Let's talk inventory—big, bulldozer-size inventory. Caterpillar Inc. is the world's largest manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. It sells its products in over 200 countries, making it one of the most successful U.S. exporters. More than 70% of its productive assets are located domestically, and nearly 50% of its sales are foreign.
In the past, Caterpillar's profitability suffered, but today it is very successful. A big part of this turnaround can be attributed to effective management of its inventory. Imagine what it costs Caterpillar to have too many bulldozers sitting around in inventory—a situation the company definitely wants to avoid. Conversely, Caterpillar must make sure it has enough inventory to meet demand.
At one time during a 7-year period, Caterpillar's sales increased by 100%, while its inventory increased by only 50%. To achieve this dramatic reduction in the amount of resources tied up in inventory, while continuing to meet customers’ needs, Caterpillar used a two-pronged approach. First, it completed a factory modernization program, which greatly increased its production efficiency. The program reduced by 60% the amount of inventory the company processed at any one time. It also reduced by an incredible 75% the time it takes to manufacture a part.
Second, Caterpillar dramatically improved its parts distribution system. It ships more than 100,000 items daily from its 23 distribution centers strategically located around the world (10 million square feet of warehouse space—remember, we're talking bulldozers). The company can virtually guarantee that it can get any part to anywhere in the world within 24 hours.
After these changes, Caterpillar had record exports, profits, and revenues. It would seem that things couldn't be better. But industry analysts, as well as the company's managers, thought otherwise. In order to maintain Caterpillar's position as the industry leader, management began another major overhaul of inventory production and inventory management processes. The goal: to cut the number of repairs in half, increase productivity by 20%, and increase inventory turnover by 40%.
In short, Caterpillar's ability to manage its inventory has been a key reason for its past success, and inventory management will very likely play a huge part in its ability to succeed in the future.
Preview of Chapter 6
In the previous chapter, we discussed the accounting for merchandise inventory using a perpetual inventory system. In this chapter, we explain the methods used to calculate the cost of inventory on hand at the balance sheet date and the cost of goods sold.
The content and organization of this chapter are as follows.
Two important steps in the reporting of inventory at the end of the accounting period are the classification of inventory based on its degree of completeness and the determination of inventory amounts.
How a company classifies its inventory depends on whether the firm is a merchandiser or a manufacturer. In a merchandising company, such as those described in Chapter 5, inventory consists of many different items. For example, in a grocery store, canned goods, dairy products, meats, and produce are just a few of the inventory items on hand. These items have two common characteristics: (1) They are owned by the company, and (2) they are in a form ready for sale to customers in the ordinary course of business. Thus, merchandisers need only one inventory classification, merchandise inventory, to describe the many different items that make up the total inventory.
In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has been placed into the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production.
For example, Caterpillar classifies earth-moving tractors completed and ready for sale as finished goods. It classifies the tractors on the assembly line in various stages of production as work in process. The steel, glass, tires, and other components that are on hand waiting to be used in the production of tractors are identified as raw materials. Illustration 6-1 shows an excerpt from Note 7 of Caterpillar's annual report, which shows the significant increases in each type of Caterpillar's inventory levels as the economy began to recover during this period.
Helpful Hint Regardless of the classification, companies report all inventories under Current Assets on the balance sheet.
By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management's production plans. For example, low levels of raw materials and high levels of finished goods suggest that management believes it has enough inventory on hand, and production will be slowing down—perhaps in anticipation of a recession. On the other hand, high levels of raw materials and low levels of finished goods probably signal that management is planning to step up production.
Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, companies manufacture or purchase goods just in time for use. Dell is famous for having developed a system for making computers in response to individual customer requests. Even though it makes each computer to meet each customer's particular specifications, Dell is able to assemble the computer and put it on a truck in less than 48 hours. The success of the JIT system depends on reliable suppliers. By integrating its information systems with those of its suppliers, Dell reduced its inventories to nearly zero. This is a huge advantage in an industry where products become obsolete nearly overnight.
The accounting concepts discussed in this chapter apply to the inventory classifications of both merchandising and manufacturing companies. Our focus here is on merchandise inventory. Additional issues specific to manufacturing companies are discussed later in the managerial section of this textbook (Chapters 19–26).
ACCOUNTING ACROSS THE ORGANIZATION
A Big Hiccup
JIT can save a company a lot of money, but it isn't without risk. An unexpected disruption in the supply chain can cost a company a lot of money. Japanese automakers experienced just such a disruption when a 6.8-magnitude earthquake caused major damage to the company that produces 50% of their piston rings. The rings themselves cost only $1.50, but without them you cannot make a car. No other supplier could quickly begin producing sufficient quantities of the rings to match the desired specifications. As a result, the automakers were forced to shut down production for a few days—a loss of tens of thousands of cars.
Similarly, a major snowstorm halted production at Canadian plants of General Motors and Ford. A Ford spokesperson said, “Because the plants run with just-in-time inventory, we don't have large stockpiles of parts sitting around. When you have a somewhat significant disruption, you can pretty quickly run out of parts.”
Source: Amy Chozick, “A Key Strategy of Japan's Car Makers Backfires,” Wall Street Journal (July 20, 2007); Kate Linebaugh, “Canada Military Evacuates Motorists Stranded by Snow,” Wall Street Journal (December 15, 2010).
What steps might the companies take to avoid such a serious disruption in the future? (See page 324.)
