Reading 22: Inventories Flashcards
Contrast costs included in inventories and costs recognised as expenses in the period period in which they are incurred.
Costs included in inventory on the balance sheet include purchase cost, conversion costs, and other costs necessary to bring the inventory to its present location and condition. All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or to ending inventory.
Period costs, such as abnormal waste, most storage costs, administrative costs, and selling costs, are expensed as incurred.
Describe different inventory valuation methods (cost formulas).
Inventory cost flow methods:
* FIFO: The cost of the first item purchased is the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases, thereby approximating current cost.
* LIFO: The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under IFRS.
* Weighted average cost: COGS and inventory values are between their FIFO and LIFO values.
* Specific identification: Each unit sold is matched with the unit’s actual cost.
Calculate and compare cost of sales, gross profit, and ending inventory usng different inventory valuation methods and using perpetual and periodic inventory systems.
Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance sheet inventory values reflect older outdated costs.
Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and balance sheet inventory values reflect the most recent costs.
Under the weighted average cost method, cost of sales and balance sheet inventory values are between those of LIFO and FIFO.
When purchase or production costs are rising, LIFO cost of sales is higher than FIFO cost of sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory.
When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is higher than FIFO inventory.
In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs).
In a periodic system, inventory values and COGS are determined at the end of the accounting period. In a perpetual system, inventory values and COGS are updated continuously.
In the case of FIFO and specific identification, ending inventory values and COGS are the same whether a periodic or perpetual system is used.
LIFO and weighted average cost, however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used.
Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods.
When prices are increasing and inventory quantities are stable or increasing:
* LIFO results in:
* * higher COGS
* * lower gross profit
* * lower inventory balances
* * higher inventory turnover
* FIFO results in:
* * lower COGS
* * higher gross profit
* * higher inventory balances
* * lower inventory turnover
When prices are decreasing and inventory quantities are stable or increasing:
* LIFO results in:
* * lower COGS
* * higher gross profit
* * higher inventory balances
* * lower inventory turnover
* FIFO results in:
* * higher COGS
* * lower gross profit
* * lower inventory balances
* * higher inventory turnover
The weighted average cost method results in values between those of LIFO and FIFO if prices are increasing or decreasing.
Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
A firm that reports under LIFO must disclose a LIFO reserve, which is the difference between LIFO inventory reported and inventory had the firm used the FIFO method. LIFO reserve will be positive during periods of rising inventory costs and negative during periods of falling inventory costs.
A LIFO liquidation occurs when a firm using LIFO sells more inventory during a period than it produces. During periods of rising prices, this drawdown in inventory reduces cost of goods sold because the lower cost of previously produced inventory is used, resulting in an unsustainable increase in gross profit margin.
Demonstrate the conversion of a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
To convert a firm’s financial statements from LIFO to what they would have been under FIFO:
1. Add the LIFO reserve to LIFO inventory.
2. Subtract the change in the LIFO reserve for the period from COGS.
3. Decrease cash by LIFO reserve × tax rate.
4. Increase retained earnings (equity) by LIFO reserve × (1 − tax rate).
Describe the measurement of inventory at the lower of cost and net realisable value.
Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory write-ups are allowed, but only to the extent that a previous write-down to net realizable value was recorded.
Under U.S. GAAP, inventories are valued at the lower of cost or net realizable value for companies using cost methods other than LIFO or the retail method. For companies using LIFO or the retail method, inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but cannot exceed net realizable value or be less than net realizable value minus a normal profit margin. No subsequent write-up is allowed for any company reporting under U.S. GAAP.
Describe implications of valuing inventory at net realisable value for financial statements and ratios.
A write-down of inventory value from cost to net realizable value will:
* Decrease inventory, assets, and equity.
* Increase asset turnover, the debt-to-equity ratio and the debt-to-assets ratio.
* Result in a loss on the income statement, which will decrease net income and the net profit margin, as well as ROA and ROE for a typical firm.
Describe the financial statement presentation of and disclosures relating to inventories.
Required inventory disclosures:
* The cost flow method (LIFO, FIFO, etc.) used.
* Total carrying value of inventory and carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate.
* Carrying value of inventories reported at fair value less selling costs.
* The cost of inventory recognized as an expense (COGS) during the period.
* Amount of inventory write-downs during the period.
* Reversals of inventory write-downs during the period (IFRS only because U.S. GAAP does not allow reversals).
* Carrying value of inventories pledged as collateral.
Explain issues that analyst should consider when examining a company’s inventory disclosures and other sources of information.
An analyst should examine inventory disclosures to determine whether:
* The finished goods category is growing while raw materials and goods in process are declining, which may indicate decreasing demand and potential future inventory write-downs.
* Raw materials and goods in process are increasing, which may indicate increasing future demand and higher earnings.
* Increases in finished goods are greater than increases in sales, which may indicate decreasing demand or inventory obsolescence and potential future inventory write-downs.
Calculate and compare ratios of companies, including companies that use different inventory methods.
Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm’s inventory management.
* Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory.
* High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled.
* High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory.
Analyze and compare the financial statements of companies, including companies that use different inventory methods.
Comparison of company financial statements may require statements to be adjusted to reflect the same inventory costing methods for both firms, or for the subject firm and any industry or peer group of firms used for comparison.
