Chapter8: Inventories: Measurement
Inventory Cost Flow Assumptions
As the data show, 7,000 units were purchased during 2011 at various prices and 6,500 units were sold. What is the cost of the 6,500 units sold? If all units, including beginning inventory, were purchased at the same price, then the answer would be simple. However, that rarely is the case.
The year started with 4,000 units, 7,000 units were purchased, and 6,500 units were sold. This means 4,500 units remain in ending inventory. This allocation of units available for sale is depicted in Graphic 8-3.
If a periodic system is used, what is the cost of the 4,500 units in ending inventory? In other words, which of the 11,000 (4,000 + 7,000) units available for sale were sold? Are they the more expensive ones bought toward the end of the year, or the less costly ones acquired before prices increased? Using the numbers given, let's consider the question as follows:p. 405
The $71,500 in cost of goods available for sale must be allocated to ending inventory and cost of goods sold. The allocation decision is depicted in Graphic 8-4.
Let's turn our attention now to the various inventory methods that can be used to achieve this allocation.
It's sometimes possible for each unit sold during the period or each unit on hand at the end of the period to be matched with its actual cost. Actual costs can be determined by reference to the invoice representing the purchase of the item. This method is used frequently by companies selling unique, expensive products with low sales volume which makes it relatively easy and economically feasible to associate each item with its actual cost. For example, automobiles have unique serial numbers that can be used to match a specific auto with the invoice identifying the actual purchase price.
The specific identification method each unit sold during the period or each unit on hand at the end of the period to be matched with its actual cost., however, is not feasible for many types of products either because items are not uniquely identifiable or because it is too costly to match a specific purchase price with each item sold or each item remaining in ending inventory. Most companies use cost flow methods to determine cost of goods sold and ending inventory. Cost flow methods are based on assumptions about how inventory might flow in and out of a company. However, it's important to note that the actual flow of a company's inventory does not have to correspond to the cost flow assumed. The various motivating factors that influence management's choice among alternative methods are discussed later in this chapter. We now explore the three most common cost flow methods: average cost, first-in, first-out (FIFO) and last-in, first-out (LIFO).
Cost of goods sold also could be determined directly by multiplying the weighted-average unit cost of $6.50 by the number of units sold ($6.50 × 6,500 = $42,250).
PERPETUAL AVERAGE COST. The weighted-average unit cost in a perpetual inventory system becomes a moving-average unit cost. A new weighted-average unit cost is calculated each time additional units are purchased. The new average is determined after each purchase by (1) summing the cost of the previous inventory balance and the cost of the new purchase, and (2) dividing this new total cost (cost of goods available for sale) by the number of units on hand (the inventory units that are available for sale). This average is then used to cost any units sold before the next purchase is made. The moving-average concept is applied in Illustration 8-5B.
On January 17 the new average of $5.667 (rounded) is calculated by dividing the $17,000 cost of goods available ($11,000 from beginning inventory + $6,000 purchased on January 17) by the 3,000 units available (2,000 units from beginning inventory + 1,000 units acquired on January 17). The average is updated to $6.333 (rounded) with the March 22 purchase. The 1,500 units sold on April 15 are then costed at the average cost of $6.333.p. 407
Periodic average cost and perpetual average cost generally produce different allocations to cost of goods sold and ending inventory.
First-In, First-Out (FIFO)
PERIODIC FIFO. Recall that we determine physical quantities on hand in a periodic inventory system by taking a physical count. Costing the 4,500 units in ending inventory this way automatically gives us the cost of goods sold as well. Using the numbers from our illustration, we determine cost of goods sold to be $38,500 by subtracting the $33,000 ending inventory from $71,500 cost of goods available for sale as shown in Illustration 8-5C.
Of course, the 6,500 units sold could be costed directly as follows:p. 408
PERPETUAL FIFO. The same ending inventory and cost of goods sold amounts are always produced in a perpetual inventory system as in a periodic inventory system when FIFO is used. This is because the same units and costs are first in and first out whether cost of goods sold is determined as each sale is made or at the end of the period as a residual amount. The application of FIFO in a perpetual system is shown in Illustration 8-5D.
