Reading 21 Inventories

FinQuiz Notes – 2 0 2 2
1. INTRODUCTION

Inventories refer to:

• Assets held by a company for the purpose of resale Ø Manufacturers can report the separate
to the company’s customers. carrying amounts of their raw materials, work-
• Assets used by a company to produce products in-progress and finished goods inventories on
for resale purpose. the balance sheet or
Ø Manufacturers can report total inventory
Merchandising Firms (wholesalers, retailers): They amount on the balance sheet; but must
purchase inventory from manufacturers; and have only disclose the carrying amounts of its raw
one type of inventory i.e. finished goods inventory. materials, work-in-progress and finished goods
inventories in a footnote to the financial
Manufacturing Firms: They purchase raw materials from statements.
suppliers and use those materials to produce finished
goods. Their inventories include raw materials, work-in-
process and finished goods.

2. COST OF INVENTORIES

Costs that are reported as expense (i.e. Cost of sales) on Inventory costs exclude the costs related to following
the Income Statement until the inventory is sold include items:
(under both IFRS and U.S.GAAP): • Abnormal amounts of wasted materials, labor and
1) All costs of purchase i.e. purchase price, import and overheads.
tax-related duties, transport, insurance during • Storage costs, unless they are required before
transport, handling and other costs directly further production process.
attributable to acquisition of finished goods, • Administrative overheads.
materials and services. • Selling costs.
2) Costs of conversion i.e. direct costs e.g. direct labor,
fixed & variable overhead costs.
These costs are reported as expense on the Income
3) Costs incurred in bringing the inventories to their
statement in the period in which they are incurred.
present location and condition.

• Both profit and inventory value is overstated when

Practice: Example 1, costs that are expensed are included in the costs
Volume 3, Reading 21. of inventory.

3. INVENTORY VALUATION METHODS

Inventory valuation methods (cost formulas under IFRS determine cost of inventory i.e. amount reported as cost
and cost flow assumptions under U.S.GAAP): Inventory of goods sold.
valuation methods refer to valuation methods used to
Under IFRS, companies can use Accounting treatment: When items are sold, inventory’s
1) FIFO carrying amount is reported as an expense (cost of
2) Weighted average cost sales) on the Income statement according to the cost
3) Specific identification formula (cost flow assumption) used.
Under U.S.GAAP, companies can use
1) FIFO
2) Weighted average cost
3) Specific identification 3.1 Specific identification method
4) LIFO
It is most frequently used when the company sells a
NOTE: A company is required to use the same inventory limited variety of expensive goods that are uniquely
valuation method for all items with similar nature and identifiable and are not ordinarily interchangeable. The
use.

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Reading 21 Inventories FinQuiz.com

specific identification method is based on the actual

physical flow of the goods.
3.3 Weighted Average cost
Ø Cost of sales and cost of ending inventory
reflect the actual costs of purchase or
In the weighted average cost method, it is assumed that
production.
Ø This method matches the physical flow of items the goods available for sale are homogeneous;
therefore, allocation of the cost of goods available for
sold and remaining in inventory to their actual
cost. sale is based on the weighted average unit cost
incurred*. The weighted average unit cost is then
multiplied by the units sold to determine the cost of
However, specific identification is often viewed as goods sold and to the units on hand to determine the
impractical. ending inventory.

3.2 First-in, first-out (FIFO) Weighted average unit cost =

!"#$% '"(# ") #*+ ,-.#( $/$.%$0%+ )"1 ($%+
!"#$% -,20+1 ") ,-.#( $/$.%$0%+ )"1 ($%+ #*+ 3+1."4
It is most frequently used when the company sells goods
that are ordinarily interchangeable. In FIFO method, Advantage: It smoothes out price changes.
earliest goods purchased is the first to be sold and the
newest goods purchased (or manufactured) are
3.4 Last-in, first-out (LIFO)
assumed to remain in inventory. The costs of the most
recent goods purchased are recognized as the ending
inventory. In the LIFO method, it is assumed that the recent goods
purchased are the first to be sold and that the earliest
goods purchased remain in ending inventory. This
Ø Under FIFO method, the the physical flow method is permitted under U.S.GAAP only; not under
of items sold and remaining in inventory is IFRS.
not matched to their actual cost.
Advantage: It better matches current costs in CGS with
revenues.
Advantage: In FIFO, ending inventory represents the
current replacement costs.

