Discussion Topic
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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, BE6.2, DO IT! 6.1, E6.1, E6.2, and E6.3.
Inventory Methods and Financial Effects
LEARNING OBJECTIVE 2
Apply inventory cost flow methods and discuss their financial effects.
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 is 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 TVs at $1,200 each. These facts are summarized in Illustration 6.3.
ILLUSTRATION 6.3 Data for inventory costing example
Purchases February 3 1 TV at $700 March 5 1 TV at $750 May 22 1 TV at $800 Sales June 1 2 TVs for $2,400 ($1,200 × 2)
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.
Specific Identification 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.
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ILLUSTRATION 6.4 Specific identification method
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 (see Ethics Note).
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.
Cost Flow Assumptions 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.
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ILLUSTRATION 6.5 Data for Houston Electronics
Houston Electronics
Astro Condensers
Date Explanation Units Unit Cost
Total Cost
Jan. 1
Beginning inventory 100 $10 $ 1,000
Apr. 15
Purchase 200 11 2,200
Aug. 24
Purchase 300 12 3,600
Nov. 27
Purchase 400
13 5,200
Total units available for sale
1,000 $12,000
Units in ending inventory
(450)
Units sold 550
The cost of goods sold formula in a periodic system is as follows.
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 depends 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.
First-In, First-Out (FIFO)
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 (see Helpful Hint).
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ILLUSTRATION 6.6 Allocation of costs—FIFO method
Cost of Goods Available for Sale
Date Explanation Units Unit Cost Total Cost
Jan. 1
Beginning inventory
100 $10 $ 1,000
Apr. 15 Purchase 200 11 2,200 Aug. 24
Purchase 300 12 3,600
Nov. 27
Purchase 400 13 5,200
Total 1,000 $12,000 Step 1: Ending Inventory Step 2: Cost of Goods Sold
Date Units Unit Cost Total Cost
Nov. 27
400 $13 $5,200 Cost of goods available for sale
$12,000
Aug. 24
50 12 600 Less: Ending inventory 5,800
Total
450 $5,800 Cost of goods sold $ 6,200
HELPFUL HINT
Note the sequencing of the allocation: (1) compute ending inventory, and (2) determine cost of goods sold.
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 (see Helpful Hint). 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.
HELPFUL HINT
Another way of thinking about the calculation of FIFO ending inventory is the LISH assumption—last in still here.
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.
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ILLUSTRATION 6.7 Proof of cost of goods sold
Date Units Unit Cost Total Cost Jan. 1 100 $10 $1,000
Apr. 15 200 11 2,200 Aug. 24 250 12 3,000
Total 550 $6,200
Last-In, First-Out (LIFO)
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.
ILLUSTRATION 6.8 Allocation of costs—LIFO method
Cost of Goods Available for Sale
Date Explanation Units Unit Cost Total Cost
Jan. 1
Beginning inventory
100 $10 $ 1,000
Apr. 15 Purchase 200 11 2,200 Aug. 24
Purchase 300 12 3,600
Nov. 27
Purchase 400 13 5,200
Total 1,000 $12,000 Step 1: Ending Inventory Step 2: Cost of Goods Sold
Date Units Unit Cost Total Cost
Jan. 1
100 $10 $1,000 Cost of goods available for sale
$12,000
Apr. 15 200 11 2,200 Less: Ending inventory 5,000 Aug. 24
150 12 1,800 Cost of goods sold $ 7,000
Total
450 $5,000
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 (see Helpful Hint). 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,
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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.
HELPFUL HINT
Another way of thinking about the calculation of LIFO ending inventory is the FISH assumption—first in still here.
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.
ILLUSTRATION 6.9 Proof of cost of goods sold
Date Units Unit Cost Total Cost Nov. 27 400 $13 $5,200 Aug. 24 150 12 1,800
Total 550 $7,000
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.
Average-Cost
The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. Illustration 6.10 presents the formula and a sample computation of the weighted-average unit cost.
ILLUSTRATION 6.10 Formula for weighted-average unit cost
Cost of Goods Available for Sale
÷ Total Units Available for Sale
= Weighted-Average Unit Cost
$12,000 ÷ 1,000 = $12
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.
