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| Cost Method for Inventory |
To evaluate the reasonableness of a company’s stated cost, the appraiser must understand the method of costing being used, which is typically one of the following:
1. In the Standard Cost method, a company sets the standard cost for each stock-keeping-unit either annually or at some assigned interval by measuring cost variations at the period’s end. This can cause the previous established standard costs to go up or down. There could be substantial changes in factors such as company rates and material costs since the last cost update. Therefore, understanding how and when a standard cost adjustment was recorded is important for the appraiser. Standard cost is one of the most common methods used in perpetual inventory reporting.
2. The Average Cost method is similar to the standard cost method. However, with this method, cost is weighted and calculated on quantity purchases, which are typically updated each time a new lot is purchased. This is done to maintain a current average cost of each item. This method allows a company to measure performance, cost, and profit on an average basis. By doing so, the effects of short-term price fluctuations can be uniformly distributed.
3. The Replacement Cost method is similar to the standard cost method but is most often used by inventory distributors. Though it is a single one-time adjustment, it may occur several times a year, or very infrequently.
4. The Lower-of-Cost-or-Market method is important to understand, as inventory is typically valued at cost; however, cost is not necessarily the market. This is because the market reflects all forms of depreciation, which cost does not. For the market price to be determined, the appraiser must look at the unique characteristics of each inventory.
For example, physical deterioration would be considered regarding factors such as limited-shelf-life inherent in perishable food items, raw chemicals, or items with a chemical makeup such as film or thermal paper. Then, the appraiser must look at functional obsolescence, which could involve factors such as new and improved technology. This could be found in most types of electronic equipment such as computer components and peripherals. The last factor to consider would be any type of economic obsolescence. This could include issues related to governmental regulations such as with refrigerants, or it could be a lack of market acceptance or the need for a particular product due to an industry downturn. Economic obsolescence could also come into play due to the trade name of a particular manufacturer having been tainted in some way, with a corresponding loss in reputation and lower market pricing. After the appraiser has measured all forms of depreciation, cost is often quite different from market value. This fact would become extremely important to a lender who has lent against an inventory, as they would ultimately get this inventory back if the loan were to go bad. Here, the lender would most likely want the appraiser to measure factors of supply and demand, mix, and obsolescence.
The same would be true of a company that pays property tax on inventory, as inventory is taxed based on its reported cost. If cost is different from market, the company may be paying higher tax dollars than required by statute. Conversely, it is possible that items within an inventory would have a higher market value than the stated cost.
Though inventories are generally valued at cost, circumstances sometimes arise where departures from cost are appropriate. As an example, assume that F. Jolly, a loan officer at the Sample Federal Bank is examining the financial statements of Autry Company for purposes of granting a loan. Jolly’s primary concern is Autry’s ability to meet loan payments as the payments come due. Jolly is also interested in the value of certain assets that might be pledged as collateral on the loan. The following disclosure appears on Autry’s balance sheet:
Inventories: at cost $84,000
Jolly knows that accounting is based on the principle of historical cost, and that several cost assignment methods are available for inventory valuation. Because Autry’s inventory levels and purchase prices have been stable, the assignment method is not an issue. Jolly’s concern is this: Can the bank get $84,000 for the inventory if Autry defaults on the loan?
Jolly may have some difficulty with the $84,000 figure if he knows the following information about Autry’s merchandise.
1. It received considerable smoke damage from a fire next door.
2. It consists heavily of electronic video games, which were purchased at $100 each. Those same video games now sell at the local discount store for $29.99.
3. It contains numerous perishable products with a six-month shelf-life that were acquired ten months ago.
Inventories are susceptible to damage, obsolescence, and spoilage. Over time, the utility or usefulness of many goods declines, and a business may have to drop its selling price to ensure disposal. To achieve a better valuation of these inventory items, accountants turn to the lower-of-cost-or-market method. Use of the lower-of-cost-or-market method is justified when the market potential for a particular product has been significantly reduced.
To illustrate this method, assume Autry stocks an electronic component that cost him $170 when originally purchased. Because of rapidly advancing technology, that component can now be replaced for $155. Therefore, Autry has suffered a $15 decline in value on this inventory item. To value this component at lower-of-cost-or-market, the $170 original cost would be compared with the $155 new cost and the lower of the two would be chosen which in this case would be the $155 new cost.
There are two exceptions to the replacement cost definition of market value. First, market value cannot be greater than net realizable value, which is an item’s selling price minus completion and disposal costs. For example, assume Autry carries an inventory item that originally cost $12; replacement cost is now $11.25. If Autry can only realize $10 by selling the item, and if there are no completion and disposal costs, the true decline in value is $2, [$12 - $10]. Thus, the item would be valued at $10, and not the higher replacement cost of $11.25.
The second exception is that market value cannot be less than the net realizable value, less a normal profit margin. For example, suppose Autry carries an item that originally cost $250 that can now be replaced for $200. Assume that Autry can sell this item for $300, which allows for recovery of a normal profit margin of 20%. Apparently, then, the "value" of this item is really $240, [$300 - 0.20 ($240)], which if valued at the lower replacement cost of $200, the asset value would be understated on the balance sheet.