3.7 Comparison of Inventory Valuation Methods

In periods of rising prices and constant or increasing inventory quantities:

Gross profit/operating Ending Inventory CGS Taxes
profit/Net Income
FIFO reports:
• Highest Gross profit
FIFO reports the FIFO reports the lowest
• Highest operating
FIFO highest ending CGS. Highest
profit.
inventory.
• Highest net income.

LIFO reports:
• Lowest Gross profit LIFO reports the
• Lowest operating lowest ending LIFO reports the
LIFO Lowest
profit inventory. highest CGS.
• Lowest net income

Weighted Falls in the

Falls in the middle i.e. < Falls in the middle i.e. Average cost falls in
Average middle i.e. <
FIFO but > LIFO. < FIFO but > LIFO. the middle.
method FIFO but > LIFO.
Reading 21 Inventories FinQuiz.com

In periods of falling prices and constant or increasing inventory quantities:

Gross profit/operating Ending Inventory CGS Taxes

profit/Net Income
FIFO reports:
• Lowest Gross profit
FIFO reports the
• Lowest operating FIFO reports the
FIFO lowest ending Lowest
profit. highest CGS
inventory.
• Lowest net income.

• LIFO reports the

highest ending
inventory
(assumes no LIFO
liquidation)*.
LIFO reports:
*LIFO Liquidation
• Highest Gross profit LIFO reports the lowest
occurs when the units
• Highest operating CGS (assumes no LIFO
LIFO of goods sold > units Highest
profit liquidation)*.
of goods purchased
• Highest net income
in the period; thus,
sales are made from
the existing, low-
priced inventory
rather than from
recent purchases.

Weighted Falls in the

Falls in the middle i.e. < Falls in the middle i.e. Average cost falls in
Average middle i.e. <
FIFO but > LIFO. < FIFO but > LIFO. the middle.
method FIFO but > LIFO.

• A company does not maintain a

When prices are constant: All cost flow methods will continuous record of the physical
provide the same results. quantities in its inventory

Practice: Example 2 &4, At purchase:

Volume 3, Reading 21. Inventory XXX
A/P XXX
At Sale:
3.6 Periodic versus Perpetual Inventory Systems CGS none
Inventory none
There are two methods of recording changes to A/R XXX
inventory: Sales XXX
1. Periodic Inventory System: In periodic inventory 2. Perpetual Inventory System: In perpetual inventory
system: system:

• Inventory balance (quantity of inventory • The inventory account and the cost of
on hand) is only determined on a periodic goods sold (CGS) account are
basis i.e. at the end of a period after an continuously updated with all purchases
inventory count and applying a cost flow and sales transactions.
assumption. • Purchases and sales of goods are directly
• Purchases are recorded in a purchase recorded in the inventory as they occur.
account. • The balance of inventory and CGS is
• Amount of goods available for sale during known at all time.
the period = Total Purchases + Beginning • CGS is determined by selecting a cost flow
inventory assumption.
• Cost of Sales = Total Purchases + • A company maintains a continuous record
Beginning inventory - Ending inventory of the physical quantities in its inventory.
• Quantity of goods in ending inventory is
obtained through a physical count of the
units in inventory.
Reading 21 Inventories FinQuiz.com

Ending Inventory = Beginning Inventory + Purchases (net) will be same under both periodic and perpetual
– cost of Goods Sold inventory systems.
At purchase: v When LIFO or weighted average method is used
Inventory XXX →Value of cost of sales and ending inventory will be
A/P XXX different under both periodic and perpetual
At Sale: inventory systems.
CGS XXX
Inventory XXX Important example to calculate cost CGS, gross profit
A/R XXX and ending inventory under perpetual and periodic
Sales XXX inventory system:
Important:
v When specific identification method or FIFO method
Practice: Example 3,
is used →Value of cost of sales and ending inventory
Volume 3, Reading 21.

