CH8 Inventories

CHAPTER 8
INVENTORIES
Lecture by: Say Vichheka
LEARNING OUTCOMES
 Distinguish between costs included in inventories and costs
recognized as expenses in the period in which they are
incurred.
 Describe different inventory valuation methods (cost formulas).
 Calculate and compare cost of sales, gross profit, and ending
inventory using different inventory valuation methods and using
periodic and perpetual inventory systems.
 Calculate and explain effects of inflation and deflation of
inventory costs on the financial statements and ratios of
companies that use different inventory valuation methods (cost
formulas or cost flow assumptions).
 Explain LIFO reserve and LIFO liquidation and their effects on
financial statements and ratios.
Copyright © 2013 CFA Institute 2

LEARNING OUTCOMES (CON’T)
 Convert a company’s reported financial statements from

LIFO to FIFO for purposes of comparison.
 Describe implications of valuing inventory at net realizable
value for financial statements and ratios.
 Describe the financial statement presentation of and
disclosures relating to inventories.
 Explain issues that analysts should consider when
examining a company’s inventory disclosures and other
sources of information.
 Analyze and compare the financial statements and ratios
of companies, including those that use different inventory
valuation methods.

COSTS INCLUDED IN INVENTORIES
Costs included in Inventories and Costs excluded from Inventories

recognized as expenses when and recognized as expenses in
goods are sold: period incurred:
• Costs of purchase, e.g. • Abnormal costs incurred as a
- purchase price, net of result of waste of materials,
discounts labor or other production
- import duties and taxes conversion inputs
- transport and handling • Storage costs (unless required
- insurance during transport as part of the production
• Costs of conversion process)
• Other costs incurred in bringing • All administrative overhead
the inventories to their present and selling costs
location and condition

COSTS INCLUDED IN INVENTORIES: EXAMPLE
Assume that during a year, a table manufacturing company
- produced 900,000 finished tables incurring
- raw material costs of €9 million,
- direct labour conversion costs of €18 million, and
- production overhead costs of €1.8 million.
- scrapped 1,000 tables (attributable to abnormal waste) incurring
- raw material costs of €10,000 and
- labor and overhead conversion costs of €20,000.
- spent
- €1 million for freight delivery charges on raw materials and
- €500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at year end.
• What costs should be expensed in the period incurred?

• What costs should be included in inventory and expensed when the goods are
sold?


- direct labour conversion costs of €18 million, and Total costs that
- production overhead costs of €1.8 million. should be expensed
- scrapped 1,000 tables (attributable to abnormal waste) €30,000
incurring 500,000
- raw material costs of €10,000 and €530,000
- labor and overhead conversion costs of €20,000.
- spent
- €1 million for freight delivery charges on raw
materials and
- €500,000 for storing the finished goods as
inventory.
What costs should be expensed in the period incurred?


- direct labour conversion costs of €18 million, and
- production overhead costs of €1.8 million. Total inventory costs
- scrapped 1,000 tables (attributable to abnormal waste) €9,000,000
incurring 18,000,000
- raw material costs of €10,000 and
- labor and overhead conversion costs of €20,000. 1,800,000
- spent 1,000,000
- €1 million for freight delivery charges on raw materials €29,800,000
and
- €500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at
year end.
What costs should be included in inventory and expensed

when the goods are sold?

INVENTORY COST FLOW
Beginning Ending
Goods
Inventory Inventory
Available
Goods For
Sale Cost of
Purchased Goods Sold
Balance Sheet Income Statement

SUMMARY TABLE ON INVENTORY
VALUATION METHODS
Method Description
Actual costs of items specifically identified as sold

Specific Identification
allocated to COGS.
Assumes that earliest items purchased were sold

FIFO (First in-First out)
first. First in to inventory = first out to COGS.
Assumes most recent items purchased were sold

LIFO (Last In-First Out)*
first. Last in to inventory = first out to COGS.
Weighted Average Cost Averages total costs over total units available.
*LIFO not permitted under IFRS

