Week 8

Week 8
ACCT 6301
FALL 2019
10/5/2019 ©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 1

Tonight’s
Topics Chapter 7 Lecture

Chapter 7 –
Reporting and
Analyzing Inventory
ACCT 6301 – FINANCIAL ACCOUNTING – FALL 2019

Interpret disclosures
of
Learning Objective information
LEARNING concerning operating
OBJECTIVE 1
expenses, including
manufacturing and
retail inventory costs.
©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 4

Expense Recognition
Expenses are recognized:
• When assets are diminished or when liabilities increase
• As a result of earning revenue or supporting operations
• Even if there is no immediate decrease in cash
Three Approaches
Immediate Systematic
Direct Association
Recognition Allocation

Expense Recognition – Direct
Association
Direct Association
• Any cost directly associated with a specific source of revenue

• Recognize at the same time the related revenue is recognized
Examples
Cost of goods sold
Warranty costs

Expense Recognition – Immediate
Recognition
Immediate Recognition
• Costs that can be associated with the revenues of an accounting period

• But not with any specific sales transaction
• Recognize in period incurred
Examples
Most administrative costs (including insurance, utilities, salaries, etc.)
Most marketing costs
Research and development costs

Expense Recognition – Systematic
Allocation
Systematic Allocation
• Costs that benefit more than one accounting period

• That are not associated with specific revenues or assigned to one specific
time period
• Capitalize as an asset and convert to an expense over its useful life
Examples
Depreciation expense

Reporting Inventories
Walmart reports the cost of its inventories sold on its income statements:
Income Statements Years Ended

(in millions) Jan. 31, 2019 Jan. 31, 2018
Total revenues $514,405 $500,343
Cost of sales 385,301 373,396
Operating, selling, general and administrative expenses 107,147 106,510
Operating income 21,957 20,437
Other expenses
One of the largest single expenses in a

company’s income statement

Inventory
• A major asset for most manufacturers and merchandisers
• When inventory is purchased or produced, it is capitalized and carried on the
balance sheet as an asset until the unit is sold
• When inventory is sold, its cost is transferred to cost of goods sold on the income
statement
• Cost of goods sold is subtracted from sales revenue to yield gross profit
Sales revenue – Cost of goods sold = Gross profit
Often called Cost of Sales or, Gross Margin

Inventory Purchasing
1) Phelp’s, Inc. a startup company, purchases 60 pairs of swim goggles for resale at a cost of
$4 each.
Balance Sheet Income Statement

Transaction Cash + Noncash = Liabilities + Contrib. + Earned Revenues – Expenses = Net
Asset Asset Capital Capital Income
Purchase –240 +240
60 pairs of Cash Inventory = ‒ =
goggles for cash
at $4 each
(1) Inventory (+A) 240

Cash (–A) 240
Inventory (A) Cash (A)

(1) 240 240 (1)

Inventory Sales
2) Phelp’s sells 50 of the swim goggles previously purchased for $10 cash each.
Balance Sheet Income Statement
Cash Noncash Contrib. Earned Net
Transaction + = Liabilities + + Revenues – Expenses =
Asset Asset Capital Capital Income
Sell 50 pairs of +500 –200 +500 +500 +200 +500
goggles for cash Cash Inventory = –200 Sales ‒ Cost of = –200
at $10 each Retained Revenue Goods Sold
Earnings
(2a) Cash (+A) 500

Sales revenue (+R, +SE) 500
(2b) Cost of goods sold (+E, –SE) 200
Inventory (–A) 200
Cash (A) Sales Revenue (R)

(2a) 500 500 (2a)
Inventory (A) Cost of Goods Sold (E)
(2b) 200 200 (2b)

Reporting Inventory – Costs
Included
Reported at ‘cost’ which includes
◦ Cost to acquire
◦ Cost for transportation
◦ Cost in preparing goods for sale
◦ Cost with consideration of incentives
◦ Volume discounts
◦ Early payment discounts
◦ Referred to as cash discounts

