Advance Accounting Ebook - Part 9

Advanced Accounting E-Book part 9 of 12
Advanced Accounting E-Book

Part 9 of 12
All Rights Reserved. Corporate Bridge
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www.educorporatebridge.com
Discussion topics Advanced Accounting E-Book part 9 of 12

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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Private and Confidential Not for Circulation
Types of Inventory Advanced Accounting E-Book part 9 of 12

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 or waiting to be worked on
Finished Goods Inventory: Finished products of the production process that are ready to be sold as completed 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 they arrive at their final destination
Goods sold FOB (Free on Board) Shipping Point: Goods sold become property of the purchaser once shipped by the seller
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Classification of Inventory Advanced Accounting E-Book part 9 of 12

Classify the following in different types of Inventory
Car Manufacturer Inventory Yes No
Raw Material Category 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
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Inventory Accounting Advanced Accounting E-Book part 9 of 12

Inventory costs are reported either on the balance sheet or they are transferred to the income statement as an expense to match against sales revenues When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold
BASE Relationship
eginning
dditions
old
nding
What we sold What we have for selling
What we end up with
Beginning Inventory
Sold Goods
Purchases
Sold Goods
Ending Inventory
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Lower of the Cost or Market (LCM) Advanced Accounting E-Book part 9 of 12

Companies must write down the carrying amount of inventories on the balance sheet if the reported cost exceeds market value This process is called reporting inventories at the lower of cost or market and creates the following financial statement effects:
Inventory book value is written down to current market value (replacement cost); reducing inventory and total 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 the inventory is valued at cost
Example
Assume that a company has inventory on its balance sheet at a cost of $55,000 and the management learns that the inventorys replacement cost is $48,000
As per the LCM method management writes inventories down to a balance of $48,000.
Assets $7,000 Inventory write-down
Liability
Shareholders Equity
$7,000 flows through the Income Statement as expense
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Methods of Inventory Accounting
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Methods of Inventory Accounting Advanced Accounting E-Book part 9 of 12

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 Inventory on January 1st, 2006 Inventory purchased in 2006 Cost of goods available for sale in 2006 Inventory sold in 2006 No. of units 600 200 800 550 $/unit 100 150 Total cost 60,000 30,000 90,000 137,500
250
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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FIFO:
Calculation of gross profit
FIFO Sales COGS (550 @ $100) Gross Profit

Balance Sheet Effect
Assets $55,000 cost of goods sold = Liability +
137,500 (55,000) 82,500
Inventory cost as on January 1st, 2006 is taken
Shareholders Equity $55,000 flows through the Income Statement as expense
LIFO:
LIFO Sales COGS (200 units @ $150) COGS (350 units @ $100) Gross Profit
Assets $65,000 cost of goods sold All Rights Reserved. Corporate Bridge
TM
137,500 (30,000) (35,000) 72,500
Last purchased inventory taken first and the remaining from the beginning of the year inventory
Liability
Shareholders Equity
$65,000 flows through the Income Statement as expense

Weighted Average Cost
Calculation of Weighted average cost
Total cost Total units Average cost

90,000 800 112.5
Weighted Average cost Sales COGS (550 @ $112.5) Gross Profit

Assets = Liability
137,500 (61,875) 75,625
Weighted average cost taken as per calculation above
Shareholders Equity $61,875 flows through the Income Statement as expense
$61,875 cost of goods sold
Summary
Summary FIFO Costing LIFO Costing Average Costing COGS 55,000 65,000 61,875 Ending Inventory 35,000 25,000 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 Advanced Accounting E-Book part 9 of 12

In an environment of Stable Prices
All three inventory valuation methods (FIFO, LIFO and Weighted Average costs) will yield the same results for Inventory, COGS and Earnings
In an environment of Rising Prices and Increasing or Stable Inventory

Item COGS LIFO Higher FIFO Lower Higher as inventory reflects the most recently purchased items Higher because earnings and inventory is higher Higher Taxes Higher because COGS is lower Same Lower because of higher tax outgo
Ending Inventory and Working Capital

Net Worth Taxes Earnings Pre-tax Cash Flows After-tax Cash flows
Lower as inventory reflects the prices of items purchased at lower prices