Last-In, First-Out (LIFO)
PERIODIC LIFO. The cost of ending inventory determined to be $25,000 (calculated below) by the LIFO assumption and using a periodic system is subtracted from cost of goods available for sale to arrive at the cost of goods sold of $46,500 as shown in Illustration 8-5E.p. 409
The 6,500 sold could be costed directly as follows:
PERPETUAL LIFO. The application of LIFO in a perpetual system is shown in Illustration 8-5F. Each time inventory is purchased or sold, the LIFO layers are adjusted. For example, after the March 22 purchase, we have three layers of inventory at different unit costs listed in the chronological order of their purchase. When 1,500 units are sold on April 15, we assume they come from the most recent layer of 3,000 units purchased at $7.00.
Notice that $44,000 of the cost of goods available for sale is allocated to cost of goods sold by perpetual LIFO and $27,500 to ending inventory (the balance after the last transaction), which is different from the periodic LIFO result of $46,500 and $25,000. Unlike FIFO, applying LIFO in a perpetual inventory system will generally result in an ending inventory and cost of goods sold different from the allocation arrived at applying LIFO in a periodic system. Periodic LIFO applies the last-in, first-out concept to total sales and total purchases only at the conclusion of the reporting period. Perpetual LIFO applies the same concept, but several times during the period—every time a sale is made.
Comparison of Cost Flow Methods
Notice that the average cost method in this example produces amounts that fall in between the FIFO and LIFO amounts for both cost of goods sold and ending inventory. This will usually be the case. Whether it will be FIFO or LIFO that produces the highest or lowest value of cost of goods sold and ending inventory depends on the pattern of the actual unit cost changes during the period.
Graphic 8-5 shows the results of a survey of inventory methods used by 500 large public companies in 2008 and 600 companies in 1973.8 FIFO is the most popular method in both periods, but there has been a significant increase in the use of LIFO since the earlier period. Notice that the column total for the number of companies is greater than 500 (600 in 1973), indicating that many companies included in this sample do use multiple methods.
*“Other” includes the specific identification method and miscellaneous less popular methods.p. 411
PHYSICAL FLOW. If a company wanted to choose a method that most closely approximates specific identification, then the actual physical flow of inventory in and out of the company would motivate the choice of method.
INCOME TAXES AND NET INCOME. If the unit cost of inventory changes during a period, the inventory method chosen can have a significant effect on the amount of income reported by the company to external parties and also on the amount of income taxes paid to the Internal Revenue Service (IRS) and state and local taxing authorities. Over the entire life of a company, cost of goods sold for all years will equal actual costs of items sold regardless of the inventory method used. However, as we have discussed, different inventory methods can produce significantly different results in each particular year.
A corporation's taxable income comprises revenues, expenses (including cost of goods sold), gains, and losses measured according to the regulations of the appropriate taxing authority. Income before tax as reported in the income statement does not always equal taxable income. In some cases, differences are caused by the use of different measurement methods.10 However, IRS regulations, which determine federal taxable income, require that if a company uses LIFO to measure taxable income, the company also must use LIFO for external financial reporting. This is known as the LIFO conformity rule if a company uses LIFO to measure taxable income, the company also must use LIFO for external financial reporting. with respect to inventory methods.
LIFO RESERVES. Many companies use LIFO for external reporting and income tax purposes but maintain their internal records using FIFO or average cost. There is a variety of reasons, including: (1) the high recordkeeping costs for LIFO, (2) contractual agreements such as bonus or profit sharing plans that calculate net income with a method other than LIFO, and (3) using FIFO or average cost information for pricing decisions.p. 413
Generally, the conversion to LIFO from the internal records occurs at the end of the reporting period without actually entering the adjustment into the company's records. Some companies, though, enter the conversion adjustment—the difference between the internal method and LIFO—directly into the records as a “contra account” to inventory. This contra account is called either the LIFO reserve or the LIFO allowance.
