Level I - Financial Reporting and Analysis

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Inventories

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 Contents
1. Introduction
2. Cost of Inventories
3. Inventory Valuation Methods
4. The LIFO Method
5. Inventory Method Changes

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6. Inventory Adjustments

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7. Evaluation of Inventory Management

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 1. Introduction

• Inventory is shown as a current asset on the balance sheet

• Manufacturing and merchandising companies generate revenue and profit

through the sale of inventory

• For many companies inventory represents a significant asset

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• Differences between IFRS and U.S. GAAP

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 2. Cost of Inventories
Capitalizing inventory related costs defers their recognition as an expense

Capitalized inventory cost consists of:

• Cost of purchases
• Cost of conversion
• Cost necessary to bring inventory to its present
location and condition

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Period costs are expensed in period incurred

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• Abnormal wastage of materials, labor or overheads

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• Storage costs

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• Administrative overheads

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• Selling costs

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 Example
Kevin Corporation manufactures high-end tractors. The inventory related costs are shown below:
Raw materials $56,000
Direct labor $40,000
Abnormal wastage $6,000
Transportation of raw materials $10,000

Storage of finished product $18,000

What value of inventory is recorded?

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 3. Inventory Valuation Methods
• Specific Identification

• FIFO (First In First Out)

• Weighted Average Cost

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• LIFO (Last In First Out)

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 Specific Identification
Specific Identification: This method is used for inventory items that are unique in
nature and not ordinarily interchangeable. This method allows for cost of sales and
ending inventory costs to reflect the actual costs incurred.

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 First-In, First-Out (FIFO)
FIFO: Assumes that the oldest goods purchased (or manufactured) are sold first and
the newest goods purchased ( or manufactured) remain in ending inventory.

Example: In Period 1 you buy two pencils for $1 each and then another two for $2 each. Before you
start selling your inventory is 4 pencils. You then sell two pencils in Period 1 and two pencils in Period
2. Complete the table below using the FIFO method.

Item FIFO $

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Prd. 1 COGS

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Inventory at the end of Prd. 1. $1 $1 $2 $2

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Prd. 2 COGS

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Inventory at the end of Prd. 2

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 Last-In, First-Out (LIFO)
LIFO: Assumes that the newest goods purchased (or manufactured) are sold first and
the oldest goods purchased (or manufactured), including beginning inventory remain
in ending inventory. Only allowed under U.S. GAAP.

Example: In Period 1 you buy two pencils for $1 each and then another two for $2 each. Before you
start selling your inventory is 4 pencils. You then sell two pencils in Period 1 and two pencils in Period
2. Complete the table below using the FIFO method.

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Item LIFO $

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Prd. 1 COGS $1 $1 $2 $2

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Inventory at the end of Prd. 1.

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Prd. 2 COGS

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Inventory at the end of Prd. 2

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 Weighted Average Cost
Weighted average cost: This method assigns the average cost of goods available for sale
(beginning inventory plus purchase, conversion and other costs) during the accounting
period to the units that are sold and as well to the units in ending inventory.
WAC = Total cost of units available for sale / Total units available for sale

Example: In Period 1 you buy two pencils for $1 each and then another two for $2 each. Before you start
selling your inventory is 4 pencils. You then sell two pencils in Period 1 and two pencils in Period 2.
Complete the table below using the FIFO method.

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Item WAC $

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Prd. 1 COGS

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Inventory at the end of Prd. 1

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Prd. 2 COGS
Inventory at the end of Prd. 2

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Calculation of Cost of Sales, Gross Profit and Ending Inventory

Assume items were sold for $5.

