3.7 Inventories

Question 1

Under both IFRS and US GAAP, inventory costs include

Answer 1

purchase costs and conversion costs incurred in the process of acquiring inventory and bringing it to its present location and condition.

Question 2

The following items are included in the cost of purchase:

Answer 2

Purchase price (less any trade discounts or rebates)

Import/tax duties

Transportation and handling costs

Insurance for transportation

Any other costs directly related to the acquisition of finished goods or services

Question 3

Conversion costs are directly related to units produced, including:

Answer 3

Direct labor

Fixed overhead (e.g., depreciation, factory maintenance)

Variable overhead (e.g., indirect labor and materials)

Question 4

Costs that are included in the inventory are not recognized as an expense until when?

Answer 4

until the item is sold, effectively deferring the expense.

Question 5

Certain costs are excluded from inventory, such as:

Answer 5

Abnormal costs due to waste

Storage costs (unless as part of the production process)

Administrative overhead

Selling costs

–> These items are expensed immediately as they are incurred.

Question 6

To determine the amount of COGS expense to recognize as inventory is sold, companies can choose between different inventory valuation methods.

Under US GAAP, the following methods are permitted:

Which of these is not allowed under IFRS?

Answer 6

Specific identification

First-in, first-out (FIFO)

Last-in, first-out (LIFO)

Weighted average cost

the use of LIFO is not allowed under IFRS.

Question 7

First-In, First-Out (FIFO)

Answer 7

The FIFO inventory valuation method assumes the oldest goods are sold first, meaning that the ending inventory balance is based on the most recently purchased items.

Question 8

Last-In, First-Out (LIFO)

Answer 8

The LIFO method, which is allowed by US GAAP but not IFRS, assumes that the most recently acquired items are sold first and the oldest items remain in inventory.

Question 9

Weighted Average Cost

Answer 9

Under this method, the average cost of goods available for sale is assigned to the units sold and the units in ending inventory.

The average cost includes beginning inventory plus purchases

Question 10

periodic inventory system

Answer 10

values of COGS and ending inventory are determined only at the end of each accounting period

All purchases during the period are added to the inventory balance at the beginning of the period to determine the total value of goods available for sale.

The ending inventory, verified by a physical count, is subtracted from the goods available for sale to determine the cost of sales.

Question 11

perpetual inventory system

Answer 11

purchases and sales are recorded directly in inventory as they occur.

Question 12

Assuming rising costs, which is typical as inflation is usually positive, using the LIFO method (compared to FIFO or weighted-average cost) will have the following effects on a company’s Income Statement:

Answer 12

Higher COGS –> Lower profit –> Lower income tax expense

Question 13

Assuming rising costs, which is typical as inflation is usually positive, using the LIFO method (compared to FIFO or weighted-average cost) will have the following effects on a company’s Balance Sheet:

Answer 13

Lower inventory –> Lower assets –> Lower equity

Question 14

Assuming rising costs, which is typical as inflation is usually positive, using the LIFO method (compared to FIFO or weighted-average cost) will have the following effects on a company’s Cash Flow Statement:

Answer 14

Lower taxes –> Higher operating cash flow

Question 15

US GAAP require companies to disclose the value of their LIFO reserve, which is calculated as follows:

Answer 15

LIFO reserve = FIFO Inventory rule - LIFO Inventory rule

Question 16

Companies that want to switch from LIFO to FIFO must make the following adjustments:

Answer 16

Adjusted inventory = Reported inventory + Lifo reserve

Adjusted cost of sales = Reported cost of sales - Change in LIFO reserve

Question 17

A LIFO liquidation

Answer 17

occurs when inventory is reduced because the units sold are more than the units purchased

If prices have been increasing, older units in inventory will have lower prices under the LIFO method. This leads to bigger gross margins when sold, but it is not sustainable.

LIFO liquidations can be done intentionally by management or be caused by external circumstances.

A decline in the LIFO reserve may indicate that a LIFO liquidation has occurred.

Question 18

a write-down

Answer 18

reduction in book value of assets

Question 19

what happens If inventory declines below the carrying amount on the balance sheet?

Answer 19

a write-down (reduction in book value of assets) is recognized as an expense on the income statement, either as part of cost of goods sold or reported separately

Any subsequent reversals of previously recognized write-downs are also reported on the income statement as a reduction in cost of goods sold.

Question 20

IFRS requires companies to hold inventory at?

Answer 20

the lower of cost and net realizable value (NRV)

Question 21

net realizable value (NRV)

Answer 21

defined as the ordinary selling price less costs of sale and costs to get ready for sale.

Question 22

US GAAP also requires companies to hold inventory at the lower of cost and net realizable value (NRV)

what’s the difference with IFRS?

Answer 22

The only exception is for companies that use the LIFO method.

These companies are required to hold inventory at the lower of cost and market value

Question 23

market value

Answer 23

defined as the current replacement cost subject to an upper limit equal to the net realizable value and a lower limit equal to the net realizable value less a normal profit margin

As with IFRS, write-downs hit the income statement. However, unlike IFRS, US GAAP does not allow reversals of write-downs.

Question 24

effects of write-downs on ratios

Answer 24

hurt profitability, liquidity, and solvency ratios.
However, write-downs help activity ratios.

Question 25

On rare occasions, a company may choose to change its inventory valuation method.

Under IFRS, such a change is only permitted if it produces what?

Answer 25

financial statements that are “reliable and more relevant.”

If allowed, the change is applied retrospectively and prior financial statements are restated.

Retroactive adjustments to previous financial statements are only required if a company is changing from LIFO to another inventory method. No restatements are required for companies that change to LIFO

Question 26

On rare occasions, a company may choose to change its inventory valuation method.

Under US GAAP, such a change is only permitted if it produces what?

Answer 26

If a change is made, the company must provide a thorough explanation of why the new inventory accounting method is superior to the old method.

Retroactive adjustments to previous financial statements are only required if a company is changing from LIFO to another inventory method. No restatements are required for companies that change to LIFO

Question 27

Three ratios that analysts commonly use to evaluate a company’s inventory management are:

Answer 27

Inventory turnover ratio

Days of inventory on hand (DOH)

Gross profit margin

Question 28

Inventory turnover ratio

Answer 28

COGS / Average Inventory

measures the number of times a company sells its inventory over the course of a year.

It is inversely related to DOH

A high inventory turnover could indicate a company is operationally efficient. Alternatively, this may be evidence that the company has an inadequate inventory.

Question 29

Days of inventory on hand (DOH)

Answer 29

Days in period / Inventory Turnover

Question 30

Gross profit margin

Answer 30

(Sales - COGS) / Sales