Chapter 9 Why Does a Company Need a Cost Flow Assumption in Reporting Inventory?

Accounting for Inventory When Costs Vary Over Time

Question: In the coverage of financial accounting to this point, general standardization has been evident. Most transactions are reported in an identical fashion by all companies. This defined structure (created by U.S. GAAP or IFRS) helps ensure understandable communication. It also enhances the ability of decision makers to compare results from one year to the next and from one company to another. For example, inventory—except in unusual circumstances—appears on a balance sheet at historical cost unless its value is lower. Consequently, experienced decision makers should be well aware of the normal meaning of a reported inventory figure.

However, an examination of the notes to financial statements for several well-known businesses shows an interesting inconsistency in the reporting of inventory (emphasis added).

Mitsui & Co. (U.S.A.)—as of March 31, 2011: “Commodities and materials for resale are stated at the lower of cost or market. Cost is determined using the specific identification method or average cost.”

Johnson & Johnson—as of January 2, 2011: “Inventories are stated at the lower of cost or market determined by the first-in, first-out method.”

Safeway Inc.—as of January 1, 2011: “Merchandise inventory of $1,685 million at year-end 2010 and $1,629 million at year-end 2009 is valued at the lower of cost on a last-in, first-out (“LIFO”) basis or market value.”

Bristol-Myers Squibb—as of December 31, 2010: “Inventories are stated at the lower of average cost or market.”

“Specific-identification method,” “first-in, first-out method,” “last-in, first-out basis,” “average cost”—these are cost flow assumptions. What information do these terms provide about reported inventory balances? Why are such methods necessary? Why are all four of these businesses using different cost flow assumptions? In the financial reporting of inventory, what is the significance of disclosing that a company applies “first-in, first-out,” “last-in, first-out,” or the like?

 

Answer: In the previous chapter, the cost of all inventory items was kept constant over time. The first bicycle cost $260 and every bicycle purchased thereafter also had a cost of $260. This consistency helped simplify the introductory presentation of accounting issues in the coverage of inventory. However, such stability is hardly a realistic assumption. For example, the retail price of gasoline has moved up and down like a yo-yo in recent years. The costs of some commodities, such as bread and soft drinks, have increased gradually for many decades. In other industries, prices actually tend to fall over time. New technology products often start with a high price that drops as the manufacturing process ramps up and becomes more efficient. Several years ago, personal computers cost tens of thousands of dollars and now sell for hundreds.

A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions take place thousands of times each day. If each item has an identical cost, no problem exists. This established amount is reclassified from asset to expense to reflect the sale (either at the time of sale in a perpetual system or when financial statements are produced in a periodic system).

However, if inventory items are acquired at different costs, a problem is created: Which of these costs is moved from asset to expense to reflect a sale? To resolve that question, a cost flow assumption must be selected by company officials to identify the cost that remains in inventory and the cost that moves to cost of goods sold. This choice can have a significant and ongoing impact on both income statement and balance sheet figures. Investors and creditors cannot properly analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been utilized.

Applying Cost Flow Assumptions

Question: To illustrate, assume a men’s retail clothing store holds $120 in cash. Numbers will be kept artificially low in this example so that the impact of the various cost flow assumptions is easier to visualize. On December 2, Year One, one blue dress shirt is bought for $50 in cash and added to inventory. Later, near the end of the year, this style of shirt suddenly becomes especially popular and prices skyrocket. On December 29, Year One, the store manager buys a second shirt exactly like the first but this time at a cost of $70. Cash on hand has been depleted ($120 less $50 and $70), but the company holds two shirts in its inventory.

On December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. Those facts are not in dispute.

From an accounting perspective, only two questions must be resolved: (1) what is the cost of goods sold reported for the one shirt that was sold, and (2) what is the cost remaining in inventory for the one item still on hand?

Should the $50 or $70 cost be reclassified to cost of goods sold? Should the $50 or $70 cost remain in ending inventory? In financial accounting, the importance of the answers to those questions cannot be overemphasized. If the shirts are truly identical, answers cannot be determined by any type of inspection; thus, a cost flow assumption is necessary. What are the various cost flow assumptions, and how are they applied to inventory?

 

Answer:

Specific Identification. In a literal sense, specific identificationInventory cost flow method in which a company physically identifies both its remaining inventory and the inventory that was sold to customers. is not a cost flow assumption. Companies that use this method are not making an assumption because they know which item was sold. In some way, the inventory conveyed to the customer can be identified so that the actual cost is reclassified to expense to reflect the sale.

For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of specific goods from seller to buyer.

Thus, if the men’s retail store maintains a system where individual shirts are coded when acquired, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the first customer. That cost can then be moved from inventory to cost of goods sold.

However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, unless merchandise items are both expensive and unique, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages.

First-in, first-out (FIFO). The FIFOInventory cost flow assumption based on the oldest costs being transferred first from inventory to cost of goods sold so that the most recent costs remain in ending inventory. cost flow assumption is based on the premise that selling the oldest item first is most likely to mirror reality. Stores do not want inventory to lose freshness. The oldest items are often displayed on top in hopes that they will sell before becoming stale or damaged. Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the first (or oldest) cost is moved from inventory to cost of goods sold when a sale occurs.