Reporting Inventory – Legal Title
Factors
A company should recognize all inventories to which it holds legal title.
Occasionally, meaning recognition will include items in inventory that are not on
premise.
◦ If purchases are “FOB shipping point,” purchasing company receives title and recognizes
inventory as soon as shipped by supplier.
◦ When a company ships its own product to a customer, but has not fulfilled its requirements
for recognizing revenue, the product remains in the seller’s inventory until revenue can be
recognized.
◦ When inventory is on consignment to a distributor

Inventories for Manufacturers
Raw Materials Inventory
Parts and materials purchased from suppliers for use in the production process
Work-in-Process Inventory
Inventory of partially completed goods; includes materials, labor, and overhead
cost
Finished Goods Inventory

Completed products ready for delivery to customers

Inventories—Pfizer, Inc.
Pfizer reports inventory totaling $7,578 million in its December 31, 2017
balance sheet:
Components of Inventory for Pfizer, Inc.

Dec. 31, 2017
Inventories ($ millions)
Finished goods …………………………………………………. $2,883
Work in process ………………………………………………… 3,908
Raw materials and supplies …………………………………. 788
Total ……………………………………………………………… $7,578

Account for
inventory and
Learning Objective
LEARNING cost of goods
sold using
OBJECTIVE 2
different costing
methods.
Calculating Cost of Goods Sold
The inventory account decreases when goods are sold.
Cost of Goods Sold Computation
The ending inventory in the current period becomes

the beginning inventory for the subsequent period.

Inventory Cost Flows
to Financial Statements
Inventory Cost Flows to Financial Statements
Includes: Amount of beginning

inventory plus current period
inventory purchases Costs of items sold during
Unsold goods the period

Inventory Costing Methods
Three commonly used inventory methods…
First-in, First-out (FIFO)
Assumes the oldest costs recorded in inventory are the first costs transferred to cost of
goods sold
Last-in, First-out (LIFO)

Assumes the most recent costs recorded in inventory are the first costs transferred out
Average Cost (AC)

Assumes the cost of goods sold is the average of the cost to purchase all of the
inventories available during the period
Physical inventory flow need not match the cost flow.

FIFO Costing Method Example
Phelps, Inc. had 100 goggles costing $4 each in inventory at June 1, and incurred
the following inventory transactions during June:
Purchased 400 goggles at $4.50 each
Sold 460 goggles at $12.00 each
Cost of goods sold during June

100 goggles at $4 each $ 400
360 goggles at $4.50 each 1,620
Cost of goods sold $2,020
Ending inventory
40 goggles at $4.50 each $180

LIFO Costing Method Example
Phelps, Inc. had 100 goggles costing $4 each in inventory at June 1, and incurred
the following inventory transactions during June:

400 goggles at $4.50 each $1,800
60 goggles at $4.00 each 240
Cost of goods sold $2,040
Ending inventory

Inventory Costing and Price
Changes
LIFO and FIFO
• Are both historical cost methods
• Allocate costs of inventory differently
• Differences arise when costs of inventory change over time

Average Cost Method Example
Phelps, Inc. had 100 goggles costing $4 each in inventory at June 1, and
incurred the following inventory transactions during June:
Average cost = [(100 × $4) + (400 × $4.50)]/500 = $4.40

460 goggles at $4.40 each $2,024
Ending inventory

Comparing the Costing Methods
Average
FIFO LIFO Cost
Ending inventory
40 @ $4.50 each $ 180
40 @ $4.00 each $ 160
40 @ $4.40 each $ 176
Cost of goods sold
100 @ $4.00 and 360 @ $4.50 2,020
400 @ $4.50 and 60 @ $4.00 2,040
460 @ $4.40 each 2,024
Total cost of goods available $2,200 $2,200 $2,200
The total cost of goods available for sale of $2,200 is divided differently between the cost of
the goods sold and the inventory that remains on hand for each of the three methods.

