Advance Accounting eBook - Part 9
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Advanced Accounting E-Book
Part 9 of 12
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Discussion topics
Inventory Accounting
Types of Inventory
Classification of Inventory
Lower of the Cost or Market (LCM)
Methods of Inventory Accounting
First-In First-Out (FIFO)
Last-In First-Out (LIFO)
Weighted average costing
Financial Statement Effects
Stable Prices Environment
Rising Prices and Increasing or Stable Inventory
LIFO /FIFO Conversion
LIFO to FIFO Conversion
FIFO /Weighted Average to LIFO Conversion
Analytical adjustments to Inventory
Profitability / Liquidity / Solvency
Caterpillar Inc, Case Study
Other Important Topics
LIFO Reserve Declines
Changes in Inventory Accounting Methods
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Inventory Accounting
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Types of Inventory
What is Inventory?
Inventory for a merchandise business?
Finished goods?
Inventory for a Car Manufacturing Firm?
Raw Material?
Finished Goods?
Work-in-Process?
Classification of Inventory
Raw Material: Purchased materials, component parts, & subassemblies
Work-in-Process: Materials that have entered the manufacturing process & are being worked on orwaiting to be worked on
Finished Goods Inventory: Finished products of the production process that are ready to be sold ascompleted items
Should we include goods in transit for inventory? Goods in transit belong to the party holding legal ownership
Goods sold FOB (Free on Board) Destination: Goods sold do not belong to the purchaser until theyarrive at their final destination
Goods sold FOB (Free on Board) Shipping Point: Goods sold become property of the purchaser onceshipped by the seller
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Classification of Inventory
Classify the following in different types of Inventory
Yes No Raw Material Work-in-Progress Finished Goods
Finished Cars awaiting for sale
Cars under production that has been
bulk ordered by XYZ company and
deposit has been made
Finished Cars shipped to the dealer,
FOB Destination
Finished Cars shipped to the dealer,
FOB Shipping point
Gears in the company Warehouse
Rolled Sheets in the company
warehouse
Inventory CategoryCar Manufacturer
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Inventory Accounting
Inventory costs are reported either on the balance sheet or they are transferred to theincome statement as an expense to match against sales revenues
When inventories are used up in production or are sold, their cost is transferred from thebalance sheet to the income statement as cost of goods sold
BASE Relationship
Beginning Additions Sold+ =
What we end up with
What we have for selling
Ending+
What we sold
Beginning Inventory
Purchases
Sold Goods
Sold Goods
Ending Inventory
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Lower of the Cost or Market (LCM)
Companies must write down the carrying amount of inventories on the balance sheet if thereported cost exceeds market value
This process is called reporting inventories at the lower of cost or market and creates thefollowing financial statement effects:
Inventory book value is written down to current market value (replacement cost); reducing inventory andtotal assets
Inventory write-down is reflected as an expense on the income statement
However, if the replacement cost is rising, the holding gains in the value of inventory are ignored and theinventory is valued at cost
Example
Assume that a company has inventory on its balance sheet at a cost of $55,000 and the managementlearns that the inventorys replacement cost is $48,000
As per the LCM method management writes inventories down to a balance of $48,000.