Note that it is not the oldest item that is necessarily sold but rather the oldest cost that is reclassified first. No attempt is made to determine which shirt was purchased by the customer. Consequently, an assumption is necessary.

Here, because the first shirt cost $50, the entry in Figure 9.1 "Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO" is made to reduce the inventory and record the expense.

After the sale is recorded, the following financial information is reported by the retail story but only if FIFO is applied. Two shirts were bought for ($50 and $70), and one shirt was sold for $110.

In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more expensive) cost remains in ending inventory. For this reason, in inflationary times, FIFO is associated with a higher reported net income as well as a higher reported inventory total on the company’s balance sheet. Not surprisingly, these characteristics help make FIFO a popular choice.

Last-in, first-out (LIFO). LIFOInventory cost flow assumption based on the most recent costs being transferred first from inventory to cost of goods sold so that the oldest costs remain in ending inventory. is the opposite of FIFO: The most recent costs are moved to expense as sales are made.

Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One was bought on December 2 whereas Shirt Two was not acquired until December 29. The sales revenue was generated on December 31. Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is more appropriate than using a cost incurred several weeks earlier. According to this reasoning, income is more properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is out-of-date.

The difference in reported figures is especially apparent in periods of high inflation which makes this accounting decision even more important. “By matching current costs against current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher because it more nearly approximates disposable income.”Clayton T. Rumble, “So You Still Have Not Adopted LIFO,” Management Accountant, October 1983, 50. Note 1 to the 2010 financial statements for ConocoPhillips reiterates that point: “LIFO is used to better match current inventory costs with current revenues.”

The last cost incurred in buying blue shirts was $70 so this amount is reclassified to expense at the time of the first sale as shown in Figure 9.2 "Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO".

Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the company holds $110 in cash), the financial picture painted using the LIFO cost flow assumption is quite different from that shown previously in the FIFO example.

Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower inventory account on the balance sheet (the earlier, cheaper costs remain in the inventory T-account). As will be discussed in a subsequent section, LIFO is popular in the United States because it helps reduce the amount many companies must pay in income taxes.

Averaging. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that averagingInventory cost flow assumption based on the average cost being transferred from inventory to cost of goods sold so that this same average cost remains in ending inventory. all costs is the most logical solution. Why choose any individual cost if no evidence exists of its validity? The first item received might have been sold or the last. Selecting either is an arbitrary decision. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units).

Although no shirt actually cost $60, this average serves as the basis for reporting both cost of goods sold and the item still on hand. Therefore, all costs are included in arriving at each of these figures.

Averaging has many supporters. However, it can be a rather complicated system to implement especially if inventory costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at practical accounting decisions based more on an evaluation of advantages and disadvantages rather than on theoretical merit.

Presenting Inventory Balances Fairly

Question: FIFO, LIFO, and averaging can present radically different portraits of identical events. Is the gross profit for this men’s clothing store really $60 (FIFO), $40 (LIFO), or $50 (averaging) following the sale of one blue dress shirt? Analyzing inventory numbers presented by most companies can be difficult if not impossible without understanding the implications of the cost flow assumption that was applied. Which cost flow assumption is viewed as most appropriate in producing fairly presented financial statements?

 

Answer: Because specific identification reclassifies the cost of the actual unit that was sold, finding theoretical fault with that approach is difficult. Unfortunately, specific identification is nearly impossible to apply unless easily distinguishable differences exist between similar inventory items. For a vast majority of companies, that leaves FIFO, LIFO, and averaging. Arguments over their merits and their problems have raged for decades. Ultimately, information in financial statements must be presented fairly based on the cost flow assumption that is utilized.

In a previous chapter, an important clarification was made about the report of the independent auditor. It never assures decision makers that financial statements are “presented fairly.” That is a hopelessly abstract concept like truth and beauty. Instead, the auditor states that the statements “present fairly…in conformity with accounting principles generally accepted in the United States of America.” That is a substantially more objective standard. Thus, for this men’s clothing store, all the numbers in Figure 9.4 "Results of Possible Cost Flows Assumptions Used by Clothing Store" are presented fairly but only in conformity with the specific cost flow assumption that was applied.

Most Popular Cost Flow Assumptions

Question: Since company officials are allowed to select a cost flow assumption, which of these methods is most typically found in the financial reporting of companies operating in the United States?

 

Answer: To help interested parties gauge the usage of various accounting methods and procedures, a survey is carried out annually of the financial statements of 500 large companies. The resulting information allows accountants, auditors, and decision makers to weigh the validity of a particular presentation. For 2009, this survey found the following frequency for the various cost flow assumptions. Some companies actually use multiple assumptions: one for a particular portion of its inventory and a different one for the remainder. Thus, the total here is above 500 even though 98 of the surveyed companies did not report having inventory or mention a cost flow assumption (inventory was probably an immaterial amount). As will be discussed later in this chapter, applying multiple assumptions is especially common when a U.S. company owns subsidiaries that are located internationally.

Interestingly, individual cost flow assumptions tend to be more prevalent in certain industries. In this same survey, 92 percent of the financial statements issued by food and drug stores made use of LIFO whereas only 11 percent of the companies labeled as “computers, office equipment” had adopted this same approach. This difference is likely caused by the presence of inflation or deflation in those industries. Prices of food and drugs tend to escalate consistently over time while computer prices often fall as technology advances.