No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for the following reasons:
1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
Companies using a periodic inventory system take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.
Companies take a physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formidable task. Retailers such as Target, True Value Hardware, or Home Depot have thousands of different inventory items. An inventory count is generally more accurate when goods are not being sold or received during the counting. Consequently, companies often “take inventory” when the business is closed or when business is slow. Many retailers close early on a chosen day in January—after the holiday sales and returns, when inventories are at their lowest level—to count inventory. Wal-Mart Stores, Inc., for example, has a year-end of January 31.
Ethics Note
In a famous fraud, a salad oil company filled its storage tanks mostly with water. The oil rose to the top, so auditors thought the tanks were full of oil. The company also said it had more tanks than it really did: It repainted numbers on the tanks to confuse auditors.
ETHICS INSIGHT
Falsifying Inventory to Boost Income
Managers at women's apparel maker Leslie Fay were convicted of falsifying inventory records to boost net income—and consequently to boost management bonuses. In another case, executives at Craig Consumer Electronics were accused of defrauding lenders by manipulating inventory records. The indictment said the company classified “defective goods as new or refurbished” and claimed that it owned certain shipments “from overseas suppliers” when, in fact, Craig either did not own the shipments or the shipments did not exist.
What effect does an overstatement of inventory have on a company's financial statements? (See page 324.)
One challenge in computing inventory quantities is determining what inventory a company owns. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?
GOODS IN TRANSIT A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods.
Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale, as shown in Illustration 6-2 and described below.
1. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.
If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted. Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on December 31. It also has the following goods in transit:
1. Sales of 1,500 units shipped December 31 FOB destination.
2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
Hargrove has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company ignores the units in transit, it would understate inventory quantities by 4,000 units (1,500 + 2,500).
As we will see later in the chapter, inaccurate inventory counts affect not only the inventory amount shown on the balance sheet but also the cost of goods sold calculation on the income statement.
CONSIGNED GOODS In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.
For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer's inventory because the dealer does not own it.
Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.
ANATOMY OF A FRAUD
Ted Nickerson, CEO of clock manufacturer Dally Industries, was feared by all of his employees. Ted also had expensive tastes. To support his expensive tastes, Ted took out large loans, which he collateralized with his shares of Dally Industries stock. If the price of Dally's stock fell, he was required to provide the bank with more shares of stock. To achieve target net income figures and thus maintain the stock price, Ted coerced employees in the company to alter inventory figures. Inventory quantities were manipulated by changing the amounts on inventory control tags after the year-end physical inventory count. For example, if a tag said there were 20 units of a particular item, the tag was changed to 220. Similarly, the unit costs that were used to determine the value of ending inventory were increased from, for example, $125 per unit to $1,250. Both of these fraudulent changes had the effect of increasing the amount of reported ending inventory. This reduced cost of goods sold and increased net income.
Total take: $245,000
THE MISSING CONTROL
Independent internal verification. The company should have spot-checked its inventory records periodically, verifying that the number of units in the records agreed with the amount on hand and that the unit costs agreed with vendor price sheets.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 502–509.
Rules of Ownership
Hasbeen Company completed its inventory count. It arrived at a total inventory value of $200,000. As a new member of Hasbeen's accounting department, you have been given the information listed below. Discuss how this information affects the reported cost of inventory.
1. Hasbeen included in the inventory goods held on consignment for Falls Co., costing $15,000.
2. The company did not include in the count purchased goods of $10,000 which were in transit (terms: FOB shipping point).
3. The company did not include in the count sold inventory with a cost of $12,000 which was in transit (terms: FOB shipping point).
Action Plan
Apply the rules of ownership to goods held on consignment.
Apply the rules of ownership to goods in transit.
Solution
The goods of $15,000 held on consignment should be deducted from the inventory count. The goods of $10,000 purchased FOB shipping point should be added to the inventory count. Sold goods of $12,000 which were in transit FOB shipping point should not be included in the ending inventory. Thus, inventory should be carried at $195,000 ($200,000 − $15,000 + $10,000).
Related exercise material: BE6-1, E6-1, E6-2, and DO IT! 6-1.
Explain the accounting for inventories and apply the inventory cost flow methods.
Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer are a selling expense.
After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at different times and at different prices.
For example, assume that Crivitz TV Company purchases three identical 50-inch TVs on different dates at costs of $700, $750, and $800. During the year, Crivitz sold two sets at $1,200 each. These facts are summarized in Illustration 6-3.
Cost of goods sold will differ depending on which two TVs the company sold. For example, it might be $1,450 ($700 + $750), or $1,500 ($700 + $800), or $1,550 ($750 + $800). In this section, we discuss alternative costing methods available to Crivitz.
If Crivitz can positively identify which particular units it sold and which are still in ending inventory, it can use the specific identification method of inventory costing. For example, if Crivitz sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is $1,500 ($700 + $800), and its ending inventory is $750 (see Illustration 6-4). Using this method, companies can accurately determine ending inventory and cost of goods sold.
Specific identification requires that companies keep records of the original cost of each individual inventory item. Historically, specific identification was possible only when a company sold a limited variety of high-unit-cost items that could be identified clearly from the time of purchase through the time of sale. Examples of such products are cars, pianos, or expensive antiques.
Today, bar coding, electronic product codes, and radio frequency identification make it theoretically possible to do specific identification with nearly any type of product. The reality is, however, that this practice is still relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold.