The lower-of-cost-or-market procedure is normally followed for each item in inventory, which consisted of the following:
|
Item No. |
Qty. |
Per unit Cost |
Per Unit Market |
Total Cost |
Total Market |
Lower Of Cost Or Market |
|
101 |
1,000 |
$ 12 |
$ 10 |
$12,000 |
$10,000 |
$10,000 |
|
102 |
500 |
$ 20 |
$ 23 |
$10,000 |
$11,500 |
$10,000 |
|
103 |
3,000 |
$ 15 |
$ 16 |
$45,000 |
$48,000 |
$45,000 |
|
104 |
100 |
$170 |
$155 |
$17,000 |
$15,500 |
$15,500 |
|
Total |
|
|
$84,000 |
$85,000 |
$80,500 |
The proper inventory valuation of $80,500, as shown above, is obtained by taking the lower of the cost and the market figures for each inventory item. However, be aware that other application methods are acceptable as well. Rather than evaluate each individual item, the inventory can be analyzed as a whole. If Autry followed this latter approach, the inventory would be valued at $84,000. This figure is obtained by comparing the inventory’s total cost of $84,000 with the total market value of $85,000, and selecting the lower amount. Turning to a third approach, significant inventory subclasses can be defined with the lower-of-cost-or-market rule applied to each subclass, which would result in the lowest and most conservative inventory valuation.
Once the proper valuation is determined, the accounting records must be updated. If Autry's inventory is presently carried at the cost of $84,000, a $3,500 reduction in value, [$84,000 - $80,500], has occurred. This reduction is a loss, and must be entered in the accounts as follows:
|
Inventory Cost |
$84,000 |
|
Loss Due To Decline In Inventory Value |
$3,500
|
|
Inventory |
$80,500 |
|
To Reduce Inventory To Lower-Of-Cost-Or-Market |
The inventory account now contains the lower-of-cost-or-market valuation of $80,500, and is reported as such on the balance sheet. Furthermore, Autry's net income is reduced by the loss. Because of this entry, normal profits are reported in the future. Why? A reduced inventory cost, because of the write-down, will be matched against reduced selling prices, the latter of which are necessary to achieve disposal.
What about increases in value?
While lower-of-cost-or-market appears logical on the surface, many argue this method is inconsistent. By using the lower of the cost and the market figures, accountants consider write-downs in inventory valuation, but not write-ups. For example, suppose a company had the following two inventory items:
|
Item No. |
Cost |
Market |
Lower-Of-Cost-Or-Market |
|
1000 |
$40 |
$37 |
$37 |
|
1001 |
$37 |
$40 |
$37 |
Item No. 1000 can be written down $3 to reflect the lower market value. On the other hand, Item No. 1001 remains on the books at $37 thus, ignoring an increase in valuation. Many accountants argue that an increase in value is just as important as a decrease. However, writing the inventory down to reflect the lower value in an asset valuation is a conservative approach. By writing Item No. 1001 up, $3 will have been gained just by holding the inventory. However, would a write-up be considered proper? Gain or profit from inventory is earned upon sale. Thus, the practice of increasing inventory above cost prematurely recognizes profit, and results in an inflated asset valuation on the balance sheet.
If the alternative costing methods were to be compared and evaluated, each method would reflect a different net income and ending inventory cost. The variance in these differences depends upon the number of units purchased and sold during the year, as well as price changes.
A decline in the value of an inventory item is measured by the difference between its cost and its market value. Any one of the previously discussed methods determines cost: Specific Identification, FIFO, LIFO, or Weighted-Average.
The effects of the four costing methods are summarized below in Exhibit 9-6. This exhibit is based on the assumption that sales and operating expenses were $125,000 and $60,000, respectively. As can be seen, each of the four methods resulted in reporting a different net income and ending inventory cost. The magnitude of this difference depends on the number of units purchased and sold during the year, and the extent of price changes. In light of the historical trend in purchase prices, Taylor Corporation was evidently experiencing an inflationary economy. Since LIFO charges recent (in this case, higher) costs to cost of goods sold, LIFO will usually report the lowest net income in a period of prices. On the other hand, FIFO will report a larger net income. The results, of course, are reversed in a period of falling prices.
Exhibit 9-6
Alternative inventory costing methods for Taylor Corporation are as follows:
|
|
Specific
Identification |
FIFO |
LIFO |
Weighted
Average |
|
Sales |
$125,000 |
$125,000 |
$125,000 |
$125,000 |
|
Cost Of Goods Sold |
|
Beginning
Inventory |
$ 9,000 |
$ 42,850 |
$ 9,000 |
$ 9,000 |
|
Add: Purchases* |
$51,850 |
$42,850 |
$42,850 |
$42,850 |
|
Goods Available
For Sale |
$51,850 |
$51,850 |
$51,850 |
$51,850 |
|
Less: Ending
Inventory** |
$14,600 |
$14,946 |
$12,720 |
$13,608 |
|
Cost Of Goods Sold |
$37,250 |
$36,904 |
$60,000 |
$38,242 |
|
Gross Profit |
$87,750 |
$88,096 |
$85,870 |
$86,758 |
|
Operating
Expenses |
$60,000 |
$60,000 |
$60,000 |
$60,000 |
|
Net Income
|
$27,750 |
$28,096 |
$25,870 |
$26,758 |
* Purchases are computed by subtracting Taylor Corporation’s beginning inventory from the cost of goods available for sale: [$51,850 - $9,000] = $42,850.
