Reporting and Analyzing Inventories



Reporting Inventories

Inventory is an asset and its ending balance should be reported as a current asset on the balance sheet.

Learning Objectives

Describe how a company reports inventory on the financial statements

Key Takeaways

Key Points

  • In a business accounting context, the word inventory is used to describe the goods and materials that a business holds for the ultimate purpose of resale.
  • Companies must choose a method to track inventory.
  • The change in inventory is a component of in the calculation of cost of goods sold, which is reported on the income statement.

Key Terms

  • inventory: Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

Inventory

In a business accounting context, the word inventory is used to describe the goods and materials that a business holds for the ultimate purpose of resale.

Inventory Accounting Systems

Companies must choose a method to track inventory. There are ways to account for inventory, periodic and perpetual. The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out.

In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods.

Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Reporting Inventory

Inventory itself is not an income statement account. Inventory is an asset and its ending balance should be reported as a current asset on the balance sheet. However, the change in inventory is a component of in the calculation of cost of goods sold, which is reported on the income statement.

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Inventory: Inventory appears as an asset on the balance sheet.

Depending on the format of the income statement it may show the calculation of Cost of Goods Sold as Beginning Inventory + Net Purchases = Goods Available – Ending Inventory. In that situation the beginning and ending inventory does appear on the income statement.

Inventory Turnover Ratio

Inventory turnover is the measure of the number of times inventory is sold or used in a time period such as a year.

Learning Objectives

Explain how a company would calculate their inventory turnover ratio

Key Takeaways

Key Points

  • The equation for inventory turnover is the cost of goods sold (COGS) divided by the average inventory.
  • A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
  • A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Key Terms

  • turnover: The number of times a stock is replaced after being used or sold, a worker is replaced after leaving, or a property changes hands
  • COGS: COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.
  • liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

Inventory Turnover Defined

In accounting, the inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. This ratio tests whether a company is generating a sufficient volume of business based on its inventory. The equation forinventory turnover is the cost of goods sold (COGS) divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

Businesses need to manage their inventories.: Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

Significance Of Turnover Rates

The turnover rate has several significant implications:

  • Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it gauges the liquidity of the firm’s inventory.
  • A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.
  • A high turnover rate may conversely indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

In assessing inventory turnover, analysts also consider the type of industry. When making comparisons among firms, they check the cost-flow assumption used to value inventory and the cost of products sold.

Differences In Calculations

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of the cost of sales. The cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. The cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded.

Sales are generally recorded at market value, which is the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm’s goods and services, the numerator may be an inaccurate measure. However, the cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms “cost of sales” and “cost of goods sold” are synonymous.

Example Of Calculating Inventory Turnover

Abercrombie & Fitch reported the following financial data for 2000 (in thousands):

  • Cost of goods sold: $728,229
  • Beginning inventory: $75,262
  • Ending inventory: $120,997

Their inventory turnover is:

[latex]\dfrac{$728,229}{\left(\dfrac{$75,262 + $120,997}{2}\right)} = 7.4 \text{ times}[/latex]

Adjusting for LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.

Learning Objectives

Explain how the LIFO reserve is calculated and how to report it on the financial statements

Key Takeaways

Key Points

  • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.
  • When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison. This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation, resulting in a FIFO inventory.
  • The SEC requires that all registered companies that use LIFO report their LIFO reserves for the start and end of the year. A company can always convert from LIFO to FIFO, which is important if you are trying to compare companies when they use different accounting methods.

Key Terms

  • FIFO: First in, first out (accounting).
  • LIFO reserve: The amount by which an entity’s taxable income has been deferred by using the LIFO method.LIFO Reserve = FIFO Valuation – LIFO Valuation
  • LIFO: Last-in, first-out (accounting).

What is the LIFO Reserve?

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

LIFO Reserve = FIFO Valuation – LIFO Valuation

SEC Requirements

The SEC requires that all registered companies that use LIFO report their LIFO reserves for the start and end of the year. A company can always convert from LIFO to FIFO, which is important if you are trying to compare companies when they use different accounting methods.

Making Adjustments

When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison. This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation.