Financial Reporting and Analysis

-Session 5-

Professor Raluca Ratiu, PhD

Reporting and Analyzing Inventory and
Costs of Good Sold

-Chapter 7-
 Reporting Operating Expenses and Inventories
Revenue is relative to resources required to achieve it
 Operating expenses:
• Costs of acquiring or producing the merchandise
• Costs of selling efforts
• Administrative costs
• Other costs supporting operations
 Costs analysis may answer questions like:
• Are the company’s costs providing products increasing or
decreasing?
• Is the company able to maintain its margins in the face of changes
in costs or competition?
• Does management’s ability to judge customer tastes and
preferences allow it to avoid overstocks of unpopular inventory
and the resulting price discounts that reduce margins?
 COGS and inventories are most impactful to above analysis
 Expense Recognition

 Matching Principle requires that expenses be recognized in the

same period that the associated revenue is recognized
 Expenses recognized when assets are decreased or liabilities are
increased, even if no immediate effect on cash happens

Three Approaches

Direct Immediate Systematic

Association Recognition Allocation
 Expense Recognition
Any cost directly associated with a specific
Direct source of revenue
Association Recognize at the same time the related
revenue is recognized

Example
Cost of goods sold
Warranty costs
 Expense Recognition

• Costs that can be associated with the

Immediate revenues of an accounting period, but not
Recognition
with any specific sales transaction
• Recognize in period incurred

Examples
Research and development costs
Most marketing costs
Most administrative costs including
insurance, utilities, salaries, etc.
 Expense Recognition

 Costs that benefit more than one accounting

period that are not associated with specific
Systematic revenues or assigned to one specific time
Allocation
period
 Capitalize as an asset and convert to an
expense over its useful life

Example
Depreciation expense
 Reporting COGS and Inventories

VTech reports the cost of its inventories sold

on its income statements:
 Inventory

A major asset for most manufacturers and

merchandisers
 When inventory is purchased or produced, it is capitalized
and carried on the balance sheet as an asset unit it is sold
 When the inventory item is sold, its cost is transferred to
cost of goods sold on the income statement
 Cost of goods sold is matched against sales revenue to
yield gross profit:
Sales revenue – Cost of goods sold = Gross profit
 Recording Inventory in the Financial Statements
1. Inventory Purchasing

Phelp’s, Inc., a startup company, purchases 60 pairs of

swim goggles for resale at a cost of $4 each.

(1) Inventory (+A) 240  

    Cash (–A)   240

  Inventory (A)     Cash (A)  

(1) 240 240 (1)
 Recording Inventory in the Financial Statements
2. Inventory Sales

Phelp’s sells 50 of the swim goggles previously

purchased for $10 cash each.

(2a) Cash (+A) 500  

    Sales revenue (+R, +SE)   500
(2b) Cost of goods sold (+E,–SE) 200  
    Inventory (–A)   200

  Cash (A)     Sales Revenue (R)  

(2a) 500 500 (2a)

  Inventory (A)     Cost of Goods Sold (E)  

(2b) 200 200 (2b)
 Reporting Inventory

Reported at ‘cost’ which includes

• Cost to acquire
• Cost for transportation
• Cost in preparing goods for sale
• Cost with consideration of incentives (under certain
conditions)
 Volume discounts
 Early payment incentives/ cash discounts:
• Stated as percentage of purchase price 2/10, n/30
• A 2% cash discount is allowed if paid within 10 days,
otherwise the full purchase price is due within 30 days
 Inventories for Manufacturers
Raw
Materials
Parts and materials purchased from
Inventory suppliers for use in the production process

Work-in- Inventory of partially completed goods;

Process includes materials, labor, and overhead
Inventory cost

Finished
Goods
Completed products ready for delivery to
Inventory customers
 VTech’s Inventories
VTech reports inventory totaling $372.6 million in its
March 31, 2020 balance sheet and provides a
breakdown of the components in the following note:
 Calculating Cost of Goods Sold for
Periodic Inventory

The inventory account decreases when goods are sold

The ending inventory in the current period

becomes the beginning inventory for the
subsequent period.
Inventory Cost Flows to Financial Statements

Inventory Cost Flows to Financial Statements

 Inventory Costing Methods

Three commonly used inventory methods…..

