Inventory
is a stock of goods a firm keeps to resale, or for processing if they are manufacturing company. Merchandise inventory is for retail or wholesale. Finished goods inventory is for manufacturing. WIP and raw materials are also for manufacturing.
Table of Contents:
Accounting for Inventory:
Note: in Accounting....Inventory (asset) and COGS (related expense)
Inventories are assets because firms expect to sell them for cash, or AR. When selling them, a firm expenses COGS for current book value (normally the acquisition cost).
Note: Financial statements report dollar amounts, not physical units such as pounds or cubic feet.
The major problem with inventory accounting is that per-unit prices of inventory items changes over time
Key Formulas
BI = Beginning Inventory
EI = Ending Inventory
COGS = Cost of Goods Sold
GAS = Goods available for sale
General inventory equation:
Beginning Inventory + Add - Withdrawals = Ending Inventory
BI + Purchases - COGS = EI
BI + Purchases - EI = COGS
BI + Purchases = GAS (Goods available for sale)
Note: because you normally know GAS, then there are 2 remaining variables (EI, and COGS) on opposite sides of the equation. If one goes up, then the other must go down.
BI
+ Purch
GAS
- EI
COGS
Valuation issues
1. What costs should be included in acquisition costs? (everything)
2. What to do if market value of inventories changes? (write down, but never mark up)
3. What cost flow assumptions should be used (LIFO, FIFO, Weighted average)?
What costs should be included?
All costs incurred to acquire goods and prepare them for sale. Include the invoice price less any cash discounts taken for prompt payment. Include the cost of purchasing, transporting, receiving, unpacking, inspecting, and shelving as well as any costs for recording purchases.
Need to subtract any cash discounts (offered) for quick payment. If its offered, then by accounting rules, you have to subtract that value whether you take it or not.
Manufacturing costs included
Manufacturing costs are both direct (materials, direct labor, and manufacturing overhead) and indirect (depreciation, insurance, taxes, supervisory labor, factory supplies). All of these manufacturing costs should be considered product costs (assets) and their value should accumulate in various inventory accounts.
activity based costing (ABC costing) is process of assigning indirect costs to processes and products. Takes longer to reach income statement
Product costs
Get capitalized rather than expensed. Add them to the value of the inventory assets. Then, at some time in the future, when you make a sale, you transfer the cost of items sold from the asset account, Finished Goods Inventory, to the expense account, Cost of Goods Sold expense, and match the timing with revenue.
Workers salaries
Debit WIP Inventory (asset increase), and Credit Cash (asset decrease). Do not Debit salaries expense. But admin salaries get expensed (see below). Therefore, workers salaries do not change RE, but instead increase an asset account. Management salaries, on the other hand, do decrease RE by the expense amount, and do not change an asset account.
Depreciation
Factory depreciation gets capitalized, and not expensed. You still CR the contra asset account “Accumulated Depreciation”, but instead of DR the retained earnings depreciation expense, instead what you do is DR the WIP (work in process) inventory accounts (making the value of the inventory more valuable). But depreciation of management offices gets CR accumulated depreciation (asset) just as above, but this time the DR is to depreciation expense, and capitalized to inventory. Depreciation of the management office, therefore, goes directly to the income statement as an expense, but the depreciation of the factory first gets capitalized, and does not get expensed until later with COGS expense once the goods are sold. In the end, both will get expensed, but at different times.
Therefore, in a manufacturing environment, the COGS will include workers salaries, depreciation, insurance, taxes, overhead….everything for the factory to make the products that are later sold. They will also include all warehousing and storage costs (and labor at the warehouse).
Period Expenses
Selling expenses, Administrative expenses…all get expensed as occurred. Directly to income statement. SGA = period expenses. Both manufacturing and merchandising companies have various marketing and administrative costs and selling costs that should be treated as period expenses. You expense them as they occur, and do not capitalize them in inventory accounts.
Specific Manufacturing inventory accounts
Have separate inventory accounts for product costs incurred at various stages of completion. The Raw Materials Inventory account, the Work-in-Process Inventory account, the Finished Goods Inventory account… materials move though this chain until finally moving to COGS when the units are sold (at which time they are expensed…but not before).
COGS of Raw Materials inventory…gets added to as an input to the WIP inventory….then the COGS of WIP inventory gets added as an input to the Finished goods inventory. Just remember to accumulate all manufacturing costs in assets (inventory).