INVENTORY VALUATION METHODS: SPECIFIC
IDENTIFICATION
Sales: 520 kg @ ¥240/kg

Purchases Goods Available Cost of Goods Sold
100 kg @ 100 kg @ ¥110/kg

600 kg @
¥110/kg 180 kg @ ¥100/kg
¥58,000 total
240 kg @ ¥90/kg
520 kg @ ¥50,600
200 kg @
¥100/kg
Total = Ending inventory
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
20 kg @ ¥100/kg
60 kg @ ¥90/kg
80 kg @ ¥7,400

INVENTORY VALUATION METHODS: WEIGHTED
AVERAGE COST
Sales: 520 kg @ ¥240/kg

600 kg @
100 kg @
¥58,000 total. 520 kg @
¥110/kg
AVERAGE ¥96.667/kg
¥96.667/kg = ¥50,267
200 kg @
¥100/kg
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @
¥96.667/kg
= ¥7,733

INVENTORY VALUATION METHODS: FIFO
Sales: 520 kg @ ¥240/kg

100 kg @ 100 kg @ ¥110/kg

600 kg @
¥110/kg 200 kg @ ¥100/kg
¥58,000 total
220 kg @ ¥90/kg
520 kg @ ¥50,800
200 kg @
¥100/kg
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @ ¥90/kg
80 kg @ ¥7,200

INVENTORY VALUATION METHODS: LIFO
Sales: 520 kg @ ¥240/kg

100 kg @ 20 kg @ ¥110/kg
600 kg @
¥110/kg 200 kg @ ¥100/kg
¥58,000 total
300 kg @ ¥90/kg
520 kg @ ¥49,200
200 kg @
¥100/kg
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @ ¥110/kg
80 kg @ ¥8,800

INVENTORY VALUATION METHODS: SUMMARY
Inventory Valuation Method
Specific Weighted
FIFO LIFO
ID Average Cost
Cost of sales 50,600 50,267 50,800 49,200

Ending inventory 7,400 7,733 7,200 8,800
Goods available for sale 58,000 58,000 58,000 58,000
Gross profit 74,200 74,533 74,000 75,600

PERIODIC AND PERPETUAL INVENTORY
SYSTEMS
• Periodic inventory system: inventory values and costs of sales are
determined at the end of an accounting period.
- Purchases are recorded in a purchases account.
- The total of purchases and beginning inventory is the amount of
goods available for sale during the period.
- The ending inventory amount is subtracted from the goods available
for sale to arrive at the cost of sales. The quantity of goods in ending
inventory is usually obtained or verified through a physical count of
the units in inventory.
• Perpetual inventory system: inventory values and cost of sales are
continuously updated to reflect purchases and sales.

SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method

Perpetual versus Periodic Inventory Systems
Purchased Sold Remaining

Units Cost Units Units COGS - perpetual
Jan 100 $110 100
Apr 80 20 =80@$110 = $8,800
July 200 $100 220
Nov 100 120 =100 @$100 = $10,000
COGS =$8,800+$10,000=$18,800

SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method

Perpetual versus Periodic Inventory Systems
Purchased Sold Remaining

Units Cost Units Units COGS -periodic
Jan 100 $110 100
Apr 80 20 NA
July 200 $100 220
Nov 100 120 NA
Goods = 0+ 100 *$110 + 200*$100
available =$31,000
Ending = 100 *$110 + 20*$100
inventory = $13,000
= $31,000 - $13,000
COGS = $18,000

EFFECTS OF INFLATION OF INVENTORY
COSTS ON THE FINANCIAL STATEMENTS
FIFO
FIFO:
FIFO:
Earlier,
Later,
lower
Costs
higher
costs in
costs in
COGS
inventory
Time
Period end

LIFO RESERVE
• LIFO reserve is the difference between inventory amount

as reported using LIFO and the inventory amount that
would have been reported using FIFO.
FIFO inventory value - LIFO inventory value = LIFO
reserve.
• Companies using the LIFO method must disclose the
amount of the LIFO reserve.
• An analyst can use the disclosure to adjust a company’s
reported cost of goods sold and ending inventory from
LIFO to FIFO.

