The content

1. Introduction
2. Cost of inventories
3. Inventory Valuation Methods
4. The LIFO Method
5. Inventory Method Changes
6. Inventory Adjustments
7. Evaluation of Inventory Management
Chapter 6: Inventories
1. Introduction
• Inventories are assets held by a company to produce finished goods
for sale.

• They are shown as a current asset on the balance sheet; and can
represent a significant part of the total assets for many companies.

• Manufacturing and merchandising companies (Ex: Nike) generate

sales and profit through the sale of inventory. An important measure
in calculating profits is cost of goods sold, i.e.,
• There is no universal inventory valuation method. IFRS and US GAAP
allow different identification methods to measure the cost of
inventory such as specific identification, weighted average cost, first
in, first out, and last in, first out.
2. Cost of Inventories
When a company spends money on inventory, most of the costs are
capitalized. Capitalizing means creating an asset on the balance sheet.
Inventory costs that are capitalized include:
• costs of purchase (this includes the purchase price, import and tax
duties, transport and handling costs).
• costs of conversion (costs such as labor, material, and overheads
which are directly related to converting raw materials to finished
goods).
• costs necessary to bring inventories to their present location and
condition (this will include the cost of transporting goods to a
showroom).
Costs that are expensed in the period incurred include:
• Abnormal costs arising due to wastage of material, labor, or other
production inputs.
• Storage costs of final/finished goods.
• Administrative overheads.
• Selling costs.
• Unused portion of fixed production overhead.
• Transportation of finished goods to the customer.
3. Inventory Valuation Methods

The four inventory valuation methods for accounting inventory are:

• Specific Identification
• FIFO (First In, First Out)
• Weighted Average Cost
• LIFO (Last In, First Out)
3.1. Specific Identification

• Specific identification is used when:

• Items are unique in nature and not interchangeable.
• Cost of inventory is high.
• Every item in the inventory can be tracked individually.

Under specific identification, items are shown on the balance sheet at

their actual costs. Examples: Jewelry, expensive watches, highly valued
art pieces, used cars, etc.
3.2. First In, First Out (FIFO)
Under First In, First Out:
• Oldest goods purchased or manufactured are assumed to be sold
first.
• Newest goods purchased or manufactured remain in ending
inventory.
• When prices are increasing or stable, cost assigned to items in
inventory is higher than the cost of items sold.
• The following example illustrates how cost of goods sold and
inventory are accounted for in each period:

Assume you bought four pencils. The first two pencils were worth $1
each and the next two pencils were worth $2 each. Before you start
selling, your inventory consists of four pencils.
3.3. Weighted Average Cost

Under weighted average cost method, each item in inventory is valued

using an average cost of all in the inventory.

• Let’s use the pencils example again to illustrate how inventory is

calculated using the WAC method.
• Total cost of pencils available for sales = $6
• Total number of pencils available for sale = 4 Weighted average cost
per pencil = $6/4 = $1.5
3.4. Last In, First Out (LIFO)
Under Last In, First Out method:
• The newest items purchased or manufactured are assumed to be sold
first.
• Oldest goods purchased or manufactured remain in ending inventory.
• The cost of goods sold reflects the cost of goods purchased or
manufactured recently; the value of inventory reflects the cost of
older goods purchased.
3.5. Calculation of Cost of Sales, Gross Profit, and Ending
Inventory
Based on the inventory valuation method used by a company, the
allocation of inventory costs between cost of goods sold on the income
statement and inventory on the balance sheet varies in periods of
changing prices.

Continuing with the pencils example, assume each of the pencils was
sold for $5
mple

company bought 400 generators at a price of $300 each on January 5. Out of these
0 generators were sold at a price of $450 each by the end of March. On April 10, 250
ore generators were bought at a price of $325 each. By May 31, 225 generators were
ld at a price of $500 each. For the period ending 30 June, what is the ending
ventory using FIFO?
3.6. Periodic versus Perpetual Inventory Systems

The two types of inventory systems used to keep track of changes in

the inventory are:
• Periodic system
• Perpetual system
Periodic system
The company measures the quantity of inventory on hand periodically.
It is not a continuous process unlike the perpetual system. Purchases
are recorded in a purchases account. Ending inventory is determined
through a physical count of the units in inventory.