Valuing the inventory as market conditions change
Record inventories initially at acquisition cost (not at market value or replacement costs). If the market value of inventory goes up, you do not have to revalue that inventory on Balance sheet. When you sell the inventory, you will record the difference in COGS and sales price as a gain, and will pay taxes on that gain.
In contrast, you must write down inventories when their replacement cost, or market value, is less than acquisition cost. You always use the lower of cost or market value. This is a “conservative” policy of always valuing the inventory at the lowest known value. The result is that you can report losses right now on the net income statement, but that you don’t have to report gains until you sell the goods.
Journal Entry:
DR retained earnings Unrealized Holding Loss
---- CR inventory
Other firms might not explicitly state the holding loss, but instead will just increase the COGS for that period. Remember that there are two unknown variables; COGS & EI, and they are on the opposite side of the equation. If one goes up then the other goes down. If you revalue the inventory lower, then by default the COGS for that period will go up. To avoid misleading readers of statements, this will be explained in the notes.
BI
+ Purch
GAS
- EI
COGS
Inventory Valuation Assumptions
When looking at inventories, it is sometimes difficult to create a valuation because there are some variables in the equation that might change depending on which assumptions you are using. Remember: the general inventory equation:
BI + Purchases - COGS = EI
Goods Available for Sale (BI + Purchases) = EI + COGS
COGS valuation & ending inventory valuation are related. The higher the value assigned to one of them, the lower must be the value assigned to the other. At the beginning of a period, a firm knows what inventory they have + they know what purchases they made. It’s usually easy to determine GAS (goods available for sale or use). Then, after the sales are made this period, at they end…you might know physically how many units of inventory are left, but you might not know for sure how much that inventory is worth. That’s because there are different assumptions that can be made for the COGS.
Choices for valuation of the ending inventory: FIFO, LIFO, average costs, or some other choice.
FIFO
First in First out ….or….last in still here (LISH)
In the first-in, first-out (FIFO) cost flow method, we assume that there is an “assembly line” of inventory, in which the oldest inventory will get sold first. Then, when trying to assign a value to COGS for the recent sale, we look at the value of the oldest piece in the inventory. Therefore, we assign the costs of the earliest units acquired to the withdrawals. The most recent purchases get added to the ending inventory.
If you use FIFO, your balance sheet will accurately show the value of the inventory, but the income statement will be using older costs for COGS (less accurate earnings reported).
When purchase prices rise, and if inventories are increasing….FIFO usually leads to the highest reported net income of the three methods and when purchase prices fall, it leads to the smallest.
LIFO
In the last-in, first-out (LIFO) cost flow method, we assume that there is a “gravel pile” of inventory, in which the newest inventory will get sold first. Much like a pile gravel, the oldest inventory might be there for a very, very long time. Then, when we sell a piece from our inventory, we assign the costs of the newest units acquired to the withdrawals. The costs of the oldest units stay with the ending inventory.
If you choose to use LIFO, then the income statement will show more accurate assessment of actual costs (and earnings), but the balance sheet might significantly underestimate the value of the inventory.
If prices are rising (and inventories are increasing), LIFO results in higher COGS, and a lower net income and a lower income tax than either of the other methods. This is not true, however, if the firm has to dip into the “LIFO layers”.
If a firm uses LIFO for income tax reporting purposes, it must also use LIFO in its financial report to shareholders.
NOTE: approximately 30% of US firms use LIFO
Weighted Average method
In the weighted average method, we assume that the inventory has an average cost, and we don’t care about which one was purchased first or last. The weighted-average method assigns costs to both inventory and withdrawals based upon a weighted average of all merchandise available for sale during the period.
The weighted-average cost flow assumption resembles FIFO more than LIFO in its effect on the financial statements. When inventory turns over rapidly, the weighed-average inventory cost flow provides amounts virtually identical to FIFO’s amounts.
Periodic vs. Perpetual inventory
A company can choose to keep track of their inventory on hand at all moments (perpetual method), or they might choose to just figure out their inventory every now and then (periodic). T
Periodic method:
The advantage is that its relatively less work, low cost, and just a little bit of paperwork. This is good for high volume, and low value goods. The accounting only records revenue effect for sales (but no cost effect at time of sale). At the time of purchase, you have to use a contra or adjunct account for purchases. Then, later the COGS is an adjusting entry that has to be inferred using the basic inventory formula (see below). The problem with this method is that you have poor control, and you have to do an end of year inventory count to figure out EI, and then work backwards to figure out your COGS (and make an adjusting entry).