Lower because earnings and inventory is lower Lower Taxes Lower because COGS is higher Same Higher because of lower tax outgo
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LIFO /FIFO Conversion
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LIFO to FIFO Conversion Advanced Accounting E-Book part 9 of 12

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 under LIFO accounting and its value under LIFO LIFO Reserve
LIFO Reserves
Inventory (FIFO)
Inventory (LIFO)
Converting LIFO to FIFO (Quick Method)

COGS (FIFO)
COGS (LIFO)
LIFO Reserve (end)
LIFO Reserve (begin)
Change in LIFO Reserves
Converting LIFO to FIFO (Long Method)

Purchases
=
=
Ending Inv (LIFO)
+ + +
Beginning Inv (LIFO)
COGS
Ending Inv (FIFO)
Ending Inv (LIFO)
LIFO Reserve (end)
Begin Inv (FIFO)
= =
Begin Inv (LIFO)
LIFO Reserve (begin)
COGS (FIFO)
Purchases
Beginning Inv (FIFO)
Ending Inv (FIFO)
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LIFO to FIFO Conversion Advanced Accounting E-Book part 9 of 12

Example : LIFO to FIFO conversion
Kappa Corp. uses LIFO inventory accounting. The footnotes to 2007 financial statements contain the following COGS LIFO Inventory Less LIFO Reserves Calculate Kappa's 2007 COGS under FIFO
Quick Method Change in LIFO Reserves (2007) COGS (2007, FIFO)
=-($45,000 - $42,000)
2006 50,000 400,000 42,000
2007 60,000 460,000 45,000
(3,000) 57,000
= $460,000 + $60,000 $400,000
= $460,000 + $45,000
Long Method Purhcases (2007) Ending Inv (2007,FIFO) Beginning Inv (2007,FIFO) COGS (2007,FIFO)
120,000 505,000 442,000 57,000
= $400,000 + $42,000
=Beginning Inv + Purchases Ending Inv
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FIFO /Weighted Average to LIFO Conversion Advanced Accounting E-Book part 9 of 12

FIFO to LIFO Conversion
Use the following formula
COGS (LIFO)
COGS (FIFO)
Begin Inventory (FIFO) X Inflation
Weighted Average to LIFO Conversion
Average cost method always reports inventory values and cost of goods sold between values reported from FIFO and LIFO
Hence, the adjustment is done by a factor of 2
COGS (LIFO)
COGS (Wgt Avg)
(1/2) X Begin Inventory (Wgt Avg) X Inflation
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
Inflation
change _ in _ LIFO _ reserves Beginning _ inv _ FIFO
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FIFO /LIFO Conversion Advanced Accounting E-Book part 9 of 12

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 COGS LIFO Inventory Less LIFO Reserves Calculate Gamma's COGS under LIFO 2006 50,000 400,000 42,000 2007 60,000 460,000 45,000
Estimating Inflation
Inflation
change _ in _ LIFO _ reserves Beginning _ inv _ FIFO
(45,000 42000) (400000 42000)
3000 442000
0.7%
Estimating COGS
COGS (LIFO) = COGS (FIFO) + Begin Inv X Inflation Rate
COGS (LIFO) = $20,000 + $3,500 X 0.7% = $20,023
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Analytical adjustments
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Analytical adjustments Advanced Accounting E-Book part 9 of 12

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 would have 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 been restated using LIFO reserve
Assets LIFO Reserve = Liability + Shareholders Equity
LIFO Reserve x Tax Rate
LIFO Reserve x (1-Tax Rate)
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 by using LIFO reserve
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Analytical treatment of Inventory Advanced Accounting E-Book part 9 of 12

Example : Inventory Adjustments
Balance Sheet Cash Accounts Receivables Inventories Plants and Equipments Total Assets Short-term Debt Long-term Debt Common Stock Additional Paid-in Capital Retained Earnings Total Liabilities & Capital Income Statement Sales COGS Interest Expense Pretax Income Income Taxes (40%) Net Income 2006 7,500 10,000 17,500 36,250 71,250 6,250 25,000 6,250 12,500 21,250 71,250 2006 68,750 (51,250) (1,875) 15,625 (6,250) 9,375 2007 8,750 12,500 13,750 37,500 72,500 5,000 25,000 6,250 12,500 23,750 72,500 2007 75,000 (53,750) (1,875) 19,375 (7,750) 11,625
Take care of all the analyst specific adjustments while calculating the ratios
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
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Analytical treatment of Inventory Advanced Accounting E-Book part 9 of 12

