BY:

ABHINAV PUJARA
ANSHUL SHARMA
RAGHAV ARORA
RAJAT JAIN
 INVENTORY ACCOUNTING
 Inventory accounting is the body of accounting that deals with valuing and accounting
for changes in inventoried assets.
 A company's inventory typically involves goods in three stages of production: raw
goods, work in-progress goods, and finished goods that are ready for sale.
 Inventory accounting will assign values to the items in each of these three processes
and record them as company assets. Assets are goods that will likely be of future value
to the company.

Beginning Inventory + Net Purchases – Cost of goods sold = Ending Inventory

 INVENTORY COST FLOWS
Inventory on January 1, Year 40 units @500 $20000
Inventory purchased during year 60 units @600 $36000
Cost of Goods available for sale 100 units $56000

 First In, First Out : First units purchased are the first units sold
Example-
Units sold= 30@800
Sales (30*800) $24000
COGS (30@500) $15000
Gross profit $9000

The remaining inventory reported on Balance Sheet is $41000

(10*500 + 60*600)
Inventory on January 1, Year 40 units @500 $20000
Inventory purchased during year 60 units @600 $36000
Cost of Goods available for sale 100 units $56000

 Last In, First Out : The last units purchased are the first to be sold

Sales (30@800) $24000

COGS(30@600) $18000
Gross Profit $6000

$38000 remains on balance sheet to be reported as inventories.

(40*500 + 30*600)
Inventory on January 1, Year 40 units @500 $20000
Inventory purchased during year 60 units @600 $36000
Cost of Goods available for sale 100 units $56000

 Average Cost : It computes COGS and ending inventory at simple average

Sales (30@800) $24000

COGS(30@560) $16800
Gross Profit $7200

$39200(70*560) is reported on balance sheet as inventories

 Analysing Inventories
. Sales COGS Gross Profit

FIFO 24000 15000 9000

LIFO 24000 18000 6000
Average 24000 16800 7200
Cost

In period of Rising Prices , FIFO produces higher gross profits than LIFO because lower
cost inventories are matched against sales revenues at current market prices. This is
referred to as FIFO’s phantom profits as the gross profit is actually a sum of 2
components : economic profit, holding gain.
EFFECT ON BALANCE SHEET
LIFO reports ending inventories at prices that can be significantly lower than
replacement cost. As a result LIFO companies’ balance sheet do not accurately
represent the current investment that the company has in its inventories.

EFFECT ON CASH FLOWS

The increase in gross profit under FIFO also results in higher pre-tax income &
consequently higher tax liability. In periods of rising prices, companies can get caught
in a cash flow squeeze as they pay higher taxes and must replace inventory sold at
replacement costs higher than original purchase costs.
 OTHER ISSUES IN INVENTORY VALUATION

 ANALYTICAL RESTATEMENT OF LIFO TO FIFO:

Adjustments required:

1. Inventories= Reported LIFO inventory + LIFO reserve

2. Increased deferred tax payable by: LIFO reserve * tax rate
3. Retained earnings= Reported retained earnings+ (LIFO reserves* (1-tax rate))
 ANALYTICAL RESTATEMENT OF FIFO TO LIFO:

Adjusting the COGS with the holding gain on the beginning inventory

COGS (LIFO)= COGS (FIFO) + (BI * r)

where BI is the beginning inventory under FIFO and

r is the inflation rate relating to the specific lines of inventory

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒

r=
𝐹𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 𝑓𝑟𝑜𝑚𝑚 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑
 LOWER OF COST OR MARKET
 Value the inventory at the lower of cost or the market
 Therefore, if the inventory declines in market value below its cost for any
reason, then the inventory is written down to reflects this loss
 This written down is charged against the revenues in the period the loss
occurs
 Conservatism principle is followed
 The market value must not be higher than net realizable value nor less than
net realizable value reduced by a normal profit margin
 The cost is calculated using various methods- FIFO, LIFO or AVERAGE
COST METHOD.
Introduction to Long - Term Assets
Long - Term Assets are resources that are used to generate operating revenues (or reduce
operating costs) for more than one period.

The most common type of Long term asset is tangible fixed assets such as property, plant
and equipment.

Long- term assets also include intangible assets such as patents, trademarks, copyrights, and
goodwill.
Capitalization
It means putting the asset on the balance sheet rather than immediately expensing its cost in
the income statement.

For hard assets, this process is relatively simple; the asset is recorded at its purchase price.

For soft assets such as R&D, advertisement, wage costs it is problematic to capitalize as we
don’t know the amount of the future benefits and the useful life of the soft assets. Thus, we
immediately record it as an expense and are not recorded on the balance sheet
Allocation
It is the periodic assignment of asset cost to expense over its useful life.