LIFO RESERVE EXAMPLE: DISCLOSURE
Inventories
Inventories are stated at the lower of cost or market. Cost is principally
determined using the last-in, first-out (LIFO) method. The value of inventories
on the LIFO basis represented about 70% of total inventories at December 31,
2008 and about 75% of total inventories at December 31, 2007 and 2006.
If the FIFO (first-in, first-out) method had been in use, inventories would have
been $3,183 million, $2,617 million and $2,403 million higher than reported at
December 31, 2008, 2007 and 2006, respectively.
Caterpillar Inc. 2008 Annual Report
Note 1. D.

LIFO RESERVE EXAMPLE: ADJUST INVENTORY
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $3,183 million, $2,617 million and
$2,403 million higher than reported on December 31, 2008, 2007 and
2006, respectively.”
• Caterpillar’s balance sheet shows inventories of $8,781 million, $7,204
million, and $6,351 million, at December 31, 2008, 2007, and 2006,
respectively.
• Adjust inventory from LIFO to FIFO by adding the amount of the LIFO
reserve to the reported inventory.
31 December ($ millions) 2008 2007 2006
Total inventories as reported (LIFO) 8,781 7,204 6,351
From Note 1. D disclosure (LIFO reserve) 3,183 2,617 2,403
Total inventories adjusted (FIFO) 11,964 9,821 8,754

LIFO RESERVE EXAMPLE: ADJUST COST OF
GOODS SOLD
$2,403 million higher than reported at December 31, 2008, 2007 and
• Caterpillar’s income statement shows Cost of Goods Sold of $38,415
million and $32,626 million for the years ending December 31, 2008
and 2007, respectively.
• Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount
of change in LIFO reserve.
31 December ($ millions) 2008 2007
Cost of goods sold as reported (LIFO) 38,415 32,626
Less: Increase in LIFO reserve* −566 −214
Cost of goods sold as adjusted (FIFO) 37,849 32,412

LIFO RESERVE EXAMPLE: ADJUST NET
INCOME
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use,
inventories would have been $3,183 million, $2,617 million and $2,403 million
higher than reported at December 31, 2008, 2007 and 2006, respectively.”
• Caterpillar’s income statement shows net Income of $3,557 million and
$32,626 million for the years ending December 31, 2008 and 2007,
respectively.
• Caterpillar’s effective tax rates were approximately 20% for 2008 and 30% for
2007 and earlier.
• Adjust net income from LIFO to FIFO by incorporating the adjustment in Cost
of Goods Sold (COGS), on an after-tax basis.
31 December ($millions ) 2008 2007

Net income as reported (LIFO) 3,557 3,541
Reduction in COGS (increase in operating profit) 566 214
Taxes on increased operating profit −113 −64
Net income as adjusted (FIFO) 4,010 3,691

LIFO RESERVE EXAMPLE: ADJUST LIABILITIES
AND EQUITY
$2,403 million higher than reported at December 31, 2008, 2007 and
• Caterpillar’s December 31, 2008 balance sheet shows total liabilities of
$61,171 million, and total equity of $6,087 million.
• Caterpillar’s effective tax rates were approximately 20% for 2008 and
30% for 2007 and earlier.
• Adjust liabilities from LIFO to FIFO by incorporating a tax liability for the
amount of accumulated tax savings over the years. Adjust equity by
including the cumulative after-tax gross profits.
31 December ($millions ) 2008 31 December ($millions ) 2008
Liabilities as reported (LIFO) $61,171 Equity as reported (LIFO) $6,087
Accumulated deferred taxes $898 Retained earnings $2,285
Liabilities as adjusted (FIFO) $62,069 Equity as adjusted (FIFO) $8,372
COMPARATIVE RATIOS
• Calculate Caterpillar’s Inventory Turnover, Gross Profit margin, and
Net Profit margin for 2008 under the LIFO and FIFO methods.
• Caterpillar’s 2008 revenues were $48,044 million from machinery
sales and $3,280 from financial products.
LIFO FIFO
Inventory turnover 4.81 3.47

