Inventory Valuation (21)

Gross Profit margin from LIFO to FIFO

(gross profit + change in LIFO reserve)/revenue

net profit margin from LIFO to FIFO

(old net income + change in LIFO reserve - tax on change difference in LIFO reserve)/revenue

Describe the ϐinancial statement presentation of and disclosures relatingto inventories.

- The cost ϐlow method (LIFO, FIFO, etc.) used. - Total carrying value of inventory, with carrying value by classiϐication (rawmaterials, work-in-process, and ϐinished goods) if appropriate -Carrying value of inventories reported at fair value less selling costs. - The cost of inventory recognized as an expense (COGS) during the period. - Amount of inventory write-downs during the period. - Reversals of inventory write-downs during the period, including a discussion of thecircumstances of reversal (IFRS only because U.S. GAAP does not allow reversals). - Carrying value of inventories pledged as collateral

FIFO

- based on the earliest purchase cost - inventory valued based on most recent purchases - in inflationary environment, COGS will be understated compared to current cost, so earnings will be overstated

replacement cost versus NRV

- if replacement cost > NRV, then market is NRV. - If replacement cost < (NRV - normal profit margin), market = NRV - normal profit margin

4 comparisons when prices increase between LIFO and FIFO

1. LIFO inventory < FIFO inventory 2. LIFO COGS > FIFO COGS 3. LIFO net income < FIFO net income 4. LIFO tax < FIFO tax

Poulter Products reports under IFRS and wrote its inventory value down from cost of$400,000 to net realizable value of $380,000. The most likely financial statement effectof this change is:

A write-down in inventory value from cost to NRV is reported on IS as an addition to cost of sales or as a separate line item

FIFO COGS

LIFO COGS - Change in LIFO Reserve

FIFO inventory

LIFO inventory + LIFO reserve = ending inventory current year + ending LIFO reserve of current year

Impact of LIFO on solvency

LIFO means lower profit margin, FIFO means higher inventory and higher profit margin, lower COGS. Higher inventory means higher assets under FIFO and higher stockholders' equity (due to higher retained earnings). So debt-equity ratio and debt ratio are smaller, meaning the company has higher chance of fulfilling

how to convert LIFO to FIFO, answer is with LIFO reserve

LIFO reserve, the amount by whichLIFO inventory is less than FIFO inventory. To make ϐinancial statements prepared underLIFO comparable to those of FIFO ϐirms, an analyst must:1. add the LIFO reserve to LIFO inventory on the balance sheet.2. increase the retained earnings component of shareholders' equity by the LIFOreserve.

during fall of price, considering reporting taxes as well, LIFO would see a lower

COGS, higher net profit margin meaning higher taxes payable, meaning lower cash balance

Why is FIFO better? (more recent purchases reflected = better approximation of economic value basically)

Ending inventory. When prices are rising or falling, FIFO provides the most usefulmeasure of ending inventory. This is a critical point. Recall that FIFO inventory is madeup of the most recent purchases. These purchase costs can be viewed as a betterapproximation of current cost, and thus a better approximation of economic value. LIFOinventory, by contrast, is based on older costs that may differ signiϐicantly from currenteconomic value.

inflationary and deflationary pressure on cost of good sold

Recall that LIFO COGS is based on the most recent purchases. As aresult, when prices are rising, LIFO COGS will be higher than FIFO COGS. When prices arefalling, LIFO COGS will be lower than FIFO COGS. Because LIFO COGS is based on theVideo coveringthis content isavailable online.most recent purchases, LIFO produces a better approximation of current cost in theincome statement.

Which of the following inventory disclosures would least likely be found in thefootnotes of a firm following IFRS?

