Afs Slides - Lifo or Fifo

Analysis of Inventories
Shoaib A. Qureshi | NUST Business School | Analysis of Inventories

The complication - FIFO, LIFO, and average cost.
Equation: Beg Inv + P COGS = End Inv
Why LIFO accounting produces a better measure
of COGS
Why FIFO accounting produces a better measure
of inventory value
compute ending inventory balances and cost of goods sold using the LIFO,
FIFO, and average cost methods to account for product inventory
2
Inventory
Accounting
US GAAP requires inventory valuation on
the basis of lower of cost or market (LCM).
If replacement cost is rising, the gains in
the value of inventory are ignored, and the
inventory is valued at cost.
Losses in the value of inventory due to
obsolescence, deterioration, etc., are
recognized, and inventory is written down
to its new market value.
Remember, LCM is applied regardless of
the inventory costing method used.
3
Inventory
Accounting
US GAAP
Cost
Cost represents reasonable and
necessary costs to get the asset in place
and ready to use.
Merchandise Inventories include costs
of purchasing, transportation, receiving,
inspecting, etc.
Manufactured Inventories include costs
of direct materials, direct labor, and
manufacturing overhead (i.e., all other
indirect costs).
4
Inventory
Accounting
Equation
EI = BI + P COGS
P = EI BI + COGS
COGS = P + BI EI
COGS + EI = BI + P
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Three methods of inventory accounting are:
1. First In, First Out (FIFO):
The cost of inventory first acquired (beginning inventory and early purchases) is
assigned to the cost of goods sold for the period.
The cost of the most recent purchases is assigned to ending inventory.
2. Last In, First Out (LIFO):
The cost of inventory most recently purchased is assigned to the cost of goods sold
for the period.
The costs of beginning inventory and earlier purchases go to ending inventory.
Note that in the United States, companies using LIFO for tax purposes must also
use LIFO in their financial statements.
3. Average cost:
Under the average cost (weighted average) method, cost per unit is calculated by
dividing cost of goods available by total units available.
This average cost is used to determine both cost of goods sold and ending
inventory.
6
Method Assumption
CGS consists
of
Ending
Inventory
consists of
FIFO
(GAAP & IFRS)
The items first
purchased are
the first to be sold
first purchased
most recent
purchases
LIFO
(GAAP Only)
The items last
purchased are
the first to be sold
last purchased
earliest
purchases
Weighted Average
Cost
(GAAP & IFRS)
Items sold are a
mix of
purchases
average cost of
all
items
average cost of
all
items
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Rising
Prices
Lower so Higher NI Higher
Higher so Lower NI Lower
explain the relationship among and the usefulness of inventory and cost of goods sold
data provided by the LIFO, FIFO, and average cost methods when prices are
(1) stable or (2) changing.
12
BI + P = COGS + EI
Prior to the preparation of financial statements, what
you already have (facts) is the Beginning Inventory &
Purchases costs (BI + P)
In preparing financial statements all you have to do is
to allocate the cost of BI + P to COGS & Ending
Inventory.
This allocation will deal with how much taxes are paid
and what are the resultant cash flows to the firm.
13
BI = 200 units @ 10 / unit
Scenario 1 Stable Prices Scenario 2 Rising Prices
Quarter Purchases
(Units)
Unit Cost
(PKR)
Purchases
(PKR)
Unit Cost
(PKR)
Purchases
(PKR)
1 100 10 1,000 11 1,100
2 150 10 1,500 12 1,800
3 150 10 1,500 13 1,950
4 100 10 1,000 14 1,400
TOT 500 5,000 6,250
Sales = 400 units BI + P = 7,000 BI + P = 8,250
Stable Prices
BI + P = COGS + EI
(200 x 10) + 5,000 = (400 x 10) + (300 x 10)
Result: In Stable Prices, all cost flow methods will yield the same result.
Stable Prices are Pretty Exceptional !
BI + P COGS = EI
200 + 500 400 = 300
14
Quarter Purchases
(Units)
Unit Cost
(PKR)
Purchases
(PKR)
Unit Cost
(PKR)
Purchases
(PKR)
1 100 10 1,000 11 1,100
2 150 10 1,500 12 1,800
3 150 10 1,500 13 1,950
4 100 10 1,000 14 1,400
TOT 500 5,000 6,250
Method BI + P = COGS + EI
FIFO 2,000 + 6,250 = 4,300 + 3,950
Weighted Average 2,000 + 6,250 = 4,714 + 3,536
LIFO 2,000 + 6,250 = 5,150 + 3,100
COGS = (2,000 = 200 x 10) + (1,100 = 100 x 11) + (1,200 = 100 x 12) = 4,300
EI = (600 = 50 x 12) + 1,950 + 1,400 = 3,950
15
Quarter Purchases
(Units)
Unit Cost
(PKR)
Purchases
(PKR)
Unit Cost
(PKR)
Purchases
(PKR)
1 100 10 1,000 11 1,100
2 150 10 1,500 12 1,800
3 150 10 1,500 13 1,950
4 100 10 1,000 14 1,400
TOT 500 5,000 6,250
Method BI + P = COGS + EI
FIFO 2,000 + 6,250 = 4,300 + 3,950
Weighted Average 2,000 + 6,250 = 4,714 + 3,536
LIFO 2,000 + 6,250 = 5,150 + 3,100
COGS = (1,400 = 100 x 14) + (1,950 = 150 x 13) + (1,800 = 150 x 12) = 5,150
EI = (1,100 = 100 x 11) + (2,000 = 200 x 10) = 3,100
16
17
LIFO
Liquidation
Selling
more than
purchases
By decreasing inventory to levels below
normal levels, thus dipping into the old
cheap inventory, a firms management
can increase profits for the period under
LIFO.
When this strategy is employed, COGS
under LIFO will be lower and profits will
be higher than if more inventory were
purchased and inventory levels not
drawn down.
This is called a LIFO liquidation.
Compare and contrast the effect of the different methods on cost of goods sold and
inventory balances and discuss how a company's choice of inventory accounting
method affects other financial items such as income, cash flow, and working capital.
18
LIFO and FIFO Comparison - Rising Prices and Stable or Increasing Inventories
LIFO results in FIFO results in
higher COGS lower COGS
lower taxes higher taxes
lower net income (EBT and EAT) higher net income (EBT and EAT)
lower inventory balances higher inventory balances
lower working capital (CA CL) higher working capital (CA CL)
higher cash flows (less taxes paid out) lower cash flows (more taxes paid out)
LIFO & FIFO Comparison
19
Example
Calculate COGS & Inventory Level at FIFO & LIFO
20
Example
Calculate Net Income under FIFO & LIFO
21
Example

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Analysis of Inventories

Shoaib A. Qureshi | NUST Business School | Analysis of Inventories

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