Apply the
lower of cost or
Learning Objective
LEARNING net realizable
value rule to
OBJECTIVE 3
value
inventory.
Lower of Cost or Net Realizable
Value
Inventory is reported on the balance sheet at
Lower of Cost or Net Realizable Value (LCNRV)
If net realizable value (NRV) of Company must write- Write-

inventory is less than down inventory to down
inventory cost NRV
If net realizable value (NRV) of Inventory cost No write-

inventory is greater than remains on the down
inventory cost balance sheet

Inventory Write-Downs Under
LCNRV
• Inventory book value is written down to net realizable value, reducing total
assets
• Inventory write-down is reflected as an expense on the income statement,
reducing current period gross profit, income, and equity
• Included as part of cost of goods sold
New Accounting Standards Update 2015-11

Requires companies (other than those using LIFO or the retail inventory
method) to apply the Lower of Cost or Net Realizable Value
(estimated selling price less costs to complete sale) for years beginning after
December 15, 2016.

IFRS Reporting Insight
Write-down of inventory cost can be reversed under IFRS if market value
increases
◦ May be reversed up to the acquisition cost
◦ Revaluation results as a debit to Inventory and credit to Cost of Goods Sold

Inventory Disclosures
Walmart’s note disclosure:
LIFO method LCNRV
valuation
The Company values inventories at the lower of cost or market as determined primarily
by the retail inventory method of accounting, using the last-in, first-out (“LIFO”)
method for Walmart U.S. segment’s inventories. The inventory at the Walmart
International segment is valued primarily by the retail inventory method of accounting,
using the first-in, first-out (“FIFO”) method. The retail inventory method of accounting
results in inventory being valued at the lower of cost or market since permanent
markdowns are immediately recorded as a reduction of the retail value of inventory.
The inventory at the Sam’s Club segment is valued based on the weighted-average
cost using the LIFO method. At January 31, 2019 and January 31, 2018, the Company’s
inventories valued at LIFO approximated those inventories as if they were valued at
FIFO.

Reasons for Inventory Disclosures
• The magnitude of a company’s investment in inventory is often very large
• Impacts the income statement and balance sheet
• Risks of inventory losses are often high

• Tied to technological obsolescence and consumer tastes
• Can provide insight into future performance

• Both good and bad
• High inventory levels result in substantial costs for a company such as

financing costs to purchase, storage, handling, and insurance costs

Evaluate how
inventory costing
affects
Learning Objective management
LEARNING decisions
OBJECTIVE 4
and outsiders’
interpretations of
financial
statements.
LIFO Reserve
The LIFO reserve is the difference between LIFO cost and the current value of
inventory
Must be reported by companies using LIFO
LIFO reserve =
FIFO ending inventory cost ‒ LIFO ending inventory cost
Estimating FIFO cost of goods sold

FIFO cost of goods sold =
LIFO cost of goods sold ‒ Change in LIFO reserve
Useful for comparing gross profits of a company using FIFO with
another company using LIFO

Income Statement Effects
of Inventory Costing
FIFO LIFO AC
Sales (460 × $12) $5,520 $5,520 $5,520
Cost of goods sold 2,020 2,040 2,024
Gross profit $3,500 $3,480 $3,496
In a period of rising prices FIFO

yields the highest gross profit
and net income.
In a period of rising prices LIFO

yields the lowest gross profit and
net income.

Balance Sheet Effects
Current Assets FIFO LIFO AC
Cash $ xxx $ xxx $ xxx
Accounts receivable xxx xxx xxx
Inventories 180 160 176
LIFO does not accurately represent the cost that a company

would incur to replace its current investment in inventories.

Balance Sheet Effects of LIFO vs.
FIFO
FIFO costing on the balance sheet
◦ Approximates current value
◦ If prices fall, more likely to require lower of cost or market adjustments
Periods of rising prices

◦ LIFO ending inventories are understated compared to FIFO
◦ Does not represent replacement cost
◦ LIFO reserve can be viewed as an ‘unrealized holding gain’
◦ A gain that results from holding inventory as prices are rising

Cash Flow Effects of LIFO vs.
FIFO
FIFO in periods of rising prices
Higher pretax income
Higher income taxes
Less cash available
LIFO in periods of rising prices
Lower pretax income
Lower income taxes
More cash available
Increased cash flow from tax savings is often cited as a compelling
reason for management to adopt LIFO.