The LIFO Conformity Rule

Question: In periods of inflation, FIFO reports a higher gross profit (and, hence, net income) and a higher inventory balance than does LIFO. Averaging presents figures that normally fall between these two extremes. Such results are widely expected by the readers of financial statements who understand the impact of the various cost flow assumptions.

In the United States, all of these methods are permitted for financial reporting. Why is FIFO not the obvious choice for every organization that anticipates inflation in its inventory costs? Officials must prefer to report figures that make the company look stronger and more profitable. With every rise in prices, FIFO shows a higher income because the earlier (cheaper) costs are transferred to cost of goods sold. Likewise, FIFO reports a higher total for ending inventory because the later (higher) cost figures are retained in the inventory T-account. The company is no different physically as a result of this decision but FIFO makes it look better. Why does any company voluntarily choose LIFO, an approach that reduces reported income and total assets when prices rise?

 

Answer: LIFO might well have faded into oblivion because of its negative impact on key reported figures (during inflationary periods) except for a U.S. income tax requirement known as the LIFO conformity ruleA United States income tax rule that requires LIFO to be used for financial reporting purposes if it is adopted for taxation purposes.. Although this tax regulation is not part of U.S. GAAP and looks rather innocuous, it has a huge impact on the way inventory and cost of goods sold are reported in this country.

If costs are increasing, companies prefer to apply LIFO for tax purposes because this assumption reduces reported income and, hence, required cash payments to the government. In the United States, LIFO has come to be universally equated with the saving of tax dollars. When LIFO was first proposed as a tax method in the 1930s, the United States Treasury Department appointed a panel of three experts to consider its validity. The members of this group were split over a final resolution. They eventually agreed to recommend that LIFO be allowed for income tax purposes but only if the company was also willing to use LIFO for financial reporting. At that point, tax rules bled over into U.S. GAAP.

The rationale behind this compromise was that companies were allowed the option but probably would not choose LIFO for their tax returns because of the potential negative effect on the figures reported to investors, creditors, and others. During inflationary periods, companies that apply LIFO do not look as financially healthy as those that adopt FIFO. Eventually this recommendation was put into law and the LIFO conformity rule was born. It is a federal law and not an accounting principle. If LIFO is used on a company’s income tax return, it must also be applied on the financial statements.

However, as the previous statistics on usage point out, this requirement did not prove to be the deterrent that was anticipated. Actual use of LIFO has remained popular for decades. For many companies, the money saved in income tax dollars more than outweighs the problem of having to report numbers that make the company look weaker. Figure 9.5 "Advantages and Disadvantages of FIFO and LIFO" shows that both methods have advantages and disadvantages. Company officials must weigh the options and make a decision.

As discussed later in this chapter, IFRS does not permit the use of LIFO. Therefore, if IFRS is ever mandated in the United States, a significant tax advantage will be lost unless the LIFO conformity rule is abolished.

Two Sets of Books

Question: The LIFO conformity rule requires companies that apply LIFO for income tax purposes to also use that same cost flow assumption in conveying financial information to investors and creditors. Are the balances submitted to the government for income tax purposes not always the same as that presented to decision makers in a set of financial statements? Reporting different numbers to different parties seems unethical.

 

Answer: In both jokes and editorials, businesses are often derisively accused of “keeping two sets of books.” The implication is that one is skewed toward making the company look good (for external reporting purposes) whereas the other makes the company look bad (for taxation purposes). However, the existence of separate accounting records is a practical necessity. One set is based on applicable tax laws while the other enables the company to prepare financial statements according to U.S. GAAP. With two different sets of rules, the outcomes have to look different.

In filing income taxes with the United States government, a company must follow the regulations of the Internal Revenue Code.Many states and some cities also charge a tax on income. Those governments have their own unique set of laws although they often resemble the tax laws applied by the federal government. Those laws have several underlying objectives that influence their development.

First, income tax laws are designed to raise money for the operation of the federal government. Without adequate funding, the government could not provide hospitals, build roads, maintain a military and the like.

Second, income tax laws enable the government to help regulate the health of the economy. Simply by raising or lowering tax rates, the government can take money out of the economy (and slow public spending) or leave money in the economy (and increase public spending). For example, in a recent year, a significant tax break was passed by Congress to aid first-time home buyers. This move was designed to stimulate the housing market by encouraging individuals to consider making a purchase.

Third, income tax laws enable the government to assist certain members of society who are viewed as deserving help. For example, taxpayers who encounter high medical costs or casualty losses are entitled to a tax break. Donations conveyed to an approved charity can also reduce a taxpayer’s tax bill. The rules and regulations were designed to provide assistance for specified needs.

In contrast, in the United States, external financial reporting is governed by U.S. GAAP, a system designed to achieve the fair presentation of accounting information. That is the reason U.S. GAAP exists. Because the goals are different, financial data reported according to U.S. GAAP will not necessarily correspond to the tax figures submitted by the same company to the Internal Revenue Service (IRS). At places, though, agreement can be found between the two sets of rules. For example, both normally recognize a cash sale of merchandise as revenue at the time of sale. However, many differences do exist between the two. A loss on the sale of an investment in equity securities is just one example of a transaction that is handled quite differently for taxes and financial reporting.

