Inventory

Question 1

Weighted Average Cost Inventory

Answer 1

Step 1: Avg $/unit = COGS AFS / Units AFS
Step 2: Avg $ x units sold = COGS ($I/S)
Step 3: EI = COGS AFS - COGS

COGS and inventory value is somewhere in between the LIFO and FIFO values

Question 2

FIFO (First-in-first-out)

Answer 2

1. COGS reflects oldest production costs and inventory value reflects most recent costs
2. Thus, FIFO inventory is a better representation of inventory replacement costs (AKA why why like FIFO B/S)
3. Rising price environment results in lower COGS and higher inventory relative to LIFO and lower inventory turnover
4. COGS and EI are the same whether using periodic or perpetual system

Question 3

LIFO

Answer 3

1. COGS reflects newest production costs and inventory value reflects most oldest costs
2. Thus, LIFO COGS is a better representation of economic reality (AKA why why like LIFO I/S)
3. Rising price environment results in higher COGS and lower inventory relative to LIFO and higher inventory turnover
4. COGS and EI are NOT the same whether using periodic or perpetual system

Question 4

Periodic system

Answer 4

Inventory and COGS are determined at the end of accounting period

Question 5

Perpetual system

Answer 5

Inventory values and CGOS are updated continuously

Question 6

LIFO Reserve

Answer 6

= FIFO EI - LIFO EI

Positive in rising price environment and negative in falling price environment

Question 7

Change in LIFO Reserve

Answer 7

= COGS - EBT

Question 8

LIFO Liquidation

Answer 8

Occurs when a LIFO firm sells more inventory than it produces to EI is constantly falling an the change in LR is negative

In rising prices, this actually reduces COGS b/c lower cost inventory is used, thus inflating gross margin

To adjust to FIFO for a more conservative margin = LIFO COGS - Change in LR

Question 9

Full LIFO to FIFO Conversion

Answer 9

1. B/S -> LIFO inventory + LR = FIFO EI
2. I/S -> LIFO COGS - Change in LR = FIFO COGS
3. C/F -> decrease cash by LR x Tax rate
4. R/E -> increase R/E (equity) by LR x (1-T)

Question 10

Inventory Adjustments (GAAP)

Answer 10

Inventory should be values at the lower of cost or market

“Middle” Market Test (unique to GAAP)

• NRV
• Replacement value
• NRV - Normal profit

If market < cost, write down the asset and take an impairment charge

No “write-up” reversals allowed under US GAAP

Question 11

Inventory Adjustments (IFRS)

Answer 11

Inventories are valued at the lower of cost or market where market is the NRV = SP - Selling costs

Write up reversals are allowed, but only the extent it was previously written down

Question 12

Inventory Adjustment Impacts

Answer 12

A writedown of inventory will result in

• Lower inventory and lower equity
• Increased asset turnover, debt-to-equity, and debt to assets
• Profit margin declines which will also cause ROA and ROE to fall as well

Question 13

Ratio Implications

Answer 13

Low ITO = slow moving or obsolete inventory

High ITO and low sales growth = inadequate inventory to meet demand

High ITO sales and high sales growth = efficient inventory management