Financial Statement Effects
FIFO LIFO AC
Sales (460 × $12) $5,520 $5,520 $5,520

Cost of goods sold 2,020 2,040 2,024
Gross profit $3,500 $3,480 $3,496
Using FIFO
Increased gross profit results in higher pretax income causing higher taxes
payable.
Using LIFO
Results in a reduced tax liability, so cash flows are higher
Opposite effects occur in deflationary periods.

Adjusting from LIFO to FIFO
Adjust the balance sheet to FIFO
FIFO inventory = LIFO reserve + LIFO inventory
Adjust the income statement to FIFO
FIFO cost of goods sold =

LIFO cost of goods sold ‒ Change in LIFO reserve
Enhances comparability between companies using FIFO vs. LIFO

IFRS Reporting Insight
LIFO not allowed by IFRS
◦ Problems inherent
◦ FIFO firms do not disclose effects of using LIFO or other methods
◦ Analysts need to track inventory differences to compare FIFO firms to LIFO firms
◦ Changing to FIFO from LIFO creates additional tax payments for
inventory costs deferred under LIFO

Define and interpret
gross profit margin and
inventory turnover
ratios.
Learning Objective
LEARNING
OBJECTIVE 5
Use inventory footnote
information
to make appropriate
adjustments
to ratios.
Gross Profit Margin
Important because it is monitored by external users and management.
Sales revenue – Cost of good sold

Gross profit margin =
Sales revenue
Home Depot’s Gross Profit Margin:
2015: ($88,519 - $58,254)/$88,519 = 0.342 or 34.2%
2016: ($94,595 - $62,282)/$94,595 = 0.342 or 34.2%
2017: ($100,904 - $66,548)/$100,904 = 0.340 or 34.0%
Home Depot’s gross profit margin

held relatively constant between 2015 and 2017.

Gross Profit
Analysis
Causes of a changing gross profit margin
◦ Product line is stale
◦ Change in product mix
◦ New competitors enter the market
◦ General decline in economic activity
◦ Inventory is overstocked
◦ Change in pricing

Gross Profit Margin Comparison
Gross profit margins of Home Gross Profit Margin Comparison
Depot and Lowe’s:
Comparison of Gross Profit Margins Among Retailers

Gross profit margins among
retailers:

Ratios for Inventory Analysis
Inventory turnover
◦ Indicates how quickly inventory is being sold
Cost of good sold

Inventory turnover =
Average inventory
Average inventory days outstanding

◦ Indicates how long inventories are held before being sold
Average inventory Average inventory

days outstanding = Average daily cost of goods sold

Applying Inventory Turnover
to Home Depot
Cost of good sold
Inventory turnover =
Average inventory
Home Depot’s Gross Profit Margin:

2015: $58,254/[($11,809 + $11,079)/2] = 5.1 times per year
2016: $62,282/[($12,549 + $11,809)/2] = 5.1 times per year
2017: $66,548/[($12,748 + $12,549)/2] = 5.3 times per year
Home Depot turned its inventory over 5.3 times in 2017.

Home Depot in Context
Home Depot’s inventory turnover ratio as compared to other companies:

Applying Inventory Turnover
to Home Depot
Average inventory Average inventory
days outstanding = Average daily cost of goods sold
Home Depot’s inventory days outstanding:

2015: [($11,809 + $11,079)/2]/($58,254/365) = 72 days
2016: [($12,549 + $11,809)/2]/($62,282/365) = 71 days
2017: [($12,748 + $12,549)/2]/($66,548/365) = 69 days
Home Depot had its inventories on its shelves for about 69 days in
2017; a three-day improvement over 2015.