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ILLUSTRATION 6.11 Allocation of costs—average-cost method
Cost of Goods Available for Sale
Date Explanation Units Unit Cost Total Cost
Jan. 1 Beginning inventory
100 $10 $ 1,000
Apr. 15 Purchase 200 11 2,200 Aug. 24 Purchase 300 12 3,600 Nov. 27 Purchase 400 13 5,200
Total 1,000 $12,000 Step 1: Ending Inventory Step 2: Cost of Goods Sold
$12,000 ÷ 1,000 = $12 Cost of goods available for sale
$12,000
Units Unit Cost Total Cost
Less: Ending inventory 5,400 Cost of goods sold $ 6,600
450 $12 $5,400
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.
Financial Statement and Tax Effects of Cost Flow Methods 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, Kroger, 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 shows the use of the three cost flow methods in 500 large U.S. companies.
ILLUSTRATION 6.12 Use of cost flow methods in major 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 (see Decision Tools).
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Decision Tools
Analyzing financial statement and tax effects helps users determine which inventory costing method best meets the company's objectives.
Income Statement 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%.
ILLUSTRATION 6.13 Comparative effects of cost flow methods
Houston Electronics
Condensed Income Statements
FIFO LIFO Average- Cost
Sales revenue $18,500 $18,500 $18,500 Beginning inventory 1,000 1,000 1,000 Purchases 11,000 11,000 11,000 Cost of goods available for sale
12,000 12,000 12,000
Ending inventory 5,800 5,000 5,400 Cost of goods sold 6,200 7,000 6,600 Gross profit 12,300 11,500 11,900 Operating expenses 9,000 9,000 9,000 Income before income taxes* 3,300 2,500 2,900 Income tax expense (30%) 990 750 870 Net income $ 2,310 $ 1,750 $ 2,030
* We are assuming that Houston Electronics is a corporation, and corporations are
required to pay income taxes.
In this example, which assumes equal beginning inventories, 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 significant impacts both on income and on evaluations of income, such as the following.
1. In a period of inflation, FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue.
2. In a period of inflation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue.
3. 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.
4. Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO.
As shown in the Houston example (Illustration 6.13), in a period of rising prices FIFO reports the highest net income ($2,310) and LIFO the lowest ($1,750); average-cost falls between these two amounts ($2,030).
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.
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Others believe that LIFO presents a more realistic net income number. That is, LIFO matches the more recent costs against current revenues to provide a better measure of net income. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that failing to match current costs against current revenues leads to an understatement of cost of goods sold and an overstatement of net income. As some indicate, net income computed using FIFO creates “paper or phantom profits”—that is, earnings that do not really exist.
Balance Sheet Effects
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 $9,700 million. But the inventory's actual current cost if FIFO had been used is $12,189 million.
Tax Effects
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 (see Helpful Hint). 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.
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Keeping an Eye on Cash
You have just seen that when prices are rising the use of LIFO can have a big effect on taxes. The lower taxes paid using LIFO can significantly increase cash flows. To demonstrate the effect of the cost flow assumptions on cash flow, we will calculate net cash provided by operating activities using the data for Houston Electronics from Illustration 6.13. To simplify our example, we assume that Houston's sales and purchases are all cash transactions. We also assume that operating expenses, other than $4,600 of depreciation, are cash transactions.
FIFO LIFO Average- Cost
Cash received from customers
$18,500 $18,500 $18,500
Cash purchases of goods 11,000 11,000 11,000 Cash paid for operating expenses ($9,000 − $4,600)
4,400 4,400 4,400
Cash paid for taxes 990 750 870 Net cash provided by operating activities
$ 2,110 $ 2,350 $ 2,230
LIFO has the highest net cash provided by operating activities because it results in the lowest tax payments. Since cash flow is the lifeblood of any organization, the choice of inventory method is very important.
LIFO also impacts the quality of earnings ratio. Recall that the quality of earnings ratio is net cash provided by operating activities divided by net income. Here, we calculate the quality of earnings ratio under each cost flow assumption.
FIFO LIFO Average- Cost
Net income (from Illustration 6.13)
$2,310 $1,750 $2,030
Quality of earnings ratio 0.91 1.34 1.10
LIFO has the highest quality of earnings ratio for two reasons. (1) It has the highest net cash provided by operating activities, which increases the ratio's numerator. (2) It reports a conservative measure of net income, which decreases the ratio's denominator. As discussed earlier, LIFO provides a conservative measure of net income because it does not include the phantom profits reported under FIFO.
Using Inventory Cost Flow Methods Consistently 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 6.14 shows a typical disclosure, using information from recent financial statements of Quaker Oats (now a unit of PepsiCo).
