Part 7. Inventories

Question 1

Manufacturing firms report inventory using 3 separate accounts:

Answer 1

1. Raw Materials
2. Work-in-process

3, Finished goods

Question 2

Product costs, capitalised in inventories account on balance sheet:

Answer 2

• Purchase cost less trade discounts and rebates.
• Conversion (manufacturing) costs including labor and overhead.
• Other costs necessary to bring inventory to its present location and condition.

Question 3

Period costs, costs expensed in the period incurred:

Answer 3

• Abnormal waste of materials, labor or overhead.
• Storage costs (unless required as part of production)
• Admin overhead
• Selling costs

Question 4

Cost flow method

Answer 4

This is used to allocate the inventory cost to the income statement (COGS) and the balance sheet (ending inventory).

Under the IFRS, the permissible methods are:

• specific identification
• first in, first out
• weighted average cost

US GAAP permits the above, plus last in, first out (LIFO), which is not allowed in IFRS.

Question 5

Specific identification method

Answer 5

This is when each unit sold is matched with the units actual cost.

This is appropriate when inventory items are not interchangeable and commonly used by firms with a small number of costly and easily distinguishable items such as jewellery.

Also appropriate for special orders or projects outside firms normal course of business.

Question 6

First in, first out (FIFO)

Answer 6

The first item purchased is assumed to be the first item sold.

Advantage:

• the ending inventory is valued based on the most recent purchases, the best approx. of current cost.
• FIFO COGS is based on earliest purchase costs.
• During inflation, COGS will be understated compared to current cost, since earnings will be overstated.

Question 7

Last in, first out (LIFO)

Answer 7

The item purchased most recently is assumed to be the first item sold.

• During inflation, LIFO COGS will be higher than FIFO COGS, and earnings will be lower.
• Low earnings translate to lower income taxes, which increase cashflow.
• LIFO ending inventory on balance sheet is valued using earliest costs, hence inflation present means LIFO ending inventory is less than current cost.

Question 8

Weighted average cost

Answer 8

The average cost per unit of inventory is computed by dividing total cost of goods available for sale (beginning inventory + purchases) by total quantity available for sale.

• during inflation or deflation, weighted average cost will produced inventory value between produced by FIFO and LIFO.

Question 9

Periodic inventory system

Answer 9

Inventory values and COGS are determined at the end of the accounting period, with no detailed records of inventory are maintained, but inventory acquired in period is reported in purchases account.

At the end of the period, purchases are added to the beginning inventory to arrive at COG available for sale.

Calculate COGS, by ending inventory subtracted from goods available for sale.

Question 10

Perpetual inventory system

Answer 10

The inventory values and COGS are updated continuously, where inventory purchased and sold is recorded directly in inventory when transactions occur, thus the purchase account is not necessary.

Question 11

periodic vs perpetual

Answer 11

periodic - this system matches the total purchases for the month with the total withdrawals of inventory units for the month.

perpetual - this system matches each unit withdrawn with the immediately preceding purchases.

Question 12

LIFO vs FIFO during periods of inflation/deflation

Answer 12

Inflation:

• LIFO COGS > FIFO COGS; as last units purchased have higher cost than first units purchased.
• LIFO; the more costly last units purchased assumed to be first units sold (to COGS)
• Higher COGS under LIFO result in lower gross profit and net income compared to FIFO.
• LIFO ending inventory is lower than FIFO, as ending inventory is valued using older lower costs.

Deflation:

• LIFO COGS < LIFO ending inventory; as the most recent lower cost purchases are assumed to be sold first under LIFO, and units in ending inventory assumed to be earliest purchases with higher costs.

Question 13

Ending inventory

Answer 13

• when prices are rising or falling, FIFO provides more useful measure of ending inventory.
• since FIFO inventory is the most recent purchase, these costs can be viewed as better approx. of current cost thus better approx. of economic value.
• LIFO inventory is based on older costs that may differ significantly from current economic value.

Question 14

COGS

Answer 14

• changing prices produce significant differences between COGS under LIFO and FIFO.
• LIFO COGS are based on most recent purchases; where prices rising LIFO COGS > FIFO COGS, and opposite when prices fall.
• LIFO produces better approx. of current cost in income statement, as LIFO is based on most recent purchases.
• with changing prices, the WAC method will produce values of COGS and ending inventory between FIFO and LIFO.

Question 15

Gross profit

Answer 15

• As COGS is subtracted from revenue in calculating gross profit; this is affected by the choice of cost flow method.
• Assuming inflation, higher COGS under LIFO will result in lower gross profit, and all profitability measures will be affected by choice of cost flow method.

Question 16

4 relations that hold when prices are rising over a relevant period:

Answer 16

1. LIFO inventory < LIFO inventory
2. LIFO COGS > FIFO COGS
3. LIFO net income < FIFO net income
4. LIFO tax < FIFO tax

Question 17

LIFO reserve

Answer 17

The amount by which LIFO inventory is less than FIFO inventory, to make financial statements prepared under LIFO comparable to those of FIFO firms, 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 LIFO reserve.