Assets Liability Shareholders Equity= +
$7,000 flows throughthe Income Statementas expense
$7,000 Inventorywrite-down
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Methods of Inventory Accounting
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Methods of Inventory Accounting
First-In First-Out (FIFO)
This method assumes that the first units purchased are the first units sold
The cost of most recent purchases is assigned to ending inventory
Last-In First-Out (LIFO)
The LIFO inventory costing method assumes that the last units purchased are the first to be sold
The costs of beginning inventory and earlier purchases go to ending inventory
Weighted average costing
This method assumes that the units are sold without regard to the order in which they are purchased
Instead, it computes COGS and ending inventories as a simple weighted average
Example
Summary Inventory Records No. of units $/unit Total cost
Inventory on January 1st, 2006 600 100 60,000
Inventory purchased in 2006 200 150 30,000
Cost of goods available for sale in 2006 800 90,000
Inventory sold in 2006 550 250 137,500
Calculate gross profit for the following methods of inventory valuation
a) FIFO
b) LIFO
c) Weighted Average Costing
Also show the Balance sheet and Income Statement Flow
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Methods of Inventory Accounting
FIFO:
Calculation of gross profit
Balance Sheet Effect
LIFO:
Calculation of gross profit
Balance Sheet Effect
Assets Liability Shareholders Equity= +
$55,000 flowsthrough the IncomeStatement as expense
$55,000
cost of goods sold
FIFO
Sales 137,500
COGS (550 @ $100) (55,000)
Gross Profit 82,500
Inventory cost as on January 1st,2006 is taken
LIFO
Sales 137,500
COGS (200 units @ $150) (30,000)COGS (350 units @ $100) (35,000)
Gross Profit 72,500
Assets Liability Shareholders Equity= +
$65,000 flowsthrough the IncomeStatement as expense
$65,000
cost of goods sold
Last purchased inventory taken firstand the remaining from the
beginning of the year inventory
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Methods of Inventory Accounting
Weighted Average Cost
Calculation of Weighted average cost
Calculation of gross profit
Balance Sheet Effect
Summary
Assets Liability Shareholders Equity= +
$61,875 flowsthrough the IncomeStatement as expense
$61,875
cost of goods sold
Weighted average cost taken as per
calculation above
Total cost 90,000
Total units 800
Average cost 112.5
Weighted Average cost
Sales 137,500
COGS (550 @ $112.5) (61,875)
Gross Profit 75,625
Summary COGS Ending Inventory
FIFO Costing 55,000 35,000
LIFO Costing 65,000 25,000
Average Costing 61,875 28,125
FIFO:200*150+50*100 = $35,000
LIFO:=250*100 = $25,000
Average Costing: = 112.5 * 250 = $28,125
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Financial Statement Effects
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Financial Statement Effects
In an environment of Stable Prices
All three inventory valuation methods (FIFO, LIFO and Weighted Average costs) will yield the sameresults for Inventory, COGS and Earnings
In an environment of Rising Prices and Increasing or Stable Inventory
Item LIFO FIFO
COGS Higher Lower
Ending Inventoryand Working Capital
Lower as inventory reflects the pricesof items purchased at lower prices
Higher as inventory reflects the mostrecently purchased items
Net WorthLower because earnings and inventory
is lowerHigher because earnings and inventory
is higher
Taxes Lower Taxes Higher Taxes
Earnings Lower because COGS is higher Higher because COGS is lower
Pre-tax Cash Flows Same Same
After-tax Cash flows Higher because of lower tax outgo Lower because of higher tax outgo
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LIFO /FIFO Conversion
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LIFO to FIFO Conversion
US GAAP requires that all companies that use LIFO to also report a LIFO reserve
LIFO reserve is the difference between what their ending inventory would have been underLIFO accounting and its value under LIFO
LIFO Reserve
Converting LIFO to FIFO (Quick Method)
Converting LIFO to FIFO (Long Method)
LIFO Reserves Inventory (FIFO) Inventory (LIFO)= -