Ethics Note
A major disadvantage of the specific identification method is that management may be able to manipulate net income. For example, it can boost net income by selling units purchased at a low cost, or reduce net income by selling units purchased at a high cost.
Because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification in that they assume flows of costs that may be unrelated to the physical flow of goods. There are three assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Last-in, first-out (LIFO)
3. Average-cost
There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.
To demonstrate the three cost flow methods, we will use a periodic inventory system. We assume a periodic system because very few companies use perpetual LIFO, FIFO, or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recalculated number.1
To illustrate the three inventory cost flow methods, we will use the data for Houston Electronics’ Astro condensers, shown in Illustration 6-5.
The cost of goods sold formula in a periodic system is:
(Beginning Inventory + Purchases) − Ending Inventory = Cost of Goods Sold
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory plus purchases). The total cost of these 1,000 units is $12,000, referred to as cost of goods available for sale. A physical inventory taken at December 31 determined that there were 450 units in ending inventory. Therefore, Houston sold 550 units (1,000 − 450) during the period. To determine the cost of the 550 units that were sold (the cost of goods sold), we assign a cost to the ending inventory and subtract that value from the cost of goods available for sale. The value assigned to the ending inventory will depend on which cost flow method we use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus the cost of the ending inventory must equal the cost of goods available for sale—in this case, $12,000.
The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise. That is, it generally is good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first. In a bin of picture hangers at the hardware store, for example, no one really knows, nor would it matter, which hangers are sold first.) Illustration 6-6 shows the allocation of the cost of goods available for sale at Houston Electronics under FIFO.
Helpful Hint Note the sequencing of the allocation: (1) Compute ending inventory, and (2) determine cost of goods sold.
Helpful Hint Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.
Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending inventory is based on the prices of the most recent units purchased. That is, under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the most recent prices. The last purchase was 400 units at $13 on November 27. The remaining 50 units are priced using the unit cost of the second most recent purchase, $12, on August 24. Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-7 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the first 550 units acquired. Note that of the 300 units purchased on August 24, only 250 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 50 of these units were assumed unsold and thus included in ending inventory.
The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Illustration 6-8 shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.
Helpful Hint Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.
Under LIFO, since it is assumed that the first goods sold were those that were most recently purchased, ending inventory is based on the prices of the oldest units purchased. That is, under LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. In this example, Houston Electronics prices the 450 units of ending inventory using the earliest prices. The first purchase was 100 units at $10 in the January 1 beginning inventory. Then, 200 units were purchased at $11. The remaining 150 units needed are priced at $12 per unit (August 24 purchase). Next, Houston Electronics calculates cost of goods sold by subtracting the cost of the units not sold (ending inventory) from the cost of all goods available for sale.
Illustration 6-9 demonstrates that companies also can calculate cost of goods sold by pricing the 550 units sold using the prices of the last 550 units acquired. Note that of the 300 units purchased on August 24, only 150 units are assumed sold. This agrees with our calculation of the cost of ending inventory, where 150 of these units were assumed unsold and thus included in ending inventory.
Under a periodic inventory system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.
The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The average-cost method assumes that goods are similar in nature. Illustration 6-10 presents the formula and a sample computation of the weighted-average unit cost.
The company then applies the weighted-average unit cost to the units on hand to determine the cost of the ending inventory. Illustration 6-11 shows the allocation of the cost of goods available for sale at Houston Electronics using average-cost.
We can verify the cost of goods sold under this method by multiplying the units sold times the weighted-average unit cost (550 × $12 = $6,600). Note that this method does not use the average of the unit costs. That average is $11.50 ($10 + $11 + $12 + $13 = $46; $46 ÷ 4). The average-cost method instead uses the average weighted by the quantities purchased at each unit cost.
DO IT!
Cost Flow Methods
The accounting records of Shumway Ag Implements show the following data.
Beginning inventory | 4,000 units at $ 3 |
Purchases | 6,000 units at $ 4 |
Sales | 7,000 units at $12 |
Determine the cost of goods sold during the period under a periodic inventory system using (a) the FIFO method, (b) the LIFO method, and (c) the average-cost method.
Action Plan
Understand the periodic inventory system.
Allocate costs between goods sold and goods on hand (ending inventory) for each cost flow method.
Compute cost of goods sold for each method.
Solution
Cost of goods available for sale = (4,000 × $3) + (6,000 × $4) = $36,000
Ending inventory = 10,000 − 7,000 = 3,000 units
(a) FIFO: $36,000 − (3,000 × $4) = $24,000
(b) LIFO: $36,000 − (3,000 × $3) = $27,000
(c) Average cost per unit: [(4,000 @ $3) + (6,000 @ $4)] ÷ 10,000 = $3.60
Average-cost: $36,000 − (3,000 × $3.60) = $25,200
Related exercise material: BE6-3, BE6-4, BE6-5, E6-3, E6-4, E6-5, E6-6, E6-7, E6-8, and DO IT! 6-2.
Each of the three assumed cost flow methods is acceptable for use. For example, Reebok International Ltd. and Wendy's International currently use the FIFO method of inventory costing. Campbell Soup Company, Krogers, and Walgreen Drugs use LIFO for part or all of their inventory. Bristol-Myers Squibb, Starbucks, and Motorola use the average-cost method. In fact, a company may also use more than one cost flow method at the same time. Stanley Black & Decker Manufacturing Company, for example, uses LIFO for domestic inventories and FIFO for foreign inventories. Illustration 6-12 (in the margin) shows the use of the three cost flow methods in 500 large U.S. companies.