= 38,415 ÷ = 37,849 ÷
[(8,781 + 7,204) ÷ 2] [(11,964 + 9,821) ÷ 2]
Gross profit margin 20.04% 21.22%
= [(48,044 – 38,415) ÷ = [(48,044 – 37,849) ÷
48,044] 48,044]
Net profit margin 6.93% 7.81%
= (3,557 ÷ 51,324) = (4,010 ÷ 51,324]

COMPARATIVE RATIOS
• Calculate Caterpillar’s Current Ratio and Total liabilities-to-

equity for 2008 under the LIFO and FIFO methods.
• In 2008, Caterpillar reported $31,633 million current assets,
$26,069 million current liabilities, 61,171 million total liabilities,
and $6,087 million total equity.
LIFO FIFO
Current ratio 1.21 1.34

= [(31,633 + 3,183) ÷
= (31,633 ÷ 26,069)
26,069]
Total liabilities-to-equity ratio 10.05 7.41
= [(61,171 +898) ÷
= (61,171 ÷ 6,087)
(6,087 + 2,285)]

LIFO LIQUIDATION
Units in to Units out of

inventory: inventory:
Purchase or Sales
Manufacture
Inventory
When the number of inventory units manufactured or purchased in

a period exceeds the number of units sold, the LIFO reserve may
increase with each increase in quantity creating a new LIFO
“layer.”

LIFO LIQUIDATION
Units in to Units out of

inventory: inventory:
Purchase or Sales
Manufacture
Inventory
When the number of units sold in a period exceeds the number of

units purchased or manufactured, the costs from older LIFO layers
will flow to COGS (some of the older units held in inventory are
assumed to have been sold), called “LIFO liquidation.”

EXAMPLE: LIFO LAYERS AND LIFO
LIQUIDATION
Assume a three year scenario during which a company’s

• cost of goods increased by $1 per unit each year from $5 to $6 to $7.
• priced its goods to achieve a 50% gross profit per unit (i.e. 100%
markup).
In years 1 and 2, the company buys 10,000 units but sells only 9,000
units. In year 3, the company buys 8,000 units, sells 10,000.

LIQUIDATION
Units Cost per unit Total costs

Beginning inventory 0
Units purchased 10,000 $5 $50,000
Units sold 9,000 $5 $45,000
Ending inventory Year 1 1,000 $5,000
Beginning inventory Year 2 1,000 - $5,000
Units sold 9,000 $6 $54,000
The ending inventory includes a “layer” of old

costs at $5 per unit x 1,000 units and another
“layer” of costs at $6 per unit x 1,000.

LIQUIDATION
Units Cost per unit Total costs
Beginning inventory 0
Units sold 9,000 $5 $45,000
Beginning inventory Year 2 1,000 - $ 5,000
Units sold 9,000 $6 $54,000
Beginning inventory Year 3 2,000 $11,000
Units sold 10,000 $67,000
Ending inventory Year 3 0 0
In Year 3, the old layers at $5 from Year 1 and

$6 from Year 2 flow to cost of goods sold

LIQUIDATION
Revenue Gross Gross

Year per unit Total revenue COGS profit margin
1 $10 $ 90,000 $ 45,000 $ 45,000 50%
2 $12 $ 108,000 $ 54,000 $ 54,000 50%
3 $14 $ 140,000 $ 67,000 $ 73,000 52%

INVENTORY ADJUSTMENTS
Inventory is measured and carried on the balance sheet at the lower of
cost of market.
- IFRS:
- Lower of cost or net realizable value
- Subsequent reversals allowed
- U.S. GAAP:
- Lower of cost or market, defined as current replacement cost
subject to upper and lower limits
- Upper limit of market: net realizable value
- Lower limit of market: net realizable value less a normal profit
margin
- Subsequent reversals prohibited

The Volvo Group reported:

• Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
• Cost of sales for 2008, as reported on Income Statement: SEK 237,578
• Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
• Compare inventory turnover

- Using numbers reported
- Assuming all past inventory write downs were reversed in 2008.