First-in, Assumes the oldest costs recorded in

First-out inventory are the first costs transferred to
(FIFO) cost of goods sold

Last-in, First- Assumes the most recent costs recorded in

out (LIFO) inventory are the first costs transferred out

Assumes the cost of goods sold is the average of

Average Cost
the cost to purchase all of the inventories
(AC)
available during the period
 FIFO Costing Method Example

Phelps, Inc. had 100 goggles costing $4 each in

inventory at June 1, and incurred the following
inventory transactions during June:
Purchased 400 goggles at $4.50 each
Sold 460 goggles at $12.00 each
Cost of goods sold during June
100 goggles at $4 each $ 400
360 goggles at $4.50 each 1,620
Cost of goods sold $2,020

Ending inventory
40 goggles at $4.50 each $180
 LIFO Costing Method Example
(not allowed under IFRS)
Phelps, Inc. had 100 goggles costing $4 each in
inventory at June 1, and incurred the following
inventory transactions during June:
 Purchased 400 goggles at $4.50 each
 Sold 460 goggles at $12.00 each

Cost of goods sold during June

400 goggles at $4.50 each $1,800
60 goggles at $4 each 240
Cost of goods sold $2,040

Ending inventory
40 goggles at $4 each $160
 Inventory Costing and Price Changes

FIFO and LIFO (not allowed under IFRS)

 Are both historical cost methods
 Allocate costs of inventory differently
 Differences arise when costs of inventory change
over time
 Average Cost Method Example

Phelps, Inc. had 100 goggles costing $4 each in

inventory at June 1, and incurred the following
inventory transactions during June:
Purchased 400 goggles at $4.50 each
Sold 460 goggles at $12.00 each
Average cost = [(100 × $4) + (400 × $4.50)]/500 = $4.40
Cost of goods sold during June
460 goggles at $4.40 each $2,024

Ending inventory
40 goggles at $4.40 each $176
 Comparing the Costing Methods
FIFO LIFO AC
Ending inventory
40 @ $4.50 each $ 180
40 @ $4.00 each $ 160
40 @ $4.40 each $ 176
Cost of goods sold
100 @ $4.00 and 360 @ $4.50 2,020
400 @ $4.50 and 60 @ $4.00 2,040
460 @ $4.40 each 2,024

Total cost of goods available $2,200 $2,200 $2,200

The total cost of goods available for sale of $2,200 is divided

differently between the cost of the goods sold and the
inventory that remains on hand for each of the three methods.
 Lower of Cost or Market/Net Realizable Value
Inventory is reported on the balance sheet at lower of
cost or market (LCM)
If market value of Company must write- Write-
inventory is less down inventory to down
than inventory cost market

If market value of
Inventory cost
inventory is greater No
remains on the
than inventory cost write-
balance sheet
down

Market value = Replacement cost or Net Realisable Value

(i.e., estimated selling price less costs to complete sale)
 Inventory Write-Downs Under LCM

 Inventory book value is written down to current

market value, reducing total assets
 Inventory write-down is reflected as an expense on
the income statement, reducing current period
gross profit, income, and equity; included as part of
Cost of Goods Sold
 Write-down of inventory cost can be reversed if
market value increases
• May be reversed up to the acquisition cost
• Revaluation results as a debit to Inventory and credit
to Cost of Goods Sold
 Inventory Statement Effects
of LIFO versus FIFO
 Function of two factors
• Speed and direction of inventory cost changes
• If costs increase more slowly, difference between LIFO
and FIFO will decrease
• If costs decrease, difference between LIFO and FIFO will
reverse
• Length of time inventory is held
• Differences increase with longer holding periods
 Effects of changing costs
• Management may change selling prices
• Lower income taxes result with LIFO when prices are
rising
 Income Statement Effects of Inventory Costing

In a period of rising In a period of rising

prices FIFO yields the prices LIFO yields the
highest gross profit lowest gross profit and
and net income net income

FIFO LIFO AC
Sales (460 × $12) $5,520 $5,520 $5,520
Cost of goods sold 2,020 2,040 2,024
Gross profit $3,500 $3,480 $3,496
 Balance Sheet Effects of LIFO versus FIFO

 FIFO costing on the balance sheet

• Approximates current value
• If prices fall, more likely to require lower of cost or
market adjustments

 Periods of rising prices

• LIFO ending inventories are understated compared to
FIFO
• Does not represent replacement cost
• LIFO reserve can be viewed as an ‘unrealised holding gain’
• A gain that results from holding inventory as prices are rising
 Balance Sheet Effects of Inventory Costing

In a period of rising prices, LIFO yields ending

inventories that are often much lower than FIFO.

Current Assets FIFO LIFO AC

$ xxx $ xxx
Cash $ xxx
Accounts receivable xxx xxx xxx
Inventories 180 160 176

LIFO does not accurately represent the cost

that a company would incur to replace its
current investment in inventories.
 Cash Flow Effects of
LIFO versus FIFO

FIFO in periods of rising LIFO in periods of rising

prices prices
 Higher pretax income  Lower pretax income
 Higher income taxes  Lower income taxes
 Less cash available  More cash available

Increased cash flow from tax savings is often cited

as a compelling reason for management to adopt
LIFO
 Financial Statement Effects of Inventory
Costing