Question 18

Profitability

Answer 18

• LIFO produces higher COGS in the income statements and results in lower earnings, whereas any profitability measure includes COGS higher under FIFO.
  e. g. reducing COGS results in higher gross, operating and net profit margins compared to LIFO.

Question 19

Liquidity

Answer 19

• LIFO results in lower inventory value on balance sheet as inventory is higher under FIFO, the current ratio a popular measure of liquidity higher under FIFO.
• working capital is higher under FIFO, because current assets are higher.

Question 20

Activity

Answer 20

• Inventory turnover (COGS/ average inventory) is higher for firms that use LIFO, compared to firms use FIFO.
• LIFO COGS is valued more recent, higher costs (higher numerator), while inventory is valued at older, lower costs (lower denominator).
• Adjusting to FIFO values will result in lower turnover and higher days of inventory on hand (365 / inventory turnover).

Question 21

Solvency

Answer 21

• Adjusting to FIFO results in higher total assets as inventory is higher.
• Higher total assets under FIFO result in higher stockholders equity (assets - liabilities), as total assets and stockholder’s equity are higher under FIFO, debt ratio and debt to equity ratio are lower in FIFO than LIFO.

Question 22

LIFO liquidation

Answer 22

This occurs when LIFO firm’s inventory quantities decline, where older lower costs are included in COGS compared to situations in which inventory quantities are not declining.

This results in higher profit margins and income taxes compared to inventory quantities not declining.

Extra profit reported with LIFO liquidation inflates operating margins by recognizing historical inflationary gains from increasing inventory prices as income in the current period.

An increase in profit margins from LIFO liquidation is not sustainable, but the firm cannot continue forever to sell existing inventory without replenishment.

Question 23

Uses of LIFO liquidation

Answer 23

• Artificially inflate current period earnings.
• Inventory declines caused by events outside management control, such as strikes, or material shortages at key suppliers make inventory reduction involuntary or fall in expected customer orders meaning a voluntary reduction in inventory to suit market conditions.
• Requires adjustment for profit margins, if LIFO reserve has decreased significantly over the period.
• decrease in COGS will increase gross profits, pretax income, and net income.
• decrease in cash expenses will increase operating cash flow, but higher income tax on higher earnings partially offset an increase in cash flow.

Question 24

Net realisable value (NRV)

Answer 24

This is equal to the expected sales price less the estimated selling costs and completion costs.

If less than balance sheet value of inventory, the inventory is written down to net realizable value and loss is recognised in income statement.

If subsequent recovery in value, the inventory can be written up and gain is recognised in income statement by reducing COGS by amount of recovery.

If an inventory is valued at lower cost or NRV, the inventory cannot be written up by more than previously written down.

Question 25

Lower cost or market

Answer 25

For companies using LIFO or retail method, the inventory reported on balance sheet.

Market is usually equal to replacement cost, but cannot be greater than NRV or less than NRV minus normal profit margin.

If replacement cost exceeds NRV then market is NRV.

If replacement cost is less than NRV minus normal profit margin, then market is NRV minus normal profit margin.

cost > market = inventory is written down to the market in BS.

• fall in value recognized in the income statement by increasing COGS for relatively small changes in value or by recording loss from inventory write-down separately for relatively large change in value.
• the market value becomes the new cost basis.

Question 26

Implications of write down:

Answer 26

• As inventory is part of current assets, an inventory write-down. decreases both current and total assets.
• Current ratio (CA/CL) decreases, but quick ratio is unaffected as inventories are not included in numerator quick ratio.
• Inventory turnover (COGS/average inventory) is increased, which decreases days inventory on hand and cash conversion cycle.
• Decrease in total assets increases total asset tunrover and increases debt to asset ratio.
• Equity is decreased, increasing debt to equity ratio.
• Increase in COGS reduced gross margin, operating margin and net margin.
• Percentage decrease in net income can be expected to be greater than percentage decrease assets or equity, as both ROA and ROE are decreased.

Question 27

Inventory disclosures

Answer 27

These are found in financial statement footnotes are useful in evaluating firms’ inventory management, and useful in making adjustments to facilitate comparison with other firms in industry.

Question 28

Required inventory disclosures include:

Answer 28

• The cost flow method (LIFO, FIFO etc) used.
• Total carrying value of inventory with carrying value by classification (raw materials, work in process, finished goods) if appropriate.
• Carrying value of inventories reported at fair value less selling costs.
• The cost of inventory recognised as expense (COGS) during period.
• Amount of inventory write-downs during the period.
• Reversals of inventory write-downs during period, including a discussion of the circumstances of reversal (IFRS only because US GAAP does not allow reversals).
• Carrying value of inventories pledged as collateral.