Reading 28 - Inventories

Question 1

IFRS and U.S. GAAP suggest a similar treatment of various expenses in the determination of inventory cost. The following items are capitalized inventory costs, which are included in the cost or carrying value of inventories on the balance sheet.

Answer 1

• Costs of purchase, which include the purchase price, import duties, taxes, insurance, and other costs that are directly attributable to the acquisition of finished goods, trade discounts, and other rebates that reduce costs of purchase. 

• Costs of conversion, which include direct labor and other (fixed and variable) direct overheads. 


Question 2

How does cost of purchases and conversion affect COGS?

Answer 2

Capitalization of these costs results in a buildup of asset balances and delays recognition of these costs (in COGS) until inventory is sold.

Question 3

How are items that are not capitalized as inventory costs dealt with?

Answer 3

The following items are not capitalized as inventory costs; they are expensed on the 
income statement as incurred under IFRS and U.S. GAAP. 


Question 4

Which items are not capitalized as inventory costs?

Answer 4

• Abnormal costs from material wastage. 

• Abnormal costs of labor or wastage of other production inputs. 

• Storage costs that are not a part of the normal production process. 

• Administrative expenses. 

• Selling and marketing costs. 


Question 5

Capitalization of costs that should be expensed result in what?

Answer 5

Capitalization of costs that should be expensed results in overstatement of net income for the year (due to the deferral of recognition of costs) and an overstatement of inventory value on the balance sheet. 


Question 6

Let’s work with an example of a trading company that purchases and retails coffee tables. At any point in time, the number of tables that the company has available for sale equals the total number of tables that it had in its inventory at the beginning of the period plus the number of tables it has purchased since then. In order to prepare its financial statements for the period, the company must allocate the cost of all units available for sale between ending inventory (EI) and costs of goods sold (COGS).

Summarize this in an equation. This is the base for all inventory valuation equations.

Answer 6

Opening inventory + Purchases = Cost of goods sold + Ending inventory

Question 7

What IFRS calls “cost of sales”, what does U.S. GAAP call it?

Answer 7

“Cost of sales” (IFRS) are also referred to as “cost of goods sold” (U.S. GAAP).

Question 8

What IFRS calls “cost formulas”, what does U.S. GAAP call it?

Answer 8

“Cost formulas” (IFRS) are also referred to as “cost flow assumptions” (U.S. GAAP).

Question 9

Explain the Separate Identification inventory valuation method? How does it relate to costs of goods sold (COGS) and ending inventory (EI)?

Answer 9

• COGS reflects actual costs incurred to purchase or manufacture the specific units that have been sold over the period. 

• EI reflects actual costs incurred to purchase or manufacture the specific units that still remain in inventory at the end of the period. 

• This method is used for items that are not interchangeable and for goods produced for specific projects. 

• It is used for expensive goods that can be identified individually (e.g., precious gemstones). 

• This method matches the physical flow of a particular inventory item with its actual cost.
• Under separate identification, costs remain in inventory until the specific unit is sold.

Opening inventory + Purchases = Cost of goods sold + Ending inventory

Question 10

Explain the First In, First Out (FIFO) inventory valuation method? How does it relate to costs of goods sold (COGS) and ending inventory (EI)?

Answer 10

• Oldest units purchased or manufactured are assumed to be the first ones sold. 

• Newest units purchased or manufactured are assumed to remain in ending 
inventory. 

• COGS is composed of units valued at oldest prices. 

• EI is composed of units valued at most recent prices. 


Opening inventory + Purchases = Cost of goods sold + Ending inventory

Question 11

Explain Weighted Average Cost (AVCO) inventory valuation method? How does it relate to costs of goods sold (COGS) and ending inventory (EI)?

Answer 11

This method allocates the total cost of goods available for sale (beginning inventory, purchases, and other inventory‐related costs) evenly across all units available for sale. 


• COGS is composed of units valued at average prices. 