Although separately developed, financial statements and income tax returns are tied together at one significant spot: the LIFO conformity rule. If a company chooses to use LIFO in filing its United States income tax return, it must do the same for financial reporting. Without that legal requirement, many companies would likely use FIFO in creating their financial statements and LIFO for their income tax returns. Much of the popularity of LIFO is undoubtedly derived from this tax requirement rather than from any theoretical merit.

Reporting Ending Inventory Using LIFO

Question: As a result of the LIFO conformity rule in the tax laws, this cost flow assumption is widely used in the United States. LIFO, though, is not allowed in many other areas of the world. It is not simply unpopular in those locations; its application is strictly forbidden by IFRS. Thus, international companies are often forced to resort to alternatives in reporting their foreign subsidiaries. For example, a note to the 2010 financial statements of American Biltrite Inc. explains that “cost is determined by the last-in, first-out (LIFO) method for approximately 47% of the Company’s domestic inventories. The use of LIFO results in a better matching of costs and revenues. Cost is determined by the first-in, first-out (FIFO) method for the Company’s foreign inventories.”

Why is LIFO not accepted in most countries outside the United States?

 

Answer: Although LIFO can be supported as providing a better matching of expenses (cost of goods sold) with revenues, a number of serious problems arise from its application. The most common accusation made against LIFO is that it often presents a balance sheet figure that is out-of-date and completely useless. When applying this assumption, the latest costs are moved to cost of goods sold so that earlier costs remain in the inventory account—possibly for years and even decades. After some period of time, this asset balance is likely to report a number that has no relevance to today’s prices.

For example, in its 2010 financial statements, ExxonMobil reported inventory on its balance sheet of approximately $13.0 billion based on applying the LIFO cost flow assumption. In the notes to those financial statements, the company disclosed that the current cost to acquire this same inventory was actually $21.3 billion higher than the number being reported. The asset was shown as $13.0 billion but the price to obtain that merchandise on the balance sheet date was $34.3 billion ($13.0 billion plus $21.3). What is the possible informational value of reporting an asset (one that is being held for sale) at an amount more than $21 billion below its current replacement cost?As will be seen in the next chapter, similar arguments are made in connection with property and equipment—the reported amount and the value can vary greatly. However, those assets are not normally held for resale purpose so that their current worth is of less interest to decision makers. That is the essential problem attributed to LIFO.

To illustrate, assume that a convenience store begins operations and has a tank that holds ten thousand gallons of gasoline. On January 1, 1972, the tank is filled at a cost of $1 per gallon. Almost immediately the price of gasoline jumps to $2 per gallon. During the remainder of 1972, the store buys and sells gas. The tank is filled one final time at the very end of the year bringing total purchases to one million gallons. The first 10,000 gallons were bought at $1.00 per gallon; the next one million gallons cost $2.00 per gallon.

LIFO and FIFO report these results as follows:

After just this initial period, the ending inventory balance shown for LIFO (10,000 gallons at $1 per gallon) already differs significantly from the current cost of $2 per gallon.

If this convenience store continues to finish each year with a full tank of 10,000 gallons (certainly not an unreasonable assumption), LIFO will report this inventory at $1 per gallon for the following decades regardless of current prices. The most recent costs get transferred to cost of goods sold every period leaving the first costs ($1 per gallon) in inventory. The tendency to report this asset at a cost expended years in the past is the single biggest reason that LIFO is viewed as an illegitimate cost flow assumption in many countries. That same sentiment would probably exist in the United States except for the LIFO conformity rule.

LIFO Liquidation

Question: In discussions of financial reporting, LIFO is also criticized because of the possibility of an event known as a LIFO liquidationA decrease in the quantity of inventory on hand when LIFO is applied so that costs incurred in a previous period are mismatched with revenues of the current period; if inflation has occurred, it can cause a significant increase in reported net income.. What is a LIFO liquidation and why does it create a theoretical problem for accountants?

 

Answer: As demonstrated above, costs from much earlier years often remain in the inventory T-account over a long period of time if LIFO is applied. With that cost flow assumption, a convenience store that opens in 1972 and ends each year with a full tank of 10,000 gallons of gasoline reports ending inventory at 1972 costs for years or even decades. Every balance sheet will show inventory as $10,000 (10,000 gallons in ending inventory at $1.00 per gallon).

However, if the quantity of inventory is ever allowed to decrease (accidentally or on purpose), some or all of those 1972 costs move to cost of goods sold. For example, if the convenience store ends 2012 with less than 10,000 gallons of gasoline, the reduction means that costs sitting in the inventory T-account since 1972 are recognized as an expense in the current year. Costs from 40 years earlier are matched with revenue in 2012. That is a LIFO liquidation and it can artificially inflate reported earnings if those earlier costs are especially low.

To illustrate, assume that this convenience store starts 2012 with 10,000 gallons of gasoline. LIFO has been applied over the years so that this inventory is reported at the 1972 cost of $1.00 per gallon. In 2012, gasoline costs the store $3.35 per gallon to buy and is then sold to the public for $3.50 per gallon creating a gross profit of $0.15 per gallon. That is the amount of income the store is making this year.

