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The Financial Reporting of Inventories (Portfolio 5168)

BNA Tax and Accounting Portfolio 5168-2nd, Benke and Vitray, The Financial Reporting of Inventories (Accounting Policy and Practice Series), reviews the most common methods of reporting inventories, the financial statement implications of changing inventory methods, and the rules for disclosing inventory methods and practices in financial statements.

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BNA Tax and Accounting Portfolio 5168-2nd, Benke and Vitray, The Financial Reporting of Inventories (Accounting Policy and Practice Series), reviews the most common methods of reporting inventories, the financial statement implications of changing inventory methods, and the rules for disclosing inventory methods and practices in financial statements.
The selection of an inventory method will have a significant effect on the financial reporting of a company. Because it is rarely possible for a company to accurately trace individual items purchased for inventory then sold to customers, the company must make an assumption about the flow of goods into the company. Then, when it sells the goods, it must make an assumption about the allocation of inventory costs between cost of goods sold and ending inventory. The most common cost flow assumptions are first-in, first-out (FIFO), last-in, last-out (LIFO), and average cost.
Profitability and measures of profitability will rise or fall, depending on the inventory method selected. In inflationary times, FIFO will report a lower Cost of Goods Sold than either LIFO or average cost. Similarly, in inflationary times, LIFO will report a higher Cost of Goods Sold than either FIFO or average cost, and average cost will report a Cost of Goods Sold between FIFO and LIFO. This Portfolio explains the rules and common practices used in selecting and implementing these methods.
The financial reporting of inventories is an enriching subject. On the surface, inventory accounting seems easy to understand and execute. Further understood, the financial reporting of inventories seems unnecessarily and sometimes confusingly complicated. Even further understood, the financial reporting of inventories becomes a perplexing subject with no final answer on how inventory should be accounted for, how it should be measured to determine if it is being efficiently managed (inventory turnover, etc.), or how the accounting policies and practices surrounding it should be disclosed in financial statements. This Portfolio not only explains the existing accounting rules regarding inventory but also identifies areas in which rules do not exist and industry practice is used.
This Portfolio may be cited as BNA Tax and Accounting Portfolio 5168-2nd, Benke and Vitray, The Financial Reporting of Inventories (Accounting Policy and Practice Series). Within the Accounting Portfolio Series, however, references to the Portfolios will include only the Portfolio numbers and titles.


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AUTHORS

DR. RALPH L. BENKE, JR., PH.D., CMA
Dr. Ralph L. Benke, Jr., CMA, Ph.D., Florida State University; M.B.A., University of Washington; B.S., Washington State University; Arthur Andersen/Journal of Accounting Education Professor (1988–1997); Professor Emeritus (1997–Present); Director, School of Accounting (1984–1986, 1994); Director, Center for Professional Development (1991–1993); Director, Accounting Information Systems Concentration (1988–1993).
Dr. Benke has won numerous teaching awards. His teaching experiences include the University of Idaho (1972–1974); Florida State University (1974–1977); the University of Georgia (1977–1981); and James Madison University (1982–1997). He has served as Founder and Editor of the Journal of Accounting Education (1982–1987) and as Founder and Director of the Center for Research of Accounting Education (1981–1984, 1986–1993). Dr. Benke has numerous publications and has contributed articles to numerous accounting and financial periodicals.

RANDALL J. VITRAY, CPA
Randall J. Vitray, CPA, B.A., Economics, Hanover College. With over 35 years of public accounting experience, Mr. Vitray was an Accounting Consulting Services Partner in the National Risk and Quality group of PricewaterhouseCoopers LLP. As part of the PwC National office, Mr. Vitray was responsible for developing guidance on emerging accounting issues.
Mr. Vitray has authored articles for the Journal of Accountancy and various other publications, and has testified at public hearings conducted by the FASB. Moreover, Mr. Vitray has served on working groups of the EITF on derivative transactions and leasing issues. Of note, Mr. Vitray also served as an advisor to the FASB on its special purpose entity consolidations project, which led to FIN 46. Mr. Vitray is a member of both the AICPA and the Pennsylvania Institute of CPAs.