• EI is also composed of units valued at average prices. 


Opening inventory + Purchases = Cost of goods sold + Ending inventory

Question 12

Explain Last In, Last Out (LILO) inventory valuation method? How does it relate to costs of goods sold (COGS) and ending inventory (EI)?

Answer 12

• Newest units purchased or manufactured are assumed to be the first ones sold. 

• Oldest units purchased or manufactured are assumed to remain in ending inventory. 

• COGS is composed of units valued at most recent prices. 

• EI is composed of units valued at oldest prices. 


Question 13

Discuss the assumptions made in the inventory valuation methods FIFO, LIFO, and AVCO.

Answer 13

Under FIFO, 
LIFO, and AVCO companies make an assumption about which goods are sold and which ones remain in inventory. Therefore, the allocation of costs to units sold and those in inventory can be different from the physical movement of inventory units.

Question 14

Discuss what a company must do when valuating inventory methods for their nature and use?

Answer 14

A company must use the same inventory valuation method for all items of a similar nature and use.

For items with a different nature or use, a different valuation method may be used.

Question 15

Which inventory valuation methods are allowed for IFRS? Which are allowed for U.S. GAAP?

Answer 15

IFRS allows companies to use any of three valuation methods for inventory—separate identification, FIFO, and AVCO. U.S. GAAP allows companies to use the three methods allowed under IFRS, and also accepts the LIFO method. 


Question 16

Discuss how the freedom to choose a particular inventory valuation method has direct impact on financial statements and their comparability across companies.

Answer 16

The freedom to choose a particular inventory valuation method affords companies significant flexibility in how they apportion costs between EI (current assets on the balance sheet) and COGS (expenses on the income statement). Given the value of beginning inventory and purchases for the year, it is obvious (from Equation 1) that the higher the value of COGS, the lower the value allocated to EI and vice versa. Therefore, inventory valuation methods have a direct, material impact on financial statements and their comparability across companies. 


Equation (1):

Opening inventory + Purchases = Cost of goods sold + Ending inventory

Question 17

Discuss the effect of inventory purchase costs and manufacturing conversion costs have a direct impact on the inventory valuation method.

Answer 17

If inventory purchase costs and manufacturing conversion costs were stable over time, it would be easy to apportion costs between EI and COGS. The number of units in inventory at the end of the year would be multiplied by the cost price per unit to compute EI, and the number of units sold multiplied by the cost price per unit to determine COGS. However,
 if prices fluctuate over the period (which is usually the case), the allocation of inventory costs becomes complicated because the valuation method used has significant implications on the value of EI and COGS for the period. 


Question 18

Under FIFO, in periods of rising prices, how does the price of the ending inventory look?

Answer 18

Under FIFO, in periods of rising prices the prices assigned to units in ending inventory are higher than the prices assigned to units sold.

Question 19

Under LIFO, in periods of rising prices, how does the price of the ending inventory look?

Answer 19

Under LIFO, in periods of rising prices the prices assigned to units in ending inventory are lower than the prices assigned to units sold.

Question 20

Under AVCO, in periods of rising prices, how does the price of the ending inventory look?

Answer 20

Under AVCO, regardless of whether prices are rising or falling the prices assigned to units in ending inventory are the same as the prices assigned to units sold.

Question 21

Under all four methods of inventory valuation, how does the first year of operation inventory value look compared to all subsequent years?

Answer 21

In the first year
 of operations, all four methods of inventory valuation will come up with the same value
 for cost of goods available for sale (OI + P).

However, in subsequent years, the cost of goods available for sale under each method would typically differ because of the different amounts allocated to opening inventory (EI in the previous year).

Question 22

For inventory valuation methods in periods with rising prices and stable inventory levels, which method results in the highest gross profit? Make sure to understand why.

Answer 22

Notice that in periods with rising prices and stable inventory levels, FIFO results in the highest gross profit.

COGS were the lowest, making a higher margin between selling price and COGS.

