Fifo fifo costing the balance sheet approximates current value prices fall

Reporting and Analyzing Inventory

Expenses are recognized when assets are diminished or liabilities increase as a result of earning revenue or supporting operations even if there is no immediate decrease in cash.

Three Approaches

Expense Recognition

Direct Association

Warranty costs

Examples

Most administrative costs (including insurance, utilities, salaries, etc.)

Systematic Allocation

 Costs that benefit more than one accounting period that are not associated with specific revenues or assigned to one specific time period

Reporting Inventories

Walmart reports the cost of its inventories sold on its income statements:

Inventory

 A major asset for most manufacturers and merchandisers When inventory is purchased or produced, it is capitalized and carried on the balance sheet as an asset until the unit is sold
 When inventory is sold, its cost is transferred to cost of goods sold on the income statement
 Cost of goods sold is subtracted from sales revenue to yield gross profit

goggles for resale at a cost of $4 each.

for $10 cash each.

 A company should recognize all inventories to which it holds legal title. Occasionally, meaning
recognition will include items in inventory that are not on premise.

 If purchases are “FOB shipping point,” purchasing company receives title and recognizes inventory as soon as shipped by supplier.

Raw Materials Inventory
Parts and materials purchased from suppliers for use in the production process

Work-in-Process Inventory
Inventory of partially completed goods; includes materials, labor, and overhead cost

sold.

Cost of Goods Sold Computation

Inventory Cost Flows to Financial Statements

Includes:

FIFO Costing Method Example

Phelps, Inc. had 100 goggles costing $4 each in inventory at June 1, and incurred the following inventory transactions during June:

 Purchased 400 goggles at $4.50 each

Average Cost Method Example

Phelps, Inc. had 100 goggles costing $4 each in inventory at June 1, and incurred the following inventory transactions during June:

Apply the lower of cost or net realizable value rule to value inventory.

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 Included as part of cost of goods sold

IFRS Reporting Insight

of Goods Sold

The Company values inventories at the lower of cost or market as determined primarily by the retail inventory method of accounting, using the last-in, first-out (“LIFO”) method for Walmart U.S. segment’s inventories. The inventory at the Walmart International segment is valued primarily by the retail inventory method of accounting, using the first-in, first-out (“FIFO”) method. The retail inventory method of accounting results in inventory being valued at the lower of cost or market since permanent markdowns are immediately recorded as a reduction of the retail value of inventory. The inventory at the Sam’s Club segment is valued based on the weighted-average cost using the LIFO method. At January 31, 2019 and January 31, 2018, the Company’s inventories valued at LIFO approximated those inventories as if they were valued at FIFO.

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 Tied to technological obsolescence and consumer tastes

 Can provide insight into future performance

Evaluate how inventory costing affects management decisions and outsiders’ interpretations of financial statements.

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 Estimating FIFO cost of goods sold

FIFO cost of goods sold =
LIFO cost of goods sold ‒ Change in LIFO reserve

In a period of rising
prices FIFO yields the
highest gross profit
and net income.

In a period of rising
prices LIFO yields the
lowest gross profit
and net income.

Balance Sheet Effects of LIFO vs. FIFO

 FIFO costing on the balance sheet
 Approximates current value
 If prices fall, more likely to require lower of cost or market adjustments

LIFO in periods of rising prices Lower pretax income
 Lower income taxes
 More cash available

Using LIFO

Results in a reduced tax liability, so cash flows are higher

FIFO cost of goods sold =

LIFO cost of goods sold ‒ Change in LIFO reserve

 Problems inherent

 FIFO firms do not disclose effects of using LIFO or other

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Gross Profit Margin

Gross Profit Margin Comparison

Gross profit margins of

Tools for Inventory Analysis

 Inventory turnover
 Indicates how quickly inventory is being sold

Home Depot’s Gross Profit Margin:

Home Depot’s inventory turnover ratio as compared

to other companies:

Turnover Factors—Inventory Quality

 Inventory turnover can be compared with prior periods and competitors
 Higher turnover is favorable
 Turnover level may imply
 Change in product mix to higher or lower margin products  Excessive purchases or production
 Missed trends or technological advances
 Increased competition
 Change in promotion policies
 Improvement in manufacturing efficiency

 Too little inventory causes stock-outs, lost sales

 Operational changes to reduce inventory

Comparing Inventory Turnover

Inventory turnover of Home Depot and Lowe’s:

 LIFO causes the cost of goods sold value per unit to differ from inventory amount per unit

 Solution

Appendix 7A
Analyze LIFO liquidations and the impact they have on the financial statements.

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 The amount by which net income would be increased if the liquidation had not occurred

 Must be disclosed in financial statement footnotes

LIFO Liquidation Implications

 Tax implications
 An incentive to avoid LIFO liquidations
 Financial reporting
 An incentive to create LIFO liquidations for earnings management purposes

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