Inventory Accounting
Why do firms have inventory?
Firms maintain inventory to ensure goods are available for sale to customers. Inventory management involves balancing the costs and benefits of holding inventory. Benefits include meeting customer demand, while costs involve tying up cash, storage costs, spoilage, and theft.
Key Components of Inventory Accounting
- What costs are included in each product's inventory account (managerial accounting topic)?
- Raw materials
- Labor
- Indirect costs like factory depreciation
- Cost Flow Decision: (LIFO/FIFO)
Once costs are in the inventory account (i.e. on the balance sheet), what costs are transferred to the income statement (this is a financial accounting topic)?
Let's discuss the cost flow aspects of financial accounting of inventory.
Inventory Equation (application of BASE)
BASE equation: Beginning balance + Additions (purchases) - Subtractions (COGS) = Ending balance
Assuming inventory accounts are updated at the end of each fiscal period, rather than after every sale/purchase:
\[\text{Beginning Inventory} + \text{Additions} = \text{Cost of goods sold} + \text{Ending Inventory}\]Last-In, First-Out (LIFO) vs. First-In, First-Out (FIFO)
LIFO: The cost of the last item purchased for inventory is allocated to COGS for the next item sold.
FIFO: The cost of the first item purchased for inventory is allocated to COGS for the next item sold.
LIFO: New costs hit Income Statement, Old costs hit Balance Sheet
FIFO: New costs hit Balance Sheet, Old costs hit Income Statement
Implications of LIFO and FIFO under Inflation
With inflation generally trending upwards, FIFO results in costs of older/cheaper products hitting current income as COGS, while LIFO leads to costs of newer/expensive products hitting current income as COGS. The choice between LIFO and FIFO shifts costs between the balance sheet and income statement but does not affect the total costs.
US LIFO Conformity Rule
In the US, a firm must use the same cost flow scheme for tax purposes as for accounting purposes. As LIFO often results in lower profits and taxes, many US firms choose LIFO during times of increasing prices. To change cost flow accounting methods, firms must apply to the IRS.
International Financial Reporting Standards (IFRS) vs. US GAAP
- IFRS is adopted by over 120 countries, with varying levels of implementation.
- IFRS focuses on accurate balance sheets, while GAAP emphasizes accurate income statements.
- GAAP is rules-based, while IFRS is principles-based.
- LIFO is not allowed under IFRS.
- IFRS allows upward revaluation of PPE; GAAP does not.
- Development costs can be capitalized under IFRS but are usually expensed under GAAP.
Comparing Peer Firms with Different Cost Flow Accounting
When comparing firms using LIFO and FIFO, adjustments are necessary for a fair comparison. US firms often use LIFO due to tax advantages during times of increasing prices. Financial statements can be adjusted from LIFO to FIFO but not vice versa. The general practice is to adjust all firms to FIFO.
LIFO Reserve
The LIFO Reserve is the difference between the current cost and LIFO inventory value. Inventory Turnover measures how fast a firm sells its inventory, with higher turnover indicating faster sales. Days Inventory measures the average period in days that inventory is held before being sold, with smaller values being better.
If a company were to switch from LIFO to FIFO, then the LIFO Reserve would effectively become income for the firm and would be taxed at the corporate tax rate.