Item FIFO ($) LIFO ($) WAC ($)

Prd. 1 COGS 2 4 3
Prd. 1 Gross Profit 8 6 7
Inventory at the end of Prd. 1 4 2 3

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Prd. 2 COGS 4 2 3

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Prd. 2 Gross Profit 6 8 7

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Inventory at the end of Prd. 2 0 0 0

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Do Example 2 in the curriculum

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 Example
A company bought 400 generators at a price of $300 each on January 5. 300 of these
generators were sold at a price of $450 each by the end of March. On April 10, 250
more generators were bought at a price of $325 each. By May 31, 225 generators were
sold at a price of $500 each. For the period ending 30 June, what is the ending
inventory using FIFO?
Purchased 400
Sold (300)
Remainder as at March 2012 100
Purchased further 250

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Sold (100 old+125 new) (225)

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Remainder (new) 125

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Therefore, inventory cost 125 x 325 = $40,625

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 Periodic vs. Perpetual Inventory Systems
Periodic system: company determines quantity of inventory on hand periodically;
necessary to maintain ‘Purchases’ account
ƒ Ending inventory determined through a physical count
ƒ COGS = BI + P – EI

Perpetual system: changes in inventory and COGS are continuously updated

Specific Identification and FIFO

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LIFO and WAC

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Periodic and perpetual Choice of system might impact

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systems give the same values values for COGS and ending

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for COGS and ending inventory inventory

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Do Example 3 if you have time

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 Comparison of Inventory Valuation Methods
Rising Prices and Stable Inventory

LIFO FIFO
COGS H L
Taxes L H
EBT and EAT L H

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Inventory Balance L H

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CA – CL L H

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Cash Flow (after tax) H L

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Note: Weighted average costs provide results between LIFO and FIFO

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 Example
Falling Prices and Stable Inventory

LIFO FIFO
COGS
Taxes
EBT and EAT

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Inventory Balance

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CA – CL

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Cash Flow (after tax)

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Do Exa
Example
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 4. LIFO Method
• LIFO is permitted under U.S. GAAP and not under IFRS
• The LIFO conformity rule: same method for tax and financial reporting
• Companies using LIFO inventory must disclose LIFO reserve
• LIFO reserve is the difference between inventory reported at FIFO and
inventory reported at LIFO

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1. LIFO Reserve

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2. LIFO Liquidations

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 LIFO Reserve
The LIFO reserve 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.

• FIFO inventory = LIFO inventory + LIFO reserve

• FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)

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• FIFO NI = LIFO NI + Change in LIFO reserve (1 – T)

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• FIFO RE = LIFO RE + LIFO reserve (1 – T)

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 Example 5: Inventory Conversion from LIFO to FIFO
1. What inventory values would CAT report for 2008, 2007, and 2006 if it had used the FIFO method instead of the
LIFO method?
2. What amount would CAT’s cost of goods sold for 2008 and 2007 be if it had used the FIFO method instead of the
LIFO method?
3. What net income (profit) would CAT report for 2008 and 2007 if it had used the FIFO method instead of the LIFO
method?
4. By what amount would CAT’s 2008 and 2007 net cash flow from operating activities decline if CAT used the FIFO
method instead of the LIFO method?
5. What is the cumulative amount of income tax savings that CAT has generated through 2008 by using the LIFO
method instead of the FIFO method?

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6. What amount would be added to CAT’s retained earnings (profit employed in the business) at 31 December ber 2008
2008

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if CAT had used the FIFO method instead of the LIFO method?

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7. What would be the change in CAT’s cash balance if CAT had used the FIFO method instead of the LIFO FO method?
method?

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8. Calculate and compare the following for 2008 under the LIFO method and the FIFO method: inventory
nventoory tturnover
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ratio, days of inventory on hand, gross profit margin, net profit margin, return on assets, current
urrent ratio, and to
total
liabilities-to-equity ratio.

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Ratios with LIFO and FIFO

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 LIFO Liquidations
• In periods of rising inventory, carrying amount of inventory
under FIFO will exceed the carrying amount of inventory under
LIFO

• LIFO reserve may increase for two reasons

ƒ increasing difference between the older costs used to value inventory
under LIFO and the more recent costs used to value inventory under FIFO
ƒ number of inventory units manufactured or purchased exceeds the

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number of units sold

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• LIFO liquidation: number of units sold exceed units

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purchases/manufactures

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ƒ Can be used by management to manipulated earnings and margins

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 Concept Check
• Company A uses LIFO and has an increasing LIFO reserve.
• Company B uses FIFO.
• Company C uses LIFO and has a decreasing LIFO reserve.
• Which company’s COGS best reflect current costs?