COGS (FIFO) COGS (LIFO) LIFO Reserve (end)= - LIFO Reserve (begin)-
Change in LIFO Reserves
Purchases Ending Inv (LIFO) Beginning Inv (LIFO)= - COGS+
COGS (FIFO) Purchases Beginning Inv (FIFO)= + Ending Inv (FIFO)-
Ending Inv (FIFO) Ending Inv (LIFO) LIFO Reserve (end)= +
Begin Inv (FIFO) Begin Inv (LIFO) LIFO Reserve (begin)= +
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LIFO to FIFO Conversion
Example : LIFO to FIFO conversion
Kappa Corp. uses LIFO inventory accounting. The footnotes to 2007 financial statements contain the following
2006 2007
COGS 50,000 60,000
LIFO Inventory 400,000 460,000
Less LIFO Reserves 42,000 45,000
Calculate Kappa's 2007 COGS under FIFO
Long Method
Purhcases (2007) 120,000Ending Inv (2007,FIFO) 505,000
Beginning Inv (2007,FIFO) 442,000
COGS (2007,FIFO) 57,000
=-($45,000 - $42,000)
=Beginning Inv +Purchases Ending Inv
= $400,000 + $42,000
= $460,000 + $45,000
= $460,000 + $60,000 -$400,000
Quick Method
Change in LIFO Reserves (2007) (3,000)
COGS (2007, FIFO) 57,000
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FIFO /Weighted Average to LIFO Conversion
FIFO to LIFO Conversion
Use the following formula
Weighted Average to LIFO Conversion
Average cost method always reports inventory values and cost of goods sold between values reportedfrom FIFO and LIFO
Hence, the adjustment is done by a factor of 2
Inflation is calculated using two methods
Industry Statistics: Inflation rate of the appropriate industry and not a general inflation rate for the
economy Company Statistics:Increase in LIFO reserve for another company in the same industry divided by that
companys beginning inventory converted to FIFO accounting
COGS (LIFO) COGS (FIFO) Begin Inventory (FIFO) X Inflation= +
FIFOinvBeginning
reservesLIFOinchangeInflation
__
___
COGS (LIFO) COGS (Wgt Avg) (1/2) X Begin Inventory (Wgt Avg) X Inflation= +
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FIFO /LIFO Conversion
Estimating Inflation
Estimating COGS
COGS (LIFO) = COGS (FIFO) + Begin Inv X Inflation Rate COGS (LIFO) = $20,000 + $3,500 X 0.7% = $20,023
Example : FIFO to LIFO conversion
Gamma is in the same industry as Kappa. Gamma uses FIFO accounting and has COGS of $20,000, ending inventory
of $5,000 and beginning inventory of $3,500
Kappa Corp 2006 2007
COGS 50,000 60,000
LIFO Inventory 400,000 460,000
Less LIFO Reserves 42,000 45,000
Calculate Gamma's COGS under LIFO
%7.0442000
3000
)42000400000(
)42000000,45(
__
___
FIFOinvBeginning
reservesLIFOinchangeInflation
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Analytical adjustments
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Analytical adjustments
Profitability
LIFO produces higher COGS balances and are better measure of true economic costs
In an environment of rising prices, LIFO produces income that are lower than FIFO
Gross margins and profit margins are lower due to lower income under LIFO
For FIFO firms, profitability ratios should be recalculated using estimates of what COGS wouldhave been under FIFO
Liquidity FIFO produces inventory figures that are higher and are a better measure of economic value
LIFO, however, uses prices that are outdated (in an environment of rising prices)
Liquidity ratios such as current ratios are higher under FIFO than in LIFO
For LIFO firms, Liquidity ratios should be recalculated using inventory balances that have beenrestated using LIFO reserve
Solvency
Solvency ratio like debt ratio, debt-to-equity ratio will be lower under FIFO because of higher denominator
For firms that use LIFO, ratios should be calculated using asset and equity figures restated byusing LIFO reserve
Assets Liability Shareholders Equity= +
LIFO Reserve LIFO Reservex Tax Rate
LIFO Reservex (1-Tax Rate)
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Analytical treatment of Inventory
Take care of all theanalyst specific
adjustments whilecalculating the ratios
Balance Sheet 2006 2007
Cash 7,500 8,750
Accounts Receivables 10,000 12,500
Inventories 17,500 13,750
Plants and Equipments 36,250 37,500
Total Assets 71,250 72,500
Short-term Debt 6,250 5,000
Long-term Debt 25,000 25,000
Common Stock 6,250 6,250Additional Paid-in Capital 12,500 12,500
