FINANCIAL ACCOUNTING Fifth Edition Thomas Dyckman Robert Magee
FINANCIAL ACCOUNTING Fifth Edition Thomas Dyckman Robert Magee Michelle Hanlon Glenn Pfeiffer CHAPTER 7 Reporting and Analyzing Inventory ©Cambridge Business Publishers, 2017
2 Learning Objective 1 Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs. ©Cambridge Business Publishers, 2017
3 Expense Recognition 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 Direct Association ©Cambridge Business Publishers, 2017 Immediate Recognition Systematic Allocation
4 Expense Recognition Direct Association § Any cost directly associated with a specific source of revenue § Recognize at the same time the related revenue is recognized Examples Cost of goods sold Warranty costs ©Cambridge Business Publishers, 2017
5 Expense Recognition Immediate Recognition § Costs that can be associated with the revenues of an accounting period, but not with any specific sales transaction § Recognize in period incurred Examples Most administrative costs (including insurance, utilities, salaries, etc. ) Most marketing costs Research and development costs ©Cambridge Business Publishers, 2017
6 Expense Recognition Systematic Allocation § Costs that benefit more than one accounting period that are not associated with specific revenues or assigned to one specific time period § Capitalize as an asset and convert to an expense over its useful life Examples Depreciation expense ©Cambridge Business Publishers, 2017
7 Reporting Inventories Walmart reports the cost of its inventories sold on its income statements: Income Statements (in millions) Total revenues Cost of sales Selling, general and administrative expenses Operating income Other expenses…………… Years Ended Jan. 31, 2015 Jan. 31, 2014 $485, 651 365, 086 $476, 294 358, 069 93, 418 27, 147 91, 353 26, 872 One of the largest single expenses in a company’s income statement ©Cambridge Business Publishers, 2017
8 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 Sales revenue – Cost of goods sold = Gross profit Often called Cost of Sales ©Cambridge Business Publishers, 2017 or, Gross Margin
9 Inventory Purchasing (1) Phelp’s, Inc. , a startup company, purchases 60 pairs of swim goggles for resale at a cost of $4 each. Balance Sheet Transaction Purchase 60 goggles for cash for $4 each Cash Asset + Noncash = Asset – 240 +240 Cash Inventory = Liabilities + Contrib. + Capital (1) Inventory (A) 240 ©Cambridge Business Publishers, 2017 Earned Revenues – Expenses = Capital ‒ (1) Inventory (+A) Cash (–A) Income Statement 240 = 240 Cash (A) 240 (1) Net Income
10 Inventory Sales (2) Phelp’s sells 50 of the swim goggles previously purchased for $10 cash each. Balance Sheet Transaction Sell 50 goggles for cash for $10 each Cash Asset + Noncash = Asset +500 – 200 Cash Inventory = Liabilities + Contrib. + Capital Income Statement Earned Revenues – Expenses = Capital +500 & – 200 +500 Sales – Cost of = – 200 Retained Revenue Earnings +200 Goods Sold (2 a) Cash (+A) Sales revenue (+R, +SE) 500 (2 b) Cost of goods sold (+E, –SE) Inventory (–A) 200 (2 a) (2 b) Cash (A) 500 Inventory (A) 200 ©Cambridge Business Publishers, 2017 Net Income Sales Revenue (R) 500 Cost of Goods Sold (E) 200 (2 a) (2 b)
11 Reporting Inventory § Reported at ‘cost’ which includes § § Cost to acquire Cost for transportation Cost in preparing goods for sale Cost with consideration of incentives § Volume discounts § Early payment discounts § Referred to as cash discounts ©Cambridge Business Publishers, 2017
12 Reporting Inventory § 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. § When a company ships its own product to a customer, but has not fulfilled its requirements for recognizing revenue, the product remains in the seller’s inventory until revenue can be recognized. § When inventory is on consignment to a distributor ©Cambridge Business Publishers, 2017
13 Inventories for Manufacturers Raw Materials Inventory Parts and materials purchased from suppliers for use in the production process Work-in-Process Inventory of partially completed goods; includes materials, labor, and overhead cost Finished Goods Inventory Completed products ready for delivery to customers ©Cambridge Business Publishers, 2017
14 Cisco Systems’ Inventories Cisco reports inventory totaling $1, 591 million in its July 26, 2014 balance sheet: Components of Inventory for Cisco Systems, Inc. ©Cambridge Business Publishers, 2017
15 Learning Objective 2 Account for inventory and cost of goods sold using different costing methods. ©Cambridge Business Publishers, 2017
