FRA: inventories

Question 1

Formula for COGS

Answer 1

COGS(t) = Inventories(t) - Inventories(t-1) + Purchases(t)

Question 2

Inventory cost flow methods

Answer 2

1) FIFO - the cost of first item purchased is the cost of first item sold
2) LIFO - the cost of last item purchased is the cost of first item sold
3) WA - unit cost is taken as average cost of items in the inventory (in between of LIFO and FIFO)
4) Specific identification - units sold are directly matched with units purchased

Question 3

Specifics of LIFO

Answer 3

1) Lowers NI leading to lower taxes and higher cash flows
2) Prohibited under IFRS
3) Lowers profitability, liquidity and solvency ratios, but increases activity ratios (e.g. inv. turnover)

Question 4

LIFO -> FIFO transformation technique

Answer 4

Based on the notion of “LIFO reserve” = FIFO inventory - LIFO inventory. LIFO reserves are usually reported on the footnotes of annual reports.

Question 5

LIFO liquidation

Answer 5

Occurs when a firm doesn’t replace its inventories and lead to lower COGS. However, these improvements are not sustainable and should be corrected.

Question 6

Inventories valuation

Answer 6

IFRS: min(costs, NRV), inventory write-ups are allowed, but only to extent of previously recognized write-downs
GAAP: min(cost, market value), inventory write-ups are not allowed. market value equals replacement costs bound by NRV and NRV - normal profit margin

Question 7

How one can reveal firm’s management expectations by looking at inventories?

Answer 7

By looking at their structure: raw vs. work-in-progress vs. final goods.