The reasons companies adopt different inventory cost flow methods are varied, but they usually involve one of three factors: (1) income statement effects, (2) balance sheet effects, or (3) tax effects.
To understand why companies might choose a particular cost flow method, let's examine the effects of the different cost flow assumptions on the financial statements of Houston Electronics. The condensed income statements in Illustration 6-13 assume that Houston sold its 550 units for $18,500, had operating expenses of $9,000, and is subject to an income tax rate of 30%.
Note the cost of goods available for sale ($12,000) is the same under each of the three inventory cost flow methods. However, the ending inventories and the costs of goods sold are different. This difference is due to the unit costs that the company allocated to cost of goods sold and to ending inventory. Each dollar of difference in ending inventory results in a corresponding dollar difference in income before income taxes. For Houston, an $800 difference exists between FIFO and LIFO cost of goods sold.
In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income. In most instances, prices are rising (inflation). In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against revenues. In a period of rising prices (as is the case in the Houston example), FIFO reports the highest net income ($2,310) and LIFO the lowest ($1,750); average-cost falls in the middle ($2,030). If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest.
To management, higher net income is an advantage. It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income.
Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom) profit as economic gain. To illustrate, assume that Kralik Company buys 200 units of a product at $20 per unit on January 10 and 200 more on December 31 at $24 each. During the year, Kralik sells 200 units at $30 each. Illustration 6-14 shows the results under FIFO and LIFO.
Under LIFO, Kralik Company has recovered the current replacement cost ($4,800) of the units sold. Thus, the gross profit in economic terms is real. However, under FIFO, the company has recovered only the January 10 cost ($4,000). To replace the units sold, it must reinvest $800 (200 × $4) of the gross profit. Thus, $800 of the gross profit is said to be phantom or illusory. As a result, reported net income is also overstated in real terms.
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost. For example, for Houston Electronics, 400 of the 450 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of $13.
Conversely, a major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost. The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior accounting periods. For example, Caterpillar has used LIFO for more than 50 years. Its balance sheet shows ending inventory of $14,544 million. But the inventory's actual current cost if FIFO had been used is $16,966 million.
We have seen that both inventory on the balance sheet and net income on the income statement are higher when companies use FIFO in a period of inflation. Yet, many companies have selected LIFO. Why? The reason is that LIFO results in the lowest income taxes (because of lower net income) during times of rising prices. For example, at Houston Electronics, income taxes are $750 under LIFO, compared to $990 under FIFO. The tax savings of $240 makes more cash available for use in the business.
Helpful Hint A tax rule, often referred to as the LIFO conformity rule, requires that if companies use LIFO for tax purposes they must also use it for financial reporting purposes. This means that if a company chooses the LIFO method to reduce its tax bills, it will also have to report lower net income in its financial statements.
Whatever cost flow method a company chooses, it should use that method consistently from one accounting period to another. This approach is often referred to as the consistency concept, which means that a company uses the same accounting principles and methods from year to year. Consistent application enhances the comparability of financial statements over successive time periods. In contrast, using the FIFO method one year and the LIFO method the next year would make it difficult to compare the net incomes of the two years.
Although consistent application is preferred, it does not mean that a company may never change its inventory costing method. When a company adopts a different method, it should disclose in the financial statements the change and its effects on net income. Illustration 6-15 shows a typical disclosure, using information from recent financial statements of Quaker Oats (now a unit of PepsiCo).
Is LIFO Fair?
ExxonMobil Corporation, like many U.S. companies, uses LIFO to value its inventory for financial reporting and tax purposes. In one recent year, this resulted in a cost of goods sold figure that was $5.6 billion higher than under FIFO. By increasing cost of goods sold, ExxonMobil reduces net income, which reduces taxes. Critics say that LIFO provides an unfair “tax dodge.” As Congress looks for more sources of tax revenue, some lawmakers favor the elimination of LIFO. Supporters of LIFO argue that the method is conceptually sound because it matches current costs with current revenues. In addition, they point out that this matching provides protection against inflation.
International accounting standards do not allow the use of LIFO. Because of this, the net income of foreign oil companies such as BP and Royal Dutch Shell are not directly comparable to U.S. companies, which makes analysis difficult.
Source: David Reilly, “Big Oil's Accounting Methods Fuel Criticism,” Wall Street Journal (August 8, 2006), p. C1.
What are the arguments for and against the use of LIFO? (See page 324.)
The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to changes in technology or fashions. These circumstances sometimes call for inventory valuation methods other than those presented so far. For example, at one time purchasing managers at Ford decided to make a large purchase of palladium, a precious metal used in vehicle emission devices. They made this purchase because they feared a future shortage. The shortage did not materialize, and by the end of the year the price of palladium had plummeted. Ford's inventory was then worth $1 billion less than its original cost. Do you think Ford's inventory should have been stated at cost, in accordance with the historical cost principle, or at its lower replacement cost?
International Note
Under U.S. GAAP, companies cannot reverse inventory write-downs if inventory increases in value in subsequent periods. IFRS permits companies to reverse write-downs in some circumstances.