TABLE OF CONTENTS

Detailed Analysis

I. Purpose and Scope of this Portfolio

A. Purpose

B. Scope

C. Significance of Inventory

D. Scope of Authorities

1. U.S. GAAP and SEC Authorities

a. ARB 43

b. FAS 151

c. SAB 58 and AICPA Issue Paper

2. The Role of Federal Tax Rules and Regulations

3. IFRS Authorities

II. Basic Inventory Accounting Concepts

A. Goods Included in Inventory-Items Held for Sale

B. Inventory Management

1. Inventory Control Systems: Perpetual v. Periodic

a. Perpetual Inventory Systems

b. Periodic Inventory Systems

2. Complexity in Accounting for Inventories

III. Perpetual Inventory Systems: The FIFO, LIFO, and Moving Average Methods for Recording Inventories

Introductory Material

A. The FIFO Inventory Method Under the Perpetual System

B. The LIFO Inventory Method Under the Perpetual System

C. The Moving Average Inventory Method Under the Perpetual System

D. Comparing FIFO, LIFO, and Moving Average

IV. Periodic Inventory System: The FIFO, LIFO, and Weighted Average Methods for Recording Inventories

Introductory Material

A. The LIFO Inventory Method Under the Periodic System

B. The Weighted Average Inventory Method Under the Periodic System

V. Journal Entries for Perpetual Versus Period Inventory Systems

VI. Adopting an Inventory Method

Introductory Material

A. The Choice Between FIFO and LIFO

B. The Reason for Different Inventory Methods

C. Partial or Gradual Adoption of LIFO

D. Disadvantages of LIFO

VII. Special Issues With LIFO

Introductory Material

A. The LIFO Conformity Requirement

1. Obtaining IRS Permission to Adopt LIFO

a. Supplemental and Explanatory Information

b. Certain Balance Sheet Disclosures

c. Internal Management Reports

d. Interim Financial Reports

e. Lower of LIFO Cost or Market

2. Permitted Differences Between LIFO Applications for Accounting and Tax Purposes

a. Different Tax and Accounting Years

b. Intercompany Profits

c. Other Permitted Differences

3. Obtaining IRS Permission to Terminate a LIFO Election

4. Consolidated Group Rules

B. LIFO Reserves

1. Defining LIFO Reserve

2. Calculating the LIFO Reserve

3. Calculating the Cost of Sales

C. LIFO Liquidations

1. LIFO Liquidations Defined and Illustrated

2. LIFO Liquidations in Interim Periods

D. LIFO Pools

1. Establishing LIFO Pools

a. LIFO Pools Under the Specific-Goods LIFO Method

b. LIFO Pools Under the Dollar-Value LIFO Method

c. Valid Business Reasons for Creating LIFO Pools

2. LIFO Increments

a. First Purchase Approach

b. Latest Purchase Approach

c. Average Purchase Approach

E. Interim Reporting

VIII. Dollar-Value LIFO

Introductory Material

A. The Double-Extension Method of Dollar-Value LIFO

1. In General

2. New Items

a. Reconstructed Cost Method

b. Definition of New Item

3. Cost Component Method v. Unit Cost Method

4. Substitute Base Year

5. Summary of Double-Extension Method

B. The Index Method

C. Link-Chain Method

D. The Inventory Price Index Computation (IPIC) Method

1. Double-Extension IPIC Example

2. The Link-Chain IPIC Method

IX. Retail Inventory Methods

Introductory Material

A. The Conventional and Cost Methods

B. The LIFO Retail Method

C. The Dollar-Value LIFO Retail Method

X. Changing Inventory Methods

Introductory Material

A. FAS 154, Accounting Changes and Error Corrections

1. Disclosing Nature of Change and Reason for Change

2. Cumulative, Retroactive Restatement of Inventories

B. Changes of Inventory Methods

C. An Illustration of a Change in Inventory Methods

1. The Old Income Statements

2. The New Income Statements

3. The Old and New Balance Sheets

4. The Cash Flow Statement

5. The Retained Earnings Statement

6. Fulfilling the Requirements of FAS 154

7. Journal Entry for Change From LIFO to FIFO

8. Disclosing Inventory Changes

XI. Inventories of Merchandisers

Introductory Material

A. Ownership of Goods in Transit

B. Sales With Right of Return Agreements

C. Sales With Product Financing Arrangements

D. Lower of Cost or Market

1. Defining the Lower of Cost or Market

2. Calculating Lower of Cost or Market

a. Replacement Cost

b. Net Realizable Value (Ceiling)

c. Net Realizable Value Less Normal Profit Margin (Floor)

