Inventories

Cards (23)

  • 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
  • inventory ratio impacts
    • inventory turnover
    • days of inventory
    • gross profit margin
    • current ratio
    • return on asset
    • debt to equity