Inventory Analysis Flashcards
Significant risks can result from holding inventory because the cost of inventory may not be recoverable due to spoilage, obsolescence, or declines in selling price.
According to IFRS, how should a company measure inventory?
At net realizable value.
What is net realizable value?
The estimated selling price in the ordinary course of business, minus the estimated costs necessary to make the sale and to get the inventory in condition for sale.
What happens when the value of the inventory declines below the carrying amount on the balance sheet, according to IFRS?
The inventory carrying amount must be written down to its net realizable value and this reduction in value must be recognized as an expense on the income statement under COGS or separately.
What happens when the value of the inventory increases again after a write-down, according to IFRS?
A reversal which is limited to the amount of the original write-down. The COGS also reduces because the inventory is worth more again.
What is the difference between IFRS and US GAAP in inventory measurement?
US GAAP prohibits the reversal of write-downs.
What is the market value of inventory for companies that use LIFO or retail inventory methods?
Current replacement costs subject to upper and lower limits. Market value cannot exceed net realizable value.
How to calculate the lower limit of the market value?
Net realizable value minus a normal profit margin
How does an inventory write-down affect performance ratios, liquidity and solvency ratios, and activity ratios?
Inventory write-downs negatively affect profit and the value of inventory so it reduces performance, liquidity and solvency ratios. However, activity ratios such as inventory turnover or asset turnover will be positively influenced. However, companies are still reluctant to write-down inventory because it reduces profitability, especially under US GAAP where reversals are prohibited.
The exception to inventory standards is applicable to agricultural and forest products, minerals and commodity broker-traders, what can they do different?
Can be measured at net realizable value. Fair value can be obtained from the potential secondary market. Changes in inventory value are recognized in profit or loss in the period of change.
Under which inventory measurement method are write-downs the least likely and why?
LIFO, because under the LIFO method, the oldest costs are reflected in the inventory carrying amount on the balance sheet. Given increasing inventory costs, the inventory carrying amounts under the LIFO method are already conservatively presented at the oldest and lowest costs. Thus, it is far less likely that inventory write-downs will occur under LIFO—and if a write-down does occur, it is likely to be of a lesser magnitude.
What are three ratios used to evaluate the efficiency and effectiveness of inventory management?
Inventory turnover
Days of inventory on hand
Gross profit margin
What is inventory turnover and how to calculate it?
It measures the number of times during the year a company sells its inventory. The higher the turnover ratio, the more times that inventory is sold during the year and the lower the relative investment of resources in inventory.
COGS / Average inventory
What are days of inventory on hand and how to calculate it?
Days in the period divided by inventory turnover.
High inventory turnover and a low number of days of inventory on hand might indicate highly effective inventory management. Alternatively, a high inventory ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values.