As you probably reasoned, this situation requires a departure from the cost basis of accounting. This is done by valuing the inventory at the lower-of-cost-or-market (LCM) in the period in which the price decline occurs. LCM is a basis whereby inventory is stated at the lower of either its cost or market value as determined by current replacement cost. LCM is an example of the accounting convention of conservatism. Conservatism means that the approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income.
Companies apply LCM to the items in inventory after they have used one of the cost flow methods (specific identification, FIFO, LIFO, or average-cost) to determine cost. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, current replacement cost is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the replacement cost of an item usually leads to a decline in the selling price of the item.
To illustrate the application of LCM, assume that Ken Tuckie TV has the following lines of merchandise with costs and market values as indicated. LCM produces the results shown in Illustration 6-16 (page 290). Note that the amounts shown in the final column are the lower-of-cost-or-market amounts for each item.
Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are caused by failure to count or price the inventory correctly. In other cases, errors occur because companies do not properly recognize the transfer of legal title to goods that are in transit. When errors occur, they affect both the income statement and the balance sheet.
Under a periodic inventory system, both the beginning and ending inventories appear in the income statement. The ending inventory of one period automatically becomes the beginning inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold and net income in two periods.
The effects on cost of goods sold can be computed by entering incorrect data in the formula in Illustration 6-17 and then substituting the correct data.
If the error understates beginning inventory, cost of goods sold will be understated. If the error understates ending inventory, cost of goods sold will be overstated. Illustration 6-18 shows the effects of inventory errors on the current year's income statement.
Ethics Note
Inventory fraud increases during recessions. Such fraud includes pricing inventory at amounts in excess of its actual value, or claiming to have inventory when no inventory exists. Inventory fraud usually overstates ending inventory, thereby understating cost of goods sold and creating higher income.
So far, the effects of inventory errors are fairly straightforward. Now, though, comes the (at first) surprising part: An error in the ending inventory of the current period will have a reverse effect on net income of the next accounting period. Illustration 6-19 shows this effect. As you study the illustration, you will see that the reverse effect comes from the fact that understating ending inventory in 2013 results in understating beginning inventory in 2014 and overstating net income in 2014.
Over the two years, though, total net income is correct because the errors offset each other. Notice that total income using incorrect data is $35,000 ($22,000 + $13,000), which is the same as the total income of $35,000 ($25,000 + $10,000) using correct data. Also note in this example that an error in the beginning inventory does not result in a corresponding error in the ending inventory for that period. The correctness of the ending inventory depends entirely on the accuracy of taking and costing the inventory at the balance sheet date under the periodic inventory system.
Companies can determine the effect of ending inventory errors on the balance sheet by using the basic accounting equation: Assets = Liabilities + Owner's Equity. Errors in the ending inventory have the effects shown in Illustration 6-20.
The effect of an error in ending inventory on the subsequent period was shown in Illustration 6-19. Recall that if the error is not corrected, the combined total net income for the two periods would be correct. Thus, total owner's equity reported on the balance sheet at the end of 2014 will also be correct.
DO IT!
LCM Basis; Inventory Errors
(a) Tracy Company sells three different types of home heating stoves (gas, wood, and pellet). The cost and market value of its inventory of stoves are as follows.
Determine the value of the company's inventory under the lower-of-cost-or-market approach.
Action Plan
Determine whether cost or market value is lower for each inventory type.
Sum the lowest value of each inventory type to determine the total value of inventory.
Solution
The lowest value for each inventory type is gas $79,000, wood $250,000, and pellet $101,000. The total inventory value is the sum of these amounts, $430,000.
(b) Visual Company overstated its 2013 ending inventory by $22,000. Determine the impact this error has on ending inventory, cost of goods sold, and owner's equity in 2013 and 2014.
Action Plan
An ending inventory error in one period will have an equal and opposite effect on cost of goods sold and net income in the next period.
After two years, the errors have offset each other.
Solution
Related exercise material: BE6-7, BE6-8, E6-9, E6-10, E6-11, E6-12, and DO IT! 6-3.
As indicated in Chapter 5, inventory is classified in the balance sheet as a current asset immediately below receivables. In a multiple-step income statement, cost of goods sold is subtracted from sales. There also should be disclosure of (1) the major inventory classifications, (2) the basis of accounting (cost, or lower-of-cost-or-market), and (3) the cost method (FIFO, LIFO, or average-cost).
Wal-Mart Stores, Inc., for example, in its January 31, 2011, balance sheet reported inventories of $36,318 million under current assets. The accompanying notes to the financial statements, as shown in Illustration 6-21, disclosed the following information.
As indicated in this note, Wal-Mart values its inventories at the lower-of-cost-or-market using LIFO and FIFO.
The amount of inventory carried by a company has significant economic consequences. And inventory management is a double-edged sword that requires constant attention. On the one hand, management wants to have a great variety and quantity on hand so that customers have a wide selection and items are always in stock. But, such a policy may incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage). On the other hand, low inventory levels lead to stock-outs and lost sales. Common ratios used to manage and evaluate inventory levels are inventory turnover and a related measure, days in inventory.
Inventory turnover measures the number of times on average the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. The inventory turnover is computed by dividing cost of goods sold by the average inventory during the period. Unless seasonal factors are significant, average inventory can be computed from the beginning and ending inventory balances. For example, Wal-Mart reported in its 2011 annual report a beginning inventory of $32,713 million, an ending inventory of $36,318 million, and cost of goods sold for the year ended January 31, 2011, of $315,287 million. The inventory turnover formula and computation for Wal-Mart are shown below.