** “Less ending inventory” costs were calculated from previous tables. See page no’s. 13, 14, 15, & 16.
All four methods are acceptable accounting alternatives and each, except the specific identification method, is used extensively. A survey of 1,073 large corporations disclosed the following:
Method |
% Of Corporations |
|
FIFO |
35.6 |
|
LIFO |
36.9 |
|
Average |
22.2 |
|
Other |
5.3 |
Which method should be selected?
Unfortunately, a generalization cannot be made by simply stating that a firm should always use FIFO, LIFO, or one of the other inventory costing methods, as no one inventory method best meets the needs and peculiarities of all businesses. The fact is management considers many factors when selecting an inventory method, including income taxes and their related cash outlays, financial statement presentation, and investor reaction to reported results.
It is not within the realm of an appraiser’s expertise to determine what method would best fit the particular needs of a company and, therefore, is a decision that must be made by that company. The benefit in remaining consistent with the selected application is that it would allow comparison measurements to be made over time. Whatever method is employed by the accountant, the appraiser will typically express value as a fixed dollar amount, regardless of cost, with the percentage of recovery illustrated as a matter of convenience.
Income Taxes
In the past few years, LIFO has gained popularity because of rapid price increases in the economy. By computing cost of goods sold based on recent (higher) costs, LIFO has produced lower net incomes and, thus, lowers income tax payments for its users. The latter results in more cash available for investment purposes.
Of course, if tax rates remain constant and inventory is reduced to zero, all the methods illustrated would produce the same long-run results. To illustrate, assume Tingle Corporation made the following purchases of a particular inventory item.
March |
500 Units @ $8 |
$4,000 |
|
September |
1,000 Units @ $10 |
$10,000 |
|
Total |
1,500 Units |
$14,000 |
If Tingle sells all 1,500 units over the next few years, its cost of goods sold would amount to $14,000 no matter which method was employed. Therefore, the same taxes would be paid. However, the use of LIFO produces a smaller net income and tax payment in earlier years, thus giving Tingle the opportunity to invest sooner and possibly generate greater dollar returns.
Financial Statement Presentation
The resulting financial statements must also be considered when selecting an inventory method. For example, the use of LIFO over a long period can generate a meaningless ending inventory valuation on a balance sheet. This is because the oldest costs are used as the basis for inventory valuation; consequently, units may be carried at costs that are no longer valid. The use of LIFO, then, could depress working capital and the current ratio. In contrast, FIFO values the ending inventory at a figure close to the cost of replacement.
While producing a reasonable balance sheet valuation, FIFO's income statement frequently results in a mismatch of revenues and expenses, because cost of goods sold is determined by using older costs. Thus, it is conceivable that say, a five-year-old cost of an item could be deducted from the item’s current selling price when computing gross profit and net income. Therefore, the meaningfulness of the net income figure is questionable.
In contrast, LIFO measures net income by charging a firm's most recent costs against sales. From an income measurement viewpoint, LIFO is superior to FIFO. Unfortunately, there is a related problem. The low tax payments associated with LIFO in an inflationary environment are based on the low net income figure LIFO generates. Given a choice, a business would rather report a larger net income to its owners than a smaller one.
When choosing an inventory valuation method, management must keep in mind that the income statement and balance sheet have different purposes. On the income statement, cost of goods sold should reflect a fair measure of inventory cost to be matched against revenue. On the other hand, the balance sheet's ending inventory valuation should be consistent with the definition of a current asset, and indicate the amount of resources available to meet current obligations. Asset valuation and income determination are not always compatible, and making compromises to suit an entity’s reporting needs is frequently necessary.
Investor Reaction
The use of LIFO in periods of rising prices lowers net income. Of course, net income is a vital element of the earnings-per-share computation, which is a key barometer used by investors to judge the success or failure of corporate operations. It is possible that continued use of LIFO could erode investor confidence in a firm's common stock, and diminish the stock's attractiveness. Though several widely publicized research studies have shown this statement not to be true, depressed earnings must give management a cause for concern.
The inventory method ultimately selected should be used consistently from one year to the next. Consistency helps to produce financial statements that can be compared over time, and is very useful when assessing trends and performing other types of analysis. Importantly, consistency should not be interpreted to mean that a firm could never change inventory valuation methods. A change can and should be made when it is desirable and beneficial in measuring financial activity, e.g., to achieve a better matching of revenues and expense. If a change is made, the impact should be fully disclosed in the financial statements.
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