Question 23

Discuss the relation with the total cost allocated to COGS and EI.

Answer 23

The total cost allocated to COGS and EI is the same across the three different cost flow methods. If one method reports higher COGS, it must report lower EI.

Question 24

Give an inequality summary, given constant or increasing inventory levels, if prices are rising over a given period: COGS & EI.

Answer 24

COGS_LIFO > COGS_AVCO > COGS_FIFO

EI_FIFO > EI_AVCO > EI_LIFO

Question 25

Give an inequality summary, given constant or increasing inventory levels, if prices are falling over a given period:

Answer 25

COGS_FIFO > COGS_AVCO > COGS_LIFO

EI_LIFO > EI_AVCO > EI_FIFO

Question 26

For LIFO with rising prices and stable or rising inventory levels, what would be the effect (higher or lower) on:

COGS

Income before taxes

Income taxes

Gross profit & net income

Total cash flow

EI

Working capital

Answer 26

COGS: Higher

Income before taxes: Lower

Income taxes: Lower

Gross profit & net income: Lower

Total cash flow: Higher

EI: Lower

Working capital: Lower

Question 27

For LIFO with rising prices and stable or rising inventory levels, what would be the effect (higher or lower) on:

COGS

Income before taxes

Income taxes

Gross profit & net income

Total cash flow

EI

Working capital

Answer 27

COGS: Lower

Income before taxes: Higher

Income taxes: Higher

Gross profit & net income: Higher

Total cash flow: Lower

EI: Higher

Working capital: Higher

Question 28

What is the only direct economic difference that results from the choice of inventory valuation method?

Answer 28

The difference
 in cash flows is
 the only direct economic difference that results from the choice of inventory valuation method.

Question 29

What is very important to remember about which inventory method better reflects the current economic value of inventory?

Answer 29

It does not matter whether prices are rising (as in our example) or falling, FIFO will always give a better reflection of the current economic value of inventory because the units currently in stock are valued at the most recent prices.

EXAMPLE FOR MORE INFO:

Nakamura (Example 2-1) has seven unsold units at the end of the year. If we were to measure the true economic value or the current replacement cost of these units, we would value them at $13 each (latest prices) for an EI value of $91. FIFO ending inventory therefore, reflects the replacement cost of inventory most accurately ($91), followed by AVCO ($79.58). The LIFO estimate for EI ($60) is farthest away from the true economic value of inventory.

Question 30

If prices are rising, falling or stable, how do the three inventory valuation methods value ending inventory?

Answer 30

If prices are rising, LIFO and AVCO will understate ending inventory value. 


If prices are falling, LIFO and AVCO will overstate ending inventory value. 


When prices are stable, the three methods will value inventory at the same level. 


Question 31

What is the difference between the original cost of inventory and its current replacement cost called?

Answer 31

The difference between the original cost of inventory and its current replacement cost is known as a holding gain or inventory profit.

Question 32

If you needed more information about inventory accounting methods, where would you look?

Answer 32

More information about inventory accounting methods is typically available in the footnotes to the financial statements.

Question 33

What is very important to remember about which inventory method better reflects the replacement costs in COGS?

Answer 33

It does not matter whether prices are rising (as in our example) or falling, LIFO will always offer a closer reflection of replacement costs in COGS because it allocates recent prices to COGS. LIFO is the most economically accurate method for income statement purposes because it provides a better measure of current income and future profitability. 


MORE INFO EXAMPLE:

COGS should ideally reflect the replacement cost of inventory. The 50 units sold should each be valued at $13 (latest prices) in calculating the true replacement cost of goods sold during the year, which equals $650 (50 units × $13). LIFO estimates of COGS capture current replacement costs fairly accurately ($588), followed by AVCO ($568.42). FIFO measures of COGS ($557) are farthest away from current replacement cost of inventory. 


Question 34

If prices are rising, falling or stable, how do the three inventory valuation methods value: replacement costs in COGS and profits?

Answer 34

If prices are rising, FIFO and AVCO will understate replacement costs in COGS and overstate profits. 


If prices are falling, FIFO and AVCO will overstate replacements costs in COGS and understate profits. 


When prices are stable, the three methods will value COGS at same level. 


Question 35

What are the two inventory systems?

Answer 35

Periodic inventory system

Perpetual inventory system

Question 36

Describe the periodic inventory system.

Answer 36

Periodic inventory system: Under this system, the quantity of inventory on hand is calculated periodically. The cost of goods available for sale during the period is calculated as beginning inventory plus purchases over the period. The ending inventory amount is then deducted from cost of goods available for sale to determine COGS. 


Question 37

Describe the perpetual inventory system.

Answer 37

Perpetual inventory system: Under this system, changes in the inventory account are updated continuously. Purchases and sales are recorded directly in the inventory account as they occur.

Question 38

Under IFRS, how must inventory value be stated?

Answer 38

Under IFRS, inventory must be stated at the lower of cost or net realizable value (NRV).

Question 39

How is net realizable value (NRV) calculated?

Answer 39

NRV is calculated as the estimated selling price minus estimated selling costs.

Question 40

If the net realizable value (NRV) of inventory falls below the carrying value recorded on the balance sheet, what must happen?

Answer 40

If the NRV of inventory falls below the carrying value recorded on the balance sheet, inventory must be written down, and a loss must be recognized on the income statement. The company may record the decrease in value directly through the inventory account or through a valuation allowance (reserve) account. If it uses the valuation allowance, the net inventory value equals the cost of inventory minus the write‐down.

Question 41

If inventory must be written down, what happens if there is a subsequent increase in net realizable value (NRV)?

Answer 41

A subsequent increase in NRV would require a reversal of the previous write‐down, which would reduce inventory‐related expenses on the income statement in the period that the increase in value occurs. However, the increase in value that can be recognized is limited to the total write‐down that had previously been recorded. Typically, inventory value cannot exceed the amount originally recognized.

Question 42

What are some adverse effects of inventory write-downs?

Answer 42

Inventory write‐downs raise concerns regarding management’s abilities to anticipate how much and what type of inventory was required. Furthermore they affect a company’s future reported earnings.

Question 43

How does IFRS and U.S. GAAP compare cost?

Answer 43

IFRS Compare cost to NRV


NRV = SP − SC

U.S. GAAP Compare cost to replacement cost (market) where:

NRV − NP margin < Replacement cost < NRV

Question 44

What does the U.S. GAAP require to value inventory?

Answer 44

On the other hand, U.S. GAAP requires the application of the LCM (lower of cost or market) principle to value inventory. Market value is defined as current replacement cost, where 
current replacement cost must lie within a range of values from NRV minus normal profit margin to NRV. If replacement cost is higher than NRV it must be brought down to NRV, and 
if replacement cost is lower than NRV minus normal profit margin it must be brought up to NRV minus normal profit margin. This adjusted replacement cost is then compared to carrying value (cost) and the lower of the two is used to value inventory. Any write‐down decreases the carrying value of inventory and is reflected on the income statement under COGS. An important thing to remember is that under U.S. GAAP, reversal of any write‐down is prohibited.

Question 45

In certain industries like agriculture, forest products, and mining, how does U.S. GAAP and IFRS allow companies to value inventory?

Answer 45

In certain industries like agriculture, forest products, and mining, both U.S. GAAP and IFRS allow companies to value inventory at NRV even when it exceeds historical cost. If an active market exists for the product, quoted market prices are used as NRV; otherwise the price of the most recent market transaction is used. Unrealized gains and losses on inventory resulting from fluctuating market prices are recognized on the income statement.

Question 46

IFRS requires companies to make the following disclosures relating to inventory: (1-3)

Answer 46

1) The accounting policies used to value inventory. 

2) The cost formula used for inventory valuation. 