Perpetual method:
The advantage is that you have excellent control, and can count your inventory at any time. You never have to make an adjusting entry because your books are always up to date. You only use the COGS and inventory accounts (no need for contra accounts). There will always be two journal entries for each sale (one for revenue, and other for COGS). This method is good for high value, but low volume items. The disadvantage is that there is lots of record keeping, and that increases costs.
Effects of using either Periodic or Perpetual:
FIFO – the COGS and EI will be the same with both Periodic & Perpetual
LIFO – the COGS and EI will be different
LIFO perpetual is different
Because LIFO starts again each period, and uses the most recent COGS. If the period is shorter, its like compounding monthly instead of yearly, and the LIFO method keeps on using the more recent COGS figures. If prices are rising, then the COGS for LIFO perpetual will be higher than it would have been under LIFO periodic. Each period starts again, and because under perpetual there are more periods, then the COGS figure is always going to be higher. The result is that under LIFO, the value of the Ending Inventory will be lower (because COGS was higher) using perpetual rather than using periodic. NOTE: the perpetual LIFO will only be different if you have inventory from various “layers” left over. If you use all inventory, except for the very first layer, then it will be the same. See below for more details about LIFO layers.
FIFO is the same:
Whether you use perpetual or periodic methods, the COGS and inventory values for FIFO will be the same. Since FIFO is always pulling the value of the COGS from the oldest item, it doesn’t matter how often you “compound”. You can break a year into monthly or daily, or unlimited periods, and it will always give the same COGS (which is the oldest inventory).
Reporting Issues
During inflation:
FIFO—lowest COGS = highest net income (and taxes) + highest balance sheet (inventory)
LIFO—Highest COGS = lowest net income (and taxes) + lowest balance sheet (inventory)
LIFO has the most accurate COGS; reflecting current costs.
LIFO has advantage of deferring income taxes (until later date when “old” inventory is sold).
If a firm uses LIFO for taxes, however, they must also use LIFO for reporting earnings.
If you use FIFO, then the balance sheet will accurately reflect up to date costs of inventory, but the income statement will use older inventory items and might overstate earnings (if inventory prices are rising). LIFO, on the other hand, might have really out dated inventory numbers on their balance sheet.
Because the Securities and Exchange Commission is concerned that this out-of-date information might mislead the readers of financial statements, it requires firms using LIFO to disclose, in notes to the financial statements, the amounts by which inventories based on FIFO or current cost exceed their amounts as reported on a LIFO basis.
Income statement – earnings
A firm using LIFO might delay purchasing new inventory so that they can dip into previous LIFO layers….to increase their earnings for this period. An analyst should re calculate the earnings and COGS assuming that they did not dip into previous layers to compare.
Balance sheet
- LIFO reported inventories could be much lower than a FIFO balance sheet. Some steel companies, for example, show inventories using LIFO 80% less than if they had been using FIFO. For this reason, any company using LIFO has to report in their notes what the inventory would have been had they used FIFO.
Return on Assets (ROA)
- ROA = profit margin for ROA * total assets turnover
Changes in COGS have an effect on the profit margin
Changes in inventory have an effect on the turnover
Current ratio:
- LIFO inventory understatement results in an understatement of the firm’s current ratio. The computed current ratio tends to underestimate the firm’s liquidity
Inventory Turnover ratio:
- LIFO inventory turnover will be overstated. Inventory turnover ratio uses COGS as the numerator, with inventory as the denominator. With LIFO there will be an exaggerated COGS, and a lower inventory number…so the inventory turnover ratio might vastly over exaggerate the speed with which the company turnover their inventory…and the efficiency with which they use their inventory asset. For example, you might think that this company is much better at using their limited amount of inventory to generate sales than if they had been using FIFO.
COGS / Sales (common sized income statement)
- LIFO will have larger COGS, and therefore higher Sales to COGS percentage.
Summary of reporting issues
Because inventory assumptions can have an effect on COGS, then they have an affect on the profit margin of the business. This is because goes into the Income Statement as an expense, reducing Net Income. COGS / Sales is a major part of the profit margin of a company. On the other hand, inventory levels have a direct impact on the Turnover ratios. A decreased value of the inventory will give you a increased inventory turnover ratio (it will look like you are more efficient in turning your inventory into sales).
Using LIFO, therefore, will likely show a lower profit margin (because of higher COGS/sales ratio), and a higher inventory turnover ratio (because of a lower value of inventory). The impact on ROA will depend upon which one is proportionally heavier.