At the beginning of 2012, the convenience store sells its entire stock of 10,000 gallons of gasoline at the market price of $3.50 and then ceases to carry this product (perhaps the owners want to focus on groceries or automobile parts). Without any replacement of the inventory, the cost of the gasoline bought in 1972 for $1.00 per gallon is shifted from inventory to cost of goods sold in 2012. Instead of recognizing the normal profit margin of $0.15 per gallon or $1,500 for the 10,000 gallons, the store reports gross profit of $2.50 per gallon ($3.50 sales price minus $1.00 cost of goods sold) or $25,000 in total. The reported profit ($25,000) does not reflect the reality of current market conditions. This LIFO liquidation allows the store to look overly profitable.

In a LIFO liquidation, costs from an earlier period are matched with revenues of the present year. Revenue is measured in 2012 dollars but cost of goods sold is stated in 1972 prices. Although the reported figures are technically correct, the implication that this store earned a gross profit of $2.50 per gallon is misleading.

To warn decision makers of the impact that a LIFO liquidation has on reported net income, disclosure in the notes to the financial statements is needed whenever costs are mismatched in this manner. According to a note in the 2010 financial statements for Alcoa Inc. (all numbers in millions), “During the three-year period ended December 31, 2010, reductions in LIFO inventory quantities caused partial liquidations of the lower cost LIFO inventory base. These liquidations resulted in the recognition of income of $27 ($17 after-tax) in 2010, $175 ($114 after-tax) in 2009, and $38 ($25 after-tax) in 2008.”

Cost Flow Assumptions and Inventory Systems

Question: In the previous chapter, periodic and perpetual inventory systems were introduced. FIFO, LIFO, and averaging have now been presented. How does all of this material come together for reporting purposes? How does the application of a cost flow assumption impact the operation of a periodic or a perpetual inventory system?

 

Answer: Each company that holds inventory must develop a mechanism to both (a) monitor the balances and (b) allow for the creation of financial statements. If a periodic system is used, officials simply wait until financial statements are to be produced before taking a physical count. Then, a formula (beginning inventory plus all purchase costs less ending inventory) is applied to derive cost of goods sold.

In contrast, a perpetual system maintains an ongoing record of the goods that remain on hand and those that have been sold. As noted, both of these systems have advantages and disadvantages.

Companies also select a cost flow assumption to specify the cost that is transferred from inventory to cost of goods sold (and, hence, the cost that remains in the inventory T-account). For a periodic system, the cost flow assumption is only applied when the physical inventory count is taken and the cost of the ending inventory is determined. In a perpetual system, the cost flow assumption is used each time a sale is made to identify the cost to be reclassified to cost of goods sold. That can occur thousands of times each day.

Therefore, companies normally choose one of six systems to monitor their merchandise balances and determine the cost assignment between ending inventory and cost of goods sold:

• Periodic FIFO
• Perpetual FIFO
• Periodic LIFO
• Perpetual LIFO
• Periodic averaging (also called weighted averaging)
• Perpetual averaging (also called moving averaging)

Periodic and Perpetual FIFO

Question: To illustrate, assume that the Mayberry Home Improvement Store starts the new year with four bathtubs (Model WET-5) in its inventory, costing $110 each ($440 in total) when bought on December 9 of the previous period. The following events then take place during the current year.

• On February 2, three of these bathtubs are sold for $200 each. (revenue $600)
• On February 6, three new bathtubs of this model are bought for $120 each. (cost $360)
• On June 8, three of these bathtubs are sold for $250 each. (revenue $750)
• On June 13, three new bathtubs of this model are bought for $130 each. (cost $390)
• On September 9, two of these bathtubs are sold for $300 each. (revenue $600)
• On September 22, two new bathtub of this model are bought for $149. (cost $298)

At the end of the year, on December 31, a physical inventory is taken that finds that four bathtubs, Model WET-5, are in stock (4 – 3 + 3 – 3 + 3 – 2 + 2). None were stolen, lost, or damaged during the period. How does a periodic FIFO system differ from a perpetual FIFO system in maintaining accounting records and reporting inventory totals?

 

Answer: Regardless of the inventory system in use, several pieces of information are established in this example. These figures are factual, not impacted by accounting.

The Facts—Purchase and Sale of WET-5 Bathtubs

• Revenue: Eight units were sold for $1,950 ($600 + $750 + $600)
• Beginning Inventory: Four units costing $110 each or $440 in total
• Purchases: Eight units were bought during the year costing a total of $1,048 ($360 + $390 + $298)
• Ending Inventory: Four units are still held according to the physical inventory

Periodic FIFO. In a periodic system, the cost of all new purchases is the focus of the record keeping. Then, at the end of the period, the accountant must count and also determine the cost of the items held in ending inventory. When using FIFO, the first costs are transferred to cost of goods sold so the cost of the last four bathtubs remain in the inventory T-account. That is the FIFO assumption. The first costs are now in cost of goods sold while the most recent costs remain in the asset account.

In this illustration, the last four costs (starting at the end of the period and moving forward) are two units at $149 each and two units at $130 each for a total of $558. Only after that cost is assigned to the ending inventory units can cost of goods sold be calculated as shown in Figure 9.6 "Periodic FIFO—Bathtub Model WET-5".

Under FIFO, the last costs for the period remain in ending inventory; the first costs have all been transferred to cost of goods sold. Based on the application of FIFO, Mayberry reports gross profit from the sale of bathtubs during this year of $1,020 (revenue of $1,950 minus the cost of goods sold figure of $930 calculated in Figure 9.6 "Periodic FIFO—Bathtub Model WET-5").