For illustration, let's say that the Doubletree Corporation began 2011 with a balance of $475,000 in its LIFO reserve account, the difference between inventory valued internally using FIFO and inventory valued using LIFO. At the end of 2011, assume this difference increased to $535,000. The entry to record the increase in the reserve is:
If the difference between inventory valued internally using FIFO and inventory valued using LIFO had decreased, this entry would be reversed. Companies such as Doubletree often use a disclosure note to show the difference between ending inventory valued using the internal method and the LIFO inventory amount reported in the balance sheet. As an example, Graphic 8-7 shows the disclosure note from a recent annual report of Winnebago Industries, Inc., that indicated the composition of the company's inventories:
Real World Financials
This distortion sometimes carries over to the income statement as well. When inventory quantities decline during a period, then these out-of-date inventory layers are liquidated and cost of goods sold will partially match noncurrent costs with current selling prices. If costs have been increasing (decreasing), LIFO liquidations produce higher (lower) net income than would have resulted if the liquidated inventory were included in cost of goods sold at current costs. The paper profits (losses) caused by including out of date, low (high) costs in cost of goods sold is referred to as the effect on income of liquidations of LIFO inventory.p. 414
To illustrate this problem, consider the example in Illustration 8-6.
Real World Financials
In our illustration, National Distributors, Inc. would disclose that LIFO liquidations increased income by $15,000 in 2011, assuming that this effect on income is considered material.
We've discussed several factors that influence companies in their choice of inventory method. A company could be influenced by the actual physical flow of its inventory, by the effect of inventory method on reported net income and the amount of income taxes payable currently, or by a desire to provide a better match of expenses with revenues. You've seen that the direction of the change in unit costs determines the effect of using different methods on net income and income taxes. While the United States has experienced persistent inflation for many years (increases in the general price-level), the prices of many goods and services have experienced periods of declining prices (for example, personal computers).
It is important for a financial analyst to evaluate a company's effectiveness in managing its inventory. As we discussed in Chapter 5, one key to profitability is how well a company utilizes its assets. This evaluation is influenced by the company's inventory method choice. The choice of inventory method is an important and complex management decision. The many factors affecting this decision were discussed in a previous section. The inventory method also affects the analysis of a company's liquidity and profitability by investors, creditors, and financial analysts. Analysts must make adjustments when evaluating companies that use different inventory methods. During periods of rising prices, we would expect a company using FIFO to report higher income than a LIFO or average cost company. If one of the companies being analyzed uses LIFO, precise adjustments can often be made using the supplemental disclosures provided by many LIFO companies. Recall that the LIFO conformity rule was liberalized to permit LIFO users to report in a note the effect of using a method other than LIFO for inventory valuation.
Real World Financials
If GAPT had used FIFO instead of LIFO, beginning inventory would have been $2 million higher, and ending inventory would have been higher by $10 million. As a result, cost of goods sold for the 2009 fiscal year would have been $8 million lower. This is because an increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2009 are the same regardless of the inventory valuation method used. Cost of goods sold, then, would have been $6,605 million ($6,613 – 8) if FIFO had been used for all inventories.
We can now use the 100% FIFO amounts to compare the two companies. Since cost of goods sold is lower by $8 million, income taxes and net income require similar adjustments before calculating a profitability ratio. Also, the converted inventory amounts can be used to compute liquidity ratios.
The 2009 gross profit ($ in millions), for GAPT, using the 100% FIFO amounts, is $2,911 ($9,516 − 6,605), and the gross profit ratio is 30.6% ($2,911 ÷ $9,516). The same ratio for the grocery industry is 20%, indicating that GAPT is able to sell its products at significantly higher markups than the average for its competitors. GAPT's percentage of each sales dollar available to cover other expenses and to provide a profit is 50% higher than the industry average.
Monitoring this ratio over time can provide valuable insights. For example, a declining ratio might indicate that the company is unable to offset rising costs with corresponding increases in selling price, or perhaps that sales prices are declining without a commensurate reduction in costs. In either case, the decline in the ratio has important implications for future profitability.
In Chapter 5 we were introduced to an important ratio, the inventory turnover ratiomeasures a company’s efficiency in managing its investment in inventory., which is designed to evaluate a company's effectiveness in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell or turn over its inventory, the lower its investment in inventory must be for a given level of sales. Usually, the higher the ratio the more profitable a company will be. Monitoring the inventory turnover ratio over time can highlight potential problems. A declining ratio generally is unfavorable and could be caused by the presence of obsolete or slow-moving products, or poor marketing and sales efforts.