A variant of the inventory turnover is days in inventory. This measures the average number of days inventory is held. It is calculated as 365 divided by the inventory turnover. For example, Wal-Mart's inventory turnover of 9.1 times divided into 365 is approximately 40.1 days. This is the approximate time that it takes a company to sell the inventory once it arrives at the store.
There are typical levels of inventory in every industry. Companies that are able to keep their inventory at lower levels and higher turnovers and still satisfy customer needs are the most successful.
ACCOUNTING ACROSS THE ORGANIZATION
Too Many TVs or Too Few?
Financial analysts closely monitored the inventory management practices of companies during the recent recession. For example, some analysts following Sony expressed concern because the company built up its inventory of televisions in an attempt to sell 25 million liquid crystal display (LCD) TVs—a 60% increase over the prior year. A year earlier, Sony had cut its inventory levels so that its quarterly days in inventory was down to 38 days, compared to 61 days for the same quarter a year before that. But now, as a result of its inventory build-up, days in inventory rose to 59 days. While management was saying that it didn't think that Sony's inventory levels were now too high, analysts were concerned that the company would have to engage in very heavy discounting in order to sell off its inventory. Analysts noted that the losses from discounting can be “punishing.”
Source: Daisuke Wakabayashi, “Sony Pledges to Corral Inventory,” Wall Street Journal Online (November 2, 2010).
For Sony, what are the advantages and disadvantages of having a low days in inventory measure? (See page 324.)
Inventory Turnover
Early in 2014, Westmoreland Company switched to a just-in-time inventory system. Its sales revenue, cost of goods sold, and inventory amounts for 2013 and 2014 are shown below.
Determine the inventory turnover and days in inventory for 2013 and 2014. Discuss the changes in the amount of inventory, the inventory turnover and days in inventory, and the amount of sales across the two years.
Action Plan
To find the inventory turnover, divide cost of goods sold by average inventory.
To determine days in inventory, divide 365 days by the inventory turnover.
Just-in-time inventory reduces the amount of inventory on hand, which reduces carrying costs. Reducing inventory levels by too much has potential negative implications for sales.
Solution
The company experienced a very significant decline in its ending inventory as a result of the just-in-time inventory. This decline improved its inventory turnover and its days in inventory. However, its sales declined by 10%. It is possible that this decline was caused by the dramatic reduction in the amount of inventory that was on hand, which increased the likelihood of “stock-outs.” To determine the optimal inventory level, management must weigh the benefits of reduced inventory against the potential lost sales caused by stock-outs.
Related exercise material: BE6-9, E6-13, E6-14, and DO IT! 6-4.
Gerald D. Englehart Company has the following inventory, purchases, and sales data for the month of March.
The physical inventory count on March 31 shows 500 units on hand.
Under a periodic inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) average-cost.
Action Plan
Compute the total goods available for sale, in both units and dollars.
Compute the cost of ending inventory under the periodic FIFO method by allocating to the units on hand the latest costs.
Compute the cost of ending inventory under the periodic LIFO method by allocating to the units on hand the earliest costs.
Compute the cost of ending inventory under the periodic average-cost method by allocating to the units on hand a weighted-average cost.
Solution to Comprehensive DO IT! 1
1 Determine how to classify inventory and inventory quantities. Merchandisers need only one inventory classification, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three categories: finished goods, work in process, and raw materials. To determine inventory quantities, manufacturers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.
2 Explain the accounting for inventories and apply the inventory cost flow methods. The primary basis of accounting for inventories is cost. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost flow methods are specific identification and three assumed cost flow methods—FIFO, LIFO, and average-cost.
3 Explain the financial effects of the inventory cost flow assumptions. Companies may allocate the cost of goods available for sale to cost of goods sold and ending inventory by specific identification or by a method based on an assumed cost flow. When prices are rising, the first-in, first-out (FIFO) method results in lower cost of goods sold and higher net income than the other methods. The reverse is true when prices are falling. In the balance sheet, FIFO results in an ending inventory that is closest to current value. Inventory under LIFO is the farthest from current value. LIFO results in the lowest income taxes.
4 Explain the lower-of-cost-or-market basis of accounting for inventories. Companies use the lower-of-cost-or-market (LCM) basis when the current replacement cost (market) is less than cost. Under LCM, companies recognize the loss in the period in which the price decline occurs.
5 Indicate the effects of inventory errors on the financial statements. In the income statement of the current year: (a) An error in beginning inventory will have a reverse effect on net income. (b) An error in ending inventory will have a similar effect on net income. In the following period, its effect on net income for that period is reversed, and total net income for the two years will be correct.
In the balance sheet: Ending inventory errors will have the same effect on total assets and total owner's equity and no effect on liabilities.
6 Compute and interpret the inventory turnover. The inventory turnover is cost of goods sold divided by average inventory. To convert it to average days in inventory, divide 365 days by the inventory turnover.
Average-cost method Inventory costing method that uses the weighted-average unit cost to allocate to ending inventory and cost of goods sold the cost of goods available for sale. (p. 285).
Consigned goods Goods held for sale by one party although ownership of the goods is retained by another party. (p. 279).
Consistency concept Dictates that a company use the same accounting principles and methods from year to year. (p. 288).