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 5. Inventory Method Changes
• Very occasionally companies change inventory valuation method
ƒ Acceptable if change ‘results in more reliable and relevant information…’

• Change must be applied retrospectively

• Carefully analyze why company is actually making the change

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ƒ Company might be trying to reduce taxes or increase reported NI

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 6. Inventory Adjustments
IFRS
• Lower of cost or net realizable value
(NRV)
• If NRV is less than the balance sheet
cost, the inventory is “written down”
to NRV and loss is recognized
• If subsequent recovery in value, the
inventory can be “written up” and a
U.S. GAAP
• Lower of cost or market
• Market is equal to replacement cost
• Market value has upper limit of net
realizable value and lower limit of NRV
less a normal profit margin
• If cost exceed market, inventory is
written down to market on balance

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gain is recognized in income statement

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sheet and loss is recognized

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but the amount of any such gain is • If subsequent recovery, no write up iss

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limited to the amount previously

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recognized as loss

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 Impact of Inventory Adjustments
• An inventory write-down reduces both profit (higher COGS) and the carrying
amount of inventory

• Positive effect on activity ratios

• Negative effect on profitability, liquidity, and solvency ratios

• Companies using specific identification, weighted average cost or FIFO

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methods are more likely to incur write-downs relative to companies using

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LIFO

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• Inventory write-down is also called a valuation allowance

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Example 9: Effect of Inventory Write-downs on Financial Ratios
1. What inventory values would Volvo have reported for 2008, 2007, and 2006 if it had no allowance for inventory
obsolescence?
2. Assuming that any changes to the allowance for inventory obsolescence are reflected in the cost of sales, what
amount would Volvo’s cost of sales be for 2008 and 2007 if it had not recorded inventory write-downs in 2008 and
2007?
3. What amount would Volvo’s profit (net income) be for 2008 and 2007 if it had not recorded inventory write-downs
in 2008 and 2007? Assume tax rates of 28.5 percent for 2008 and 30 percent for 2007.

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 7. Evaluation of Inventory Management
• Efficiency and effectiveness of inventory management can be evaluated using the
following ratios
ƒ Inventory Turnover
ƒ Days of Inventory On Hand
ƒ Gross Profit Margin

• Choice of inventory valuation method impacts several ratios

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• Need to be particularly careful when comparing an IFRS and U.S. GAAP firm

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 Presentation and Disclosure
IFRS require the following financial statement disclosures concerning inventory:

a. The accounting policies adopted in measuring inventories, including the cost formula (inventory
valuation method) used;
b. The total carrying amount of inventories and the carrying amount in classifications (for example,
merchandise, raw materials, production supplies, work in progress and finished goods) appropriate
to the entity;
c. The carrying amount of inventories carried at fair value less costs to sell;
d. The amount of inventories recognized as an expense during the period (cost of sales);

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e. The amount of any write-down of inventories recognized as an expense in the period;

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f. The amount of any reversal of any write-down that is recognized as a reduction in cost of sales
sales in

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the period;

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g. The circumstance or events that led to the reversal of a write-down of inventories; and
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h. The carrying amount of inventories pledged as security for liabilities.

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 Example
What is the impact of the inventory valuation method on the following ratios:
ƒ Inventory turnover

ƒ Days of inventory

ƒ Gross profit margin

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ƒ Current ratio

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ƒ Return on assets

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ƒ Debt to equity

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 Summary
• Cost of inventories

• Specific Identification, FIFO, LIFO, WAC

• Impact of valuation method on inventory balance and COGS

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• Impact of valuation method or ratios

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• Measurement of inventory value

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 Conclusion
• Read summary

• Review learning objectives

• Examples

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• Practice problems: good but not enough

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• Practice questions from other sources

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