Inventory is shown as a current asset on the balance sheet for manufacturing and merchandising companies
Revenue and profit is generated through the sale of inventory
For many companies, inventory represents a significant asset
Cost of inventories
1. Capitalizing inventory related costs defers their recognition as an expense
2. Costs capitalized
3. Costs expensed
Inventory valuation methods
Specific identification, FIFO, LIFO, Weighted average cost
LIFO is allowed under U.S. GAAP but not under IFRS
Inventory systems
Periodic
Perpetual
Periodic system
Inventory quantity determined periodically through physical count, purchases account maintained, COGS computed using beginning inventory, purchases, and ending inventory
Perpetual system
Changes in inventory and COGS continuously updated
Periodic and perpetual systems give same values for COGS and ending inventory if using specific identification or FIFO, but may differ if using LIFO or weighted average cost</b>
Rising prices and stable inventory
LIFO firm has higher COGS, lower profit, lower taxes, lower inventory balance, lower working capital, higher cash flow compared to FIFO firm
Falling prices and stable inventory
LIFO firm has lower COGS, higher profit, higher taxes, higher inventory balance, higher working capital, lower cash flow compared to FIFO firm
LIFO gives better income statement, FIFO gives better balance sheet
LIFO reflects current economic reality better on income statement, FIFO reflects current economic reality better on balance sheet
costs capitalized
cost of purchases
cost of conversion
cost necessary to bring inventory to its present location and condition
costs expensed
period costs
abnormal wastage
storage cost
administrative overheads
selling costs
companies change inventory valuation method if it results to more reliable and relevant information, some are only trying to reduce taxes or increase reported net income
changes in inventory valuation method should be applied retrospectively
inventory adjustment for IFRS
lower of cost or net realizable value
if less than BS cost, inventory can be written down
once written down it can only be written up to the original amount
inventory adjustment for US GAAP
lower of cost or market
market is equal to replacement cost
MV upper limit NRV, lower limit NRV-profit margin
cost exceed margin - write down
no write up
impact of inventory adjustments
inventory write down reduces both profit and carrying amount of inventory
positive on activity ratio
negative on profitability, liquidity and solvency ratio
write downs usually on weighted average cost, FIFO and specific identification
inventory write down is also called a valuation allowance
evaluation of inventory management ratios
inventory turnover
days of inventory on hand
gross profit margin
choice of inventory valuation methods impacts several ratio