Allocation of costs is called depreciation when applied to tangible fixed assets, amortization
when applied to intangible assets, and depletion when applied to natural resources.

Three Factors determine the cost allocation amount :

1. Useful life
2. Salvage Value
3. Allocation method
Impairment
When the expected (undiscounted) cash flows are less than the asset’s carrying amount (cost
less accumulated depreciation), the asset is deemed to be impaired and is written down to
its fair market value.

The fair value then becomes the new cost and is depreciated over its remaining useful life.

Asset is not written up if expected cash flows improve.

Two Distortions arise from Impairment

1. Conservative biases distort long-term asset valuation because assets are written down
but not written up
2. Large Transitory effects from recognizing asset impairments distort net income
Effect of Capitalizing Vs. Expensing
1. Effect on Income : Capitalizing postpones recognition of expenses in the income
statement. Thus higher income in the acquisition period but lower income in
subsequent period as compared with expensing of costs.
2. Effect on Return on Investment: Capitalizing decreases volatility in income measures
and, similarly, return on investment ratios as it affects both the numerator (income)
and denominator (investment base) whereas opposite happens in expensing
3. Effect on Solvency Ratio: Under expensing, solvency ratios reflect poorly then what is
warranted because expensing of costs understates equity for companies with
productive assets
4. Effect on Operating Cash Flows : In expensing, reported as operating outflow,in
contrast in capitalization they are reported as investing outflow
 Investment Securities
Classification

Investment Securities

Debt Securities Equity Securities

No Influence (below 20% holding)
Trading - Trading
- Available-for-Sale

Held-to-Maturity Significant Influence (between

20% and 50% holding)

Controlling Interest (above 50%

Available-for-Sale holding)
 Accounting for Debt Securities

Accounting
Balance Sheet Income Statement
Category Description Unrealized Gains/Losses Other

Trading Securities acquired Fair Value Recognize in net income Recognize realized
mainly for short-term or gains/losses and interest
trading gains (usually income in net income
less than three months)

Available-for-Sale Securities neither held Fair Value Not recognized in net Recognize realized
for trading nor held-to- income, but recognized gains/losses and interest
maturity in comprehensive income income in net income

Held-to-Maturity Securities acquired with Amortized Cost Not recognized in either Recognize realized
both the intent and net income or gains/losses and interest
ability to hold to comprehensive income income in net income
maturity
 Accounting for Transfers between Security Classes
Transfer Accounting
Effect on Asset Value in Effect on Income Statement
From To Balance Sheet
Trading Available-for-Sale No effect Unrealized gain or loss on date of
transfer included in net income

Available-for-Sale Trading No effect Unrealized gain or loss on date of

transfer included in net income

Available-for-Sale Held-to-Maturity No effect at transfer; however, Unrealized gain or loss on date of

asset reported at (amortized) transfer included in
cost instead of fair value at comprehensive income
future dates

Held-to-Maturity Available-for-Sale Asset reported at fair value Unrealized gain or loss on date of
instead of (amortized) cost transfer included in
comprehensive income
 Classification and Accounting for Equity Securities

Category No Influence Significant Influence Controlling Interest

Available-for-Sale Trading
Ownership Less than 20% Less than 20% Between 20% and 50% About 50%

Purpose Long- or intermediate- Short-term Degree of business control Full business control
term investment investment or
trading
Valuation Basis Fair value Fair value Equity method Consolidation

Balance Sheet Asset Fair value Fair value Acquisition cost adjusted for Consolidated balance
Value proportionate share of investee’s sheet
retained earnings and appropriate
amortization

Income Statement: In comprehensive In income Not recognized Not recognized

Unrealized Gains income
Income Statement: Recognize dividends Recognize dividends Recognize proportionate share of Consolidated income
Other Income Effects and realized gains and and realized gains investee’s net income less statement
losses in income and losses in appropriate amortization in
income income
 Analyzing Investment Securities

At least two main objectives:

(1) to separate operating from investing (and financing) performance
(2) to analyze accounting distortions due to accounting rules and
/or earnings management involving investment securities
 Separating Operating from Investing Assets
and Performance
Determine whether investment securities (and related income streams) are investing or
operating in nature—based on an assessment of whether each investment is strategic or made
purely for the purpose of investment

Remove all gains (losses) relating to investing activities—including dividends, interest

income, and realized and unrealized gains and losses—when evaluating the operating
performance of a company

Separate operating and non-operating assets when determining operating return on

investment.
 Analyzing Accounting Distortions from
Investment Securities
Potential accounting distortions an analyst must be alert to:

• Classification based on intent

• Opportunities for gains trading
• Liabilities recognized at cost
• Inconsistent definition of equity
securities
THANK YOU