4. THE LIFO METHOD

Using LIFO method in case of rising prices results in: NOTE:

• Ending inventory’s Carrying amounts < Current Declining prices (negative LIFO reserve) would result in
Replacement costs FIFO inventory being less than LIFO inventory.
• Cost of Sales more closely reflects current And
replacement costs. FIFO COGS = LIFO COGS – Change in LIFO reserve
• Lower ending inventory, working capital, total
assets, retained earnings, and shareholders’ FIFO COGS = LIFO COGS – (Ending LIFO Reserve –
equity. Beginning LIFO reserve)

NOTE:
LIFO is the most informative inventory accounting
Declining prices (negative LIFO reserve) would result in
method for income statement purposes in periods of
FIFO COGS being greater than LIFO COGS.
rising prices and stable or growing inventories. It
allocates the most recent purchase prices to COGS, and
Net Income (FIFO method) = Net Income (LIFO) +
thus provides a better measure of current income and
[change in LIFO reserve × (1 – tax rate)]
future profitability.
Retained Earnings (FIFO method) = Retained Earnings
Advantage of using LIFO
(LIFO) + [LIFO reserve × (1 – tax rate)]
i. When inventory costs are increasing, using LIFO
results in higher cost of sales, and lower gross Tax liability (FIFO method) = Tax liability (LIFO) + (LIFO
profit, operating profit, income tax expense, reserve × tax rate)
and net income. Consequently, it results in
income tax savings. Cumulative amount of Income Tax savings using the LIFO
ii. The higher cash flows due to lower income method e.g. in year 2010= (LIFO Reserve at end of 2010 ×
taxes may make the company more valuable tax rate in 2010)
because value is based on the PV of its future
cash flows. The amount added to Retained Earnings e.g. in year
2010, if FIFO method is used instead of LIFO method =
LIFO Conformity Rule: [LIFO Reserve at end of 2010 × (1 - tax rate in 2010)]
If a U.S. firm uses LIFO for tax purposes, it must also use
LIFO for financial reporting purposes, according to U.S.
tax law.
To convert Balance Sheet to FIFO:
4.1 LIFO Reserve § Inventory is increased by LIFO Reserve.
§ Cash is decreased by (LIFO Reserve × Tax rate
%).
A firm using LIFO is required to disclose the LIFO reserve. § Shareholders’ equity (Retained Earnings) is
This disclosure provides the information to adjust increased by [LIFO Reserve × (1 – tax rate %)]
company’s cost of sales (COGS) and ending inventory
balance based on LIFO method to the FIFO method.
LIFO Reserve = FIFO Inventory – LIFO Inventory
Therefore,
FIFO Inventory = LIFO Inventory + LIFO Reserve
Reading 21 Inventories FinQuiz.com

due to additional cash resulting from lower taxes under

Comparison of Ratios: LIFO.
Inventory Turnover Ratio:
5"(# ") 6""4( 7"%4 Total Liabilities-to-Equity Ratio:
Inventory Turnover Ratio = 8/+1$9+ :-/+-#"1;
!"#$% ?.$0.%.#.+(
Total Liabilities to Equity Ratio = !"#$% 7*$1+*"%4+1(!@ABCDE
Ø The ratio is higher under LIFO because, when
inventory costs are rising, cost of goods sold will Ø The ratio is higher under LIFO. The company
be higher and inventory carrying amounts will appears to be more highly leveraged under
be lower under LIFO. LIFO because the addition (net of tax LIFO
reserve amount) to retained earnings under
the FIFO method reduces the ratio.
Days of Inventory on hand:
<,20+1 ") 4$;( .- 3+1."4 Value of a Company:
Days of Inventory on hand = :-/+-#"1; !,1-"/+1 =#$."
Cash flows are higher in earlier years in LIFO due to lower
Ø Days of inventory on hand is less using LIFO taxes paid out. This results in higher value of a company
method as compared to FIFO method. Thus, because company’s value is based on PV of future cash
using LIFO, inventory appears to be managed flows.
more efficiently. In the absence of taxes, there is no difference in cash
flow between LIFO and FIFO.
Gross Profit margin:
61"(( >1").# NOTE:
Gross Profit margin =
!"#$% =+/+-,+ In general, an analyst should use LIFO when examining
profitability or cost ratios and FIFO when examining asset
Ø The gross profit margin is lower under LIFO or equity ratios.
because COGS is higher in LIFO when
inventory costs are rising.
Practice: Example 5,
Volume 3, Reading 21.
Net Profit margin:
<+# :-'"2+
Net Profit margin = !"#$% =+/+-,+ 4.2 LIFO Liquidations