Perpetual FIFO. Perpetual accounting systems are constructed so that costs can be moved from inventory to cost of goods sold at the time of each new sale. With modern computer processing, that is a relatively simple task. In Figure 9.7 "Perpetual FIFO—Bathtub Model WET-5", one format is shown that provides the information needed for this store about the cost and quantity of its inventory of bathtubs. In this figure, at points A, B, and C, costs are moved from inventory on hand to cost of goods sold based on FIFO. The cost of the first goods in the “inventory on hand” is reclassified to cost of goods sold at each of those three points in time.

On this perpetual inventory spreadsheet, the final cell in the “inventory on hand” column ($558 or two units @ $130 and two units at $149) provides the cost of the ending inventory to be reported on the balance sheet. However, it is the summation of the entire “cost of goods sold” column that arrives at the expense for the period ($930 or $330 + $350 + $250).

One important characteristic of FIFO should be noted here. Under both periodic and perpetual FIFO, ending inventory is $558 and cost of goods sold is $930. The reported numbers are identical. The first cost for the period is always the first cost regardless of when the assignment to expense is made. Thus, the resulting amounts are the same when using either FIFO system.

For that reason, many companies that apply FIFO maintain perpetual records to track the units on hand throughout the period but ignore the costs. Later, when financial statements are prepared, a periodic computation is used to determine the cost of ending inventory in order to calculate cost of goods sold. That allows these companies to monitor their inventory quantities every day without the expense and effort of identifying the specific cost associated with each new sale.

Applying LIFO

Question: LIFO reverses the FIFO cost flow assumption so that the last costs incurred are the first reclassified to cost of goods sold. How is LIFO applied to the inventory of an actual business? If the Mayberry Home Improvement Store adopted LIFO, how would the reported figures for its inventory have been affected by this decision?

 

Answer: Periodic LIFO. In a periodic system, only the computation of the ending inventory is directly affected by the choice of a cost flow assumption.Because ending inventory for one period becomes the beginning inventory for the next, application of a cost flow assumption does change that figure also. However, the impact is only indirect because the number is simply carried forward from the previous period. No current computation of beginning inventory is made based on the cost flow assumption in use. Thus, for this illustration, beginning inventory remains $440 (4 units at $110 each), and the number of units purchased is still eight with a cost of $1,048. The figure that changes is the cost of the ending inventory. Four bathtubs remain in stock at the end of the year. According to LIFO, the last (most recent) costs are transferred to cost of goods sold. Only the cost of the first four units remains in ending inventory. That is $110 per unit or $440 in total.

If Mayberry Home Improvement Store uses a periodic LIFO system, gross profit for the year will be reported as $902 (revenue of $1,950 less cost of goods sold of $1,048).

Note here that the anticipated characteristics of LIFO are present. Ending inventory of $440 is lower than that reported by FIFO ($558). Cost of goods sold ($1,048) is higher than under FIFO ($930) so that reported gross profit (and, hence, net income) is lower by $118 ($1,020 for FIFO versus $902 for LIFO).

Perpetual LIFO. The mechanical structure for a perpetual LIFO system is the same as that demonstrated previously for perpetual FIFO except that the most recent costs are moved into cost of goods sold at the time of each sale (points A, B, and C).

Once again, the last cell at the bottom of the “inventory on hand” column contains the asset figure to be reported on the balance sheet (a total of $538) while the summation of the “cost of goods sold” column provides the amount to be shown on the income statement ($950).

As can be seen here, periodic and perpetual LIFO do not necessarily produce identical numbers.

periodic LIFO: ending inventory $440 and cost of goods sold $1,048 perpetual LIFO: ending inventory $538 and cost of goods sold $950

Although periodic and perpetual FIFO always arrive at the same results, balances reported by periodic and perpetual LIFO frequently differ. The first cost incurred in a period (the cost transferred to expense under FIFO) is the same regardless of the date of sale. However, the identity of the last or most recent cost (expensed according to LIFO) depends on the perspective.

To illustrate, note that two bathtubs were sold on September 9 by the Mayberry Home Improvement Store. Perpetual LIFO immediately determines the cost of this sale and reclassifies the amount to expense. On that date, the cost of the most recent two units ($130 each) came from the June 13 purchase. In contrast, a periodic LIFO system makes this same determination but not until December 31. As viewed from year’s end, the last bathtubs had a cost of $149 each. Although these items were bought on September 22, after the final sale, their costs are included in cost of goods sold when applying periodic LIFO.

Two bathtubs were sold on September 9, but the identity of the specific costs to be transferred (when using LIFO) depends on the date on which the determination is made. A periodic system views the costs from the perspective of the end of the year. A perpetual system determines the expense immediately when each sale is made.

In practice, many companies are unlikely to use perpetual LIFO inventory systems. They are costly to maintain and, as has been discussed previously, provide figures of dubious usefulness. For that reason, companies often choose to maintain a perpetual FIFO system for internal decision making and then use the periodic LIFO formula at the end of the year to convert the numbers for external reporting purposes.

For example, The Kroger Co. presented the following balances on its January 29, 2011, balance sheet:

• FIFO inventory: $5,793 million
• LIFO reserve: (827) million

Kroger apparently monitors its inventory on a daily basis using FIFO and arrived at a final cost of $5,793 million. However, at the end of that year, the company took a physical inventory and applied the LIFO cost flow assumption to arrive at a reported balance that was $827 million lower. The reduced figure was used for reporting purposes because of the LIFO conformity rule. However, investors and creditors could still see that ending inventory actually had a current cost of $5,793 million.