3) The total carrying value of inventories and the carrying value of different 
classifications (e.g., merchandise, raw materials, work‐in‐progress, finished goods). 


Question 47

IFRS requires companies to make the following disclosures relating to inventory: (4-6)

Answer 47

4) The value of inventories carried at fair value less selling costs. 

5) Amount of inventory‐related expenses for the period (cost of sales).
6) The amount of any write‐downs recognized during the period. 


Question 48

IFRS requires companies to make the following disclosures relating to inventory: (7-9)

Answer 48

7) The amount of reversal recognized on any previous write‐down. 

8) Description of the circumstances that led to the reversal. 

9) The carrying amount of inventories pledged as collateral for liabilities. 


Question 49

How does the U.S. GAAP treat prior-year inventory write-downs?

Answer 49

U.S. GAAP does not permit the reversal of prior‐year inventory write‐downs. U.S. GAAP also requires disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.

Question 50

How does U.S. GAAP and IFRS view consistency in the inventory costing methods?

Answer 50

Consistency in the inventory costing method used is required under U.S. GAAP and IFRS.

Question 51

Under IFRS, when is a change in policy acceptable in inventory valuation?

Answer 51

Under IFRS, a change in policy is acceptable only if the change results in the provision of more reliable and relevant information in the financial statements, these include:

• Changes in inventory accounting policy are applied retrospectively. 

• Information for all periods presented in the financial report is restated. 

• Adjustments for periods prior to the earliest year presented in the financial report 
are reflected in the beginning balance of retained earnings for the earliest year presented in the report. 


Question 52

What are the U.S. GAAP requirements for changes in inventory accounting policies?

Answer 52

• However, a company must thoroughly explain how the newly adopted inventory 
accounting method is superior and preferable to the old one. 

• The company may be required to seek permission from the Internal Revenue 
Service (IRS) before making any changes. 

• If inventory‐related accounting policies are modified, the changes to the financial 
statements must be made retrospectively, unless the LIFO method is being adopted (which is applied prospectively). 


Question 53

The three most important ratios used in the evaluation of a company’s inventory management are?

Answer 53

the inventory turnover ratio

the number of days of inventory

gross profit margin: 


Question 54

Out of the three most important ratios used in the evaluation of a company’s inventory management, what is the equation for inventory turnover?

Answer 54

Inventory turnover = COGS / Average Inventory

Question 55

Out of the three most important ratios used in the evaluation of a company’s inventory management, what is the equation for No. of days of inventory?

Answer 55

No. of days of inventory = 365 / Inventory Turnover

Question 56

Out of the three most important ratios used in the evaluation of a company’s inventory management, what is the equation for gross profit margin?

Answer 56

Gross profit margin = Gross profit / Sales revenue

Question 57

If a company has a higher inventory turnover ratio and a lower number of days of inventory than the industry average, it could mean one of three things:

Answer 57

1) It could indicate that the company is more efficient in inventory management, as fewer resources are tied up in inventory. 

2) It could also suggest that the company does not carry enough inventory at any point in time, which could hurt sales. 

3) It could also mean that the company might have written‐down the value of its inventory. 


Question 58

If a company has a higher inventory turnover ratio and a lower number of days of inventory than the industry average, it could mean one of three things:

1) It could indicate that the company is more efficient in inventory management, as fewer resources are tied up in inventory. 


2) It could also suggest that the company does not carry enough inventory at any point in time, which could hurt sales. 


3) It could also mean that the company might have written‐down the value of its inventory. 


How do you determine which explanation holds true?

Answer 58

To determine which explanation holds true, analysts should compare the firm’s revenue growth with that of the industry and examine the company’s financial statement disclosures. A low sales growth compared to the industry would imply that the company is losing out on sales by holding low inventory quantities. A higher inventory turnover ratio combined with minimal write‐downs and a sales growth rate similar to or higher than industry sales growth would suggest that the company manages inventory more efficiently than its peers. Frequent, significant write‐downs of inventory value may indicate poor inventory management. 


