Vol.3 LM5 Inventory Systems Flashcards
List
Companies typically record changes to inventory using either of these two inventory systems
p. 263
- periodic inventory system
OR - perpetual inventory system
Under a periodic inventory system
when are inventory values and costs of sales determined?
p. 263
at the end of accounting period
Under periodic inventory system
quantity of goods in ending inventory
p. 263
usually obtained or verified through a physical count of the units in inventory
Under perpetual inventory system
when are inventory values and cost of sales determined?
p. 263
continuously updated to reflect purchases and sales
Inventory valuation methods
the allocation of goods available for sale to cost of sales and ending inventory is the same under which inventory valuation methods
p. 263
specific identification
FIFO
inventory valuation method
under which inventory valuation methods will allocations to cost of sales and ending inventory be different?
p. 263
LIFO
sometimes for weighted average cost
Compare
LIFO vs FIFO
p. 263
- the higher cost of sales under LIFO will result in lower gross profit
- income tax expense will be lower under LIFO, causing the company’s net operating cash flow to be higher
- the lower cost of sales under FIFO will result in higher gross profit
- income tax expense will be higher under FIFO, causing the company’s net operating cash flow to be lower
Benefits of using
LIFO in an increasing inventory cost environment
p. 268
- income tax svings
- higher cash flows due to lower income taxes may make the company more valuable based the present value of its future cash flows
undesirable outcomes
LIFO in an increasing inventory cost environment
p. 268
- higher cost of sales
- lower gross profit
- lower operating profit
- lower net income
All these consequences may reflect poorly in the balance such as lower current ratio, higher debt-to-equity
Reason
publicly traded companies must take care when choosing an inventory valuation method
p. 268
while it may benefit the company to use LIFO during increasing inventory costs, it may not be able to switch inventory methods once inventory costs decrease.
Concept
is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used
p. 268
LIFO Reserve
Describe
LIFO reserve
p. 268
is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used
under US GAAP
companies using LIFO must disclose this either in the notes to the financial statement or on the balance sheet
p. 269
LIFO reserve
How to
compare companies using LIFO and FIFO
p. 269
- an analyst must add the LIFO reserve to the inventory balance reported on the balance sheet
- this is because the LIFO inventory balance + LIFO reserve = FIFO balance that would have been reported
Explain
LIFO liquidation
p. 269
when the number of units sold exceeds the number of units purchased or manufactured, the number of units in ending inventory is lower than the number of units in beginning inventory and a company using LIFO will experience a LIFO liquidation. Inventory appears to have been sold that has not been sold.
what will result if
If inventory unit costs have been rising from period to period and LIFO liquidation occurs
p. 269
- this will produce an inventory-related increase in gross profits
- this will only be a one-time event
A decline in the LIFO reserve from the prior period may be indicative of …
p. 270
LIFO liquidation
During economic downturns, LIFO liquidation may result in …
p. 270
higher gross profit than would otherwise be realized
What inventory values would CAT report for 2017, 2016, and 2015 if had used FIFO instead of LIFO?
Balance Sheet
….Total inventories 2017: 10,018 2016: 8,614
….LIFO reserve 2017: 1,924 2016: 2,189
p. 272
Inventories
2017: 10,018+1,924=11,942
2016: 8,614+2,129=10,753
What amount would be added to CAT’s retained earnings (profit employed in the business) at 31 December 2017 if CAT had used the FIFO method instead of the LIFO method?
LESS: increase in cost of goods sold (decrease in operating profit) 2017: -215 2016: -359
Tax reduction on decreased operating profit 2017: 60 2016: 129
FIFO inventories 2017: 1,924 2016 2,137
p. 273
(60/215)=0.28; (129/359)=0.36
(-215 x (1-0.28) + 2,139 x (1-0.36)) = 1,214 retained earnings
Some analysts advocate ignoring the tax consequences and suggest simply adjusting inventory and equity by the same amount.
Calculate inventory turnover ratio, days of inventory on hand for 2017 for CAT
Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773
p. 270
Inventory turnover ratio = cost of goods sold / average inventory
LIFO = 31,049 / [(10,018 + 8,614)/2] = 3.33
FIFO = [31,049 + (2,139-1,924)] / [[(10,018+1,924) + (8,614+1,924)]/2] = 2.76
days of inventory on hand = number of days in period / inventory turnover ratio
LIFO = (365 / 3.33) = 109.6 days
FIFO = (365 / 2.76) = 132.2 days
without adjustment, a company using the LIFO method might appear to manage its inventory more effectively
Calculate gross profit margin for 2017 for CAT
Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773
p. 270
gross profit margin = gross profit / total revenue
LIFO = [(42,676 - 31,049) / 42,676] = 27.24 percent
FIFO = [(42,676 - (31,049+215)) / 42,676] = 26.74 percent
Revenue of financial products is excluded from the calculation of gross profit.
Gross profit is sales of machinery and engines less cost of goods sold.
Calculate gross profit margin for 2017 for CAT
Cost of goods sold 2017 31,049 2016 28,309
Inventories 2017 10,018 2016 8,614
FIFO inventories 2017: 1,924 2016 2,137
Sales of Machinery and Engines 2017 42,676 2016 35,773
Net income (loss) (FIFO method) 2017 599 2016 -297
Net income (loss) (LIFO method) 2017 754 2016 -67
Total assets 2017 76,692 2016 74704
p. 270
return on assets = net income / average total assets
LIFO = 754 / [(76,962 +74,704) / 2] = 0.99 percent
LIFO = 754 / [(76,962 +1,924) + (74,704 +2,139)/ 2] = 0.77 percent
The total assets under FIFO are the LIFO total assets increased by the LIFO reserve.
The return on assets is lower under FIFO because of the lower net income due to the higher cost of goods sold as well as higher total assets due to the LIFO reserve adjustment.
Under IFRS
a change in the inventory valuation method is acceptable only if
p. 277
the change in method is acceptable only if the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events, or conditions on the business entity’s financial position
Describe
retrospective restatement
p. 277
when a company makes a change in accounting policy in the current period, it must present a comparative financial statements for previous periods as if the new policy had been used the entire time.
List reasons
cost of inventory may not be recoverable
p. 278
- spoilage
- obsolescence
- declines in selling prices
Concept
is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale
p. 278
net realisable value
Describe
net realisable value
p. 278
is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale
