Inventory

Concept of Inventory

  • Inventory consists of goods waiting to be sold alongside the associated direct and indirect costs related to production or procurement.

Types of Inventory

  • Merchandisers: For companies like Walmart, inventory primarily represents products procured for resale.
    • Example: Walmart purchasing TVs from manufacturers to sell to customers.
  • Manufacturers: For companies such as General Motors, inventory includes:
    • Raw materials: Resources used in manufacturing finished goods.
    • Work in progress: Costs associated with partly finished products, encompassing direct labor and factory overhead.
    • Finished goods: The complete products ready for sale.

Inventory Accounting Cycle

  • Inventory acts as an asset on the balance sheet until it is sold.
  • When inventory is sold, it transitions from the balance sheet to the income statement as Cost of Goods Sold (COGS).
    • This reflects the matching principle: Expenses are matched with the revenues they generate.

Inventory Valuation on Balance Sheet

  • Inventory consists of:
    • Beginning inventory balance
    • New purchases of inventory
    • Subtracting Cost of Goods Sold to arrive at the ending inventory balance.
  • Example: If beginning inventory is $500,000, purchases are $300,000, and COGS is $200,000, then:
    • Ending Inventory Calculation: $500,000 + $300,000 - $200,000 = $600,000.

Inventory Costing Methods

  • Understanding how to value inventory is crucial as companies may choose different methods to assign costs to inventory:

Costing Methods Overview

  1. First In First Out (FIFO)

    • The first items purchased are the first sold.
    • Remaining inventory reflects the latest costs.
    • May provide more accurate inventory values during inflation.

  2. Last In First Out (LIFO)

    • The last items purchased are the first sold.
    • Often results in lower profits and taxable income when prices are rising.
    • Not allowed under IFRS.

  3. Average Cost Method

    • Averages the cost of all inventory available for sale.
    • Cost of goods sold is determined by: (Total cost of goods available for sale) / (Total units available for sale).

FIFO vs LIFO Example

  • Situational Calculation:

    • Walmart procures 1,000 TVs at $500 each and then another 1,000 at $600 each.
    • If Walmart sells 1,300 TVs, the COGS value differs significantly:
    • Under FIFO: Assigns the first purchase prices to earlier sales, resulting in lower COGS.
    • Under LIFO: Assigns the last purchase prices to sales, resulting in higher COGS.

  • Demonstration:

    • FIFO Calculation:
    • First 1,300 units sold would primarily use the lower-cost units leading to lower reported COGS.
    • LIFO Calculation:
    • First 1,300 units sold would use the higher-cost inventory leading to higher reported COGS and lower gross margins.
    • Example Findings:
    • If sales figures remain unchanged, cost implications of FIFO show higher profitability than LIFO during inflationary periods.

Practical Application of Costing Methods

  • The choice between FIFO, LIFO, and Average Cost can drastically influence net income figures:
    • During rising prices, LIFO leads to lower gross margins whereas FIFO leads to higher gross margins.
    • Tax Implications: Companies often prefer LIFO to reduce tax liabilities since it shows lower profits.
    • Disclosures needed under US GAAP: Companies using LIFO must disclose the adjustable reserves (LIFO reserves) for comparative purposes against FIFO companies.

Inventory Write Downs

  • Inventory is typically shown on the balance sheet at historical cost, adhering to the conservatism principle.
  • Companies cannot mark up the value of inventories but can mark them down.
  • Under US GAAP the Lower of Cost or Market Rule states that inventories must be written down to market value if they fall below historical cost.
    • IFRS Equivalent: Known as Lower of Cost or Net Realizable Value.

Write Down Accounting Treatment

  • Recognizing a loss on inventory health must be reported on the income statement immediately.

  • Impacts on financial statements:

    • Inventory value is decreased (credit the inventory asset).
    • Loss recognized as an expense (debit to retained earnings via the income statement).

  • Example: If $5,000 worth of lemons spoil:

    • Inventory reduction entry: $5,000 (credit inventory).
    • Recognized loss entry: $5,000 (debit retained earnings).

Conclusion

  • Understanding inventory accounting methods is critical for accurate financial reporting and analysis as they significantly affect financial health and tax obligations. The choice of method should align with business strategy, operational realities, and market conditions.