Current replacement cost The current cost to replace an inventory item. (p. 289).
Days in inventory Measure of the average number of days inventory is held; calculated as 365 divided by inventory turnover. (p. 293).
Finished goods inventory Manufactured items that are completed and ready for sale. (p. 276).
First-in, first-out (FIFO) method Inventory costing method that assumes that the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. (p. 282).
FOB (free on board) destination Freight terms indicating that ownership of the goods remains with the seller until the goods reach the buyer. (p. 278).
FOB (free on board) shipping point Freight terms indicating that ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. (p. 278).
Inventory turnover A ratio that measures the number of times on average the inventory sold during the period; computed by dividing cost of goods sold by the average inventory during the period. (p. 293).
Just-in-time (JIT) inventory Inventory system in which companies manufacture or purchase goods just in time for use. (p. 276).
Last-in, first-out (LIFO) method Inventory costing method that assumes the costs of the latest units purchased are the first to be allocated to cost of goods sold. (p. 284).
Lower-of-cost-or-market (LCM) A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost.(p. 289).
Raw materials Basic goods that will be used in production but have not yet been placed into production. (p. 276).
Specific identification method An actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory. (p. 281).
Weighted-average unit cost Average cost that is weighted by the number of units purchased at each unit cost. (p. 285).
Work in process That portion of manufactured inventory that has been placed into the production process but is not yet complete. (p. 276).
What inventory cost flow methods do companies employ if they use a perpetual inventory system? Simple—they can use any of the inventory cost flow methods described in the chapter. To illustrate the application of the three assumed cost flow methods (FIFO, LIFO, and average-cost), we will use the data shown in Illustration 6A-1 and in this chapter for Houston Electronics’ Astro condensers.
LEARNING OBJECTIVE 7
Apply the inventory cost flow methods to perpetual inventory records.
Under perpetual FIFO, the company charges to cost of goods sold the cost of the earliest goods on hand prior to each sale. Therefore, the cost of goods sold on September 10 consists of the units on hand January 1 and the units purchased April 15 and August 24. Illustration 6A-2 shows the inventory under a FIFO method perpetual system.
The ending inventory in this situation is $5,800, and the cost of goods sold is $6,200 [(100 @ $10) + (200 @ $11) + (250 @ $12)].
Compare Illustrations 6-6 (page 283) and 6A-2. You can see that the results under FIFO in a perpetual system are the same as in a periodic system. In both cases, the ending inventory is $5,800 and cost of goods sold is $6,200. Regardless of the system, the first costs in are the costs assigned to cost of goods sold.
Under the LIFO method using a perpetual system, the company charges to cost of goods sold the cost of the most recent purchase prior to sale. Therefore, the cost of the goods sold on September 10 consists of all the units from the August 24 and April 15 purchases plus 50 of the units in beginning inventory. Illustration 6A-3 shows the computation of the ending inventory under the LIFO method.
The use of LIFO in a perpetual system will usually produce cost allocations that differ from those using LIFO in a periodic system. In a perpetual system, the company allocates the latest units purchased prior to each sale to cost of goods sold. In contrast, in a periodic system, the latest units purchased during the period are allocated to cost of goods sold. Thus, when a purchase is made after the last sale, the LIFO periodic system will apply this purchase to the previous sale. Compare Illustrations 6-8 (page 284) and 6A-3. Illustration 6-8 shows that the 400 units at $13 purchased on November 27 applied to the sale of 550 units on September 10. Under the LIFO perpetual system in Illustration 6A-3, the 400 units at $13 purchased on November 27 are all applied to the ending inventory.
The ending inventory in this LIFO perpetual illustration is $5,700, and cost of goods sold is $6,300, as compared to the LIFO periodic Illustration 6-8 (on page 284) where the ending inventory is $5,000 and cost of goods sold is $7,000.
The average-cost method in a perpetual inventory system is called the moving-average method. Under this method, the company computes a new average after each purchase, by dividing the cost of goods available for sale by the units on hand. The average cost is then applied to (1) the units sold, to determine the cost of goods sold, and (2) the remaining units on hand, to determine the ending inventory amount. Illustration 6A-4 shows the application of the moving-average cost method by Houston Electronics.
As indicated, Houston Electronics computes a new average each time it makes a purchase. On April 15, after it buys 200 units for $2,200, a total of 300 units costing $3,200 ($1,000 + $2,200) are on hand. The average unit cost is $10.667 ($3,200 ÷ 300). On August 24, after Houston Electronics buys 300 units for $3,600, a total of 600 units costing $6,800 ($1,000 + $2,200 + $3,600) are on hand, at an average cost per unit of $11.333 ($6,800 ÷ 600). Houston Electronics uses this unit cost of $11.333 in costing sales until it makes another purchase, when the company computes a new unit cost. Accordingly, the unit cost of the 550 units sold on September 10 is $11.333, and the total cost of goods sold is $6,233. On November 27, following the purchase of 400 units for $5,200, there are 450 units on hand costing $5,767 ($567 + $5,200) with a new average cost of $12.816 ($5,767 ÷ 450).
Compare this moving-average cost under the perpetual inventory system to Illustration 6-11 (on page 285) showing the average-cost method under a periodic inventory system.
