Fifo Method

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CHAPTER9INVENTORIES


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Roadmap

Components of inventories

Two inventory system

Allocate Fixed Overhead costs: variablecosting vs. absorption costing

Three cost flow assumptions

LIFO reserve and LIFO liquidations

Adjusting FIFO Lower of cost or market

Dollar value of LIFO


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I. An Overview of Inventory

Accounting Issues

A. Inventoriesare assets held for sale.

1.Inventory includes

a. Raw materials inventory

b. Work-in-process inventory

c. Finished goods inventory


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Two Inventory Systems

Perpetual inventory system

Periodic inventory system


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II. Determining Inventory Quantities

A. A perpetual inventory system keeps

a running (or perpetual) record of theamount in inventory.1. Purchases are debited to the inventory

account.

2. Cost of units sold is removed from the

inventory account as sales are made.

3. No need to close accounts


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II. Determining Inventory Quantities B. A periodic inventory system does not

keep a running record of the amount ofinventory on hand.

1. Purchases are accumulated in a separatepurchases account.

2. No entry is made at the time of sale toreflect cost of goods sold.

3. Closing entry is needed and endinginventory is determined by a physical count.


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IV. Costs Included in Inventory

A. The carrying cost of inventory shouldinclude all costs required to obtain physicalpossession and to put the merchandise insaleable condition.

B. The inventory costs of a manufacturerinclude raw material, labor, and certainoverhead items (i.e., product costs).

C. General administrative costs and sellingcosts are expensed in the period in whichthey are incurred (i.e., period costs).


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V. To allocate fixed overhead costs

Variable costs are those that change in proportion

to the level of production, such as raw materialscost, direct labor, and certain overhead items.

Fixed costs of production are costs that do not

change as production levels changes, such asproduction facilities rental, depreciation ofproduction equipment, property taxes, etc.

A. Variable costing includes in inventory only variable costsof production.Fixed overhead costs are not included as part ofthe inventory cost, but are treated as period costs.

B. Absorption costing include both variable costs and fixed

costs.


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V. Absorption Costing Versus

Variable Costing B. Underabsorption costing, all

production costs are inventoried.

1. Fixed production costs are notwritten-off to expense as incurred, ratherthey are treated as product costs.

2. The rationale is that both variableand fixed production costs are assets sinceboth are needed to produce a saleable

product.


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V. Absorption Costing Versus Variable Costing

D. Generally accepted accounting principals do not

allow variable costing to be used in external financialstatements.

1. Absorption costing makes it difficult to interpretyear-to-year changes in reported income when inventorylevels change.

2. As the number of units being produced increases,under absorption costing, the amount of fixed cost

assigned to each unit decreases and the profit margin goesup.


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III. Cost Flow Assumptions: The Concepts

A. Under specific identification, the cost ofgoods sold (ending inventory) can bemeasured by reference to the known cost of theactual units sold (still on hand).1. This method is used by businesses that sell a

small number of high value items.2. This method makes it relatively easy to manipulateincome.3. This method is usually not feasible for most

businesses, so one of the following cost flowassumptions is required to allocate the cost of goodsavailable for sale between ending inventory and cost

of goods sold.


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Cost Flow Assumptions: The Concepts B. FIFO cost flow:

1. This method presumes that sales are made

from the oldest available goods and that ending

inventory is comprised of the most recently acquired

goods.

2. FIFO charges the oldest costs against revenues

on the income statement.

a. This characteristic is often viewed as a deficiency sincecurrent costs of replacing the units sold are not being matched

with current revenues.

b. However, on the balance sheet, FIFO inventory

represents the most recent purchases and will usually

approximate current replacement costs.


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Cost Flow Assumptions: The

Concepts C. LIFO cost flow:

1. This method presumes that sales are

made from the most recently acquired units andthat ending inventory is comprised of the oldestavailable goods.