16 Calculating Cost of Goods Sold The inventory account decreases when goods are sold. Cost of Goods Sold Computation The ending inventory in the current period becomes the beginning inventory for the subsequent period. ©Cambridge Business Publishers, 2017
Inventory Cost Flows to Financial Statements Unsold goods ©Cambridge Business Publishers, 2017 Includes: Amount of beginning inventory plus current period inventory purchases Costs of items sold during the period 17
18 Inventory Costing Methods Three commonly used inventory methods… First-in, First-out (FIFO) Assumes the oldest costs recorded in inventory are the first costs transferred to cost of goods sold Last-in, First-out (LIFO) Assumes the most recent costs recorded in inventory are the first costs transferred out Average Cost (AC) Assumes the cost of goods sold is the average of the cost to purchase all of the inventories available during the period Physical inventory flow need not match the cost flow. ©Cambridge Business Publishers, 2017
19 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 § Sold 460 goggles at $12. 00 each Cost of goods sold during June 100 goggles at $4 each 360 goggles at $4. 50 each Cost of goods sold Ending inventory 40 goggles at $4. 50 each ©Cambridge Business Publishers, 2017 $ 400 1, 620 $2, 020 $180
20 LIFO 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 § Sold 460 goggles at $12. 00 each Cost of goods sold during June 400 goggles at $4. 50 each 60 goggles at $4 each Cost of goods sold Ending inventory 40 goggles at $4 each ©Cambridge Business Publishers, 2017 $1, 800 240 $2, 040 $160
21 Inventory Costing and Price Changes LIFO and FIFO § Are both historical cost methods § Allocate costs of inventory differently § Differences arise when costs of inventory change over time ©Cambridge Business Publishers, 2017
22 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: § Purchased 400 goggles at $4. 50 each § Sold 460 goggles at $12. 00 each Average cost = [(100 × $4) + (400 × $4. 50)]/500 = $4. 40 Cost of goods sold during June 460 goggles at $4. 40 each Ending inventory 40 goggles at $4. 40 each ©Cambridge Business Publishers, 2017 $2, 024 $176
23 Comparing the Costing Methods FIFO Ending inventory 40 @ $4. 50 each 40 @ $4. 00 each 40 @ $4. 40 each Cost of goods sold 100 @ $4. 00 and 360 @ $4. 50 400 @ $4. 50 and 60 @ $4. 00 460 @ $4. 40 each Total cost of goods available LIFO AC $ 180 $ 160 $ 176 2, 020 2, 040 2, 024 $2, 200 The total cost of goods available for sale of $2, 200 is divided differently between the cost of the goods sold and the inventory that remains on hand for each of the three methods. ©Cambridge Business Publishers, 2017
24 Learning Objective 3 Apply the lower of cost or market rule to value inventory. ©Cambridge Business Publishers, 2017
25 Lower of Cost or Market Inventory is reported on the balance sheet at Lower of Cost or Market (LCM) If market value of inventory is less than inventory cost Company must write-down inventory to market Writedown Market value = Replacement cost If market value of inventory is greater than inventory cost ©Cambridge Business Publishers, 2017 Inventory cost remains on the balance sheet No writedown
26 Inventory Write-Downs Under LCM § Inventory book value is written down to current market value, reducing total assets § Inventory write-down is reflected as an expense on the income statement, reducing current period gross profit, income, and equity § Included as part of cost of goods sold New Accounting Standards Update 2015 -11 Requires companies (other than those using LIFO or the retail inventory method) to apply the Lower of Cost or Net Realizable Value (estimated selling price less costs to complete sale) for years beginning after December 15, 2016. ©Cambridge Business Publishers, 2017
27 IFRS Reporting Insight § Write-down of inventory cost can be reversed under IFRS if market value increases § May be reversed up to the acquisition cost § Revaluation results as a debit to Inventory and credit to Cost of Goods Sold ©Cambridge Business Publishers, 2017
28 Inventory Disclosures Walmart’s note disclosure: LIFO method LCM valuation 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 substantially all of the 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, 2015 and January 31, 2014, the Company’s inventories valued at LIFO approximated those inventories as if they were valued at FIFO. ©Cambridge Business Publishers, 2017
29 Reasons for Inventory Disclosures § The magnitude of a company’s investment in inventory is often very large § Impacts the income statement and balance sheet § Risks of inventory losses are often high § Tied to technological obsolescence and consumer tastes § Can provide insight into future performance § Both good and bad § High inventory levels result in substantial costs for a company such as financing costs to purchase, storage, handling, and insurance costs ©Cambridge Business Publishers, 2017