Ø The Net profit margin is lower under LIFO A company using LIFO will experience LIFO liquidation
because COGS is higher in LIFO when when:
inventory costs are rising.
• Number of units sold is greater than number of
units purchased or manufactured.
• The number of units in ending inventory is less
Return on Assets: than the number of units in beginning
<+# :-'"2+
Return on Assets = 8/+1$9+ !"#$% 8((+#( inventory.
Ø The return on assets is lower under LIFO
because the lower net income due to the When inventory costs are rising and liquidation occurs,
higher COGS has a greater impact on the ratio an inventory related increase in gross profits occurs.
than the lower total assets due to lower However, these inventory related profits caused by LIFO
inventory carrying amounts. Thus, a company liquidation are not sustainable.
appears to be less profitable under LIFO
method. Reasons for LIFO Liquidations:
• Firms can deliberately increase earnings by
liquidating the older, lower cost inventory and
Current Ratio: not replacing the inventory.
5,11+-# 8((+#(
• LIFO liquidations can occur due to events that
Current Ratio = 5,11+-# ?.$0.%.#.+( are not under management’s control i.e. labor
Ø The current ratio is lower under LIFO because strikes, recessions, or declining demand from
of lower inventory carrying amount. Thus, a customers.
company appears to be less liquid under LIFO.
Consequences of LIFO Liquidation:
NOTE: • LIFO liquidation results in higher taxable
The Quick Ratio is same under any inventory cost flow income.
method since inventory is excluded from the numerator • LIFO liquidation results in higher tax payments.
of the formula. However, there can be an indirect effect
Reading 21 Inventories FinQuiz.com

Calculation of Gross Profit due to LIFO Liquidation: Gross Profit due to LIFO Liquidation = Number of units
liquidated × (Replacement cost per unit – Historical cost
Gross Profit due to LIFO Liquidation = Reported Gross per unit)
profit – Gross profit that would have been reported
without the LIFO Liquidation
Practice: Example 6 & 7,
Or
Volume 3, Reading 21.

LIFO and FIFO Comparison… Assuming Inflation and stable or increasing Quantities

LIFO results in FIFO results in

Higher COGS Lower COGS
Lower Gross profit Higher Gross profit
Income Statement
Lower operating income (EBIT) Higher operating income (EBIT)
Consequences
Lower taxes Higher taxes
Lower net income (EBT& EAT) Higher net income (EBT& EAT)
Lower ending inventory Higher ending inventory
Balance Sheet
Lower working capital (current Higher working capital (current
Consequences
assets – current liabilities) assets – current liabilities)
Cash Flows Higher cash flows due to less Lower cash flows due to more
taxes paid out taxes paid out
Profitability Ratio Lower net and gross margins Higher net and gross margins

LIFO results in FIFO results in

Liquidity Ratio Lower current ratio Higher current ratio

Activity Ratio Higher inventory turnover Lower inventory turnover
Solvency Ratio Higher debt-to equity Lower debt-to equity

NOTE: When there is no inflation or deflation with respect to inventory costs and unit costs remain unchanged, all
inventory valuation methods provide the same results.
Inventory Valuation and COGS under different economic environments (assuming inflation and stable or
increasing quantities)

Economic Account FIFO LIFO Weighted Average

Environment cost
Ending Inventory Higher Lower In Between
Inflationary
COGS Lower Higher In Between
Ending Inventory Lower Higher In Between
Deflationary
COGS Higher Lower In Between

5. INVENTORY METHOD CHANGES

IFRS
Change in inventory valuation method is allowed under Example: If the company changes its inventory method
IFRS only if the change results in the financial statements in 2010 and it presents three years of comparative
providing reliable and more relevant information about financial statements i.e. 2008, 2009 and 2010 in its annual
the effects of transactions on: report, then the change will be reflected retrospectively
as far back as possible i.e. in three years of financial
§ the business entity’s financial position, statements as follows:
§ financial performance, or
§ cash flows o The Financial statements for 2008 and 2009 and
would be restated as if the new method had
If the change is justifiable, then it is applied been used in these periods.
retrospectively. o The cumulative effect of the change on periods
Reading 21 Inventories FinQuiz.com

prior to 2008 would be reflected in the 2008 § financial performance, or

opening balance of each affected component § cash flows
of equity.
U.S. GAAP also requires company to thoroughly explain
NOTE: An exemption to the restatement applies when it why the newly adopted method is superior and
is impracticable to determine either: preferable to the old method.