Using FIFO, we will see a higher profit margin (using lower COGS creates a larger profit from our holding gain on inventory) resulting in lower COGS/ sales ratio. Also, FIFO will create a lower inventory turnover ratio because the value of the inventory will be higher (since its not just the really old inventory on the balance sheet, but instead is the newer, and more expensive inventory).
Rate of price change is important:
The speed at which prices are changing (for purchases) makes a difference. If there is fast inflation, then the newer products will be much more expensive than the older ones…and LIFO will have a larger impact. If the prices are not changing, then there is very little difference between COGS or inventory reported.
Inventory turnover rate is important:
The faster the turnover, the smaller the differences between LIFO, FIFO and weighted average inventory reporting. Company with fast inventory turnover will not be as effected by LIFO as a company with a really long inventory turnover. For example, if a retail store uses LIFO, they will see a small impact from LIFO because ending inventory is small compared to the volume of sales. But a whiskey distiller that keeps their product in inventory for a long period of time would see a greater impact from using LIFO.
Time Factor
The longer a firm uses LIFO, the greater the impact. If a company were to use LIFO for 100+ years, they might still have some of the old prices in their inventory on their books. Therefore their balance sheet for inventory could be vastly understated. All of the ratios such as ROA (return on assets), or inventory turnover ratio…will be misleading. Be careful when comparing a company using LIFO vs one that is using FIFO. Note: if the company ever had to “use” that old inventory as the extremely low prices, then they would show massive earnings, and would have to eventually pay the taxes. For this reason, they hope to never use the old purchase prices using LIFO.
LIFO layers
In any year that purchases exceed sales, the quantity of units in inventory increases. This increase is called a LIFO inventory layer. But, if a firm reduces inventory quanti¬ties, then the COGS will include some of the older and lower costs in the beginning inventory. Such a firm will have larger reported income and income taxes in that period than if the firm had maintained its ending inventory at beginning-of-period levels. LIFO results in firms deferring taxes as long as they do not dip into LIFO layers.
Because firms can control last minute purchases, LIFO gives companies an opportunity to manage their earnings in a particular year. A firm can also dip into LIFO layers during the period to meet earnings targets. Be aware of companies that do this.
Mixed incentives: managers of companies that use LIFO might face tough decisions about whether or not to purchase more inventories at the end of the year. LIFO managers might purchase inventory for tax reasons rather than for purely operational necessities. Managers might do things that are unwise economically, but make sense for saving taxes.
Gross Margin
Sales – COGS
Comprised of 2 parts:
1. Operating margin- difference between the selling price of an item and its replacement cost at the time of sale. By definition, the operating margin is the same under LIFO and FIFO because the replacement cost at the time of sale is always the same.
2. Realized holding gain (or loss)- the difference between COGS based on replacement cost, and the COGS based on acquisition cost. This will be different for LIFO and FIFO. Under FIFO, a firm will have a greater realized holding gain because they are selling older pieces. This extra holding gain explains why FIFO net income is higher. The term “inventory profit” sometimes denotes the realized holding gain on inventory, but does not need to appear on the statements. The amount of inventory profit varies from period to period as the rate of change in the purchase price of inventories varies. The larger the inventory profit, the less sustainable are earnings and therefore the lower the quality of earnings.
Unrealized Holding Gains - Inventory
Unrealized holding gains on ending inventory do not appear in a firm’s income statement as presently prepared under GAAP. The unrealized holding gain under LIFO is larger than under FIFO since LIFO assumes that earlier purchases with lower costs remain in ending inventory.
The sum of the operating margin plus all holding gains (both realized and unrealized) is the same under FIFO and LIFO. Most of the holding gain under FIFO is included in net income each period, whereas most of the holding gain under LIFO is not currently recognized in the income statement. Under LIFO, the unrealized holding gain remains unreported as long as the older acquisition costs appear on the balance sheet as ending inventory.
International Inventories
All major industrialized countries require the lower-of-cost-or-market method in the valuation of inventories. Firms in most countries use FIFO and weighted-average cost flow assumptions. Few countries except the United States and Japan allow LIFO as an acceptable cost flow assumption.
Cash flow affects of inventory
How much cash did the company use to purchase inventory?
All transactions involving inventory affect the operations section of the statement of cash flows. An increase in inventory during the year is subtracted from net income in computing cash flows from operations. A decrease in inventory during the year is added to net income in computing cash flows from operations.
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