In the previous chapter you learned that there are several methods a company could use to determine the cost of inventory at the end of a period and the corresponding cost of goods sold for the period. You also learned that it is important for a company to disclose the inventory method that it uses. Otherwise, investors and creditors would be unable to meaningfully compare accounting information from company to company. This disclosure typically is made in the summary of significant accounting policies accompanying the financial statements. Coca-Cola Company's inventory method disclosure is shown in Graphic 9-1.
Disclosure of Inventory Method—Coca–Cola Company
Real World Financials
Inventories consists primarily of raw materials and packaging (which includes ingredients and supplies) and finished goods (which includes concentrates and syrups in our concentrate and foodservice operations, and finished beverages in our bottling and canning operations). Inventories are valued at the lower of cost or market. We determine cost on the basis of the average cost or first-in, first-out methods.
The disclosure indicates that Coca-Cola uses both the average cost and FIFO methods to determine the cost of its inventories. Notice that inventories actually are valued at the lower of cost or market. Assets are initially valued at their historical costs, but a departure from cost is warranted when the utility of an asset (its probable future economic benefits) is no longer as great as its cost. Accounts receivable, for example, are valued at net realizable value by reducing initial valuation with an allowance for uncollectible accounts.
The utility, or benefits, a company receives from inventory result from the ultimate sale of the goods. So deterioration, obsolescence, changes in price levels, or any situation that might compromise the inventory's salability impairs that utility. The lower-of-cost-or- market (LCM) recognizes losses in the period that the value of inventory declines below its cost. approach to valuing inventory was developed to avoid reporting inventory at an amount greater than the benefits it can provide. Reporting inventories at LCM causes losses to be recognized in the period the value of inventory declines below its cost rather than in the period in which the goods ultimately are sold. LCM is not an optional approach to valuing inventory; it is required by GAAP.
The LCM approach to valuing inventory is required by GAAP.
Real World Financials
The tremendous growth of the Internet that took place during the decade of the 90s allowed companies that produced products that support the Internet to become extremely profitable. Cisco Systems, Inc., the world's largest networking products company, is one of those companies. In 1993, Cisco reported $649 million in sales revenue. By 2000, sales had reached nearly $19 billion! Growth rates of 50% year-to-year were commonplace. The company's market capitalization (price per share of common stock multiplied by the number of common shares outstanding) soared to over $500 billion. To keep pace with this growth in sales, inventories swelled from $71 million in 1993 to over $2.5 billion in 2000.
At the end of 2000, corporate spending on Internet infrastructure took a drastic downturn. Many dot-com companies went bankrupt, and companies like Cisco saw their fantastic growth rates nosedive. Early in 2001, the company reported its first-ever quarterly loss and, due to declining demand for its products, recorded an inventory write-down in excess of $2 billion. The company's once lofty market capitalization dropped to just over $100 billion.
| ||CISCO POSTS $5BN LOSS ON HUGE WRITE-DOWNS|
Technology giant Cisco Systems posted on Tuesday a third-quarter net loss of $2.69 billion, its first ever, following a write-down of inventory, restructuring costs and a sharp drop-off in corporate spending.
… and a write-down of over $2 billion for excess inventory.
Cisco said 80 percent of the inventory charge relates to raw materials, such as semiconductor memories, optical components, …
“Most of the excess inventory cannot be sold as it is custom built for Cisco,” chief financial officer Mr. Larry Carter said in a conference call.1
1Fiona Buffini, “Cisco Posts $5bn Loss on Huge Writedowns,” Financial Review, May 9, 2001.