Home Depot in Context
Home Depot’s average inventory days outstanding as compared to other
companies:

Turnover Factors—Inventory
Quality
Inventory turnover can be compared with prior periods and competitors
◦ Higher turnover is favorable
Turnover level may imply

◦ Change in product mix to higher or lower margin products
◦ Excessive purchases or production
◦ Missed trends or technological advances
◦ Increased competition
◦ Change in promotion policies
◦ Improvement in manufacturing efficiency

Turnover Factors—Asset
Utilization
Optimizing inventory investment
◦ Too much inventory is expensive
◦ Too little inventory causes stock-outs, lost sales
Operational changes to reduce inventory

◦ Improved manufacturing processes to eliminate bottlenecks and work-in-process buildup
◦ Just-in-time deliveries from suppliers to reduce raw material inventories
◦ Demand-pull production in which raw materials are released to production when final goods
are demanded by customers

Comparing Inventory Turnover
Inventory turnover of Home Depot and Lowe’s:
Inventory Turnover Comparison

Adjusting Turnover Ratios
Adjusted LIFO cost of goods sold
=
inventory turnover *Average FIFO inventory
* Represents average adjusted LIFO company inventory to a FIFO basis
Advisable to adjust before calculating turnover ratios

Potential mismatch
◦ LIFO causes the cost of goods sold value per unit to differ from inventory
amount per unit
Solution
◦ Update beginning and ending inventory values using the LIFO reserve
information

Appendix 7A
Analyze LIFO
Learning Objective
LEARNING
OBJECTIVE 6 liquidations and the
impact they have
on the financial
statements.

LIFO Liquidation Implications
Tax implications
◦ An incentive to avoid LIFO liquidations
Financial reporting
◦ An incentive to create LIFO liquidations for earnings management purposes

LIFO Liquidation Example
Phelps has 200 units Phelps sells Liquidation
available to sell 150 units part of an
old layer
Available for Sale

Cost of 100 @ $12
Purchase Goods
100 @ $12 Sold
50 @ $10
Beginning Inventory
100 @ $10 Ending
50 @ $10
Inventory
Profits are $100 higher ($2 x 50 units) than if additional $12 units would have been purchased.

LIFO Liquidation Disclosure
LIFO liquidation gain
◦ The amount by which net income would be increased if
the liquidation had not occurred
◦ Must be disclosed in financial statement footnotes

LIFO Liquidation Implications
LIFO liquidation boosts gross profit
◦ Because older, lower costs are matched against revenues based on current sales prices
Reasons for material LIFO liquidation

◦ Involuntary, such as
◦ Supply disruption due to natural disasters
◦ Intentional, such as
◦ Efforts to lower costs
◦ Efforts to improve efficiency
◦ Earnings management

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10/5/2019 ©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 1

10/5/2019 ©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 2

10/5/2019 ©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 3

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 4

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 5

• Any cost directly associated with a specific source of revenue

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 6

• Costs that can be associated with the revenues of an accounting period

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 7

• Costs that benefit more than one accounting period

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 8

Income Statements Years Ended

One of the largest single expenses in a

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Sales revenue – Cost of goods sold = Gross profit

Often called Cost of Sales or, Gross Margin

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Balance Sheet Income Statement

(1) Inventory (+A) 240

Inventory (A) Cash (A)

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(2a) Cash (+A) 500

Cash (A) Sales Revenue (R)

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Finished Goods Inventory

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Components of Inventory for Pfizer, Inc.

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Cost of Goods Sold Computation

The ending inventory in the current period becomes

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Includes: Amount of beginning

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Last-in, First-out (LIFO)

Average Cost (AC)

Physical inventory flow need not match the cost flow.

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Cost of goods sold during June

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Cost of goods sold during June

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Average cost = [(100 × $4) + (400 × $4.50)]/500 = $4.40

Cost of goods sold during June

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If net realizable value (NRV) of Company must write- Write-

If net realizable value (NRV) of Inventory cost No write-

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New Accounting Standards Update 2015-11

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©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 29

10/5/2019 ©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 30

• Risks of inventory losses are often high

• Can provide insight into future performance

• High inventory levels result in substantial costs for a company such as

©2020 JEFFREY KROMER AND CAMBRIDGE BUSINESS PUBLISHERS 31

Estimating FIFO cost of goods sold

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In a period of rising prices FIFO