Inventory

Question 1

product cost

Answer 1

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.

Question 2

period cost

Answer 2

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.

Question 3

Assuming rising prices and stable or increasing inventory levels,

Answer 3

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

Question 4

LIFO reserve

Answer 4

LIFO ending reserve = FIFO ending inventory - LIFO ending inventory

Question 5

To make financial statements prepared under LIFO compared to financial statements prepared under FIFO, an analyst must

Answer 5

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)

Question 6

To convert LIFO COGS to FIFO COGS

Answer 6

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.

Question 7

Convert LIFO net income to FIFO net income

Answer 7

FIFO Net income = LIFO net income + [(end LIFO reserve - beg LIFO reserve) x (1 - t)]

t = tax rate

Question 8

Convert LIFO Retained Earnings to FIFO Retained Earnings

Answer 8

FIFO Retained Earnings = LIFO Retained Earnings + (end LIFO reserve - beg LIFO reserve ) x (1 - t)

t = tax rate

Question 9

The LIFO reserve will increase when

Answer 9

prices are rising and inventory quantities are stable or increasing

Question 10

The LIFO reserve will decrease when

Answer 10

prices are falling or firm is liquidiating its inventory

Question 11

Firms tend to do LIFO liquidation when

Answer 11

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

Question 12

Adjustment to retained earnings

Answer 12

Adjustment to retained earnings = LIFO reserve x (1 − t)

Question 13

Adjustments to cash

Answer 13

Cash + LIFO reserve x (1 - t)

Question 14

Under IFRS, inventory must be reported at

Answer 14

lower of cost or net realizable value (NRV)

NRV = Sale price - selling cost

Question 15

If net realizable value < balance sheet value of inventory

Answer 15

the inventory is written down to net realizable value and the loss is recognized in the income statement

Question 16

Under US GAAP, inventory is reported at

Answer 16

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

Question 17

if replacement costs > NRV

Answer 17

then market = NRV

Question 18

If replacement costs < NRV - normal profit margin

Answer 18

replacement cost is adjusted up to (NRV - normal profit margin) value

Question 19

If market < cost

Answer 19

inventory must be written down

Question 20

“writing-up” assets (e.g. subsequent recovery in value) under US GAAP and IFRS

Answer 20

• 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)

Question 21

if replacement cost < NRV - a normal profit margin

Answer 21

then market = NVR - a normal profit margin

Question 22

Effects of a write-down of inventory on income statement, balance sheet

Answer 22

For both IFRS and US GAAP, when you write down inventory, during that period:

• COGS increases

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