The Volvo Group reported:
• Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
• Cost of sales for 2008, as reported on Income Statement: SEK 237,578
• Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
• Compare inventory turnover

• Inventory Turnover = Cost of Goods Sold/ Average Inventory
• Using numbers reported, 4.81 = 237,578 ÷ [(55,045 + 43,645) ÷ 2]
• Assuming all past inventory write downs were reversed, using adjusted
numbers = 4.51 = 236,893 ÷ [(58,567 + 46,482) ÷ 2]

INVENTORY DISCLOSURES: ANALYTICAL
CONSIDERATIONS
• Examine changes in inventory ratios relative to sales growth.
- High turnover + sales growth slower than industry: Is the company’s
level of inventory adequate?
- High turnover + sales growth same or faster than industry: Probably
indicates efficient inventory management
• Examine changes in inventory components relative to other
components and relative to sales growth.
- Significant increase in finished goods inventories while raw materials
and work-in-progress inventories are declining could signify a
possible decline in demand
- Growth of finished goods inventory higher than sales growth could
also signify a possible decline in demand

SUMMARY
• Total cost of inventories comprises all costs of purchase, costs of

conversion, and other costs incurred in bringing the inventories to their
present location and condition.
• The choice of inventory valuation method determines how the cost of
goods available for sale during the period is allocated between inventory
and cost of sales. It affects the financial statements and any financial ratios
that are based on them.
• IFRS allow three inventory valuation methods (cost formulas): first-in, first-
out (FIFO); weighted average cost; and specific identification.
• U.S. GAAP allow the three methods above plus the last-in, first-out (LIFO)
method.
• Companies that use the LIFO method must disclose in their financial notes
the amount of the LIFO reserve. This information can be used to adjust
reported LIFO inventory and cost of goods sold balances to the FIFO
method for comparison purposes.

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CH8 Inventories

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CHAPTER 8

Copyright © 2013 CFA Institute 2

 Convert a company’s reported financial statements from

Copyright © 2013 CFA Institute 3

Costs included in Inventories and Costs excluded from Inventories

Copyright © 2013 CFA Institute 4

• What costs should be expensed in the period incurred?

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Assume that during a year, a table manufacturing company

What costs should be expensed in the period incurred?

Copyright © 2013 CFA Institute 6

Assume that during a year, a table manufacturing company

What costs should be included in inventory and expensed

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Balance Sheet Income Statement

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Actual costs of items specifically identified as sold

Assumes that earliest items purchased were sold

Assumes most recent items purchased were sold

*LIFO not permitted under IFRS

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Sales: 520 kg @ ¥240/kg

100 kg @ 100 kg @ ¥110/kg

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Sales: 520 kg @ ¥240/kg

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Sales: 520 kg @ ¥240/kg

100 kg @ 100 kg @ ¥110/kg

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Sales: 520 kg @ ¥240/kg

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Inventory Valuation Method

Cost of sales 50,600 50,267 50,800 49,200

Goods available for sale 58,000 58,000 58,000 58,000

Gross profit 74,200 74,533 74,000 75,600

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Cost of Goods Sold Using LIFO valuation method

Purchased Sold Remaining

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Cost of Goods Sold Using LIFO valuation method

Purchased Sold Remaining

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• LIFO reserve is the difference between inventory amount

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31 December ($millions ) 2008 2007

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Inventory turnover 4.81 3.47

= (3,557 ÷ 51,324) = (4,010 ÷ 51,324]

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• Calculate Caterpillar’s Current Ratio and Total liabilities-to-

Current ratio 1.21 1.34

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Units in to Units out of

When the number of inventory units manufactured or purchased in

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Units in to Units out of

When the number of units sold in a period exceeds the number of

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Assume a three year scenario during which a company’s