Inventory Flashcards
product cost
Costs that are included in inventory. These costs are known as product cost and are capitalized in the Inventories account on the balance sheet
Examples:
- Purchase cost less trade discounts and rebates
- Conversion (manufacturing) costs include labor and overhead
- Other costs necessary to bring inventory to its present location and condition
By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold and revenue is recognized.
period cost
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.
Assuming rising prices and stable or increasing inventory levels,
FIFO COGS < LIFO COGS
FIFO Ending Inventory > LIFO Ending Inventory
FIFO Gross Profit > LIFO Gross Profit
*LIFO Cash flow > FIFO cash flow
*LIFO results in higher cash flow because with lower reported income, income tax will be lower.
Avg cost method will always be in between LIFO and FIFO if prices are rising and inventory levels are stable/increasing
LIFO reserve
LIFO ending reserve = FIFO ending inventory - LIFO ending inventory
To make financial statements prepared under LIFO compared to financial statements prepared under FIFO, an analyst must
1) add the LIFO reserve to LIFO inventory on the balance sheet.
2) increase the retained earnings component of shareholders’ equity by the LIFO reserve x (1 - tax rate)
To convert LIFO COGS to FIFO COGS
FIFO COGS = LIFO COGS - (end LIFO reserve amount - beg. LIFO reserve amount)
For comparison purposes, it is also necessary to convert the LIFO firm’s COGS to FIFO COGS.
Convert LIFO net income to FIFO net income
FIFO Net income = LIFO net income + [(end LIFO reserve - beg LIFO reserve) x (1 - t)]
t = tax rate
Convert LIFO Retained Earnings to FIFO Retained Earnings
FIFO Retained Earnings = LIFO Retained Earnings + (end LIFO reserve - beg LIFO reserve ) x (1 - t)
t = tax rate
The LIFO reserve will increase when
prices are rising and inventory quantities are stable or increasing
The LIFO reserve will decrease when
prices are falling or firm is liquidiating its inventory
Firms tend to do LIFO liquidation when
COGS > Purchases
LIFO liquidation results in higher profit margins and higher income taxes compared to what they would be if inventory quantities were not declining. Increases in profit margins from LIFO liquidation are not sustainable, however, because a firm cannot continue forever to sell existing inventory without replenishment.
Mgmt can use LIFO liquidation to artificially inflate earnings
Adjustment to retained earnings
Adjustment to retained earnings = LIFO reserve x (1 − t)
Adjustments to cash
Cash + LIFO reserve x (1 - t)
Under IFRS, inventory must be reported at
lower of cost or net realizable value (NRV)
NRV = Sale price - selling cost
If net realizable value < balance sheet value of inventory
the inventory is written down to net realizable value and the loss is recognized in the income statement
Under US GAAP, inventory is reported at
lower of cost or market
market = replacement cost. The replacement cost can’t be greater than NRV or less than (NRV - a normal profit margin); it has to be within the NRV and (NRV - normal profit margin)
If the inventory has been revalued, that’s it - you can’t revalue it again
if replacement costs > NRV
then market = NRV
If replacement costs < NRV - normal profit margin
replacement cost is adjusted up to (NRV - normal profit margin) value
If market < cost
inventory must be written down
“writing-up” assets (e.g. subsequent recovery in value) under US GAAP and IFRS
- under US GAAP: you can’t write-up assets
- under IFRS: yes, you can write-up assets (that’s why we have the ‘inventory valuation account’ to see the max amount we can write-up the asset)
if replacement cost < NRV - a normal profit margin
then market = NVR - a normal profit margin
Effects of a write-down of inventory on income statement, balance sheet
For both IFRS and US GAAP, when you write down inventory, during that period:
- COGS increases
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