Inventories

1
Inventories

• Methods, Income, and Impact on Cash Flows

2
Retail

• Beginning Inventory
• Purchases
• Goods Available for Sale
• -
• Ending Inventory On the Balance Sheet
• Cost of Goods Sold On the Income Statement

3
Manufacturing
4
Periodic versus Perpetual

• Periodic
• Count Inventory at end of period and determine
  CGS
• Perpetual
• Continuously track CGS and Inventory Levels

5
Cost Flow Assumptions

• Specific Identification
• First-In, First-Out (FIFO)or Last In Still
  Here
• Last-In, First-Out (LIFO)or FISHFirst-In Still
  Here
• Weighted Average

6
Flows

• Assumed Flows
• Not Equal to Each Other
• Actual Flows

7
Inventory Facts
8
More Facts

• The firm sells 3 units during 2005 at a Selling
  Price of 12 per unit for a Total Sales Revenue
  of 36
• Other Operating Costs are 10 in 2005
• There is a 30 Tax Rate

9
What is the Cost of the 3 units Sold?FIFO refers
to Units Sold
10
What is the Cost of the 3 units Sold?LIFO refers
to Units Sold
11
What is the Cost of the 3 units Sold?Weighted
Average
12
What is the Cost of the 3 units Sold?FIFO
13
What is the Cost of the 3 units Sold?LIFO
14
What is the Cost of the 3 units Sold?Weighted
Average
15
CGS SUMMARY
16
Impact on Net Income
17
Why Would A Manager Use LIFO?
18
Capital Market Efficiency

• WEAK-FORM EFFICIENCY No investor can earn excess
  returns by developing trading rules based solely
  on historical price or return information.
• SEMISTRONG-FORM EFFICIENCY No investor can earn
  excess returns from using trading rules based on
  any publicly available information. Examples of
  publicly available information are annual
  reports of companies, investment advisory
  newsletters, and ticker tape information.
• STRONG-FORM EFFICIENCY No investor can earn
  excess returns using any information whether
  publicly available or not.

19
The Efficient Capital Markets Hypothesis and
Accounting Changes

• If Capital Markets are efficient, what, if any,
  is the impact on security prices when a firm
  switches from using Fifo to Lifo.
• If Capital Markets are inefficient, what, if any,
  is the impact on security prices when a firm
  switches from using Fifo to Lifo.

20
Change from FIFO To LIFO During Inflation
Reported Net Income and all related ratios
Decrease
Rise
The Firms Security Prices
Stay the Same
Fall
21
Impact on CFOA
22
Revenue Acts of 1938 1939

• LIFO is a Tax Cut if Factor Input Prices are
  Rising
• LIFO is an Example of Supply Side Economics
• Value CFOA / Discount
• If Taxes Decrease, then CFOA Increases and Value
  Increases

23
In an Efficient Capital Market

• Other things equal, Security Prices Move in the
  Same Direction as a Firms Underlying Economic
  Value
• What Helps Make a Market Efficient?
• Information Disclosure
• User Groups Exist That Understand the Information
• Costs of Obtaining and Using the Information is
  less that the Benefit of Having the Information

24
Conflict or Agency Costs

• Would a manager ever use FIFO during a period of
  Inflation?
• Use FIFO, Higher Reported Net Income, Higher
  Taxes Paid, and Firm Value.
• Use LIFO, Lower Reported Net Income, Lower Taxes
  Paid, and Firm Value.

25
Manager Motivation To Use Fifo during Inflation

• Higher Reported Net Income but Higher Taxes Paid
• To Impact A Promotion or Compensation Level or
  Annual Bonus
• To Prevent the Violation of a Debt Covenant
• An industry can have falling factor input prices
  during general price inflation, e.g. Computer
  parts.

26
Impact of Inventory Methods
27
Impact of Inventory Methods
28
Impact of Inventory Methods
29
If a Manager Uses FIFO
30
If a Manager Uses LIFO
31
What About a Lifo Layer Liquidation or a Lifo
Dip? Will Lifo always generate the Lowest
Reported Net Income?

• In our original example the firm began the year
  with 1 unit of inventory and purchased 3 more
  units during the year and the firm sold 3 units
  during the year.
• What if the firm delayed the third purchase
  during 12/05 to the next year 2006?

32
What is the Cost of the 3 units Sold?LIFO, Buy 3
units and Sell 3 units
33
What is the Cost of the 3 units Sold?Use Lifo,
Buy 2 Units and Sell 3 Units
34
Impact of a Lifo Dip

• Note that Cost of Goods Sold Without a Lifo Dip
  is 9
• But with a Lifo Dip Cost of Goods Sold falls to
  6
• The Dip lowers cost, increases Reported Income
  and Increases Tax Payments.

35
When Do Lifo Dips Often Happen?

• As part of an Earnings Management Scheme.
• At the initial phases of an economic expansion
  following a recession.
• When customers start buying again, firms are
  reluctant to increase production or purchase.
  When sales volume is greater than production
  volume, a firm can sell off lower costed Lifo
  inventory layers.
• This income increase in sometime called an
  inventory profit.

36
Realized Holding Gains or Inventory Profits From
a Lifo Dip

• CGScurrent cost less CGShistorical cost
  Inventory Profit

Current Costs During Inflation are the Higher
Costs of Current Replacements to Inventory
Includes Low Cost of Older Purchases Liquidated
From the Initial Lifo Layer in Beginning Inventory
37
How to Avoid Inventory Profits

• Dont Liquidate Low Cost Lifo Inventory Layers
• Use a Non-Gaap, Non-Historical Cost Inventory
  Method Use Replacement Cost to Calculate CGS
• Inflation Accounting (1979 to 1985)
  usedreplacement cost as a supplementary
  information disclosure.

38
Accounting Changes and Security Prices

• Cosmetic Accounting Changes Impact reported Net
  Income but do not affect Cash Flows, e.g. A
  Change in a Depreciation Method to raise or lower
  expense but no change in tax depreciation. What
  Should Happen to Security Prices?
• If there is An Inefficient Capital Market, then
  Security Prices might Change
• If there is an ECM, then Security Prices should
  remain unchanged
• If there is an ECM, perhaps the accounting change
  contains an Information Signal that should
  change an analysts forecast of the level and/or
  risk of future Cash Flows and consequently
  Security Prices should Change

39
Accounting Changes and Security Prices

• A Non-Cosmetic Accounting Change ( a Cash Flow
  Accounting Change) Affects CFOA for example,
  a Change from FIFO to LIFO changes the cash paid
  for taxes and can increase CFOA. This should
  impact Security Prices.
• A Cosmetic Accounting Change Today Could Cause a
  Cash Flow Change somewhere down the line during a
  second round of financial reporting as a
  consequence of a change in actual business
  decisions this is the issue of Information
  Inductance.
• Information Inductance asserts that How you keep
  score can change How you play the game. If
  Actual Firm Operations Change because of an
  Accounting Rule then Cash Flows will Change. For
  example, If a firm must start recognizing Health
  Insurance for future retirees today (no tax
  impact today) and then some firms may stop
  providing the benefit. Future CFOA will rise and
  Security Prices should Change (Rise).