Book 3 - FRA - Inventory Flashcards
Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
The costs included in inventory are similar under IFRS and U.S. GAAP. These costs, known as product costs, are capitalized in the Inventories account on the balance sheet and include:
- Purchase cost less trade discounts and rebates.
- Conversion costs including labor and overhead.
- Other costs necessary to bring the inventory to its present location and condition.
Not all inventory costs are capitalized; some costs are expensed in the period incurred. These costs, known as period costs, include:
- Abnormal waste of materials, labor, or overhead.
- Storage costs (unless required as part of production) .
- Administrative overhead.
- Selling costs.
Describe different inventory valuation methods (cost formulas).
Under IFRS, the permissible methods are:
- Specific identification.
- First-in, first-out.
- Weighted average cost.
U.S. GAAP permits these same cost flow methods, as well as the last-in, first-out (LIFO) method. LIFO is not allowed under IFRS.
Under the first-in, first-out (FIFO) method, the first item purchased is assumed to be the first item sold. The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current cost. Conversely, FIFO COGS is based on the earliest purchase costs. In an inflationary environment, COGS will be understated compared to current cost. As a result, earnings will be overstated.
Under the last-in, first-out (LIFO) method, the item purchased most recently is assumed to be the first item sold. In an inflationary environment, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the earliest costs. Therefore, in an inflationary environment, LIFO ending inventory is less than current cost.
Explain the impact of the inventory valuation method choice on gross profit.
Be able to describe the effects ofLIFO and FIFO, assuming inflation, in your sleep. When prices are falling, the effects are simply reversed.
Compare cost of sales, gross profit, and ending inventory using perpetual and periodic inventory systems.
Firms account for changes in inventory using either a periodic or perpetual system. In a periodic inventory system, inventory values and COGS are determined at the end of the accounting period. No detailed records of inventory are maintained; rather, inventory acquired during the period is reported in a Purchases account. At the end of the period, purchases are added to beginning inventory to arrive at cost ofgoods available for sale. To calculate COGS, ending inventory is subtracted from goods available for sale.
In a perpetual inventory system, inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur. Thus, a Purchases account is not necessary.
For the FIFO and specific identification methods, ending inventory values and COGS are the same whether a periodic or perpetual system is used. However, periodic and perpetual inventory systems can produce different values for inventory and COGS under the LIFO and weighted average cost methods.
Compare and contrast cost of sales, ending inventory, and gross profit using different inventory valuation methods.
During periods of stable prices, all three cost flow methods will yield the same results for inventory, COGS, and gross profit. During periods of trending prices (up or down), different cost flow methods may result in significant differences in these items.
Ending inventory. When prices are rising or falling, FIFO provides the most useful measure of ending inventory. LIFO inventory, by contrast, is based on older costs that may differ significantly from current economic value.
Cost of goods sold. When prices are rising, LIFO COGS will be higher than FIFO COGS. When prices are falling, LIFO COGS will be lower than FIFO COGS. Because LIFO COGS is based on the most recent purchases, LIFO produces a better approximation of current cost in the income statement.
Gross profit. Because COGS is subtracted from revenue in calculating gross profit, gross profit is also affected by the choice of cost Bow method. Assuming inflation, higher COGS under LIFO will result in lower gross profit.
Describe the measurement of inventory at the lower of cost and net realisable value under IFRS.
Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. Net realizable value is equal to the expected sales price less the estimated selling costs and completion costs. If net realizable value is less than the balance sheet value of inventory, the inventory is “written down” to net realizable value and the loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be “written up” and the gain is recognized in the income statement by reducing COGS by the amount of the recovery. Because inventory is valued at the lower of cost or net realizable value, inventory cannot be written up by more than it was previously written down.
Describe the measurement of inventory at the lower of cost and net realisable value under GAAP.
Under U.S. GAAP, inventory is reported on the balance sheet at the lower of cost or market. Market is usually equal to replacement cost, but cannot be greater than net realizable value (NRV) or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin.
*Think of lower of cost or market, where “market” cannot be outside a range of values. The range is from net realizable value minus a normal profit margin, to net realizable value. So the size ofthe range is the normal profit margin. *
If cost exceeds market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement. The market value becomes the new cost basis. If there is a subsequent recovery in value, no write-up is allowed under U.S. GAAP.
Describe the financial statement presentation ofand disclosures relating to inventories.
Inventory disclosures, usually found in the financial statement footnotes. The disclosures are also useful in making adjustments to facilitate comparisons with other firms in the industry.
Required inventory disclosures are similar under U.S. GAAP and IFRS and include:
- The cost flow method (LIFO, FIFO, etc.) used.
- Total carrying value of inventory, with carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate.
- Carrying value of inventories reported at fair value less selling costs.
- The cost of inventory recognized as an expense (COGS) during the period.
- Amount of inventory writedowns during the period.
- Reversals of inventory writedowns during the period, including a discussion of the circumstances of reversal (IFRS only because U.S. GAAP does not allow reversals).
- Carrying value of inventories pledged as collateral.
