14521044 inventory-valuation-methods


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14521044 inventory-valuation-methods

  1. 1. INVENTORY VALUATION METHODSQ: Discuss the types of inventory valuation methods – First-in-First-out (FIFO), Last-in-First-out(LIFO), and Average Cost Method (AVCO), analyze them and explain their impact on the recordsof the financial statements?INTRODUCTION: By definition, inventory is the term used to describe the assets of a company that areintended for sale in the ordinary course of business, are in the process of being produced forsale, or are to be used currently in producing goods to be sold. (Chasteen, Flaherty, & OConnor,1989) Inventory in a business is a list of goods or products that is held in stock. It takes a lot oftime to keep inventory, but failure to do so could result in major financial disasters. Dependingon the size of your business, there are people whose sole job is to keep track of inventory. In asmall business, this would not have to be their only task. Treatment in Financial Statement: Inventory is converted into cash within the company’s operating cycle and, therefore, isregarded as a current asset. In the balance sheet, inventory is listed immediately after AccountsReceivable, because it is just one step farther removed from conversion into cash thancustomer receivables. Being an asset, it is shown in the balance sheet at its cost. As items aresold from this inventory, their costs are transferred into cost of goods sold, which is offsetagainst sales revenue in the income statement. (Meigs, Williams, Haka, & Bettner, 1999) Having no inventory or having wrong inventory can lead to many problems. Becauseinventory is reflected in the company’s books, a business owner may make decisions based onthe inventory numbers he sees in the books. If the number is wrong, he just made a wrongdecision that could be costly. In order to prevent this from happening in your business, there
  2. 2. are ways to keep proper inventory that any sized business can use. (Inventory and itsImportance, 2009) Classifying Inventories:Inventories can be classified according to type of business: 1. Merchandise Inventory: merchandise available of hand and available for sale to customers. For e.g.: canned foods, meats, dairy products etc. Items in the merchandise inventory have two common characteristics: a: they are owned by the company b: they are in the form ready for sale to customers in the ordinary course of business.Inventory sold becomes the cost of merchandise sold. It is the ready-to-sell inventory ofmerchandising firms. 2. Manufacturing Inventory: merchandise that needs to be produced in order to sell is called manufacturing inventory. Although products may differ, manufacturers normally have three inventory accounts, each of which is associated with a stage of the production process: raw materials inventory, work-in-process inventory, finished goods inventory. a. Raw Materials Inventory: It consists of goods and materials that ultimately will become part of the manufactured product but have not yet entered the production process. For example, the raw materials of an automobile manufacturer generally include sheet metal, nuts, bolts, and paint. b. Work-In- Process Inventory: It consists of units in the production process that require additional work or processing before becoming finished goods. c. Finished Goods Inventory: It consists of units that have been completed and are available for sale at the end of the accounting period. (Chasteen, Flaherty, & OConnor, 1989)