30 Learning Objective 4 Evaluate how inventory costing affects management decisions and outsiders’ interpretations of financial statements. ©Cambridge Business Publishers, 2017
31 LIFO Reserve § The LIFO reserve is the difference between LIFO cost and the current value of inventory § Must be reported by companies using LIFO reserve = FIFO ending inventory cost ‒ LIFO ending inventory cost § Estimating FIFO cost of goods sold = LIFO cost of goods sold ‒ Change in LIFO reserve Useful for comparing gross profits of a company using FIFO with another company using LIFO ©Cambridge Business Publishers, 2017
Income Statement Effects of LIFO versus FIFO 32 § Function of two factors § Speed and direction of inventory cost changes § If costs increase more slowly, difference between LIFO and FIFO will decrease § If costs decrease, difference between LIFO and FIFO will reverse § Length of time inventory is held § Differences increase with longer holding periods § Effects of changing costs § Management may change selling prices § Lower income taxes result with LIFO when prices are rising ©Cambridge Business Publishers, 2017
33 Income Statement Effects of Inventory Costing Sales (460 × $12) Cost of goods sold Gross profit FIFO LIFO AC $5, 520 2, 020 $3, 500 $5, 520 2, 040 $3, 480 $5, 520 2, 024 $3, 496 In a period of rising prices FIFO yields the highest gross profit and net income. ©Cambridge Business Publishers, 2017 In a period of rising prices LIFO yields the lowest gross profit and net income.
Balance Sheet Effects of Inventory Costing In a period of rising prices, LIFO yields ending inventories that are often much lower than FIFO. Current Assets Cash Accounts receivable Inventories FIFO $ xxx 180 LIFO AC $ xxx $ xxx 160 176 LIFO does not accurately represent the cost that a company would incur to replace its current investment in inventories. ©Cambridge Business Publishers, 2017 34
Balance Sheet Effects of LIFO versus FIFO 35 § FIFO costing on the balance sheet § Approximates current value § If prices fall, more likely to require lower of cost or market adjustments § Periods of rising prices § LIFO ending inventories are understated compared to FIFO § Does not represent replacement cost § LIFO reserve can be viewed as an ‘unrealized holding gain’ § A gain that results from holding inventory as prices are rising ©Cambridge Business Publishers, 2017
Cash Flow Effects of LIFO versus FIFO in periods of rising prices § Higher pretax income § Higher income taxes § Less cash available LIFO in periods of rising prices § Lower pretax income § Lower income taxes § More cash available Increased cash flow from tax savings is often cited as a compelling reason for management to adopt LIFO. ©Cambridge Business Publishers, 2017 36
37 Financial Statement Effects of Inventory Costing Sales (460 × $12) Cost of goods sold Gross profit FIFO LIFO AC $5, 520 2, 020 $3, 500 $5, 520 2, 040 $3, 480 $5, 520 2, 024 $3, 496 Using FIFO Increased gross profit results in higher pretax income causing higher taxes payable. Using LIFO Results in a reduced tax liability, so cash flows are higher Opposite effects occur in deflationary periods. ©Cambridge Business Publishers, 2017
38 Adjusting from LIFO to FIFO § Adjust the balance sheet to FIFO inventory = LIFO reserve + LIFO inventory § Adjust the income statement to FIFO cost of goods sold = LIFO cost of goods sold ‒ change in LIFO reserve Enhances comparability between companies using FIFO versus LIFO ©Cambridge Business Publishers, 2017
39 IFRS Reporting Insight § LIFO not allowed by IFRS § Problems inherent § FIFO firms do not disclose effects of using LIFO or other methods § Analysts need to track inventory differences to compare FIFO firms to LIFO firms § Changing to FIFO from LIFO creates additional tax payments for inventory costs deferred under LIFO ©Cambridge Business Publishers, 2017
40 Learning Objective 5 Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios. ©Cambridge Business Publishers, 2017
41 Gross Profit Margin Important because it is monitored by external users and management. Gross profit margin = Sales revenue - Cost of good sold Sales revenue Home Depot’s Gross Profit Margin: Home Depot’s gross profit margin held relatively constant between 2012 and 2014. ©Cambridge Business Publishers, 2017
42 Gross Profit Analysis § Causes of a changing gross profit margin § § § Product line is stale Change in product mix New competitors enter the market General decline in economic activity Inventory is overstocked Change in pricing ©Cambridge Business Publishers, 2017