FIFO Inventory
FIFO inventory (2006) FIFO inventory (2007) 18,000 14,400
Calculating COGS
Quick method COGS change in LIFO reserves COGS (FIFO) Long method Purchases Ending Inv (FIFO) Beginning Inv (FIFO) COGS (FIFO) 53,750 (150) 53,600
50,000 14,400 18,000 53,600
= $11,625/$75,000
Calculating Ratios
Profit Margin (2007) Profit Margin (2007) Current Ratio (2007) Current Ratio (2007) Inventory turnover (2007) Inventory turnover (2007) Debt-to-equity (2007) Debt-to-equity (2007) Net Income under LIFO / Sales 15.5% Current assets under FIFO/Current liabilities 7.1 COGS under LIFO/Avg. inventory under FIFO 3.3 Long term debt / (equity under FIFO) 103.6%
TM
= ($8,750 + $12,500+ $13,750+ $650)/5000 = ($53,750/($18,000+ $14,400)/2)
= $25,000/($23,750 + $650*(1-40%))
Caterpillar Inc, Case Study
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Caterpillar Inc, Case Study Advanced Accounting E-Book part 9 of 12

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 Advanced Accounting E-Book part 9 of 12

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 Income will 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 of decline 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 the reported 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 Advanced Accounting E-Book part 9 of 12

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 net income 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 at the 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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Advanced Accounting E-Book part 9 of 12

Advanced Accounting E-Book

All Rights Reserved. Corporate Bridge

Discussion topics Advanced Accounting E-Book part 9 of 12

Methods of Inventory Accounting

Last-In First-Out (LIFO)

Financial Statement Effects

LIFO /FIFO Conversion

Analytical adjustments to Inventory

Caterpillar Inc, Case Study Other Important Topics

Changes in Inventory Accounting Methods

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 9 of 12

All Rights Reserved. Corporate Bridge

Private and Confidential Not for Circulation

Types of Inventory Advanced Accounting E-Book part 9 of 12

Inventory for a Car Manufacturing Firm?

Raw Material: Purchased materials, component parts, & subassemblies

Should we include goods in transit for inventory?

Goods in transit belong to the party holding legal ownership

All Rights Reserved. Corporate Bridge

Classification of Inventory Advanced Accounting E-Book part 9 of 12

All Rights Reserved. Corporate Bridge

Inventory Accounting Advanced Accounting E-Book part 9 of 12

What we sold What we have for selling

What we end up with

All Rights Reserved. Corporate Bridge

Lower of the Cost or Market (LCM) Advanced Accounting E-Book part 9 of 12

Assets $7,000 Inventory write-down

$7,000 flows through the Income Statement as expense

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 9 of 12

Methods of Inventory Accounting

All Rights Reserved. Corporate Bridge

Methods of Inventory Accounting Advanced Accounting E-Book part 9 of 12

Last-In First-Out (LIFO)

Weighted average costing

Methods of Inventory Accounting Advanced Accounting E-Book part 9 of 12

FIFO Sales COGS (550 @ $100) Gross Profit

137,500 (55,000) 82,500

Inventory cost as on January 1st, 2006 is taken

Shareholders Equity $55,000 flows through the Income Statement as expense

137,500 (30,000) (35,000) 72,500

$65,000 flows through the Income Statement as expense

Methods of Inventory Accounting Advanced Accounting E-Book part 9 of 12

Total cost Total units Average cost

90,000 800 112.5

Weighted Average cost Sales COGS (550 @ $112.5) Gross Profit

137,500 (61,875) 75,625

Weighted average cost taken as per calculation above

Shareholders Equity $61,875 flows through the Income Statement as expense

$61,875 cost of goods sold

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 9 of 12

Financial Statement Effects

All Rights Reserved. Corporate Bridge

Financial Statement Effects Advanced Accounting E-Book part 9 of 12

In an environment of Rising Prices and Increasing or Stable Inventory

Ending Inventory and Working Capital

Lower as inventory reflects the prices of items purchased at lower prices

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 9 of 12

LIFO /FIFO Conversion