  3. 3. INVENTORY VALUATION: Goods sold (or used) during ac accounting period seldom correspond exactly to the goodsbought (or produced) during that period. As a result, inventories either increase or decreaseduring the period. Companies must then allocate the cost of all the goods available for sale (orused) between the goods that were sold or used and those that are still on hand. The cost ofgoods available for sale or use is a sum of 1. The cost of goods on hand at the beginning of the period. 2. The cost of goods acquired of produced during the period. The cost of goods sold is the difference between the cost of goods available for sale duringthe period and the cost of goods on hand at the end of the period. Valuing inventories can be complex. It requires determining the following: 1. The physical goods to include in inventory (who owns the goods – goods in the transit, consign goods, special sales agreements). 2. The cost to include in inventory (product vs. period cost) 3. The cost flow assumptions to adopt (specific identification, average cost, FIFO, LIFO, retail, etc.). (Kieso, Weygandt, & Warfield, 2004)INVERTORY VALUATION METHODS:There are three methods of valuation of inventories under the accounting systems based on thetype and nature of products. 1. First-In-First Out (FIFO) 2. Last-In-First Out (LIFO) 3. Average Cost Method (AVCO)
  4. 4. a. FIRST-IN-FIRST OUT METHOD (FIFO): The FIFO method assumes that a company uses the goods in the order in which it purchases them. In other words, the FIFO method assumes that the first goods purchased are the first used (manufacturing concern), or the first sold (in a merchandising concern). The inventory remaining must therefore represent the most recent purchases. (Kieso, Weygandt, & Warfield, 2004) FIFO often parallels the actual physical flow of merchandise because it generally is good business practice to sell the oldest units first. That is, under FIFO, companies obtain the cost of ending inventory by taking the unit cost of the most recent purchase and working backwards until all units of inventory have been costed. (Kimmel, Weygandt, & Kieso, 2007) This is true whether a company computes cost of goods sold as it sells goods throughout the accounting period (perpetual system) or as a residual at the end of the accounting period (periodic system). The example below illustrates this approach. Receipts Issues Balance Date Quantity Unit Cost Amount Quantity Unit Cost Amount Quantity Unit Cost AmountJan-09 40 $3 $120 - - - 40 $3 $120 40 @ $3Mar-12 50 $5 $250 - - - 90 $370 50 @ $5 40 @ $5Mar-15 - - - 80 $320 10 $5 $50 40 @ $3 10 @ $5Jun-07 100 $7 $700 - - - 110 $750 100 @ $7 10 @ $5Aug-05 - - - 105 $715 5 $7 $35 95 @ $7 5 @ $7Oct-02 140 $9 $1260 - - - 145 $1295 140 @ $9 5 @ $7Nov-03 200 $12 $2400 - - - 345 140 @ $9 $3695 200 @ $12 5 @ $7 - - - 320 140 @ $9 $3395 25 $12 $300Dec-30 175 @ $12TOTAL - - - - - $4430 - - $300 Cost of Good Sold Balance Sheet as an (ending) inventory
  5. 5. b. LAST-IN-FIRST OUT METHOD (LIFO): The LIFO method assumes the cost of the total quantity sold or issued during the monthcomes from the most recent purchases. That is, the latest goods purchased are the first to besold. LIFO coincides with the actual physical flow of inventory. The method matches the cost ofthe last goods purchased against revenue. Under the LIFO method, the costs of the latestgoods purchased are the first to be recognized in determining the cost of goods sold. Theending inventory is based on the prices of the oldest units purchased. Companies obtain the cost of the ending inventory by taking the unit cost of the earliestgoods available for sale and working forward until all units of inventory have been costed.(Kimmel, Weygandt, & Kieso, 2007)The example given above, when solved using LIFO will give a different result. Receipts Issues Balance Unit Unit Date Quantity Amount Quantity Amount Quantity Unit Cost Amount Cost Cost Jan-09 40 $3 $120 - - - 40 $3 $120 Mar- 40 @ $3 50 $5 $250 - - - 90 $370 12 50 @ $5 Mar- 50 @ $5 - - - 80 $340 10 $3 $30 15 30 @ $3 10 @ $3 Jun- 100 $7 $700 - - - 110 100 @ $730 07 $7 100 @ Aug- - - - 105 $7 $715 5 $3 $15 05 5 @ $3 5@3 Oct- 140 $9 $1260 - - - 145 140 @ $1275 02 $9 5 @ $3 140 @ Nov- 200 $12 $2400 - - - 345 $9 $3675 03 200 @ $12 200 @ Dec- 12 5@3 - - - 320 $3480 25 30 120 @ 20 @ 9 $195 $9 TOTAL - - - - - $4535 - - $ 195 Cost of Good Sold Balance Sheet as an (ending) inventory