Question 59

A firm whose inventory turnover is lower and number of days of inventory higher than industry average could mean what?

Answer 59

They have a problem with slow‐moving or obsolete inventory. Again, a comparison with industry sales growth and an examination of financial statement disclosures would provide further information. 


Question 60

The gross profit margin indicates the percentage of sales that is contributing to net income as opposed to covering the cost of sales. How do gross profit margins look in competitive industries?

Answer 60

Firms in relatively competitive industries have lower gross profit margins. 


Question 61

The gross profit margin indicates the percentage of sales that is contributing to net income as opposed to covering the cost of sales. How do gross profit margins, volumes and inventory turnover ratios look in firms selling luxury products?

Answer 61

Firms selling luxury products tend to have lower volumes and higher gross profit 
margins. 


Firms selling luxury products are likely to have lower inventory turnover ratios. 


Question 62

What assumptions are made when computing inventory ratios?

Answer 62

Remember that inventory ratios are directly affected by the cost flow assumption used by the company. When making comparisons across firms, analysts must understand the differences that arise from the use of different cost flow assumptions. 


Question 63

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the profitability ratios – NP and GP margins – numerator and denominator effected? Also, how is the entire ratio effected?

Answer 63

Type of Ratio

Profitability ratios

NP and GP margins

Effect on Numerator

Income is lower under LIFO because COGS is higher

Effect on Denominator

Sales are the same under both

Effect on Ratio

Lower under LIFO

Question 64

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the solvency ratios – debt-to-equity and debt ratio – numerator and denominator effected? Also, how is the entire ratio affected?

Answer 64

Type of Ratio

Solvency ratios

Debt‐to‐equity and debt ratio

Effect on Numerator

Same debt levels

Effect on Denominator

Lower equity and assets under LIFO

Effect on Ratio

Higher under LIFO

Question 65

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the liquidity ratios – current ratio – numerator and denominator effected? Also, how is the entire ratio affected?

Answer 65

Type of Ratio

Liquidity ratios

Current ratio

Effect on Numerator

Current assets are lower under LIFO because EI is lower

Effect on Denominator

Current liabilities are the same

Effect on Ratio

Lower under LIFO

Question 66

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the liquidity ratios – quick ratio – numerator and denominator effected? Also, how is the entire ratio affected?

Answer 66

Type of Ratio

Liquidity ratios

Quick ratio

Effect on Numerator

Quick assets are higher under LIFO as a result of lower taxes paid

Effect on Denominator

Current liabilites are the same

Effect on Ratio

Higher under LIFO

Question 67

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the activity ratios – inventory turnover – numerator and denominator effected? Also, how is the entire ratio affected?

Answer 67

Type of Ratio

Activity ratios

Inventory turnover

Effect on Numerator

COGS is higher under LIFO

Effect on Denominator

Average inventory is lower under LIFO

Effect on Ratio

Higher under LIFO

Question 68

For LIFO vs. FIFO with rising prices and stable inventory levels, how are the activity ratios – total asset turnover – numerator and denominator effected? Also, how is the entire ratio affected?

Answer 68

Type of Ratio

Activity ratios

Total asset turnover

Effect on Numerator

Sales are the same

Effect on Denominator

Lower total assets under LIFO

Effect on Ratio

Higher under LIFO

Question 69

Summarize the importance of understanding inventory valuation methods.

Answer 69

The choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies.

Question 70

In what industry are inventories a major factor of analysis? Why?

Answer 70

Inventories are a major factor in the analysis of merchandising and manufacturing companies. Such companies generate their sales and profits through inventory transactions on a regular basis. An important consideration in determining profits for these companies is measuring the cost of sales when inventories are sold.

Question 71

What does the total cost of inventories comprise of?

Answer 71

The total cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Storage costs of finished inventory and abnormal costs due to waste are typically treated as expenses in the period in which they occurred.

