4. Inventories Flashcards
Inventory cost flow is a major determinant of what?
Net income for merchandising and manufacturing companies.
What are significant assets on the balance sheets of merchandising and manufacturing companies?
Inventories.
What methods are used to account for inventory under IFRS and US GAAP?
IAS 2 for IFRS and Topic 330 for US GAAP.
How does the choice of inventory accounting method affect financial statements?
It results in different values for cost of goods sold and inventory.
What qualifies as inventories?
Assets held for sale, in production, or materials/supplies for production or service.
How are inventories measured under IFRS?
At the lower of cost and net realizable value.
What are the components of the cost of inventories under IFRS?
Costs of purchase, costs of conversion, and other costs to bring inventories to their location and condition.
What is net realizable value?
Estimated selling price minus estimated costs to make the sale.
What is excluded from the cost of inventories?
Abnormal wasted materials, storage costs, administrative overheads not contributing to inventory location, selling costs, and foreign currency losses.
Which inventory accounting method is allowed only under US GAAP?
LIFO (Last In, First Out).
What percentage of US companies use the LIFO method and why?
Approximately 30%, mostly due to potential income tax savings.
What happens to financial statements when LIFO is used during rising costs?
Gross profit, operating profit, and income before taxes are lower, income tax is reduced, and net operating cash flow increases.
What must companies disclose when using the LIFO inventory method?
The amount of the LIFO reserve or the difference between FIFO and LIFO inventory values.
How does using LIFO affect profitability, liquidity, and solvency ratios?
It materially affects these ratios, often requiring a restatement to FIFO for comparison with other companies.
What is the impact of FIFO in an environment of increasing inventory costs?
It allocates a lower cost of goods sold on the income statement and reflects current replacement values.
What are the costs of purchase under IFRS?
Purchase price (less discounts), import duties, taxes, transport, handling, and other costs directly attributable to acquiring goods.
What are costs of conversion under IFRS?
Direct labor, fixed and variable production overheads incurred in converting materials into finished goods.
What is the allocation of fixed production overheads based on?
Normal capacity of the production facilities.
When are other costs included in the cost of inventories under IFRS?
When they are incurred in bringing inventories to their present location and condition.
What does the market value represent under US GAAP for inventories?
Current replacement cost, not greater than net realizable value and not less than net realizable value reduced by a normal sales margin.
When is a write-down required under IFRS?
When the value of inventory declines below its historical cost.
What happens when inventory previously written down increases in value under IFRS?
A reversal of the write-down is required, limited to the original write-down amount.
What is the financial statement effect of a write-down under IFRS?
The write-down is recognized as an expense in the period it occurs.
What inventory cost formulas are permitted under both IFRS and US GAAP?
FIFO and weighted average cost.
How are non-interchangeable inventory items accounted for under IFRS and US GAAP?
By using specific identification of individual costs.
When must the net realizable value of inventory be reassessed?
In each subsequent period.
What costs are excluded from the cost of inventories under IFRS?
Abnormal wasted materials, labor, storage costs (unless necessary before further production), administrative overheads, selling costs, and foreign currency losses.
How are costs of purchase calculated under IFRS?
Purchase price minus discounts, plus import duties, taxes, transport, and handling costs.
What does the cost of conversion include?
Direct labor and production overheads incurred in converting materials into finished goods.
When can different cost formulas for inventories be justified under IFRS?
When inventories have a different nature or use.
How is the net realizable value calculated?
Estimated selling price minus costs of completion and selling costs.
How is market value defined under US GAAP?
Current replacement cost, but not higher than net realizable value and not lower than net realizable value minus normal sales margin.
What are companies required to disclose when using LIFO under US GAAP?
The LIFO reserve, which is the difference between the FIFO and LIFO inventory values.
What is the purpose of disclosing the LIFO reserve?
To allow analysts to compare companies using LIFO with those using FIFO.
What happens to net operating cash flow when using LIFO during rising costs?
It increases due to lower income tax expenses.
How does LIFO impact working capital and total assets on the balance sheet?
LIFO results in lower inventory carrying values, reducing both working capital and total assets.
How does LIFO affect gross profit, operating profit, and income before taxes during rising costs?
It lowers gross profit, operating profit, and income before taxes.
Why do some U.S. companies prefer the LIFO method?
For potential income tax savings.
How does the LIFO method affect financial ratios?
It materially affects profitability, liquidity, activity, and solvency ratios.
What is the impact on financial statements when using LIFO compared to FIFO?
LIFO results in lower inventory values, lower gross profit, and lower total assets, affecting key financial metrics.
Why is restating to FIFO important for analysts?
To make valid comparisons with companies using FIFO.
What is the treatment of inventories held for firm sales contracts under IFRS?
They are valued based on the contract price.
When are costs excluded from the cost of inventories under IAS 2?
When they involve abnormal waste, storage costs, administrative overheads, selling costs, or foreign currency losses.
What must companies using LIFO under US GAAP disclose in their financial notes?
The amount of the LIFO reserve or the difference between FIFO and LIFO inventory values.
What are the three primary inventory accounting methods under both IFRS and US GAAP?
FIFO, weighted average cost, and specific identification.
How often is the net realizable value of inventory reassessed?
In each subsequent reporting period.
What is the definition of inventories under IAS 2?
Inventories are assets held for sale, in production for sale, or materials and supplies used in production or service.
How does the IFRS define the cost of inventories?
Costs of purchase, conversion, and other costs incurred to bring the inventories to their location and condition.
What are the components of costs of purchase?
Purchase price (minus discounts), import duties, taxes, transport, handling, and other direct acquisition costs.
What are the components of costs of conversion?
Direct labor and production overheads.
What is the purpose of including non-production overheads in inventory costs under IAS 2?
To cover costs incurred in bringing inventories to their current location and condition.
What is net realizable value under IAS 2?
The estimated selling price in the ordinary course of business minus the costs to complete and sell the inventory.
Under IFRS, how are costs that do not contribute to bringing inventories to their location treated?
They are excluded from the cost of inventories.
What is the role of normal capacity in allocating fixed production overheads?
Normal capacity is used to allocate fixed overheads to the costs of conversion.
What must be done when inventory value declines below historical cost under IFRS?
A write-down must be recorded and disclosed.
Can a write-down of inventory be reversed under IFRS?
Yes, but only up to the amount of the original write-down.
What does US GAAP define as market value for inventories?
Current replacement cost, not greater than net realizable value and not less than net realizable value minus a normal profit margin.
What does US GAAP allow that IFRS does not in inventory accounting?
The use of the LIFO (Last In, First Out) method.
What happens if inventory is sold under IAS 2?
The carrying amount of the inventory is recognized as an expense.
How does FIFO affect inventory valuation during periods of rising costs?
FIFO allocates a lower cost of goods sold and reflects current replacement values.
What is required for inventories of items that are not interchangeable under both IFRS and US GAAP?
The specific identification of their individual costs.
What cost formula must be used for inventories with a similar nature and use?
The same cost formula, such as FIFO or weighted average cost.
What is the impact of using LIFO during periods of rising inventory costs?
It increases the cost of goods sold, reduces taxable income, and lowers net income.
How do rising costs affect the comparison between LIFO and FIFO methods?
LIFO results in higher costs of goods sold and lower profits, while FIFO shows lower costs and higher profits.
Why is the LIFO method not allowed under IFRS?
Due to differences in how it affects income and inventory valuation compared to other methods like FIFO and weighted average cost.
What must a company disclose if they use the LIFO method under US GAAP?
The LIFO reserve, which is the difference between the FIFO and LIFO inventory values.
What is included in the cost of inventories under US GAAP?
Costs of purchase, conversion, and other costs incurred to bring the inventories to their present location and condition.
How is “market” defined in relation to inventory under US GAAP?
Market is defined as the current replacement cost, subject to limits based on net realizable value.
What does a write-down of inventory affect under IFRS?
It reduces the carrying value of inventory and is recognized as an expense.
What conditions trigger the reassessment of inventory’s net realizable value?
It is reassessed at the end of each reporting period.