2. This method seldom corresponds to theactual physical flow of goods.


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Cost Flow Assumptions: The Concepts

C. LIFO cost flow

3. LIFO matches the most recently incurredcosts against revenues.

a. This characteristic is often viewed as an advantage since

current costs of replacing the units sold are being matched withcurrent revenues.

b. However, on the balance sheet, LIFO inventory represents

the oldest available costs, which usually do not approximate

current replacement costs.

c. For firms that have used LIFO for many years, the LIFO

inventory amount may reflect only a small fraction of what it

would cost to replace this inventory at todays prices.


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Concepts

D. Frequency of inventory cost flowassumptions.

1. FIFO is the most popular method, followedclosely by LIFO.

2. Most firms use a combination of inventorycosting methods.

3. Few firms use LIFO exclusively, largelybecause LIFO is prohibited in most countries outsideof the United States.


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Example

1. Facts:a. Retailer started the year with a beginninginventory of one refrigerator that cost $300.b. The retailer purchases another identicalrefrigerator for a cost of $340 during the year.c. At the end of the year, the retailer sellsone of the refrigerators for $500.

2. The total cost of goods available forsale equals beginning inventory pluspurchases ($640 in this example).


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Example (Contd)

The first-in, first-out (FIFO) method of inventorycosting method assumes that the first unitpurchased is the first unit sold. Therefore, cost of

goods sold in this example is $300.

The last-in, first-out (LIFO) method of inventorycosting method assumes that the last unit

purchased is the first unit sold. Therefore, cost ofgoods sold in this example is $340.


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Concepts E. FIFO, LIFO, and inventory holding

gains:

1. Inventory holding gains and losses arethe input cost changes that occur followingthe purchase of inventory.

a. These holding gains are treated as acomponent of net income when the unit is sold.b. One alternative is to recognize thisunrealized holding gain as an owners equity

increase that is part of comprehensive income.


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Concepts 2. Current cost accounting records

unrealized holding gains on financialstatements as they arise.

a. Inventory is debited and unrealized holdinggains is credited for the input cost changes.

b. As a result, current costs are recorded bothin cost of goods sold and in ending inventory.

c. The current cost operating profit reflects theexpected ongoing profitability of current operations atcurrent levels of costs and selling prices.


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Concepts 3. The primary difference between FIFO and LIFO

is that each method makes a different choiceregarding which element is shown at the out-of-datecost.

a. FIFO shows inventory at approximately currentcost, but is then forced to reflect cost of goods sold athistorical cost.

b. LIFO shows cost of goods sold at

approximately current cost, but is then forced to reflectinventory on the balance sheet at historical cost.

c. By charging the oldest costs to the incomestatement, FIFO automatically includes in income theholding gain on the unit that was sold.


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Concepts F. The LIFO reserve disclosure:

1. The LIFO reserve is a mandateddisclosure that shows the dollar magnitude of thedifference between LIFO and FIFO inventorycosts.

2. By adding the reported LIFO reserve to

the balance sheet LIFO inventory number, onecan estimate FIFO inventory.


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Concepts F. The LIFO reserve disclosure:

3. The LIFO reserve disclosure also allowsthe analyst to convert reported LIFO cost of goodssold amounts to FIFO amounts.(Exhibit 8.5 Page 390)

a. LIFO cost of goods sold Increase in LIFO reserve= FIFO cost of goods sold.

b. LIFO cost of goods sold + Decrease in LIFOreserve = FIFO cost of goods sold.

C t Fl A ti Th


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Concepts

A. LIFO liquidation can seriously distortreported net income.

1. LIFO liquidation results when there is adecline in inventory quantities, I.e, you sold morethan what you bought in current period.

2. The older costs in the LIFO layerliquidated are matched with current sales dollars.

In other words, previously ignored holding gainsare included in income as old layers areliquidated.

3. This results in inflated or illusory profitmargins.


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Concepts A. LIFO liquidation can seriously distort

reported net income.