  6. 6. c. AVERAGE COST METHOD (AVCO) Under the average cost method, the costs of goods are equally divided, or averaged, among the units of inventory. It is also called the weighted average method. When this method is used, costs are matched against revenue according to an average of the unit of cost of goods sold. The same weighted average unit costs are used in determining the cost of the merchandise inventory at the end of the period. For businesses in which merchandise sales may be made up of various purchases of identical units, the average method approximates the physical flow of goods. This method is determined by dividing the total cost of the units of each item available for sale during the period by the related number of units of that item. (Warren & Reeve, 2004) Receipts Issues Balance Date Quantity Unit Cost Amount Quantity Unit Cost Amount Quantity Unit Cost AmountJan-09 40 $3 $120 - - - 40 $3 $120Mar-12 50 $5 $250 - - - 90 $4.1 $369Mar-15 - - - 80 $4.1 $328 10 $4.1 $41Jun-07 100 $7 $700 - - - 110 $6.73 $740Aug-05 - - - 105 $6.73 $707 5 $6.73 $34Oct-02 140 $9 $1260 - - - 145 $8.92 $1293Nov-03 200 $12 $2400 - - - 345 $10.7 $3692Dec-30 - - - 320 $10.7 $3424 25 $10.7 $268TOTAL - - - - - $4459 - - $ 268It is also refer as weighted average cost. Cost of Good Sold Balance Sheet asAverage Unit Cost = Total amount (ending) inventory Total quantityTherefore: 40 @ $3 = $120 50 @ $5 = $250 90 $370 = $4.1 (taking values as on January 9th)Average Unit Cost = 41 + 700 = $6.73 110Average Unit Cost = 34 + 1260 = $8.92 145Average Unit Cost = 1293.4 + 2400 = $10.7 345
  7. 7. COMPARISON BETWEEN THE METHODS OF INVENTORY VALUATION a. FIFO – Advantages and Disadvantages ADVANTAGES DISADVANTAGEConfirms to the actual flow of inventory items Fails to match current costs against current revenues on income statementSimple assumption for valuation of inventory Company charges the oldest costs against the more current revenue, distorting gross profit and net incomeComparatively inexpensive to use Higher revenues leads to higher tax paymentsLess subject to management manipulation The matching of old, comparatively low acquisition costs against higher sales revenue can give an inflated net incomeReports somewhat higher profits by assigning It ignores the cost of replacing inventory at higherlower (older) costs to cost of goods sold in case of prices (during rising prices),rising pricesAssets in balance sheet closely approximate its it leads to misleading figures probably forcurrent replacement costs investors, giving figures of inventory the company doesn’t haveA company cannot pick a certain cost item tocharge to expenseEnding inventory is close to current costsInventory consistent with most recent purchases.(Kieso, Weygandt, & Warfield, 2004); b. LIFO – Advantages and Disadvantages ADVANTAGE DISADVANTAGEMatches most recent inventory costs against sales Lower profits reported during inflationary timesrevenue serve for managers as a distinct disadvantageReported income is more likely to approximate the May have a distorting affect of company’s balanceamount that really is available for distributors or sheet, which is usually outdated because oldestowners costs remain in inventory, making working capital position of the company appear worse than realityBy giving low net income during rising prices, it Does not approximate the physical flow of theactually defers income taxes items except in specific situationsCost flow often approximates the physical flow of It may match old, irrelevant costs against currentthe goods in and out of inventory revenues, distorting net incomeMatches current revenues to better measure of May cause poor buying habits – purchase morecurrent earnings goods against revenue to avoid charging the old cost to expenseFuture price declines do not affect company’s Net income can be altered by simply altering its
