The Financial Reporting of Inventories, written by Dr. Ralph L. Benke, Jr., Ph.D., CMA, Professor Emeritus at James Madison University and Randall J. Vitray, CPA, Former Partner, PricewaterhouseCoopers LLP, 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.
The Financial Reporting of Inventories allows you to benefit from:
This Portfolio is included in the Accounting Policy & Practice Series, a comprehensive series of titles which explain, explicate, and offer commentary on a wide range of accounting and financial management topics, including revenue recognition, income taxes, leasing, business combinations, debt instruments, risk management, internal controls and more.
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
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
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
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
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
A. The Conventional and Cost Methods
B. The LIFO Retail Method
C. The Dollar-Value LIFO Retail Method
X. Changing Inventory Methods
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
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
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
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
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
2. Cost Flow Assumptions
3. Interim Period Recognition of Losses
D. Disclosure
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
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Financial Accounting Standards Board
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