§ the period-specific effects or • If a company decides to change from LIFO to

§ the cumulative effect of the change. another inventory method and if the change is
justifiable, then it is applied retrospectively;
U.S. GAAP: similar to IFRS requirements (see above).
Change in inventory valuation method is allowed only if • If a company decides to change to the LIFO
the change results in the financial statements providing method, then this change is applied
reliable and more relevant information about the effects prospectively i.e. the carrying amount of
of transactions on: inventory under old method becomes the initial
LIFO layer in the year of LIFO adoption.
§ the business entity’s financial position,

6. INVENTORY ADJUSTMENTS

Costs related to Inventory include:

Inventory Valuation Rules under IFRS: Under IFRS,
o Spoilage inventory is measured (carried on the balance sheet) at
o Obsolescence lower of cost and net realizable value.
o Insurance
o Declines in selling prices
Where, Net Realizable Value (NRV) = Estimated Sales
price – Estimated Selling costs and completion costs
Inventory valuation method is different from Inventory
cost flow method. Inventory valuation method is used to
determine the carrying amount on the balance sheet
and for testing inventory for impairment.

Then
•When NRV < •Loss is recognized
balance sheet cost as an expense in
(carrying amount) •Inventory carrying the income
amount is written statement (part of
down to NRV COGS or reported
separately)

Then

Subsequent Recovery in Value: cannot be reported on the balance sheet at an

amount greater than its original cost.
• If there is a subsequent increase in value of
inventory, the inventory can be written up and a Inventory Valuation Rules under U.S. GAAP:
gain (reduction in cost of sales) is recognized in the Under U.S. GAAP, for LIFO and retail methods, inventory is
income statement. measured (carried on the balance sheet) at lower of
cost or market.
• The amount of reversal is limited to the amount of
the original write-down. This implies that inventory
Reading 21 Inventories FinQuiz.com

Market is usually equal to replacement cost, subject to • If Replacement cost < (NRV – normal profit
upper and lower limits i.e. margin) è Market is (NRV – normal profit
margin)
• Market cannot be > NRV and Market cannot be
< (NRV – normal profit margin) Important: After December 15, 2016, inventories
• If Replacement cost >NRV è Market is NRV measured using other than LIFO and retail methods,
are measured at lower of cost or NRV similar to IFRS.

Then
•When Market < • Loss is
balance sheet cost recognized as an
(carrying amount) •Inventory carrying expense in the
amount is written Income Statement
down to Market (part of COGS or
reported
separately)
Then

inventory write-downs than companies that use the LIFO

method because under LIFO method, the inventory
Subsequent Recovery in Value: carrying amounts reflect the oldest costs and are
If there is a subsequent increase in value of inventory, already conservatively presented.
the inventory cannot be written up. In this case, the
market value becomes the new cost basis. Inventory can be reported at NRV instead of historical
cost (both under IFRS and U.S. GAAP) in certain industries
Effects of Inventory write-down: and the unrealized gain/losses from changing market
prices are recognized in the income statement. These
• Inventory write-down reduces profit. industries include:

• Inventory write-down reduces carrying amount • Producers of agricultural products.

of inventory on the balance sheet. • Producers of forest products.
• Producers of minerals and mineral products.
• Inventory write-down has a negative effect on • Commodity broker-dealers.
profitability, liquidity & solvency ratios.
Determining Fair value of Inventory in above mentioned
o The gross profit margin and net profit industries:
margin are lower with inventory write
down because cost of sales is higher.
• If an active market exists for these products,
then quoted market price is used to determine
• Inventory write-down has a positive effect on
fair value of the inventory.
activity ratios.
• If an active market does not exist, the most
recent market transaction price can be used
o The company appears to manage its
to determine fair value of the inventory.
inventory more efficiently when it has
inventory write-downs i.e. Inventory
turnover ratio is higher and days of Practice: Example 8 & 9,
inventory on hand are lower with Volume 3, Reading 21.
inventory write-down.
o

