Reading 32 Inventories Flashcards
How is inventory reported under IFRS?
At the lower of cost or net realizable value (NRV)
NRV is equal to the expected sales price less estimated selling and completion costs.
What happens if NRV is less than the balance sheet value of inventory?
The inventory is ‘written down’ to NRV, and the loss is recognized in the income statement
This can be as a separate line item or by increasing cost of goods sold (COGS).
What is the maximum amount inventory can be written up after a write-down?
It cannot be written up by more than it was previously written down
This applies under IFRS.
What is a valuation allowance account?
A contra-asset account similar to accumulated depreciation used for inventory write-downs
It separates the original cost of inventory from the carrying value.
How do U.S. GAAP and IFRS differ in reporting inventory for companies using LIFO or the retail method?
U.S. GAAP reports inventory at the lower of cost or market; market is defined differently than NRV
Market cannot be greater than NRV or less than NRV minus a normal profit margin.
What is the formula for calculating market value under U.S. GAAP?
Market is usually equal to replacement cost, but it cannot exceed NRV or be less than NRV minus a normal profit margin
If replacement cost exceeds NRV, market is NRV.
What is the retail method of inventory valuation?
A method for companies that resell merchandise, involving estimating COGS and ending inventory based on sales and profit margins
It computes cost of goods available for sale and adjusts for sales minus normal profit margin.
What happens when the market value of inventory decreases below its cost?
The inventory is written down to market on the balance sheet
The decrease is recognized in the income statement by increasing COGS or separately for large changes.
What is the impact of a subsequent recovery in value under IFRS?
Inventory can be written up to the original cost, recognizing a gain in the income statement
The write-up is limited to the amount of the original write-down.
What is the impact of a subsequent recovery in value under U.S. GAAP?
No write-up is allowed; carrying value remains at the lower amount
Higher profit is recognized when the inventory is sold.
How does LIFO affect the likelihood of recognizing inventory write-downs?
LIFO firms are less likely to recognize write-downs than firms using FIFO or weighted average cost
This is due to LIFO ending inventory being based on older, lower costs.
What are the effects of an inventory write-down on financial statements?
Decreases current and total assets, affects ratios like current ratio and inventory turnover
It also decreases equity and increases COGS, affecting margins.
What happens to the current ratio after an inventory write-down?
It decreases
The quick ratio remains unaffected.
How does inventory write-down affect inventory turnover?
It increases inventory turnover
This decreases days’ inventory on hand and cash conversion cycle.
What is the expected impact on net income from an inventory write-down?
The percentage decrease in net income is expected to be greater than the percentage decrease in assets or equity
This results in decreased return on assets (ROA) and return on equity (ROE).
What is the exception for reporting inventory above historical cost?
It applies to certain industries, allowing inventory to be reported at NRV with unrealized gains and losses recognized
This applies mainly to commodities like agricultural products and precious metals.
What happens to reported ROA and ROE in subsequent periods following a write-down?
ROA and ROE may increase from decreased COGS leading to higher profitability
This occurs alongside decreases in assets and equity from the write-down.
What happens to LIFO COGS compared to FIFO COGS during inflationary periods?
LIFO COGS is higher than FIFO COGS because the last units purchased have a higher cost than the first units purchased.
How does LIFO affect ending inventory during inflation?
LIFO ending inventory is lower than FIFO ending inventory because it is valued using older, lower costs.
What occurs to LIFO and FIFO COGS during deflationary periods?
LIFO COGS will be lower, and LIFO ending inventory will be higher.
What is the impact of stable prices on LIFO, FIFO, and average cost methods?
The LIFO, FIFO, and average cost methods will yield the same results for inventory, COGS, and gross profit.
What type of inventory does FIFO provide during periods of rising or falling prices?
FIFO provides the most useful measure of ending inventory made up of the most recent purchases.
How does the average cost method compare to LIFO and FIFO when prices are changing?
The average cost method will produce values of COGS and ending inventory between those of FIFO and LIFO.
What is the effect of LIFO on gross profit compared to FIFO during inflation?
Higher COGS under LIFO will result in lower gross profit compared to FIFO.
What are the effects of using LIFO versus FIFO on profitability measures?
Any profitability measure that includes COGS will be higher under FIFO.
How does LIFO affect liquidity compared to FIFO?
LIFO results in a lower inventory value on the balance sheet, making the current ratio and working capital lower than FIFO.
What is the effect of LIFO on inventory turnover compared to FIFO?
Inventory turnover is higher for firms that use LIFO compared to those that use FIFO.
What happens to total assets when adjusting from LIFO to FIFO?
Total assets are higher under FIFO because inventory is higher.
What is a LIFO liquidation?
A LIFO liquidation occurs when a LIFO firm’s inventory quantities decline, resulting in older, lower costs in COGS.
What is the impact of LIFO liquidation on profit margins?
LIFO liquidation results in higher profit margins and higher income taxes.
What should analysts look for in LIFO reserve disclosures?
Analysts should check if the LIFO reserve has decreased, indicating the possibility of a LIFO liquidation.
In Year 3, why does LIFO give a higher gross margin despite inflation?
This is caused by a LIFO liquidation.
Fill in the blank: When prices are rising, LIFO COGS will be _______ than FIFO COGS.
higher
Fill in the blank: Under LIFO, ending inventory is valued using _______ costs.
older, lower
True or False: Under stable prices, LIFO and FIFO will produce different results.
False
What is the purpose of inventory disclosures in financial statements?
Useful for evaluating a firm’s inventory management and adjusting financial statements for comparability with other firms
What are required inventory disclosures under U.S. GAAP and IFRS?
- Cost flow method used (LIFO, FIFO, etc.)
- Total carrying value of inventory by classification
- Carrying value of inventories at fair value less selling costs
- Cost of inventory recognized as expense (COGS)
- Amount of inventory write-downs during the period
- Reversals of inventory write-downs (IFRS only)
- Carrying value of inventories pledged as collateral
How do merchandising firms report inventory compared to manufacturing firms?
Merchandising firms report inventory in one account, while manufacturing firms report using three accounts: raw materials, work in progress, and finished goods
What does an increase in raw materials or work in progress inventory indicate?
The firm expects an increase in demand, leading to higher revenues and earnings
What may an increase in finished goods inventory indicate?
Decreasing demand and potential inventory write-downs in the future
What does a high inventory turnover ratio suggest?
Generally desirable, but may also indicate insufficient inventory to meet customer needs
What is the inventory turnover ratio formula?
Cost of sales / Average inventory
What does the days of inventory on hand measure?
The average number of days inventory is held before it is sold
How do you calculate days of inventory on hand?
365 / Inventory turnover
What indicates that inventory turnover may be too high?
High inventory turnover may mean the firm does not have enough inventory to satisfy customer needs
What does a declining gross profit margin indicate?
Increased costs of raw materials or manufacturing costs
What should analysts consider when interpreting declining inventory balances?
Potential misinterpretation as a sign of declining demand
What is the current ratio formula?
Current assets / Current liabilities
What is the quick ratio formula?
(Cash + Market securities + Receivables) / Current liabilities
Fill in the blank: Analysts should seek further explanation for inventory decline from ______.
[Management discussion and analysis, significant events disclosed in accounts, conferences with management, media reports, accounts of industry companies]
True or False: U.S. GAAP allows for reversals of inventory write-downs.
False