The formula for LIFO Reserve is:
\( \text{LIFO Reserve} = \text{End Inventory (FIFO)} - \text{End Inventory (LIFO)} \)The basic formula for inventory accounting is:
\( \begin{aligned} \text{End Inventory} &= \text{Begin Inventory} + \text{Purchases} - \text{COGS} \\ \end{aligned} \)We can then write the equations for LIFO and FIFO accounting as:
\( \begin{aligned} \text{FIFO Inventory}_{\text{end}} &= \text{FIFO Inventory}_{\text{begin}} + \text{Additions} - \text{COGS}_{FIFO} \\ \text{LIFO Inventory}_{\text{end}} &= \text{LIFO Inventory}_{\text{begin}} + \text{Additions} - \text{COGS}_{LIFO} \\ \end{aligned} \)From there we can see that if we subtracted the ending LIFO from the ending FIFO we would have:
\( \text{LIFO Reserve}_{\text{end}} = (\text{FIFO Inventory}_{\text{begin}} - \text{LIFO Inventory}_{\text{begin}}) + \text{COGS}_{LIFO} - \text{COGS}_{FIFO} \\ \)Rearranging and recognizing that:
\((\text{FIFO Inventory}_{\text{begin}} - \text{LIFO Inventory}_{\text{begin}}) = \text{LIFO Reserve}_{\text{begin}}\)Then we have:
\( \text{LIFO Reserve}_{\text{end}} - \text{LIFO Reserve}_{begin} = \text{COGS}_{LIFO} - \text{COGS}_{FIFO} \\ \)And recognizing that:
\(\text{LIFO Reserve}_{\text{end}} - \text{LIFO Reserve}_{begin} = \Delta\text{LIFO Reserve} \)We then have:
\( \begin{cases} \boldsymbol\Delta\textbf{LIFO Reserve} = \textbf{COGS}_{LIFO} - \textbf{COGS}_{FIFO} \\ \textbf{COGS}_{FIFO} = \textbf{COGS}_{LIFO} - \boldsymbol\Delta\textbf{LIFO Reserve} \\ \textbf{FIFO Inventory} = \textbf{LIFO Inventory} + \textbf{LIFO Reserve} \end{cases} \)LIFO Reserve and Inventory Turnover
Inventory Turnover measures how fast a firm is able to sell its inventory. Higher turnover indicates the a faster sale of inventory.
\( \text{Inventory Turnover} = \frac{\text{COGS}}{\text{Average Inventory}} \)
Days Inventory measures the average period in days that inventory is held before it is sold. Smaller is better.
\( \text{Days Inventory} = \frac{365}{\text{Inventory Turnover}} \)
Impact of LIFO and FIFO on Inventory Turnover and Days Inventory
Under LIFO, COGS are generally higher due to inflation, leading to higher inventory turnover. In contrast, under FIFO, it appears that inventory is turned over more slowly. This difference can be substantial, so it is important to make appropriate adjustments when comparing companies using different cost flow accounting methods. The LIFO Reserve is usually found in the supplemental balance sheet notes of the firms financial statements.
Adjusting LIFO to FIFO
To adjust the cost of goods sold (COGS) from the Last-In, First-Out (LIFO) method to the First-In, First-Out (FIFO) method, you need to consider the LIFO reserve, which is the difference in inventory value under the LIFO and FIFO methods. The LIFO reserve allows you to make the necessary adjustments and compare the financial performance of companies using different inventory accounting methods.
Given the percentage of COGS that are LIFO, the percentage of COGS that are FIFO, the LIFO reserve, and \(COGS_{LIFO}\), follow these steps to adjust LIFO to FIFO.
1) Determine the LIFO reserve adjustment for the period by calculating the change in LIFO reserve:
\[ \text{Change in LIFO Reserve} = \text{LIFO Reserve}_{\text{end}} - \text{LIFO Reserve}_{\text{begin}} \]2) Adjust \(COGS_{LIFO}\) to \(COGS_{FIFO}\) by subtracting the change in LIFO reserve:
\[ \text{COGS}_{\text{FIFO}} = \text{COGS}_{\text{LIFO}} - \Delta\text{LIFO Reserve} \]Conclusion
We have explored essential aspects of financial accounting, focusing on inventory. By understanding these concepts, businesses and investors can make informed decisions based on a company's financial health.
First, we examined the reasons why inventory exists and how it plays a crucial role in the operations of a business. We reviewed flow of costs, discussing the Last-In, First-Out (LIFO) and First-In, First-Out (FIFO) methods of inventory accounting. These methods impact the financial statement analysis and are important to understand for decision-making purposes.