NOTE:
Companies that use specific identification, weighted
average cost or FIFO methods are more likely to incur
Reading 21 Inventories FinQuiz.com

7. EVALUATION OF INVENTORY MANAGEMENT

5F67
7.1 Presentation and Disclosure Inventory Turnover Ratio =
8/+1$9+ :-/+-#"1;

Under IFRS: Companies are Under U.S.GAAP: Days of Inventory on Hand/Days in Inventory/Average
required to disclose: Companies are required inventory days outstanding:
to disclose:
a) Accounting policies • Same except for Days of Inventory on hand (DOH) =
GHI
applied in inventory ‘f’ and ‘g’ (:-/+-#"1; !,1-"/+1 =$#.")
measurement. because under
b) Total carrying amount U.S.GAAP, Ø High turnover ratio and low number of days of
of inventories and reversal are not inventory on hand represent efficient inventory
carrying amount in allowed. management i.e. fewer funds tied up in
each category of • Significant inventories.
inventory (materials, estimates Ø High inventory and low number of days of
WIP, finished goods, applied to inventory on hand may also indicate under-
production supplies, inventories. stocking and lost orders or company has written
merchandise). • Any significant down inventory values.
Ø Manufacturing amount of Ø Slower growth combined with lower inventory
companies classify income earned turnover (& high number of days of inventory on
inventories as as a result of hand) relative to industry norms may indicate slow-
production liquidation of moving or obsolete inventory.
supplies, raw LIFO inventory. Ø Low turnover & high number of days of inventory
materials, work in on hand can also indicate valid reasons i.e.
progress, and preparing for a strike, increased demand, etc.
finished goods. Ø Write-downs of inventory could reflect poor
Ø Retailers classify inventory management. Higher turnover reflects
inventories as greater efficiency in managing inventory when it is
significant accompanied by minimal write-downs and sales
categories of growth rates at or above the industry’s growth
merchandise or the rates.
grouping of 61"(( 31").#
Gross profit margin = =+/+-,+
inventories with
similar attributes. Ø It is a measure of profitability of a firm e.g. 40%
c) Carrying amount of any gross margin means that each dollar of sales
inventory measured at (revenue) generate 40 cents of gross profit.
fair value less costs to Ø Firms operating in highly competitive industries
sell. have lower gross profit margins relative to firms
d) Amount of inventory operating in industries with few competitors.
recognized as an Ø Firms that sell luxury products tend to have higher
expense (cost of gross profit margins relative to firms that sell staple
sales/cost of goods products.
sold)
e) Amount of write-downs
7.3 Financial Analysis Illustrations
to NRV or other losses
f) Amount of any write-
down reversals Growth in finished goods inventories and raw materials
g) Circumstances that and work-in-progress inventories:
resulted in reversals
h) Carrying amount of v If there is a significant increase (in terms of volume)
inventories pledged as in raw materials and/or work-in-progress inventories
collateral for liabilities. of a company, it may indicate that the company is
expecting an increase in demand for its products,
7.2 Inventory Ratios which subsequently will lead to increase in sales
and profit.

Following ratios are used to evaluate the efficiency and v In contrast, if there is a substantial increase in
effectiveness of inventory management of a firm: finished goods inventories while raw materials and
Reading 21 Inventories FinQuiz.com

work-in-progress inventories are declining, it may

indicate that the company is expecting a
decrease in demand for its products and hence
lower future sales and profit. Resultantly, there is
also a likelihood of write down of finished goods
inventory in future.

Growth in sales and finished goods inventories:

v If the growth of inventories is greater than the

growth of sales, this may signal a decline in demand
and a decrease in future earnings. In addition, it
may result in inventory write-downs and / or increase
in inventory related expenses such as insurance,
storage costs, and taxes and less cash and working
capital available for other purposes.

The impact of inventory write-downs can be minimized

by the companies by better matching their inventory
composition and growth with prospective customer
demand.

Practice: Example 10, 11 & 12,

Volume 3, Reading 30.

Practice: CFA Institute’s end of

Chapter Practice Problems and
FinQuiz Questions.