  8. 8. future report earnings pattern of purchases(Chasteen, Flaherty, & OConnor, 1989) c. Average Cost – Advantages and Disadvantages ADVANTAGE DISADVANTAGEIts very practical – easy to apply changes in current replacement costs are concealed because these costs are averaged with older costsDoes not lend itself to manipulation neither the valuation of ending inventory nor the cost of goods sold will quickly reflect changes in the current replacement costs of merchandiseidentical items have the same accounting valuesnot necessary to keep track of inventory(Chasteen, Flaherty, & OConnor, 1989)EFFECT OF THE VALUATION METHODS ON FINANCIAL STATEMENTSince prices keep on changing, the three methods yield different amounts for (1) the cost ofmerchandise sold for the period (2) the gross profit (net income) for the period (3) the endinginventory. There is also a tax effect that varies with changes in net income among differentvaluation methods. (Warren & Reeve, 2004) a. Income Statement:FIFO: FIFO gives the highest amount of gross profit (hence, net income) because the lower unitcosts of the first units purchased are matched against revenues, especially in times of inflation.However in times of falling prices, FIFO will report lowest inventory. It also yields the highestamount of ending inventory and the lowest cost of goods sold. This will give a false impressionof paper profit.LIFO: LIFO gives the lowest amount of net income during inflationary times and the highest netincome during price declines. It gives the lowest amount of ending inventory and the highestcost of goods sold. (Kimmel, Weygandt, & Kieso, 2007)AVCO: Average Costs approach tends to produce cost of goods sold and ending inventoryresults between the results by LIFO and FIFO. (Chasteen, Flaherty, & OConnor, 1989)
  9. 9. To the management, higher net income is an advantage: it causes external users to viewthe company more favorably. In addition, management bonuses, if based on net income, will behigher. Hence during inflationary times, companies prefer using FIFO. (Warren & Reeve, 2004) Methods Cost of Goods Sold Ending Inventory Net Income FIFO Understated Overstated Overstated LIFO Overstated Understated Understated AVCO In between FIFO & LIFO In between FIFO & LIFO In between FIFO & LIFO b. Balance Sheet:FIFO: During periods of inflation, the costs allocated to ending inventory will approximate theircurrent cost. In fact, the balance sheet will report the ending merchandise inventory at anamount that is about the same as its current replacement costs. As inventories are overstatedin FIFO, this will affect the total assets and hence the stockholder’s equity, overstating it.LIFO: In a period of inflation, the costs allocated to ending inventory may be significantlyunderstated in terms of current costs. This is because more recent costs are higher thanthe earlier unit costs. Thus it matches current costs nearly with current revenues. (Warren &Reeve, 2004)In LIFO, inventories are understated. This, in turn, affects the stockholder’s equityby understating the actual figures.AVCO: Average cost approach for series of purchases will be same, regardless of direction ofprice trends. In its effect on the balance sheet, however, it is more like FIFO than LIFO.(Chasteen, Flaherty, & OConnor, 1989) Methods Inventory Current Assets Stockholder’s Equity FIFO Overstated Overstated Overstated LIFO Understated Understated Understated AVCO In between FIFO & LIFO In between FIFO & LIFO In between FIFO & LIFO
  10. 10. References(1989). Inventory Valuation: determing costs and using cost flow assumtions. In L. G. Chasteen, R. E. Flaherty, & M.C. OConnor, Intermediate Accounting (pp. 398 - 423). Mc-GRAW-HILL Publishers.Inventory and its Importance. (2009, March 7). Retrieved March 19, 2008, from Contractor Blog:http://www.contractorblabblog.com/2009/03/inventory-and-its-importance/(2004). Valuation of Inventories - A cost-Basis Approach. In D. E. Kieso, J. J. Weygandt, & T. D. Warfield,Intermediate Accounting (pp. 383 - 410). John Wiley and Sons.(2007). Reporting and Analyzing Inventory. In P. D. Kimmel, J. J. Weygandt, & D. E. Kieso, Financial Accounting (pp.273 - 290). John Wiley and Sons.(1999). Inventories and the Cost of Goods Sold. In R. F. Meigs, J. R. Williams, S. F. Haka, & M. S. Bettner, Accounting(pp. 330 - 339). Mc-GRAW-HILL Publishers.(2004). Inventories. In C. S. Warren, & J. M. Reeve, Finanical Accounting (pp. 372 - 390). Thomsom.