Retained Earnings 21,250 23,750
Total Liabilities & Capital 71,250 72,500
Income Statement 2006 2007
Sales 68,750 75,000
COGS (51,250) (53,750)
Interest Expense (1,875) (1,875)
Pretax Income 15,625 19,375
Income Taxes (40%) (6,250) (7,750)
Net Income 9,375 11,625
Note: a) Company uses LIFO inventory method
b) LIFO reserves for 2002 and 2003 is $500 and $650, resp
Calculate the following
a) FIFO Inventory for 2006 and 2007 and COGS for 2007 into FIFO
b) Calculate the net profit margin, current ratio, inventory turnover, and long term debt-to-equity
ratio using the accounting figures that are most appropriate to compare to industry
Example : Inventory Adjustments
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Analytical treatment of Inventory
FIFO Inventory
Calculating COGS
Calculating Ratios
FIFO inventory (2006) 18,000
FIFO inventory (2007) 14,400
Quick method
COGS 53,750
change in LIFO reserves (150)
COGS (FIFO) 53,600
Long method
Purchases 50,000
Ending Inv (FIFO) 14,400
Beginning Inv (FIFO) 18,000
COGS (FIFO) 53,600 = $11,625/$75,000
= ($8,750 + $12,500+$13,750+ $650)/5000
= ($53,750/($18,000+$14,400)/2)
= $25,000/($23,750 +$650*(1-40%))
Profit Margin (2007) Net Income under LIFO / Sales
Profit Margin (2007) 15.5%
Current Ratio (2007) Current assets under FIFO/Current liabilities
Current Ratio (2007) 7.1
Inventory turnover (2007) COGS under LIFO/Avg. inventory under FIFO
Inventory turnover (2007) 3.3
Debt-to-equity (2007) Long term debt / (equity under FIFO)
Debt-to-equity (2007) 103.6%
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Caterpillar Inc, Case Study
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Caterpillar Inc, Case Study
Please analyze the Caterpillar (CAT) 2003 10K for Inventory adjustments
Answer the following:
Which method of inventory valuation does CAT follow?
Determine COGS using LIFO and FIFO for 2003?
Find the analyst adjusted profit margin?
Find the analyst adjusted current ratio?
Find the analyst adjusted inventory turnover?
Find the analyst adjusted Debt-to-Equity ratio?
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Other Important Topics
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LIFO Reserve Declines
Usually LIFO Reserves increases from year to year due to an increasing volumes of inventory
and rising price levels
However, sometimes LIFO reserves may decline and COGS sold will be lower and Net Incomewill be higher
Interpretation would depend on the reason why the LIFO reserve declined
There could be two reasons of such a decline
Inventory Liquidation
If there is a physical inventory liquidation, we should restate COGS and Income to eliminate the impact ofdecline in LIFO reserves
Reported results are distorted due to inclusion of low cost-LIFO inventory
LIFO liquidations occurs mostly in times of economic distress
Strike or Recession might cut production faster than sales are decreasing to reduce inventories
Footnotes generally carry information regarding LIFO liquidation so that we can eliminate excess profits
Declining Prices
If LIFO reserve declines because the prices of the inventory items are declining, we do not adjust thereported COGS or Net Income
LIFO will produce higher profits than FIFO and cash flow will be affected by higher tax outgo
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Changes in Inventory Accounting Methods
Change from FIFO to LIFO
The change is only made prospectively
A retrospective restatement or disclosure of cumulative effect are not required
The firm is only required to disclose in its footnotes the effect on current period net income and netincome before extraordinary items
Change from LIFO to FIFO
All reported prior financial data must be restated retroactively to reflect FIFO accounting
Cumulative effect of the accounting change on prior periods must be credited to retained earnings atthe beginning of the earliest restated year
All reserves become taxable immediately at the time the change is made
Negative impact on net after-tax cash flow
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Sum up..
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