Using FIFO Using LIFO

Increased gross profit Results in a reduced tax
results in higher pretax liability, so cash flows are
income causing higher higher
taxes payable
FIFO LIFO AC
Sales (460 × $12) $5,520 $5,520 $5,520
Cost of goods sold 2,020 2,040 2,024
Gross profit $3,500 $3,480 $3,496

Opposite effects occur in deflationary periods

 LIFO Reserve
 What is LIFO reserve?
• Difference between LIFO cost and the current
value of inventory
 Must be reported by companies using LIFO
LIFO reserve =
FIFO ending inventory cost ‒ LIFO ending inventory cost

 Estimating FIFO cost of goods sold

FIFO cost of goods sold =
LIFO cost of goods sold ‒ change in LIFO reserve during year

Useful for comparing gross profits of a

company using FIFO with another company
using LIFO
 IFRS Reporting Insight

LIFO not allowed by IFRS

 Problems inherent when comparing companies
using different methods:
• FIFO firms do not disclose effects of using
LIFO or other methods
o Analysts need to track inventory
differences to compare FIFO firms to LIFO
firms
• Changing to FIFO from LIFO is permitted, but
creates additional tax payments for inventory
costs deferred under LIFO
 Reasons for Inventory Disclosures

The magnitude of a company’s investment in

inventory is often very large
• Impacts the income statement and balance sheet

Risks of inventory losses are often high

• Tied to technological obsolescence and consumer tastes

Can provide insight into future performance

High inventory levels result in substantial costs for a

company such as financing costs to purchase,
storage, handling, and insurance costs
 VTech’s Inventory Disclosures

 VTech’s note disclosure:

Stocks are stated at the lower of cost and net realisable value. Cost is
calculated on the weighted average or the first-in-first-out basis, and
comprises materials, direct labour and an appropriate share of
production overheads incurred in bringing the inventories to their
present location and condition. Net realisable value is the estimated
selling price in the ordinary course of business, less estimates of costs of
completion and selling expenses.
When stocks are sold, the carrying amount of those stocks is
recognised as an expense in the period in which the related revenue is
recognised. The amount of any write-down of stocks to net realisable
value and all losses of stocks are recognised as an expense in the period
the write-down or loss occurs. The amount of any reversal of any write-
down of stocks is recognised as a reduction in the amount of stocks as
an expense in the period in which the reversal occurs.
VTech’s Inventory Disclosures
Calculate Gross Profit Margin, Inventory Turnover
and Days Inventory Outstanding
 Gross Profit Margin
Important because it is monitored by external users and
management
Sales revenue - Cost of good sold
Gross profit margin =
Sales revenue

VTech’s Gross Profit Margin

VTech’s gross profit margin dropped from 33% in 2018 to about

30% in 2019 and 2020.
 Gross Profit Margin Comparison

Gross profit margins of VTech and Nintendo:

 Gross Profit Analysis

 Causes of a changing gross profit margin

• Product line is stale
• Change in product mix
• New competitors enter the market
• General decline in economic activity
• Inventory is overstocked
• Change in pricing
 Tools for Inventory Analysis

 Inventory turnover indicates how quickly inventory is

being sold
Cost of goods sold
Inventory turnover =
Average inventory

 Average inventory days outstanding indicates how

long inventories are held before being sold

Average
Average inventory inventory 365
= =
Average
days outstanding daily Inventory
cost of goods sold Turnover
 Applying Inventory Turnover to VTech

Inventory turnover = Cost of goods sold

Average inventory

Vtech’s Inventory Turnover:

VTech turned its inventory over 4.0 times in 2020.

Its INVT stayed steady over the period 2018-2020.
 VTech in Context

VTech’s inventory turnover (INVT) ratio as

compared to Nintendo:
 VTech’s
Inventory Days Outstanding

Home Depot’s average inventory days outstanding for

its year ending January 31 , 2015:
st

Average inventory 365

days outstanding = Inventory Turnover

VTech had its inventories on its shelves for about 91

days in 2020, compared with 89 days in 2018 and
2019.
 VTech in Context

VTech’s average inventory days outstanding

(DIO) as compared to Nintendo:
 Turnover Factors - Inventory Quality

 Inventory turnover can be compared with prior periods

and competitors
• Higher turnover is favorable
 Turnover level may imply
• Change in product mix to higher or lower margin
products
• Excessive purchases or production
• Missed trends or technological advances
• Increased competition
• Change in promotion policies
• Improvement in manufacturing efficiency
 Turnover Factors - Asset Utilisation

 Optimising inventory investment

• Too much inventory is expensive
• Too little inventory causes stock-outs, lost sales
 Operational changes to reduce inventory
• Improved manufacturing processes to eliminate
bottlenecks and work-in-process buildup
• Just-in-time deliveries from suppliers to reduce raw
material inventories
• Demand-pull production in which raw materials are
released to production when final goods are demanded
by customers