29. Inventories
Merchandising firms, such as wholesalers and retailers, purchase inventory that is ready for sale. In this case, inventory is reported in one account on the balance sheet. Manufacturing firms normally report inventory using three separate accounts: raw materials, work-in-process, and finished goods.
Cost of goods sold (COGS) is related to the beginning balance of inventory, purchases, and the ending balance of inventory. The relationship is summarized in the following equation :
ending inventory = beginning inventory + purchases - COGS
A. Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred :
The costs included in inventory are similar under IFRS and U.S. GAAP. These costs, known as product costs, are capitalized in the Inventories account on the balance sheet and include :
- Purchase cost less trade discounts and rebates.
- Conversion costs including labor and overhead.
- Other costs necessary to bring the inventory to its present location and condition.
By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold and revenue is recognized.
Not all inventory costs are capitalized, some costs are expensed in the period incurred. These costs, known as period costs, include :
- Abnormal waste of materials, labor, or overhead.
- Storage costs (unless required as part of production).
- Administrative overhead.
- Selling costs.
B. Different inventory valuation methods (cost formulas) :
It is likely that the cost of purchasing or producing inventory will change over time. As a result, firms must select a cost flow method to allocate the inventory cost to the income statement (COGS) and the balance sheet (ending inventory).
Under IFRS, the permissible methods are :
- Specific identification.
- First-in, first-out (FIFO).
- Weighted average cost.
U.S. GAAP permits these same cost flow methods, as well as the last-in, first-out (LIFO) method. LIFO is not allowed under IFRS. A firm can use one or more of the inventory cost flow methods. However, a firm must employ the same cost flow method for inventories of similar nature and use.
Under the specific identification method, each unit sold is matched with unit’s actual cost. Specific identification is appropriate when inventory items are not interchangeable and is commonly used by firms with a small number of costly and easily distinguishable items such as jewelry.
Under the first-in, first-out (FIFO) method, the first item purchased is assumed to be the first item sold. The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current cost. Conversely, FIFO COGS is based on the earliest purchase costs. Inflationary environment, COGS will be understated compared to current cost. As a result, earnings will be overstated.
Under the last-in, first-out (LIFO) method, the item purchased most recently is assumed to be the first item sold. In an inflationary environment, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the earliest costs. Therefore, in an inflationary environment, LIFO ending inventory is less than current cost. The LIFO conformity rule in the U.S. requires firms to use LIFO for their financial statements if they use FIFO for income tax purposes.
Weighted average cost is a simple and objective method. The average cost per unit of inventory is computed by dividing the total cost of goods available for sale by the total quantity available for sale. To compute COGS, the average cost per unit is multiplied by the number of units that remain.
C. Impact of the inventory valuation method choice on gross profit :
During inflationary periods and with stable or increasing inventory quantities, LIFO COGS is higher than FIFO COGS. This is because the last units purchased have a higher cost than the first unit purchased. Of course, higher COGS under LIFO will result in lower gross profit and net income compared to FIFO.
Using similar logic, we can see that LIFO ending inventory is lower than FIFO ending inventory because under LIFO, ending inventory is valued using older, lower costs.
During deflationary periods and stable or increasing inventory quantities, the cost flow effects of using LIFO and FIFO will be reversed.
In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs).
Under the weighted average cost method, cost of sales and balance sheet inventory values are between those of LIFO and FIFO.
D. Perpetual and periodic inventory systems :
In a periodic inventory system, inventory values and COGS are determined at the end of the accounting period. No detailed records of inventory are maintained; rather, inventory acquired during the period is reported in a Purchases account.
In a perpetual inventory system, inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur. Thus, a Purchases account is not necessary.
In the case of FIFO and specific identification, ending inventory values and COGS are the same whether a periodic or perpetual system is used. LIFO and weighted average cost, however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used.
E. Comparing COGS, ending inventory, and gross profit using different inventory valuation methods :
When prices are rising and inventory quantities are stable or increasing :
LIFO results in :
Higher COGS
Lower gross profit
Lower inventory balances
Higher inventory turnover
FIFO results in:
Lower COGS
Higher gross profit
Higher inventory balances
Lower inventory turnover
The weighted average cost method results in values between those of LIFO and FIFO.
F. Measurement of inventory at the lower of cost and net realizable value :
Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. Net realizable value is equal to the expected sales price less the estimated selling costs and completion costs. If net realizable value is less than the balance sheet value of inventory, the inventory is “written down” to net realizable value and the loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be “written up” and the gain can be recognized in the income statement by reducing COGS by the amount of the recovery. The carrying value cannot exceed original cost, except in the case of some agricultural and mineral products.
Under U.S. GAAP, inventory is reported on the balance sheet at the lower of cost or market. Market is usually equal to replacement cost, but cannot be greater than net realizable value (NRV) or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin.
If cost exceeds market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement. The market value becomes the new cost basis. If there is a subsequent recovery in value, no write-up is allowed under U.S. GAAP.
The write-down, or subsequent write-up, of inventory is usually accomplished through the use of a valuation allowance account. A valuation allowance account is a contra-asset account, similar to accumulated depreciation. By using a valuation allowance account, the firm is able to separate the original cost of inventory from the carrying value of the inventory.
G. Financial statement presentation of and disclosures relating to inventories :
Required inventories disclosures (usually found in the financial statement footnotes) are similar under U.S. GAAP and IFRS and include :
- The cost flow method (LIFO, FIFO, etc.) used.
- Total carrying value of inventory, with carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate.
- Carrying value of inventories reported at fair value less selling costs.
- The cost of inventory recognized as an expense (COGS) during the period.
- Amount of inventory write-downs during the period.
- Reversals of inventory write-downs during the period, including a discussion of the circumstances of reversal (IFRS only because U.S. GAAP does not allow reversal).
- Carrying value of inventories pledged as collateral.
Although rare, a firm can change inventory cost flow methods. In most cases, the change is made retrospectively; that is, the prior years’ financial statements are recast based on the new cost flow method. An exception to retrospective application applies when a firm changes to LIFO from another cost flow method. In this case, the change is applied prospectively (no adjustments are made to the prior periods). The carrying value of inventory is considered to be the first LIFO layer.
H. Interpretation of ratios used to evaluate inventory management :
A firm’s choice of inventory cost flow method can have a significant impact on profitability, liquidity, activity, and solvency ratios.
Profitability. As compared to FIFO, LIFO produces higher COGS in the income statement and will result in lower net income.
Liquidity. Compared to FIFO, LIFO results in a lower inventory value on the balance sheet. Because inventory (a current asset) is lower under LIFO, the current ratio is also lower under LIFO than under FIFO. Working capital is also lower under LIFO.
Activity. Inventory turnover (COGS/average inventory) is higher with LIFO. Under LIFO, COGS is higher while inventory is lower. Higher turnover under LIFO will result in lower days of inventory on hand (365/inventory turnover).
Solvency. LIFO will result in lower total assets compared to FIFO because LIFO inventory is lower. The debt ratio and the debt-to-equity ratio are higher under LIFO compared to FIFO.
Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory.
High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled.
High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory.
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