Question 72

What do allowable inventory valuation methods make assumptions of? What does the choice in inventory valuation method determine?

Answer 72

The allowable inventory valuation methods implicitly involve different assumptions about cost flows. The choice of inventory valuation method determines how the cost of goods available for sale during the period is allocated between inventory and cost of sales.

Question 73

Which inventory valuation methods does IFRS allow?

Answer 73

IFRS allow three inventory valuation methods (cost formulas): first-in, first-out (FIFO); weighted average cost; and specific identification. The specific identification method is used for inventories of items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects.

Question 74

Which inventory valuation methods does US GAAP allow?

Answer 74

US GAAP allow the three methods above plus the last-in, first-out (LIFO) method. The LIFO method is widely used in the United States for both tax and financial reporting purposes because of potential income tax savings.

Question 75

Describe the implications on the choice of inventory method. Describe what an analyst must do to make a correct assessment.

Answer 75

The choice of inventory method affects the financial statements and any financial ratios that are based on them. As a consequence, the analyst must carefully consider inventory valuation method differences when evaluating a company’s performance over time or in comparison to industry data or industry competitors.

Question 76

What must a company do for all inventories having similar nature and use to the entity?

Answer 76

A company must use the same cost formula for all inventories having a similar nature and use to the entity.

Question 77

Describe the effects of the different inventory accounting systems.

Answer 77

The inventory accounting system (perpetual or periodic) may result in different values for cost of sales and ending inventory when the weighted average cost or LIFO inventory valuation method is used.

Question 78

Under US GAAP, companies that use the LIFO method must do what?

Answer 78

Under US GAAP, companies that use the LIFO method must disclose in their financial notes the amount of the LIFO reserve or the amount that would have been reported in inventory if the FIFO method had been used. This information can be used to adjust reported LIFO inventory and cost of goods sold balances to the FIFO method for comparison purposes.

Question 79

What happens if LIFO liquidation occurs?

Answer 79

LIFO liquidation occurs when the number of units in ending inventory declines from the number of units that were present at the beginning of the year. If inventory unit costs have generally risen from year to year, this will produce an inventory-related increase in gross profits.

Question 80

Describe the requirement of consistency of inventory costing under both IFRS and US GAAP.

Answer 80

Consistency of inventory costing is required under both IFRS and US GAAP. If a company changes an accounting policy, the change must be justifiable and applied retrospectively to the financial statements. An exception to the retrospective restatement is when a company reporting under US GAAP changes to the LIFO method.

Question 81

Under IFRS, for inventories, describe the role of net realizable value.

Answer 81

Under IFRS, inventories are measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Under US GAAP, inventories are measured at the lower of cost or market value. Market value is defined as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. Reversals of previous write-downs are permissible under IFRS but not under US GAAP.

Question 82

Describe the different feelings towards reversals of inventory write-downs between IFRS and US GAAP.

Answer 82

Reversals of inventory write-downs may occur under IFRS but are not allowed under US GAAP.

Question 83

Describe the impact of changes in the carrying amounts within inventory classification.

Answer 83

Changes in the carrying amounts within inventory classifications (such as raw materials, work-in-process, and finished goods) may provide signals about a company’s future sales and profits. Relevant information with respect to inventory management and future sales may be found in the Management Discussion and Analysis or similar items within the annual or quarterly reports, industry news and publications, and industry economic data.

Question 84

What ratios are useful in evaluating the management of a company’s inventory?

Answer 84

The inventory turnover ratio, number of days of inventory ratio, and gross profit margin ratio are useful in evaluating the management of a company’s inventory.

Question 85

Inventory management may have a substantial impact on which company ratios? What is critical for analysts to know?

Answer 85

Inventory management may have a substantial impact on a company’s activity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends and management’s intentions.

Question 86

In regards to inventories, what do financial statement disclosures provide? How does this help the analyst?

Answer 86

Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company’s inventory management.