ILLUSTRATION 6.14 Disclosure of change in cost flow method
Quaker Oats
Notes to the Financial Statements Note 1: Effective July 1, the Company adopted the LIFO cost flow assumption for valuing the majority of U.S. Grocery Products inventories. The Company believes that the use of the LIFO method better matches current costs with current revenues. The effect of this change on the current year was to decrease net income by $16.0 million.
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International Insight ExxonMobil Corporation
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 can make 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? (Go to WileyPLUS for this answer and additional questions.)
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DO IT! 2 | 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, BE6.6, DO IT! 6.2, E6.4, E6.5, and E6.7.
Inventory Presentation and Analysis
LEARNING OBJECTIVE 3
Explain the statement presentation and analysis of inventory.
Presentation Recall that 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 net sales. There also should be disclosure of (1) the major inventory classifications, (2) the basis of accounting (cost, or lower-of-cost-or-net realizable value), and (3) the cost method (FIFO, LIFO, or average-cost).
Wal-Mart Stores, Inc., for example, in its January 31, 2017, balance sheet reported inventories of $43,046 million under current assets. The accompanying notes to the financial statements, as shown in Illustration 6.15, disclosed the following information.
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ILLUSTRATION 6.15 Inventory disclosures by Wal-Mart
Wal-Mart Stores, Inc.
Notes to the Financial Statements Note 1. Summary of Significant Accounting Policies Inventories The Company values inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, first-out (“LIFO”) method for substantially all of the 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 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 using the LIFO method. At January 31, 2017 and 2016, the Company's inventories valued at LIFO approximate those inventories as if they were valued at FIFO.
Lower-of-Cost-or-Net Realizable Value The value of inventory for companies selling high-technology or fashion goods can drop very quickly due to continual changes in technology or fashion. 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 net realizable value?
As you probably reasoned, this situation requires a departure from the cost basis of accounting. When the value of inventory is lower than its cost, companies must “write down” the inventory to its net realizable value. This is done by valuing the inventory at the lower-of-cost-or-net realizable value (LCNRV) in the period in which the price decline occurs.
LCNRV is an example of the accounting concept of conservatism, which means that the best choice among accounting alternatives is the method that is least likely to overstate assets and net income. Critics of accounting conservatism argue that it introduces bias into accounting numbers. This can reduce the representational faithfulness as well as relevance of financial reports.
Under the LCNRV basis, net realizable value refers to the net amount that a company expects to realize (receive) from the sale of inventory. Specifically, net realizable value is the estimated selling price in the normal course of business, less estimated costs to complete and sell.
Companies apply LCNRV to the items in inventory after they have used one of the inventory costing methods (specific identification, FIFO, or average-cost) to determine cost. To illustrate the application of LCNRV, assume that Ken Tuckie TV has the following lines of merchandise with costs and net realizable values as indicated. LCNRV produces the results shown in Illustration 6.16. Note that the amounts shown in the final column are the lower-of-cost-or-net realizable value amounts for each item.
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ILLUSTRATION 6.16 Computation of lower-of-cost-or-net realizable value
Units
Cost
per Unit
Net
Realizable
Value per Unit
Lower-of-Cost-or-Net
Realizable Value Flat- screen TVs
100 $600 $550 $ 55,000 ($550 × 100)
Satellite radios
500 90 104 45,000 ($90 × 500)
DVD recorders
850 50 48 40,800 ($48 × 850)
DVDs 3,000 5 6 15,000 ($5 × 3,000)
Total inventory
$155,800
Companies that use the LIFO method or the retail inventory method (such as Wal-Mart in Illustration 6.15) are not required to use lower-of-cost-or-net realizable value for inventory valuation. Instead, they use a lower-of-cost-or-market approach which is a more complex calculation. The computation for the lower-of-cost-or-market method is discussed in more advanced accounting courses.
Analysis For companies that sell goods, managing inventory levels can be one of the most critical tasks. Having too much inventory on hand costs the company money in storage costs, interest cost (on funds tied up in inventory), and costs associated with the obsolescence of technical goods (e.g., computer chips) or shifts in fashion (e.g., clothes). But having too little inventory on hand results in lost sales.
Clearly inventory management is an area that benefits from data analytics. Companies such as Wal-Mart collect massive amounts of data about every inventory item and every customer. They analyze customer habits, buying patterns, and sales trends. Using sophisticated models that incorporate economic variables, weather patterns, and many other factors, they strive to optimize inventory levels to maximize sales while minimizing inventory holding costs. In this section, we discuss some issues related to evaluating inventory levels.
