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INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

Inventories

Key Terms

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LIFO. LIFO which is allowed under US-GAAP, but not allowed under IFRS assumes that the inventory items purchased
or manufactured most recently are sold first. The items remaining in the inventory are assumed to be oldest items
purchased or manufactured.
FIFO. FIFO assumes that the inventory items purchased or manufactured first are sold first. The items remaining in the
inventory are assumed to be the most recently purchased.
Weighted average cost. Weighted average cost assumes that the inventory items sold and those remaining in the
inventory are the same average age and cost. Weighted average cost assigns the average cost of goods available for
sale (beginning inventory plus purchases divided by total units) during the accounting period to the units sold as well as
to the units in the ending inventory.
LIFO and FIFO comparison with rising prices
COGS
EBT
Taxes paid
Net Income
Cash-flow from operations (CFO)

LIFO
Higher
Lower
Lower
Lower
Higher

FIFO
Lower
Higher
Higher
Higher
Lower

LIFO COGS is always greater than FIFO COGS. FIFO is the most accurate measure of ending inventory.
Consequences of using LIFO Method
Balance Sheet
Lower inventory
Lower current assets
Lower total assets

Income Statement
Higher Cost of Sales
Lower Operating Income(EBT)
Lower taxes paid
Lower net income
Lower retained earnings and
owners equity

Cash-Flow Statement
Lower taxes paid
Higher CFO
Higher free-cash flows
Higher valuation

Periodic and Perpetual Inventory Systems


Companies typically record changes to inventory using either a periodic inventory system or a perpetual inventory
system. Under a periodic inventory system, inventory value and COGS are determined at the end of the accounting
period. Under a perpetual inventory system, inventory values and COGS are continuously updated to reflect
purchases and sales.

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

LIFO Reserve
For companies using the LIFO method, US GAAP requires disclosure, in the notes to the financial statements or on the
balance sheet, of the amount of LIFO reserve.
A LIFO reserve is an accumulated cost of sales account. Imagine a company that uses LIFO as the inventory cost-flow
method that has just begun operations. The LIFO reserve is 0. In each accounting period, if the prices are rising, LIFO
method allocates more costs to the Cost of Goods Sold (items purchased most recently are sold first) than FIFO
method. This difference between LIFO COGS minus FIFO COGS is added to the LIFO reserve account, each period.
The cumulative effect is that, any year LIFO inventory must be adjusted by adding the total cumulative LIFO reserve, to
arrive at the FIFO inventory.
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Inventory conversion from LIFO to FIFO
When a firm reporting under LIFO method uses FIFO method, it affects the firm as follows,
The inventory value would differ by the LIFO reserve.
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The Cost of Sales under FIFO is lower than the Cost of Sales under LIFO, by the amount

The taxes paid under FIFO would be more and differ from the taxes paid under LIFO in the current accounting period
by,
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The net income under FIFO would be higher than the net income under LIFO by an amount,
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The cumulative amount of income tax savings generated by using LIFO over all prior periods, rather than FIFO is,
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When you make adjustments to a LIFO companys balance sheet for comparison with another FIFO company, all prior
financial results are adjusted. As Cash and marketable securities, inventory, retained earnings and comprehensive
income are balance sheet items, historical in nature, their carrying amounts are adjusted to include cumulative
increases (decreases) in value over all prior periods, due to the LIFO reserve.

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

The cash balance under LIFO would be more than the cash balance under FIFO,
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The retained earnings and comprehensive income under FIFO would be higher than the retained earnings under
LIFO by an amount,
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The Cash flow from Operations (CFO) under FIFO would be lower than the CFO under LIFO by an amount,
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LIFO Liquidation
When the number of units sold exceeds the number of units purchased or manufactured, the number of units in the
ending inventory is lower than the number of units in the beginning inventory and a company using LIFO will experience
a LIFO liquidation (some of the older units held in the inventory are assumed to have sold). If inventory unit costs have
been rising from period to period and LIFO liquidation occurs, this will produce an inventory-related increase in gross
profits. The increase in gross profits occurs because of the lower inventory carrying amounts of the liquidated units. The
gross profit on these units is higher than the gross profits that would be recognized using more current costs.

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Inventory Method Changes
Companies on rare occasion can change inventory valuation methods. If the change is justifiable, then it is applied
retrospectively. This means, that the change is applied to the comparative information for prior periods as far back as
practicable. The cumulative amount of the adjustments relating to the periods prior to those presented in the current
financial statements is made in the opening balance of each affected component of equity.
Inventory Adjustments
IFRS states that the inventories shall be measured and carried on the balance sheet at the lower of the cost and net
realizable value.
Net Realizable Value. The net realizable value (NRV) is the estimated selling price in the course of ordinary business
less the estimated costs necessary to make the sale and the estimated costs to get the inventory in the condition for
sale.
In the event that the realizable value of the inventory declines below the carrying amount of the inventory on the
balance sheet, the inventory carrying amount must be written down to the net realizable value (NRV), the reduction in

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

value is recorded in a contra account - allowance for inventory obsolescence (valuation allowance) and the loss is
recognized as an expense; an increase in Cost of Sales, on the income statement.
In each subsequent period, a new assessment of the net realizable value is made, and a reversal (limited to the original
amount of the write down) is required for a subsequent increase in the value of the inventory previously written down.
The reversal of any write-down of inventories is recognized as a reduction in the cost of sales (reduction in the
amount of inventories recognized as an expense).
Adjustments to inventory and COGS to assume no inventory write-down.
The adjusted value of inventory without the inventory write-down would be,
Net Inventory reported at lower of cost or net realizable value
plus Valuation allowance
Adjusted gross inventory without valuation allowance
The reduction in the Cost of Sales, therefore, without the inventory write-down would be,
Cost of sales
less Change in valuation allowance
Adjusted cost of sales without valuation allowance
The net income without the inventory write-down (or reversal of the write-down) would increase by,
( )
These effects are propagated to the retained earnings, owners equity.
US GAAP specifies the lower of the cost or market price to value inventories. The market price is defined as the current
replacement cost subject to upper and lower limits. The upper limit is the net realizable value (NRV). The lower limit is
the net-realizable value less a normal profit margin. Any write-downs are realized as a loss on the income statement.
US GAAP, however, does not allow reversal of write-downs.
Financial Statement Ratios. An inventory write-down reduces both the profit and the carrying amount of the inventory
on the balance sheet and thus has a negative effect on profitability, liquidity and solvency ratios. However, activity ratios
(for example inventory turnover ratio and total asset turnover ratio) will be positively affected by a write-down, because
the average inventory and total assets (denominator) is reduced.
Amongst all the costing methods, LIFO produces the lowest value of the inventory. By that logic, the possibility of a
company that uses LIFO method is least likely to write-down its inventory.