4. LIFO liquidation profit is calculated as

(Current cost LIFO layer cost) Quantity liquidated.

5. When LIFO liquidation profits are material,the SEC requires that its income effect be reported.

6. LIFO liquidationresults in an (unsustainable)increase in the gross margin percentage.

V Eli i ti LIFO R ti


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V. Eliminating LIFO Ratio

Distortions

A. To adjust the current ratio, we should theLIFO reserve to the numerator, convertingLIFO inventory to FIFO inventory.

B. To adjust the inventory turnover ratio:

1. LIFO liquidation profits should be added tothe numerator.

2. The denominator should be adjusted toreflect FIFO inventory instead of LIFO inventory.

VI T I li i f LIFO


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VI. Tax Implications of LIFO

A. The LIFO conformity rule requiresthat if LIFO is used for income tax

purposes, the financial statements mustalso use LIFO.


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VI. Tax Implications of LIFO B. LIFOs tax advantage is that it provides a lower income

number than FIFO, thus lowering the immediate tax liability.

1. This benefit can be reversed if LIFO layers areliquidated or if future purchase costs fall.

2. These cash flow benefits can induce undesirablemanagerial behavior.

a. This may happen if a firm has depleted itsinventories during the year and it wants to avoid the taxliability associated with the LIFO liquidation.

b. A manager can avoid taxes by simply purchasing alarge amount of inventory at the end of the year to bring itback up to beginning-of-year levels.

VII Eliminating Realized


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VII. Eliminating Realized

Holding Gains for FIFO Firms A. Reported income for FIFO firms always includes some realized

holding gains during periods of rising inventory costs.

B. Since holding gains are potentially unsustainable, analysts tryto remove them from reported FIFO income.

1. The greater the amount of cost change, the larger thedivergence between FIFO and replacement cost of goods sold.

2. The slower that inventory turns over, the larger thedivergence between FIFO and replacement cost of goods sold.


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VII. Eliminating Realized

Holding Gains for FIFO Firms C. The adjustment procedure comprises

three steps:

1. Determine FIFO cost of goods sold.

2. Adjust the beginning inventory for onefull year of specific price change.

3. Replacement cost of goods sold is thesum of the amounts in step 1 and the

amount in step 2.


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X. Appendix BLower of

Cost or Market Method Lower of cost or market method:

1. The relevant comparison is betweenhistorical cost and replacement cost.

X Appendix B Lower of


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X. Appendix B

Lower of

Cost or Market Method

The market value used to compare tocost in applying the lower of cost ormarket rule is the middle value of (1)

replacement cost, (2) net realizable value,and (3) net realizable value less a normalprofit margin.

XI D ll V l LIFO


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XI. Dollar Value LIFO

A. The LIFO inventory method requires

data on each separate product orinventory item.

1. This system necessitatesconsiderable clerical work and cost.

2. The likelihood of liquidating a LIFO

layer is greatly increased when LIFO recordsare kept by individual item.


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XI. Dollar Value LIFO B. The steps involved in computing dollar value

LIFO are summarized as follows:

a. Ending inventory is initially computed interm of year-end costs.

b. To determine whether a new LIFO layerhas been added or liquidated, the endinginventory is restated to base-period cost andcompared to the beginning inventory at base-yearcost.

i. This eliminates the effect of cost changes.

ii. The comparison indicates whetherquantities have changed.


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XI. Dollar Value LIFO

c. Any inventory change is costed as follows:

i. New LIFO layers are valued using cost of the

year in which the layer was added.

ii. Decreases in old layers are removedusing costs that were in effect when the layer wasoriginally formed.


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Summary

Components of inventories

Two inventory system

Allocate Fixed Overhead costs: variablecosting vs. absorption costing

Three cost flow assumptions

LIFO reserve and LIFO liquidations

Adjusting FIFO Lower of cost or market

Dollar value of LIFO


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Fifo Method

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