Inventory Turnover
The inventory turnover is calculated as cost of goods sold divided by average inventory. It indicates the liquidity of inventory by measuring the number of times the average inventory “turns over” (is sold) during the year. Inventory turnover can be divided into 365 days to compute days in inventory, which indicates the average number of days inventory is held (see Decision Tools).
Decision Tools
Inventory turnover and days in inventory help users determine how long an item is in inventory.
High inventory turnover (low days in inventory) indicates the company has minimal funds tied up in inventory—that it has a minimal amount of inventory on hand at any one time. Although minimizing the funds tied up in inventory is efficient, too high an inventory turnover may indicate that the company is losing sales opportunities because of inventory shortages. For example, investment analysts at one time suggested that Office Depot had gone too far in reducing its inventory—they said they were seeing too many empty shelves. Thus, management should closely monitor this ratio to achieve the best balance between too much and too little inventory.
We have previously discussed the increasingly competitive environment of retailers, such as Wal-Mart and Target. Wal-Mart has implemented just-in-time inventory procedures as well as many technological innovations to improve the efficiency of its inventory management. The following data are available for Wal-Mart at January 31, 2017 (labeled 2016), and January 31, 2016 (labeled 2015).
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(in millions) 2016 2015 Ending inventory $ 43,046 $44,469 Cost of goods sold 361,256
Illustration 6.17 presents the inventory turnovers and days in inventory for Wal-Mart and Target, using data from the financial statements of those corporations for 2016 and 2015.
ILLUSTRATION 6.17 Inventory turnovers and days in inventory
Ratio
Wal-Mart
($ in millions) Target 2016 2015 2016
Inventory turnover
8.1 times
5.8 times
Days in inventory 45.1 days
62.9 days
The calculations in Illustration 6.17 show that Wal-Mart turns its inventory more frequently than Target (8.3 times for Wal-Mart versus 5.8 times for Target). Consequently, the average time an item spends on a Wal-Mart shelf is shorter (44.0 days for Wal-Mart versus 62.9 days for Target).
This analysis suggests that Wal-Mart is more efficient than Target in its inventory management. Wal-Mart's sophisticated inventory tracking and distribution system allows it to keep minimum amounts of inventory on hand, while still keeping the shelves full of what customers are looking for.
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Accounting Across the Organization Sony
Too Many TVs or Too Few?
Financial analysts closely monitor the inventory management practices of companies. 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 in the next year, as a result of its inventory build-up, days in inventory rose to 59 days. Management said that it didn't think that Sony's inventory levels were too high. However, 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? (Go to WileyPLUS for this answer and additional questions.)
Adjustments for LIFO Reserve Earlier, we noted that using LIFO rather than FIFO can result in significant differences in the results reported in the balance sheet and the income statement. With increasing prices, FIFO will result in higher income than LIFO. On the balance sheet, FIFO will result in higher reported inventory. The financial statement differences from using LIFO normally increase the longer a company uses LIFO.
Use of different inventory cost flow assumptions complicates analysts' attempts to compare companies' results. Fortunately, companies using LIFO are required to report the difference between inventory reported using LIFO and inventory using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods (see Decision Tools).
Decision Tools
Adjusting inventory from LIFO to FIFO helps users analyze the impact of LIFO on the company's reported income.
Illustration 6.18 presents an excerpt from the notes to Caterpillar's 2016 financial statements that discloses and discusses Caterpillar's LIFO reserve.
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ILLUSTRATION 6.18 Caterpillar's LIFO reserve
Caterpillar Inc.
Notes to the Financial Statements Inventories: Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method …. If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,139 million and $2,498 million higher than reported at December 31, 2016, and 2015, respectively.
Caterpillar has used LIFO for over 50 years. Thus, the cumulative difference between LIFO and FIFO reflected in the Inventory account is very large. In fact, the 2016 LIFO reserve of $2,498 million is 29% of the 2016 LIFO inventory of $8,614 million. Such a huge difference would clearly distort any comparisons you might try to make with one of Caterpillar's competitors that used FIFO.
To adjust Caterpillar's inventory balance, we add the LIFO reserve to reported inventory, as shown in Illustration 6.19. That is, if Caterpillar had used FIFO all along, its inventory would be $11,112 million, rather than $8,614 million.
ILLUSTRATION 6.19 Conversion of inventory from LIFO to FIFO
(in millions) 2016 inventory using LIFO $ 8,614 2016 LIFO reserve 2,498 2016 inventory assuming FIFO $11,112
The LIFO reserve can have a significant effect on ratios that analysts commonly use. Usi
