Reading 17: Inventories

Question 1

Calculate and explain how inflation and deflation of inventory affects the financial statements and ratios of companies that use different inventory valuation methods.

Answer 1

INVENTORY SYSTEMS

1. You get the same results with FIFO under either inventory system.
2. You get different results with LIFO under the two different inventory systems. (Avg cost method is also affected)

PRICE CHANGES

when prices are rising:

1. Analysts like LIFO on the Income Statement and FIO on the balance sheet

Question 2

Explain LIFO reserve and LIFO liquidation and thier effects on financial statements and ratios.

Answer 2

LIFO RESERVE

• Difference in LIFO and FIFO inventory
• Disclosed in LIFO firm’s footnotes
• Use to convert LIFO balance sheet and income statement to FIFO for comparative purposes

LIFO EFFECT

• Change in LIFO reserve from one period to the next (difference in LIFO and FIFO COGS)

LIFO LIQUIDATION

• occurs when goods sold exceed goods replaced
• Older (lower) inventory costs are used, and therefore, earnings increase
• Higher earnings are NOT sustainable
• Can be intential (earnings manipulation) or unintential
• Analysts should eliminate liquidation effects by adjusting COGS (amount disclosed in footnotes)

Question 3

Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.

Answer 3

Can only go LIFO to FIFO

See formula sheet

Question 4

Describe the implications of valuing inventory at net realizable value for financial statements and ratios.

Answer 4

BALANCE SHEET VALUATION (IFRS): must hold at the lower of cost and net realizable value

• Cost of goods excludes:
  
  • Abnormal costs
  • Storage costs
  • Admin ovrheads
  • Selling costs
    *

Question 5

Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.

Answer 5

• LIFO is better for the income statement, it gives you higher cogs and lower margins
• FIFO is better for the balance sheet, it gives you higher current assets
• LIFO producs higher inventory turnover and lower days inventory on hand
• FIFO results in higher assets and higher equity

Question 6

Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information.

Answer 6

• More raw and WIP = expected increase in demand
• Increase in Finished Goods = decrease in demand
• Finish goods growing faster tha nsales = decrease in demand and could cause obsolete inventory