Applying Averaging as a Cost Flow Assumption

Question: Not surprisingly, averaging follows a path similar to that of the previous examples. Costs are either moved to cost of goods sold at the end of the year (periodic or weighted average) or at the time of each new sale (perpetual or moving average). The only added variable to this process is the calculation of average cost. In the operation of an averaging system, when and how is the average cost of inventory determined?

 

Answer: Periodic (weighted) average. In the problem being examined here, Mayberry Home Improvement Store eventually held twelve bathtubs. Four of these units were on hand at the start of the year and the other eight were acquired during the period. The beginning inventory cost $440 and the new purchases were bought for a total of $1,048.

These twelve units had a total cost of $1,488 ($440 + $1,048) or $124 per bathtub ($1,488/12 units). When applying a weighted average system, this single average for the entire period is the basis for both the ending inventory and cost of goods sold to be reported in the financial statements. No item actually cost $124 but that average is applied to all units.

Perpetual (moving) average. In this final approach to maintaining and reporting inventory, each time that a company buys inventory at a new price, the average cost is recalculated. Therefore, a moving average system must be programmed to update the average whenever additional merchandise is acquired.

In Figure 9.11 "Perpetual (Moving) Average—Bathtub Model WET-5", a new average is computed at points D, E, and F. This figure is found by dividing the number of units on hand after the new purchase into the total cost of those items. For example, at point D, the company now has four bathtubs. One cost $110 while the other three were newly acquired for $120 each or $360 in total. Total cost was $470 ($110 + $360) for these four units for an updated average of $117.50 ($470/4 units). That average is used until the next purchase is made on June 13. The applicable average at the time of sale is transferred from inventory to cost of goods sold at points A ($110.00), B ($117.50), and C ($126.88).

Summary. The six inventory systems shown here for Mayberry Home Improvement Store provide a number of distinct pictures of ending inventory and cost of goods sold. As stated earlier, these numbers are all fairly presented but only in conformity with the specified principles being applied. Interestingly, gross profit ranges from $902.00 to $1,020.00 based on the system applied by management.

Making Comparisons When LIFO Is Applied

Question: The point has been made several times in this chapter that LIFO provides a lower reported net income than does FIFO when prices are rising. In addition, the inventory figure shown on the balance sheet will be below current cost if LIFO is applied during inflation. Comparison between companies that are similar can become difficult, if not impossible, when one uses LIFO and the other FIFO.

For example, Rite Aid, the drug store giant, applies LIFO while its rival CVS Caremark applies FIFO to the inventory held in its pharmacies. How can an investor or creditor possibly evaluate these two companies to assess which has the brightest financial future? In this situation, the utility of the available information seems limited. How do experienced decision makers manage to compare companies that apply LIFO to other companies that do not?

 

Answer: Significant variations in reported balances frequently result from the application of different cost flow assumptions. Because of the potential detrimental effects, companies that use LIFO often provide additional information to help interested parties understand the impact of this choice. For example, in discussing the use of LIFO, a note to the financial statements for Rite Aid explains (numbers are in thousands): “At February 26, 2011 and February 27, 2010, inventories were $875,012 and $831,113, respectively, lower than the amounts that would have been reported using the first-in, first-out (‘‘FIFO’’) method.”

Here, the reader is informed that the company’s reported inventory balance would be nearly $900 million higher if FIFO was applied. That one sentence allows for a better comparison with a company like CVS Caremark that uses FIFO. The dampening impact of LIFO on reported assets can be removed by the reader as shown in Figure 9.13 "Adjusted Rite Aid’s Inventory Balances from LIFO to FIFO". Restatement of financial statements in this manner is a common technique relied on by investment analysts around the world to make available information more usable.

Adjusting Rite Aid’s inventory balance from LIFO to FIFO is not difficult because the relevant information is available. However, restating the company’s income statement to numbers in line with FIFO is a bit more challenging. Rite Aid reported an overall net loss for the year ended February 26, 2011, of $555,424,000. How would this number have been different with the application of FIFO?

As seen in the periodic inventory formula, beginning inventory is added to purchases in determining cost of goods sold while ending inventory is subtracted. With the LIFO figures reported by Rite Aid, $3,238,644,000 (beginning inventory) was added in arriving at this expense and then $3,158,145,000 (ending inventory) was subtracted. Together, the net effect is an addition of $80,499,000 in computing cost of goods sold for the year ended February 26, 2011. The resulting expense was $80,499,000 higher than the amount of inventory purchased.

If FIFO had been used by Rite Aid, $4,069,757,000 (beginning inventory) would have been added with $4,033,157,000 (ending inventory) subtracted. These two balances produce a net effect on cost of goods sold of adding $36,600,000.

