Inventory Valuation Methods

INVENTORY VALUATION METHODS Q: 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 records of the financial statements?

INTRODUCTION: By definition, inventory is the term used to describe the assets of a company that are intended for sale in the ordinary course of business, are in the process of being produced for sale, or are to be used currently in producing goods to be sold. () Inventory in a business is a list of goods or products that is held in stock. It takes a lot of time to keep inventory, but failure to do so could result in major financial disasters. Depending on the size of your business, there are people whose sole job is to keep track of inventory. In a small 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, is regarded as a current asset. In the balance sheet, inventory is listed immediately after Accounts Receivable,because it is just one step farther removed from conversion into cash than customer receivables. Being an asset, it is shown in the balance sheet at its cost. As items are sold from this inventory, their costs are transferred into cost of goods sold, which is offset against sales revenue in the income statement. () Having no inventory or having wrong inventory can lead to many problems. Because inventory is reflected in the company’s books, a business owner may make decisions based on the inventory numbers he sees in the books. If the number is wrong, he just made a wrong decision that could be costly. In order to prevent this from happening in your business, there are ways to keep proper inventory that any sized business can use. () •

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 of merchandising 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. ()

INVENTORY VALUATION: Goods sold (or used) during ac accounting period seldom correspond exactly to the goods bought (or produced) during that period. As a result,

inventories either increase or decrease during the period. Companies must then allocate the cost of all the goods available for sale (or used) between the goods that were sold or used and those that are still on hand. The cost of goods 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 during the 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.). ()

INVERTORY VALUATION METHODS: There are three methods of valuation of inventories under the accounting systems based on the type and nature of products. 1. First-In-First Out (FIFO) 2. Last-In-First Out (LIFO) 3. Average Cost Method (AVCO)

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. () 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. () 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. Date

Quanti ty

Receipts Unit Cost

Amoun t

Quanti ty

Issues Unit Cost

Amoun t

Quantit y

Balance Unit Cost

Amount

Jan-09

40

$3

$120

-

-

-

40

$3

$120

50

$5

$250

-

-

-

90

40 @ $3 50 @ $5

$370

-

-

-

80

40 @ $5 40 @ $3

$320

10

$5

$50

Jun-07

100

$7

$700

-

-

-

110

10 @ $5 100 @ $7

$750

Aug05

-

-

-

105

10 @ $5 95 @ $7

$715

5

$7

$35

Oct02

140

$9

$1260

-

-

-

145

Nov03

200

$12

$2400

-

-

-

345

$3395

25

$12

$300

$4430

-

-

$300

Mar12 Mar15

Dec30 TOTAL

-

-

-

320

-

-

-

-

5 @ $7 140 @ $9 175 @ $12 -

Cost of Good Sold

b. LAST-IN-FIRST OUT METHOD (LIFO):

5 @ $7 140 @ $9 5 @ $7 140 @ $9 200 @ $12

$1295

$3695

Balance Sheet as an (ending) inventory

The LIFO method assumes the cost of the total quantity sold or issued during the month comes from the most recent purchases. That is, the latest goods purchased are the first to be sold. LIFO coincides with the actual physical flow of inventory. The method matches the cost of the last goods purchased against revenue. Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining the cost of goods sold. The ending 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 earliest goods available for sale and working forward until all units of inventory have been costed. () The example given above, when solved using LIFO will give a different result. Date

Quanti ty

Jan09

40

Mar12 Mar15 Jun07

50

-

100

Receipts Unit Amou Cost nt $3 $5

-

$7

$120 $250

-

$700

Quant ity

Issues Unit Cost

Amou nt

Quant ity

Balance Unit Cost

Amou nt

-

-

-

40

$3

$120 $370

-

-

-

90

40 @ $3 50 @ $5

80

50 @ $5 30 @ $3

$340

10

$3

$30

$730

$15

-

-

-

110

10 @ $3 100 @ $7

$715

5

$3

Aug05

-

-

-

105

100 @ $7 5@ $3

Oct02

140

$9

$1260

-

-

-

145

Nov03

200

$12

$2400

-

-

-

345

$3480

25

5@3 20 @ 9

$195

$453 5

-

-

$ 195

Dec30

-

-

-

320

200 @ 12 120 @ $9

T OTA L

-

-

-

-

-

5@3 140 @ $9 5 @ $3 140 @ $9 200 @ $12

$1275

$3675

Cost of Good Sold

Balance Sheet as an (ending) inventory

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. () Date Jan-09 Mar12 Mar15 Jun-07 Aug05 Oct-02 Nov03 Dec30 TOTAL

Quantit y 40

Receipts Unit Cost $3

Issues Unit Cost -

Amount

$120

Quantit y -

-

Quantit y 40

Balance Unit Cost $3

Amount

Amoun t $120

50

$5

$250

-

-

-

90

$4.1

$369

-

-

-

80

$4.1

$328

10

$4.1

$41

100

$7

$700

-

-

-

110

$6.73

$740

-

-

-

105

$6.73

$707

5

$6.73

$34

140

$9

$1260

-

-

-

145

$8.92

$1293

200

$12

$2400

-

-

-

345

$10.7

$3692

-

-

-

320

$10.7

$3424

25

$10.7

$268

-

-

-

-

-

$4459

-

-

$ 268

Cost of Good Sold

Balance Sheet as (ending) inventory

COMPARISON BETWEEN THE METHODS OF INVENTORY VALUATION a. FIFO – Advantages and Disadvantages ADVANTAGES Confirms to the actual flow of inventory items Simple assumption for valuation of inventory

DISADVANTAGE Fails to match current costs against current revenues on income statement Company charges the oldest costs against the more current revenue, distorting gross profit and net income Comparatively inexpensive to use Higher revenues leads to higher tax payments Less subject to management The matching of old, comparatively low manipulation acquisition costs against higher sales revenue can give an inflated net income Reports somewhat higher profits by It ignores the cost of replacing inventory assigning lower (older) costs to cost of at higher prices (during rising prices), goods sold in case of rising prices Assets in balance sheet closely it leads to misleading figures probably approximate its current replacement for investors, giving figures of inventory costs the company doesn’t have A company cannot pick a certain cost item to charge to expense Ending inventory is close to current costs Inventory consistent with most recent purchases. (Kieso, Weygandt, & Warfield, 2004); b. LIFO – Advantages and Disadvantages ADVANTAGE DISADVANTAGE Matches most recent inventory costs Lower profits reported during inflationary against sales revenue times serve for managers as a distinct disadvantage Reported income is more likely to May have a distorting affect of approximate the amount that really is company’s balance sheet, which is available for distributors or owners usually outdated because oldest costs remain in inventory, making working capital position of the company appear worse than reality

By giving low net income during rising prices, it actually defers income taxes Cost flow often approximates the physical flow of the goods in and out of inventory Matches current revenues to better measure of current earnings Future price declines do not company’s future report earnings

Does not approximate the physical flow of the items except in specific situations It may match old, irrelevant costs against current revenues, distorting net income May cause poor buying habits – purchase more goods against revenue to avoid charging the old cost to expense affect Net income can be altered by simply altering its pattern of purchases

(Chasteen, Flaherty, & O'Connor, 1989) c. Average Cost – Advantages and Disadvantages ADVANTAGE Its very practical – easy to apply

Does not lend itself to manipulation

DISADVANTAGE changes in current replacement costs are concealed because these costs are averaged with older costs neither the valuation of ending inventory nor the cost of goods sold will quickly reflect changes in the current replacement costs of merchandise

identical items have the same accounting values not necessary to keep track of inventory ()

EFFECT OF THE VALUATION METHODS ON FINANCIAL STATEMENT Since prices keep on changing, the three methods yield different amounts for (1) the cost of merchandise sold for the period (2) the gross profit (net income) for the period (3) the ending inventory. There is also a tax effect that varies with changes in net income among different valuation methods. ()

a. Income Statement: FIFO: FIFO gives the highest amount of gross profit (hence, net income) because the lower unit costs 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 highest amount of ending

inventory and the lowest cost of goods sold. This will give a false impression of paper profit. LIFO: LIFO gives the lowest amount of net income during inflationary times and the highest net income during price declines. It gives the lowest amount of ending inventory and the highest cost of goods sold. () AVCO: Average Costs approach tends to produce cost of goods sold and ending inventory results between the results by LIFO and FIFO. () To the 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. Hence during inflationary times, companies prefer using FIFO. () Methods FIFO LIFO AVCO

Cost of Goods Sold Understated Overstated In between FIFO &

Ending Inventory Overstated Understated In between FIFO &

Net Income Overstated Understated In between FIFO &

LIFO

LIFO

LIFO

b. Balance Sheet: FIFO: During periods of inflation, the costs allocated to ending inventory will approximate their current cost. In fact, the balance sheet will report the ending merchandise inventory at an amount that is about the same as its current replacement costs. As inventories are overstated in 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 significantly understated in terms of current costs.

This is because more

recent costs are higher than the earlier unit costs. Thus it matches current costs nearly with current revenues. ()In LIFO, inventories are understated. This, in turn, affects the stockholder’s equity by understating the actual figures.

AVCO: Average cost approach for series of purchases will be same, regardless of direction of price trends. In its effect on the balance sheet, however, it is more like FIFO than LIFO. () Methods

Inventory

Current Assets

Stockholder’s

FIFO LIFO AVCO

Overstated Understated In between FIFO &

Overstated Understated In between FIFO &

Equity Overstated Understated In between FIFO &

LIFO

LIFO

LIFO

References (1989). Inventory Valuation: determing costs and using cost flow assumtions. In L. G. Chasteen, R. E. Flaherty, & M. C. O'Connor, Intermediate Accounting (pp. 398 - 423). McGRAW-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.