The separate carrying values of raw materials, work-in-process, and finishedgoods computed under the LIFO cost flow method.

inventory written down and up in terms of net realizable value

if NRV is less than the balance sheet value of inventory, inventory is written down to net realizable value and the loss is recognized in the income statement. NRV, if there is a subsequent recovery in value, inventory can be written up and the gain is recognized in the income statement by reducing COGS by the amount of the recovery

What is the implication behind high inventory turnover coupled with low sales growth relative to the industry average

inadequate inventory levels (firm may be losing sales by not carrying enough inventory)

Notes on inventory reporting for methods other than LIFO and retail method report under U.S GAAP

inventories are reported at the lower of cost or NRV

For companies using LIFO or the retail method

inventory is reported on the balance sheet at the lower of cost or market. Market is equal to replacement cost, but cannot be greater than NRV or less than NRV minus a normal profit margin

inventory for merchanidising and wholesalers/retailers versus manufacturing firms

inventory that is ready for sale, is reported in one account on the balance sheet while manufacturing firms normally report inventory using three separate accounts: raw materials, work-in-process, and finished goods

periodic inventory system

inventory values and COGS are determined at the end of the acounting period

perpetual inventory system

inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur. Thus, a Purchases account is not necessary

LIFO (Last-in, first-out)

item purchased most recently is assumed to be the first item sold. In an inflationary environment, LIFO COGS will be higher than FIFO, COGS, and earnings will be lower. Low earnings translate into lower income taxes, which increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the earlier costs. Hence, LIFO ending inventory is less than current cost

debt-to-equity ratio

long-term debt/stockholders' equity Under FIFO, long-term debt to equity = long-term debt/(stockholders' equity minus taxes on LIFO reserve plus LIFO reserve), the higher equity means debt to equity ratio is lower here

will capitalized cost such as production overhead be included in a firm's ending inventory?

no, capitalized costs will not be included, and storage costs of finished goods are not related to production.

When finished goods grow faster than sales

the firm should anticipate declining demand for its product, as its inventory turnover ratio will decrease, meaning longer to process the inventory, meaning lower demand

Net Realizable Value (NRV)

the selling price less costs to sell expected sales price less than the estimated selling costs and completion costs

concern about inventory turnover

high inventory turnover is desirable, but not too high as it means the firm fails to satisfy customers' needs, which can cause the firm to lose sales, or a result of significant inventory-write downs have occurred, showing poor inventory management (net realizable value is less than inventory)

Impact of inflation and deflation of inventory costs affect the financial statements

Inflation means higher costs for the last unit which are supposed to be sold first in the case of LIFO, meaning COGS is higher under LIFO with lower gross profit. During deϐlationary periods and stable or increasing inventory quantities, the cost ϐloweffects of using LIFO and FIFO will be reversed; that is, LIFO COGS will be lower and LIFOending inventory will be higher. This makes sense because the most recent lower-costpurchases are assumed to be sold ϐirst under LIFO, and the units in ending inventory areassumed to be the earliest purchases with higher costs.

inventory turnover (converted from LIFO to FIFO)

Under LIFO COGS + change in LIFO reserve /average inventory From LIFO to FIFO average inventory: average LIFO reserve is added to average LIFO inventory (COGS - LIFO reserve)/(average LIFO inventory + average LIFO reserve)

Kamp, Inc., sells specialized bicycle shoes. At year-end, due to a sudden increase inmanufacturing costs, the replacement cost per pair of shoes is $55. The original cost is$43, and the current selling price is $50. The normal profit margin is 10% of the sellingprice, and the selling costs are $3 per pair. Using the lower of cost or market methodunder U.S. GAAP, which of the following amounts should each pair of shoes bereported on Kamp's year-end balance sheet?

Upper bound: NRV = 50 - 3 = 47 Lower bound: NRV - net profit margin = 47 * (1-10%) * 50 = 42 Replacement cost > NRV, market = NRV = 47. We use lower of original cost or market method, cost reported of each unit pair of shoes to be the original cost: $43 (using lower of cost method)

average cost for inventory compared to LIFO

higher gross margin due to lower COGS, higher ending inventory due to lower COGS, so lower asset turnover

Will period costs such as abnormal waste and selling & administrative costs be included in the firm's ending inventory?

Yes, they will be included in the firm's ending inventory

market

a range of values between NRV and NRV - normal profit margin

weighted average cost

average cost per unit of inventory is computed by dividing the total cost of goods available for sale (beg inventory + purchases)/(quantity available for sales So during inflationary or deflationary environment, weighted average cost produces a value between LIFO and FIFO

FIFO and specific identification methods' special feature

ending inventory values and COGS are the same whether a periodic or perpetual system is used