inventory valuations

Question 1

what are the two ways inventory can be classified?

Answer 1

identifiable products and indistinguishable products

Question 2

what are identifiable products?

Answer 2

many products have an identifiable characteristic, and many such items can be identified through serial numbers or model codes. The costs embedded in each item sold can be readily tracked.

Question 3

what are indistinguishable products?

Answer 3

some goods are indistinguishable in nature, examples of these include commodities such as oil, gas, coal, petrochemicals, steel, copper, gold and silver and non-wasting standardised industrial products such as rivets, screws, copper tubing, bricks and concrete blocks. It would be very difficult (and in most cases impossible) to track embedded costs in each product sold

Question 4

what is the cost-of-sales equation?

Answer 4

value for inventory at end of period = value at start of period + cost additions - cost of goods sold from inventory

Question 5

what is the cost-of-sales equation rearranged?

Answer 5

cost-of-sales for period = inventory value at start of period + cost of additions - inventory value at end of period

Question 6

why is this a better way to calculate cost-of-sales for many goods rather than trying to track the costs of individual items that are sold?

Answer 6

• it is easier to calculate as it relies on a physical stock check at the end of each period rather than trying to track individual units sold over the period
• it captures any inventory wastages or losses which are included in the cost-of-sales for the period they are lost

Question 7

what is affected by how cost-of-sales is calculated?

Answer 7

revenue is unaffected by how we account for the inventory sold but profit depends on how cost-of-sales is calculated and this in turn depends on how inventory is valued

Question 8

what are the three inventory valuation methods?

Answer 8

First-in-First-out (FIFO)
Last-in-Last-out (LIFO)
Average cost (AVCO)

Question 9

what is cost-of-sales based on under FIFO?

Answer 9

Under First-in-First-out cost-of-sales (the first-out) is based on the cost of the oldest stock (the first-in) bought and hence inventory valuation is based on the costs of the last (the most recent) stock bought

Question 10

what is cost-of-sales based on under LIFO?

Answer 10

Under Last-in-First-out the cost-of-sales (the first-out) is based on the cost of the newest stock (the last in) bought and hence inventory valuation is based on the costs of the first (the oldest) stock bought

Question 11

what is cost-of-sales based on under AVCO?

Answer 11

under average cost both the cost of sales and inventory valuation are based on the average cost of inventory bought

Question 12

why inventory valuation gives highest cost-of-sales and which gives highest profit?

Answer 12

LIFO gives highest cost-of-sales and lowest profit
FIFO gives the lowest cost-of-sales and highest profit
AVCO gives cost-of-sales and profit values between FIFO and LIFO

Question 13

what is the impact on cost-of-sales and profits if prices are flat for extended period of time?

Answer 13

no difference between cost-of-sales, and hence profits, for the two methods

Question 14

what is the impact on cost-of-sales and profits if prices are rising?

Answer 14

cost-of-sales under LIFO will be higher and profits lower than under FIFO because under FIFO the firm will take some of the older-cheaper stock through cost-of-sales while under LIFO the oldest stock remains in inventory

Question 15

what is the impact on cost-of-sales and profits if prices are falling?

Answer 15

cost-of-sales under LIFO will be lower and profits higher than under FIFO. This is because under LIFO some of the more recent, cheaper stock is taken through as cost-of-sales but remains in inventory valuation for FIFO.

Question 16

why do US firms opt for LIFO but it is prohibited under IFRS?

Answer 16

Using LIFO gives lowest profit and lowest inventory valuation when prices are rising and it is not obvious why anyone would chose this method given both FIFO and AVCO give higher reported profit and inventory values. Under IFRS it is prohibited.

In the US, its use it permitted under US GAAP and many oil majors and other companies with large stocks of indistinguishable inventory have opted to prepare their financial statements LIFO. Their motive is to avoid paying taxes on the gains on their inventory from decades of rising prices.

Question 17

why is LIFO prohibited under IFRS? (reflecting businesses practices)

Answer 17

It does not reflect business practices

Firms sell their oldest stock first, not the stock that they have most recently acquired as implied by LIFO. The only reason that US firms use LIFO is for the tax advantages the method brings and it is only a very narrow group of firms that can benefit from these.

Question 18

why is LIFO prohibited under IFRS? (part of its inventory is “never” sold)

Answer 18

part of its inventory is “never” sold

inventory valuation methods for indistinguishable items track costs rather than physical goods. Under LIFO, provided the firm maintains a constant or increasing inventory and volume sales are less than purchases part of its inventory is never considered as sold.

Companies applying LIFO that have existed for many years appear to have inventory that dates to when they first started using LIFO - which may well have been more than 40 years ago. Firms do not have inventory sitting in their factories, warehouses or refineries that was bought many years previously, but it is these goods rather than the more expensive ones bought more recently that are represented in the SOFP.

Question 19

why is LIFO prohibited under IFRS? (understated book values)

Answer 19

the use of LIFO has led to seriously understated inventory valuations and hence book values at long-established companies holding commodities such as oil companies

Question 20

why is LIFO prohibited under IFRS? (investment comparison is harder)

Answer 20

investment comparison is harder

LIFO is prohibited under IFRS and it is harder for investors to compare the performance of US oil companies and other US firms using LIFO with their peers in other countries following IFRS.

Question 21

what are the other reasons to argue LIFO should be prohibited in the US

Answer 21

incentivises inefficient inventory management

there is an incentive for firms that have adopted LIFO to increase the amount of their stocks held above that needed on operational grounds in order to increase their LIFO reserver [Kleinbard et al., 2006]

unfair

proponents of LIFO argue that taxes being avoided are taxes on profits arising from inflation. This many be true, but this is also the case for the much larger group of firms trading in goods that are identifiable and they have had to pay taxes on these profits.