Comprehensive DO IT! 2
Comprehensive DO IT! 1 on page 294 showed cost of goods sold computations under a periodic inventory system. Now let's assume that Gerald D. Englehart Company uses a perpetual inventory system. The company has the same inventory, purchases, and sales data for the month of March as shown earlier:
The physical inventory count on March 31 shows 500 units on hand.
Instructions
Under a perpetual inventory system, determine the cost of inventory on hand at March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) moving-average cost.
Action Plan
Compute the cost of goods sold under the perpetual FIFO method by allocating to the goods sold the earliest cost of goods purchased.
Compute the cost of goods sold under the perpetual LIFO method by allocating to the goods sold the latest cost of goods purchased.
Compute the cost of goods sold under the perpetual average-cost method by allocating to the goods sold a moving-average cost.
Solution to Comprehensive DO IT! 2
7 Apply the inventory cost flow methods to perpetual inventory records. Under FIFO and a perpetual inventory system, companies charge to cost of goods sold the cost of the earliest goods on hand prior to each sale. Under LIFO and a perpetual system, companies charge to cost of goods sold the cost of the most recent purchase prior to sale. Under the moving-average (average cost) method and a perpetual system, companies compute a new average cost after each purchase.
LEARNING OBJECTIVE 8
Describe the two methods of estimating inventories.
In the chapter, we assumed that a company would be able to physically count its inventory. What if it cannot? What if the inventory were destroyed by fire or flood, for example? In that case, the company would use an estimate.
Two circumstances explain why companies sometimes estimate inventories. First, a casualty such as fire, flood, or earthquake may make it impossible to take a physical inventory. Second, managers may want monthly or quarterly financial statements, but a physical inventory is taken only annually. The need for estimating inventories occurs primarily with a periodic inventory system because of the absence of perpetual inventory records.
There are two widely used methods of estimating inventories: (1) the gross profit method, and (2) the retail inventory method.
The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net sales. This method is relatively simple but effective. Accountants, auditors, and managers frequently use the gross profit method to test the reasonableness of the ending inventory amount. It will detect large errors.
To use this method, a company needs to know its net sales, cost of goods available for sale, and gross profit rate. The company then can estimate its gross profit for the period. Illustration 6B-1 shows the formulas for using the gross profit method.
To illustrate, assume that Kishwaukee Company wishes to prepare an income statement for the month of January. Its records show net sales of $200,000, beginning inventory $40,000, and cost of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit rate. It expects to earn the same rate this year. Given these facts and assumptions, Kishwaukee can compute the estimated cost of the ending inventory at January 31 under the gross profit method as follows.
The gross profit method is based on the assumption that the gross profit rate will remain constant. But, it may not remain constant, due to a change in merchandising policies or in market conditions. In such cases, the company should adjust the rate to reflect current operating conditions. In some cases, companies can obtain a more accurate estimate by applying this method on a department or product-line basis.
Note that companies should not use the gross profit method to prepare financial statements at the end of the year. These statements should be based on a physical inventory count.
A retail store such as Home Depot, Ace Hardware, or Wal-Mart has thousands of different types of merchandise at low unit costs. In such cases, it is difficult and time-consuming to apply unit costs to inventory quantities. An alternative is to use the retail inventory method to estimate the cost of inventory. Most retail companies can establish a relationship between cost and sales price. The company then applies the cost-to-retail percentage to the ending inventory at retail prices to determine inventory at cost.
Under the retail inventory method, a company's records must show both the cost and retail value of the goods available for sale. Illustration 6B-3 presents the formulas for using the retail inventory method.
We can demonstrate the logic of the retail method by using unit-cost data. Assume that Ortiz Inc. has marked 10 units purchased at $7 to sell for $10 per unit. Thus, the cost-to-retail ratio is 70% ($70 ÷ $100). If four units remain unsold, their retail value is $40 (4 × $10), and their cost is $28 ($40 × 70%). This amount agrees with the total cost of goods on hand on a per unit basis (4 × $7).
Illustration 6B-4 shows application of the retail method for Valley West. Note that it is not necessary to take a physical inventory to determine the estimated cost of goods on hand at any given time.
Helpful Hint In determining inventory at retail, companies use selling prices of the units.
The retail inventory method also facilitates taking a physical inventory at the end of the year. Valley West can value the goods on hand at the prices marked on the merchandise, and then apply the cost-to-retail ratio to the goods on hand at retail to determine the ending inventory at cost.
The major disadvantage of the retail method is that it is an averaging technique. Thus, it may produce an incorrect inventory valuation if the mix of the ending inventory is not representative of the mix in the goods available for sale. Assume, for example, that the cost-to-retail ratio of 75% for Valley West consists of equal proportions of inventory items that have cost-to-retail ratios of 70%, 75%, and 80%. If the ending inventory contains only items with a 70% ratio, an incorrect inventory cost will result. Companies can minimize this problem by applying the retail method on a department or product-line basis.
__________
1Also, some companies use a perpetual system to keep track of units, but they do not make an entry for perpetual cost of goods sold. In addition, firms that employ LIFO tend to use dollar-value LIFO, a method discussed in upper-level courses. FIFO periodic and FIFO perpetual give the same result. Therefore, companies should not incur the additional cost to use FIFO perpetual. Few companies use perpetual average-cost because of the added cost of recordkeeping. Finally, for instructional purposes, we believe it is easier to demonstrate the cost flow assumptions under the periodic system, which makes it more pedagogically appropriate.