Cost of goods sold (COGS) = Beginning Inventory + Purchases – Ending

Inventory.
The formula above can be rearranged to determine the value of any of
the items. For example:
Ending inventory = Beginning Inventory + Purchases - COGS
Perpetual system

As the name implies, inventory and COGS are continuously updated in

this system. Purchases and sale of units are directly recorded in the
inventory as and when they occur.
3.7. Comparison of Inventory Valuation
Methods
The allocation of total cost of goods available for sale to COGS and
ending inventory varies under different inventory valuation methods.
Example: 1 ,1,2,2
4. The LIFO Method

LIFO is permitted under US GAAP, but not under IFRS.

Under the LIFO conformity rule, When prices are increasing, LIFO
method will result in higher COGS, lower profit, income tax expense,
and net income. Due to lower taxes, the LIFO method will also result in
higher after- tax cash flow.

LIFO conformity rule which is extremely important and this rule say that
the same method must be used for tax and financial report. In other
words, if you are using LIFO for your financial reporting then that same
method is used for tax reporting.
• This is different from depreciation, with depreciation you are allowed to used
straight-line method or whatever method is appropriate for financial reporting
and a different method for tax reporting.

• In this particular case, if a company wants to reduce its taxes it can use the LIFO
method in the US because that is where it was allowed.

• LIFO method reduces earnings before tax and then reduces taxes/
However Companies which use the LIFO method must also disclose LIFO
reserve.

• LIFO reserve is the difference between inventory reported at FIFO and inventory
reported at LIFO.
4.1. LIFO Reserve
The LIFO reserve is the difference between the reported LIFO inventory
carrying amount and the inventory amount that would have been
reported if the FIFO method has been used instead. The equation for
LIFO reserve is given by:
LIFO reserve = FIFO inventory value – LIFO inventory value.
4.1. LIFO Reserve
US GAAP requires companies using the LIFO method to disclose the
amount of the LIFO reserve either in the notes to financial statements
or in the balance sheet. An analyst can use the disclosure to adjust a
company’s COGS and ending inventory from LIFO to FIFO. This makes it
easier to compare the company’s performance with other companies
that use FIFO.
• The following formulas show how to make adjustments for inventory,
COGS, and net income from LIFO to FIFO:
4.2. LIFO Liquidations

In periods of rising inventory, the carrying amount of inventory under

FIFO will exceed the carrying amount of inventory under LIFO.

Foe example: 22 44 66

LIFO reserve = FIFO inventory value – LIFO inventory value

LIFO reserve is equal to the difference between
LIFO inventory and FIFO inventory.
FIFO liquidation

When the number of units sold in a period exceeds the number of units
purchased/manufactured, it is called LIFO liquidation

Example: 22 44 66
5. Inventory Method Change

Companies occasionally change their inventory valuation method. The

change is acceptable if it results in the financial statements providing
reliable and more relevant information.

If the change is justified, then it must be applied retrospectively.

Analysts must carefully analyze why a company is actually changing the

inventory valuation method. Often, the company might be trying to
reduce taxes or increase reported net income
6. Inventory Adjustments

Holding inventory for a prolonged period results in the risk of spoilage,

obsolescence, or decline in prices, and the cost of inventory may not be
recoverable in such circumstances.

For example: Your company purchased inventory at $5 per unit. Now,

the price your company can only sell at $3. In such circumstances. How
how inventory is measured under IFRS and GAAP.
We define some terms first before looking at the differences in how
inventory is measured under IFRS and GAAP.
Net realizable value: Estimated selling price under ordinary business
conditions minus estimated costs necessary to get the inventory in
condition for sale.

