time. The historical GM% ( rac{ ext{Gross Margin}}{ ext{Sales}}) is used for estimation.
Key Relationships/Equations:
- ext{Sales Revenue} - ext{COGS} = ext{Gross Margin}
- ext{GM%} = rac{ ext{Gross Margin}}{ ext{Sales}}
- ext{Beginning Inventory} + ext{Purchases} = ext{Cost of Goods Available for Sale (COGAS)}
- ext{COGAS} - ext{COGS} = ext{Ending Inventory}
Example (Estimating Inventory Loss - Prentiss Sporting Goods):
- Beginning Inventory: \$60,000
- Purchases to date of storm: \$190,000
- Sales to date of storm: \$300,000
- Undamaged inventory counted: \$3,600
- Historical Gross Margin Percentage: 25\% of sales
1. Calculate COGAS: \$60,000 ( ext{BI}) + \$190,000 ( ext{Purchases}) = \$250,000
2. Estimate Gross Margin in dollars: \$300,000 ( ext{Sales}) imes 0.25 ( ext{GM%}) = \$75,000
3. Estimate COGS: \$300,000 ( ext{Sales}) - \$75,000 ( ext{Est. GM}) = \$225,000
4. Estimate Inventory balance just before the storm (Estimated Ending Inventory):
  - ext{COGAS} - ext{Estimated COGS} = \$250,000 - \$225,000 = \$25,000
5. Calculate Amount of Lost Inventory:
  - ext{Estimated Total Ending Inventory} - ext{Undamaged Inventory} = \$25,000 - \$3,600 = \$21,400

Inventory Turnover Ratio

Purpose: This financial ratio offers insights into how efficiently a company manages its inventory.
- It indicates how many times, approximately, a company sells through and replenishes its entire inventory in a given accounting period.
- It also helps determine, on average, how long inventory sits in the warehouse before it is sold.
Formulas:
- ext{Inventory Turnover} = rac{ ext{COGS}}{ ext{Inventory (Average)}}
- ext{Average # of days to sell inventory} = rac{365}{ ext{Inventory Turnover}} (also known as Average days in inventory)
Example (Boardwalk Taffy vs. Beach Sweets):
- Boardwalk Taffy (Uses FIFO):
  - Merchandise Inventory: \$350,000
  - COGS: \$2,000,000
  - Sales Revenue: \$3,000,000
  - Gross Margin Percentage: \frac{\$3,000,000 - \$2,000,000}{\$3,000,000} = 33.33\%
  - Inventory Turnover: \frac{\$2,000,000}{\$350,000} hickapprox 5.71 ext{ times}
  - Average days to sell inventory: \frac{365}{5.71} hickapprox 63.92 ext{ days}
- Beach Sweets (Uses LIFO):
  - Merchandise Inventory: \$300,000
  - COGS: \$2,050,000
  - Sales Revenue: \$3,000,000
  - Gross Margin Percentage: \frac{\$3,000,000 - \$2,050,000}{\$3,000,000} hickapprox 31.67\%
  - Inventory Turnover: \frac{\$2,050,000}{\$300,000} hickapprox 6.83 ext{ times}
  - Average days to sell inventory: \frac{365}{6.83} hickapprox 53.44 ext{ days}
- Analysis:
  - Boardwalk Taffy appears to be charging higher prices in relation to its cost (higher gross margin percentage).
  - Boardwalk Taffy has a higher average number of days to sell inventory (63.92 days compared to 53.44 days for Beach Sweets), which suggests it has higher inventory financing costs because inventory sits longer before being sold.