Recall that the ratio is computed as follows:
If the analysis is prepared for the fiscal year reporting period, we can divide the inventory turnover ratio into 365 days to calculate the average days in inventory indicates the average number of days it normally takes to sell inventory., which indicates the average number of days it normally takes the company to sell its inventory.
For GAPT, the inventory turnover ratio for the 2009 fiscal year, using the 100% FIFO amounts, is 13.33 ($6,605 ÷ [($484 + 507) ÷ 2]) and the average days in inventory is 27 days (365 ÷ 13.33). This compares to an industry average of 23 days. GAPT's products command a higher markup (higher gross profit ratio) but take longer to sell (higher average days in inventory) than the industry average.
Inventory increases that outrun increases in cost of goods sold might indicate difficulties in generating sales. These inventory buildups may also indicate that a company has obsolete or slow-moving inventory. This proposition was tested in an important academic research study. Professors Lev and Thiagarajan empirically demonstrated the importance of a set of 12 fundamental variables in valuing companies' common stock. The set of variables included inventory (change in inventory minus change in sales). The inventory variable was found to be a significant indicator of returns on investments in common stock, particularly during high and medium inflation years.16p. 420
EARNINGS QUALITY. Changes in the ratios we discussed above often provide information about the quality of a company's current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).
The choice of which inventory method to use also affects earnings quality, particularly in times of rapidly changing prices. Earlier in this chapter we discussed the effect of a LIFO liquidation on company profits. A LIFO liquidation profit (or loss) reduces the quality of current period earnings. Fortunately for analysts, companies must disclose these profits or losses, if material. In addition, LIFO cost of goods sold determined using a periodic inventory system is more susceptible to manipulation than is FIFO. Year-end purchases can have a dramatic effect on LIFO cost of goods sold in rapid cost-change environments. Recall again our discussion in Chapter 4 concerning earnings quality. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. We discuss these issues in the next chapter.•
7 The differences between the various methods also hold when a perpetual inventory system is used.
8Accounting Trends and Techniques—2009 and 1974 (New York, New York: AICPA, 2009 and 1974), p. 195.
9 “Inventories,” International Accounting Standard No. 2 (IASCF), as amended effective January 1, 2009.
10 For example, a corporation can take advantage of incentives offered by Congress by deducting more depreciation in the early years of an asset's life in its federal income tax return than it reports in its income statement.
11 The concept of capital market efficiency has been debated for many years. In an efficient capital market, the market is not fooled by differences in accounting method choice that do not translate into real cash flow differences. The only apparent cash flow difference caused by different inventory methods is the amount of income taxes paid currently. In an efficient market, we would expect the share price of a company that switched its method to LIFO and saved tax dollars to increase even though it reported lower net income than if LIFO had not been adopted. Research on this issue is mixed. For example, see William E. Ricks, “Market's Response to the 1974 LIFO Adoptions,” Journal of Accounting Research (Autumn 1982), and Robert Moren Brown, “Short-Range Market Reaction to Changes to LIFO Using Preliminary Earnings Announcement Dates,” Journal of Accounting Research (Spring 1980).
12 For example, see P. M. Healy, “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting and Economics (April 1985), and D. Dhaliwal, G. Salamon, and E. Smith, “The Effect of Owner Versus Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics (July 1982).
13 The Great Atlantic and Pacific Tea Company uses both the FIFO and LIFO cost methods. Earlier in the chapter we noted that a company need not use the same inventory method for all of its inventories.
14The cost of carrying inventory includes the possible loss from the write-down of obsolete inventory. We discuss inventory write-downs in Chapter 9. There are analytical models available to determine the appropriate amount of inventory a company should maintain. A discussion of these models is beyond the scope of this text.
15 Eugene Brigham and Joel Houston, Fundamentals of Financial Management, 12th ed. (Florence, Kentucky: South-Western, 2010).
16 B. Lev and S. R. Thiagarajan, “Fundamental Information Analysis,” Journal of Accounting Research (Autumn 1993). The main conclusion of the study was that fundamental variables, not just earnings, are useful in firm valuation, particularly when examined in the context of macroeconomic conditions such as inflation.