Net realizable value = estimated sales price – estimated selling costs

For example: Your company purchased inventory at $5 per
unit. Now, the price your company can only sell at $3. In
such circumstances. How how inventory is measured
under IFRS
- IFRS
- Lower of cost or net realizable value (NRV)
- If NRV is less than the balance sheet cost, the inventory is “written
down” to NRV. The loss in value is reflected in the income statement
in cost of goods sold.
- If value recovers subsequently, inventory can be written up and gain
is recognized in the income statement. The amount of gain is limited
to loss previously recognized.
U.S GAAP

- Lower of cost or market value

- Market value has upper limit of net realizable value and lower limit
of NRV.
- If cost exceeds market value, inventory is written down to market
value on the balance sheet and the loss is recognized.

- If value recovers subsequently, no write up is allowed. There is no

reversal of write downs. It is different from IFRS.
The following table shows the effect of inventory write-downs on various financial
ratios:
Ratio Effect reason
Liquidity ratios
Current ratio Lower Current assets decrease due to lower
inventory.
Activity ratios
Inventory turnover Higher COGS increases assuming inventory write downs are reported as part
of cost of sales. Average inventory decreases. Lower inventory carrying
amounts make it appear as if the company is managing its inventory
effectively, but write-downs reflect poor inventory management.

Days of inventory on Lower Inventory turnover is higher.

hand
Profitability ratios
Net profit margin Lower Cost of sales is higher. Sales stay the same.
Gross profit margin Lower Cost of sales is higher. Sales stay the same.
7. Evaluation of Inventory Management

The efficiency and effectiveness of inventory management can be

evaluated using the following ratios:
- Inventory Turnover
- Days of Inventory on hand
- Gross Profit Margin

An analyst must understand that the choice of inventory valuation

method can impact several financial ratios and make comparisons
between two firms difficult. He needs to be particularly careful when
comparing an IFRS and US GAAP firm.
7.1 Presentation and Disclosure

IFRS requires the following financial statement disclosures concerning

inventory:
- The accounting policies used to measure inventory, including the cost
formula.
- The total carrying amount of inventories and the carrying amount in
classification (for example, merchandise, raw materials, production
supplies, work in progress, and finished goods appropriate to entity).
- The carrying amount of inventories carried at fair value less costs to
sell.
- The amount of inventories recognized as an expense in the period
(cost of sales).
- The amount of any reversal of any write-down recognized as a
reduction in cost of sales in the period.
- What led to the reversal of a write-down in the inventories?
- Carrying amount of inventories pledged as a security for liabilities.

Disclosures under U.S. GAAP are similar to IFRS except that it does not
permit reversal of write down of inventories. In addition, any income
from liquidation of LIFO inventory must be disclosed.
7.2 Inventory Ratios

The choice of inventory valuation method impacts various components

of the financial statements such as cost of goods sold, net income,
current assets, and total assets. As a result, it affects the financial ratios
containing these items. Analysts must consider the differences in
valuation methods when evaluating a company’s performance over
time or in comparison to other companies.
The table below summarizes the impact of valuation
method on inventory-related ratios in an inflationary
environment:
Ratio Numerator Denominator Impact on ratio

Inventory Cost of goods sold is Average inventory is Higher under

turnover higher under LIFO. lower under LIFO. LIFO

Days of inventory No. of days are the Higher under LIFO. Lower under
same LIFO
Total asset Revenue is the Lower average total Higher under
turnover same assets under LIFO LIFO.
Current ratio Ending inventory is Current liabilities are Lower under
lower under LIFO so the same. LIFO.
current assets are
lower.
Cash ratio Cash is higher under Current liabilities are Higher under
LIFO because taxes the same LIFO.
are lower.
Gross profit Gross profit is lower Revenue is the Lower under
margin under LIFO as COGS same. LIFO.
is higher.
Return on assets Net income is lower Lower average total Lower under
under LIFO as COGS assets under LIFO. LIFO.
is higher.
Debt to equity Debt is the same. Lower equity under Higher under
LIFO. Equity = assets – LIFO.
liabilities. Total assets
under LIFO are lower
as ending inventory is
lower.

The ratios that are important in evaluating a company’s management of inventory are
inventory turnover, number of days of inventory, and gross profit margin.
A high inventory turnover implies that a company is utilizing inventory efficiently.