LIFO: cost of goods sold = purchases + $80.499 million FIFO: cost of goods sold = purchases + $36.600 million

Under LIFO, cost of goods sold is the purchases for the period plus $80,499,000. Using FIFO, cost of goods sold is the purchases plus only $36,600,000. The purchase figure is the same in both equations. Thus, cost of goods sold will be $43,899,000 lower according to FIFO ($80,499,000 less $36,600,000) so that net income is $43,899,000 higher. If FIFO had been used, Rite Aid’s net loss for the period would have been $511,525,000 instead of $555,424,000. Knowledgeable decision makers can easily make this adjustment to help in evaluating a company. They can determine the amount of net income to be reported if FIFO had been selected and can use that figure for comparison purposes.

Analyzing Vital Signs for Inventory

Question: When examining receivables in a previous chapter, the assertion was made that companies have vital signs that can be studied as an indication of financial well-being. These are ratios or other computed amounts considered to be of particular significance. In that coverage, the age of receivables and the receivable turnover were both calculated and explained. For inventory, do similar vital signs exist that decision makers should consider? What vital signs should be determined in connection with inventory when analyzing the financial health and future prospects of a company?

 

Answer: No definitive list of ratios and relevant amounts can be identified because different people tend to have their own personal preferences. However, several figures are widely computed and discussed in connection with inventory and cost of goods sold when the financial condition of a company and the likelihood of its prosperity are being evaluated.

Gross profit percentage. The first of these vital signs is the gross profit percentageFormula measuring profitability calculated by dividing gross profit (sales less cost of goods sold) by sales., which is found by dividing the gross profitDifference between sales and cost of goods sold; also called gross margin or markup. for the period by net salesSales less sales returns and discounts..

sales – sales returns and discounts = net sales net sales – cost of goods sold = gross profit gross profit/net sales = gross profit percentage

As has been mentioned, gross profit is also commonly referred to as gross margin or markup. In simplest terms, it is the difference between the amount paid to buy (or manufacture) inventory and the amount received from an eventual sale. The gross profit percentage is often used to compare one company to another or one time period to the next. If one book store manages to earn a gross profit percentage of 35 percent and another only 25 percent, questions should be raised about this difference and which percentage is better? One company is making more profit on each sale but, possibly because of higher sales prices, it might be making significantly fewer sales.

For the year ended January 29, 2011, Macy’s Inc. reported a gross profit percentage of 40.7 percent and reported net income for the year of $847 million on sales of approximately $25 billion. At the same time, Walmart earned a gross profit percentage of only 24.7 percent but managed to generate net income of nearly $17 billion on sales of just under $419 billion. With these companies, a clear difference in pricing strategy can be seen.

The gross profit percentage is also watched closely from one year to the next. For example, if this figure falls from 37 percent to 34 percent, analysts will be quite interested in the reason. A mere 1 percent drop in the gross profit percentage for Walmart in the previous year would have reduced gross profit by over $4 billion ($419 billion × 1 percent).

Such changes have a cause and any individual studying the company needs to consider the possibilities.

• Are costs rising more quickly than the sales price of the merchandise?
• Has a change occurred in the types of inventory being sold?
• Was the reduction in the gross profit offset by an increase in sales?

Amazon.com Inc., for example, reports that its gross profit was 22.6 percent in 2009 and 22.3 percent in 2010. That is certainly one piece of information to be included in a detailed investigation of this company.

Number of days inventory is held. A second vital sign is the number of days inventory is heldMeasures the average number of days that a company takes to sell its inventory items; computed by dividing average inventory for the period by the cost of inventory sold per day. on average. Companies want to turn their merchandise into cash as quickly as possible. Holding inventory for a length of time can lead to several unfortunate repercussions. The longer it sits in stock the more likely the goods are to get damaged, stolen, or go out of fashion. Such losses can be avoided through quick sales. Furthermore, as long as merchandise is sitting on the shelves, it is not earning any profit. Money is tied up with no return until a sale takes place.

Consequently, decision makers (both internal and external to the company) watch this figure closely. A change (especially any lengthening of the time required to sell merchandise) is often a warning of problems.

The number of days inventory is held is found in two steps. First, the cost of inventory that is sold each day on the average is determined.Some analysts prefer to use 360 instead of 365 days to make this computation simpler.

cost of goods sold/365 days = cost of inventory sold per day

Second, this daily cost figure is divided into the average amount of inventory held during the period. The average amount of inventory can be based on beginning and ending totals, monthly balances, or other available figures.

average inventory/cost of inventory sold per day = number of days inventory is held

If a company sells inventory costing $40,000 each day and holds an average inventory during the period of $520,000, the average item takes thirteen days ($520,000/$40,000) to be sold. Again, the significance of that figure depends on the type of inventory, a comparison to results reported by similar companies, and any change seen in recent periods of time.

Inventory turnover. A third vital sign that is often analyzed is the inventory turnoverRatio used to measure the speed at which a company sells inventory; computed by dividing cost of goods sold by average inventory for the period., which is simply another way to measure the speed by which a company sells inventory.

cost of goods sold/average inventory = inventory turnover

The resulting turnover figure indicates the number of times during the period that an amount equal to the average inventory was sold. The larger the turnover number, the faster inventory is selling. For example, Best Buy Co. Inc. recognized cost of goods sold for the year ending February 26, 2011, of $37,611 million. The company also reported beginning inventory for that period of $5,486 million and ending inventory of $5,897 million. Hence, the inventory turnover for this retail electronics giant was 6.61 times during that year.

($5,486 + $5,897)/2 = average inventory of $5,691.5 million $37,611/$5,691.5 = inventory turnover of 6.61 times