43 Gross Profit Margin Comparison Gross profit margins of Home Depot and Lowe’s: Gross Profit Margin Comparison Gross profit margins among retailers: Comparison of Gross Profit Margins Among Retailers ©Cambridge Business Publishers, 2017
44 Tools for Inventory Analysis § Inventory turnover § Indicates how quickly inventory is being sold Inventory turnover = Cost of goods sold Average inventory § Average inventory days outstanding § Indicates how long inventories are held before being sold Average inventory = Avg. daily cost of goods sold days outstanding ©Cambridge Business Publishers, 2017
Applying Inventory Turnover to Home Depot Inventory turnover = Cost of goods sold Average inventory Home Depot’s inventory turnover: Home Depot turned its inventory over 4. 9 times in 2014. ©Cambridge Business Publishers, 2017 45
46 Home Depot in Context Home Depot’s inventory turnover ratio as compared to other companies: ©Cambridge Business Publishers, 2017
47 Home Depot’s Inventory Days Outstanding Average inventory = Avg. daily cost of goods sold days outstanding Home Depot’s inventory days outstandng: Home Depot had its inventories on its shelves for about 75 days in 2014; a three day improvement over 2012. ©Cambridge Business Publishers, 2017
48 Home Depot in Context Home Depot’s average inventory days outstanding as compared to other companies: ©Cambridge Business Publishers, 2017
49 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 ©Cambridge Business Publishers, 2017
50 Turnover Factors—Asset Utilization § Optimizing inventory investment § Too much inventory is expensive § Too little inventory causes stock-outs, lost sales § Operational changes to reduce inventory § Improved manufacturing processes to eliminate bottlenecks and work-in-process buildup § Just-in-time deliveries from suppliers to reduce raw material inventories § Demand-pull production in which raw materials are released to production when final goods are demanded by customers ©Cambridge Business Publishers, 2017
51 Comparing Inventory Turnover Inventory turnover of Home Depot and Lowe’s: Inventory Turnover Comparison Inventory turnover of various retail companies: Inventory Turnover for Various Companies ©Cambridge Business Publishers, 2017
52 Adjusting Turnover Ratios Adjusted inventory = turnover LIFO cost of goods sold *Average FIFO inventory * Represents average adjusted LIFO company inventory to a FIFO basis § Advisable to adjust before calculating turnover ratios § Potential mismatch § LIFO causes the cost of goods sold value per unit to differ from inventory amount per unit § Solution § Update beginning and ending inventory values using the LIFO reserve information ©Cambridge Business Publishers, 2017
53 Learning Objective 6 Appendix 7 A Analyze LIFO liquidations and the impact they have on the financial statements. ©Cambridge Business Publishers, 2017
54 LIFO Liquidation § Occurs when the quantity sold exceeds the quantity purchased § Old inventory costs from the older cost layers are transferred to cost of goods sold Creates larger than normal profits because older layers are usually less costly per unit when prices are rising. § Prevention § Keep purchases equal or greater than the quantity sold, so that older cost layers remain in inventory ©Cambridge Business Publishers, 2017
55 LIFO Liquidation Example Phelps has 200 units available to sell. Available for Sale Phelps sells 150 units. Cost of Goods Sold Purchase 100 @ $12 Beginning inventory 100 @ $10 100 @ $12 50 @ $10 Ending Inventory Liquidation of part of an old layer 50 @ $10 Profits are $100 higher ($2 x 50 units) than if additional $12 units would have been purchased. ©Cambridge Business Publishers, 2017
56 LIFO Liquidation Disclosure § LIFO liquidation gain § The amount by which net income would be increased if the liquidation had not occurred § Must be disclosed in financial statement footnotes ©Cambridge Business Publishers, 2017
57 LIFO Liquidation Implications § LIFO liquidation boosts gross profit § Because older, lower costs are matched against revenues based on current sales prices § Reasons for material LIFO liquidation § Involuntary, such as § Supply disruption due to natural disasters § Intentional, such as § Efforts to lower costs § Efforts to improve efficiency § Earnings management ©Cambridge Business Publishers, 2017
58 LIFO Liquidation Implications § Tax implications § An incentive to avoid LIFO liquidations § Financial reporting § An incentive to create LIFO liquidations for earnings management purposes ©Cambridge Business Publishers, 2017
The End ©Cambridge Business Publishers, 2017
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