3. Changing the Inventory Value From Cost to Market

4. LCM Rule Applied to Interim Financial Statements

5. Application of the LCM Rule to LIFO Inventories

E. Goods That Cannot Be Sold at Normal Prices

F. Goods Held on Consignment

XII. Inventories of Manufacturers

Introductory Material

A. Types of Costs in Manufacturing Inventories

1. Variable Costs

2. Fixed Costs

3. Mixed or Semi-Variable Costs

a. The Basics of Mixed or Semi-Variable Costs

b. Separating the Fixed and Variable Portions of a Mixed Cost

4. Normal Capacity

a. Abnormally High Production

b. Abnormally Low Production

B. The Flow of Manufacturing Inventories

C. Standard Costing Systems

D. Just-in-Time Inventory (JIT) Systems

E. Activity Based Costing

XIII. Practical Methods of Forecasting Inventory Levels

Introductory Material

A. The Moving Average Method of Forecasting Inventory Levels

B. Eliminating Seasonal Influences in Data

C. Regression Method

D. Making the Forecast of Inventory Levels

1. Using the LOGEST equation

2. Entering the Monthly Predictions

3. Adjusting the Annual Prediction by the Monthly Indices

4. Graphing the Monthly Prediction Against 2007 Data

5. Summary of the Result

XIV. Inventory Disclosures

A. Disclosure Requirements

1. Disclosure of Cost Flow Assumption

2. Items for Which Disclosure Is Not Necessary

3. Disclosure of LIFO Reserves

4. Disclosure of LIFO Liquidations

5. Supplemental Disclosures of Non-LIFO Methods

B. Disclosing the Efficiency of Inventory Management

1. Inventory Turnover (Activity Measure)

2. Inventory Growth Rate Compared to Sales Growth Rate

XV. IFRS Rules on Inventories

Introductory Material

A. Scope of IAS 2

1. Agricultural Activity

a. Biological Assets

b. Agricultural Produce at Point of Harvest

c. Other Agricultural Products

2. Commodities Held by Broker-Dealers

B. Measurement Requirement Under IAS 2

1. Cost of Inventories

a. Costs of Purchase

b. Conversion Costs

c. Other Costs

(1) In General

(2) Borrowing Costs

(a) Specific Borrowings

(b) General Business Borrowings

(3) Deferred Settlement Terms

2. Techniques for Measuring Costs

3. Net Realizable Value

4. Reversals of Market Write-Downs

C. Recognition of Inventory Expense

1. In General

2. Cost Flow Assumptions

3. Interim Period Recognition of Losses

D. Disclosure


WORKING PAPERS

Working Papers

TABLE OF WORKSHEETS

Worksheet 1 Glossary

Worksheet 2 Hierarchy of U.S. Generally Accepted Accounting Principles

Worksheet 3 ARB 43, Ch. 4 (Authority: AICPA)

Worksheet 4 FASB Statement No. 151 Inventory Costs: An Amendment of ARB No. 43, Chapter 4 (Authority: FASB)

Worksheet 5 AICPA Task Force on LIFO Inventory Problems, Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories

Worksheet 6 Sample Disclosures Supplemental Disclosure of Non-LIFO Results Partial LIFO Adoption

Worksheet 7 Sample Disclosures Lower of Cost or Market Method Retail Inventory Method Supplemental Disclosure of Non-LIFO Results Partial LIFO Adoption

Worksheet 8 Sample Disclosures Supplemental Disclosure of Non-LIFO Results

Worksheet 9 Sample Disclosures LIFO Liquidation Supplemental Disclosure of Non-LIFO Results Partial LIFO Adoption

Worksheet 10 Sample Disclosures Obsolete Inventory Disclosure

Worksheet 11 Descriptive and Diagnostic Statistics of Regression

Worksheet 12 Sample of 50 Foreign Registrants Filing Form 20-F Using IFRS in 2006

Worksheet 13 Inventory Effect on Reconciliation of Earnings and Shareholders' Equity for 2006

Bibliography

OFFICIAL

Statutes:

Federal Regulations:

Securities and Exchange Commission

Treasury Department:

U.S. GAAP:

Financial Accounting Standards Board

Accounting Principles Board

Accounting Research Bulletins

American Institute of Certified Public Accountants

SEC Pronouncements:

International Accounting Standards:

Internal Revenue Service Pronouncements:

Case Law:

UNOFFICIAL

SEC Filings:

Textbooks, Handbooks, and Articles:

Web Sites:

BNA Portfolios:

Miscellaneous: