Module 5

Reporting and
Analyzing Operating
Assets

Inventory Issues

What is inventory?
What costs are included in inventory?
How do we separate COGS from End. Inv?

Inventory Cost Flows to

Financial Statements

Inventories

Inventory costs either are reported on the

balance sheet or they are transferred to
the income statement as an expense (cost
of goods sold) to match against sales
revenues.
The process for which costs are removed
from the balance sheet is important.

Capitalization Costs

Capitalization means that a cost is recorded

on the balance sheet and is not immediately
expensed on the income statement.
Once costs are capitalized, they remain on the
balance sheet as assets until they are used up,
at which time they are transferred from the
balance sheet to the income statement as
expense.
If costs are capitalized rather than expensed,
then assets, current income, and current equity
are all greater.

Cost of Goods Sold

When inventories are used up in

production or are sold, their cost is
transferred from the balance sheet to the
income statement as cost of goods sold
(COGS). COGS is then matched against
sales revenue to yield gross profit:
Sales revenue
- COGS
Gross profit

When Do You Transfer From

Inventory To COGS?

Every so often when you count the remaining

inventory.

Periodic
COGS = Beginning Inventory + Purchases
Ending Inventory
A Plug figure

At time of the sale

Perpetual

Effects of errors

Common source of manipulation

Often difficult for the auditor to catch
Affects two years
Example

Inventory Costing Methods

First-In. First-Out (FIFO). This method assumes

that the first units purchased are the first units
sold.
Last-In, First-Out (LIFO). The LIFO inventory
costing method assumes that the last units
purchased are the first to be sold.
Average cost. The average cost method assumes
that the units are sold without regard to the order
in which they are purchased. Instead, it computes
COGS and ending inventories as a simple
weighted average.
Specific identification. Uniquely identified items.

Inventory Costing Effects on

Cash Flows

One reason frequently cited for using LIFO is the

reduced tax liability in periods of rising prices.
The IRS requires, however, that companies using
LIFO for tax purposes also use it for financial
reporting. This is the LIFO conformity rule.
Companies using LIFO are also required to
disclose the amount at which inventories would
have been reported had it used FIFO. The
difference between these two amounts is called
the LIFO reserve.

LIFO vs FIFO

Compute gross profit, ending inventory, and

LIFO reserve for years 1 and 2
Year 1
Purchases

Sales

4@20

10

10

10

12

12

13

13

Year 2
Purchases

10

Sales

5@20

Impairment of Inventories

Companies are required to write down the carrying

amount of inventories on the balance sheet if, at the
statement date, the reported cost exceeds their market
value (determined as the current replacement cost).
This is called reporting inventories at the lower of
cost or market.

Inventory book value is written down to market value.

Inventory write-down is reflected as an expense (part

of cost of goods sold) on the income statement.

Inventory Turnover Rates for

Selected Companies

In Class Case

Joes TV