Inventories

• 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