Financial Reporting and Analysis: Inventories (pg. 345 - 413)

LIFO Reserve (Example 5 pg. 357)

For companies using the LIFO method, US GAAP requires disclosure, in the notes to the financial statements or on the balance sheet, of the amount of the 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 had been used (in other words, the FIFO inventory value less the LIFO inventory value). The reported inventory balance, using LIFO, plus the LIFO reserve equals the inventory that would have been reported under FIFO. Cost of sales is adjusted by subtracting the increase in the LIFO reserve during the period from the cost of sales amount that is reported on the income statement. If the LIFO reserve has declined during the period, the decrease in the reserve is added to the cost of sales amount that is reported on the income statement. Cost of Sales Adjustment to FIFO= Cost of Sales - LIFO Reserve increase

Net Realisable Value (NRV)

Estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. The assessment of net realisable value is typically done item by item or by groups of similar or related items. In the event that the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realisable value and the loss (reduction in value) recognised as an expense on the income statement. This expense may be included as part of cost of sales or reported separately.

First-In, First-Out (FIFO)

FIFO assumes that the oldest goods purchased (or manufactured) are sold first and the newest goods purchased (or manufactured) remain in ending inventory. In periods of rising prices, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold. Conversely, in periods of declining prices, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold. The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items.

Last-In, First-Out (LIFO)

Only permitted under US GAAP. This method assumes that the newest goods purchased (or manufactured) are sold first and the oldest goods purchased (or manufactured), including beginning inventory, remain in ending inventory. The cost of sales under LIFO will more closely reflect current replacement value. LIFO ending inventory amounts are typically not reflective of current replacement value because the ending inventory is assumed to be the oldest inventory and costs are allocated accordingly.

Specific Identification

The specific identification method is used for inventory items that are not ordinarily interchangeable and for goods that have been produced and segregated for specific projects. Under this method, the cost of sales and the cost of ending inventory reflect the actual costs incurred to purchase (or manufacture) the items specifically identified as sold and the items specifically identified as remaining in inventory.

Inventory Adjustments

An inventory write-down reduces both profit and the carrying amount of inventory on the balance sheet and thus has a negative effect on profitability, liquidity, and solvency ratios. For fiscal years beginning after December 15, 2016, inventories measured using other than LIFO and retail inventory methods are measured at the lower of cost or net realisable value. This is broadly consistent with IFRS with one major difference: US GAAP prohibit the reversal of write-downs. For inventories measured using LIFO and retail inventory methods, market value is defined as current replacement cost subject to upper and lower limits. Market value cannot exceed net realisable value (selling price less reasonably estimated costs of completion and disposal). The lower limit of market value is net realisable value less a normal profit margin. Any write-down to market value or net realisable value reduces the value of the inventory, and the loss in value (expense) is generally reflected in the income statement in cost of goods sold. The potential for inventory write-downs can be high for companies in industries where technological obsolescence of inventories is a significant risk. Analysts should carefully evaluate prospective inventory impairments (as well as other potential asset impairments) and their potential effects on the financial ratios when debt covenants include financial ratio requirements. The breaching of debt covenants can have a significant impact on a company. Companies that use specific identification, weighted average cost, or FIFO methods are more likely to incur inventory write-downs than companies that use the LIFO method. Thus, it is far less likely that inventory write-downs will occur under LIFO—and if a write-down does occur, it is likely to be of a lesser magnitude.

The LIFO Method

In the United States, the LIFO method is widely used (approximately 36 percent of US companies use the LIFO method). The potential income tax savings are a benefit of using the LIFO method when inventory costs are increasing. If the purchase prices (purchase costs) or production costs of inventory are increasing, the income statement consequences of using the LIFO method compared to other methods will include higher cost of sales, and lower gross profit, operating profit, income tax expense, and net income. The balance sheet consequences include lower ending inventory, working capital, total assets, retained earnings, and shareholders' equity. The lower income tax paid will result in higher net cash flow from operating activities

Periodic Inventory

Inventory values and costs of sales are determined at the end of an accounting period. The total of purchases and beginning inventory is the amount of goods available for sale during the period. The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory.

Cost of Inventories

Under IFRS, the costs to include in inventories are "all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition."Trade discounts, rebates, and similar items reduce the price paid and the costs of purchase. The costs of conversion include costs directly related to the units produced, such as direct labour, and fixed and variable overhead costs. The costs of purchase include the purchase price, import and tax-related duties, transport, insurance during transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Both IFRS and US GAAP exclude the following costs from inventory: abnormal costs incurred as a result of waste of materials, labour or other production conversion inputs, any storage costs (unless required as part of the production process), and all administrative overhead and selling costs.

INVENTORY METHOD CHANGES

Under US GAAP, the conditions to make a change in accounting policy and the accounting for a change in inventory policy are similar to IFRS. US GAAP, however, requires companies to thoroughly explain why the newly adopted inventory accounting method is superior and preferable to the old method. However, if a company decides to change to the LIFO method, it must do so on a prospective basis and retrospective adjustments are not made to the financial statements. The carrying amount of inventory under the old method becomes the initial LIFO layer in the year of LIFO adoption.

Perpetual Inventory

Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales. You have to calculate the carry value at the end of the period, but to do so, you need to update each date of purchase and sale. Look at example 3 on page 352

Periodic versus Perpetual Inventory Systems

Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales. As a result, the amount of cost of goods available for sale allocated to cost of sales and ending inventory is similar under the FIFO and weighted average cost methods. Because of lack of disclosure and the dominance of perpetual inventory systems, analysts typically do not make adjustments when comparing a company using the weighted average cost method with a company using the FIFO method. Under either a perpetual or periodic inventory system, the use of the LIFO method will generally result in significantly different allocations to cost of sales and ending inventory compared to other inventory valuation methods. When inventory costs are increasing and inventory unit levels are stable or increasing, using the LIFO method will result in higher cost of sales and lower inventory carrying amounts than using the FIFO method. The higher cost of sales under LIFO will result in lower gross profit, operating income, income before taxes, and net income. Income tax expense will be lower under LIFO, causing the company's net operating cash flow to be higher. On the balance sheet, the lower inventory carrying amount will result in lower reported current assets, working capital, and total assets. Analysts must carefully assess the financial statement implications of the choice of inventory valuation method when comparing companies that use the LIFO method with companies that use the FIFO method.

Weighted Average Cost

Weighted average cost assigns the average cost of the goods available for sale (beginning inventory plus purchase, conversion, and other costs) during the accounting period to the units that are sold as well as to the units in ending inventory. In an accounting period, the weighted average cost per unit is calculated as the total cost of the units available for sale divided by the total number of units available for sale in the period (Total cost of goods available for sale/Total units available for sale).

LIFO Liquidations

When the number of units sold exceeds the number of units purchased or manufactured, the number of units in ending inventory is lower than the number of units in beginning inventory and a company using LIFO will experience a LIFO liquidation (some of the older units held in inventory are assumed to have been sold). If inventory unit costs have been rising from period to period and LIFO liquidation occurs, this will produce an inventory-related increase in gross profits. The increase in gross profits occurs because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for cost of sales and the sales are at the current prices. Analysts should be aware that management can potentially manipulate and inflate their company's reported gross profits and net income at critical times by intentionally reducing inventory quantities and liquidating older layers of LIFO inventory (selling some units of beginning inventory). During economic downturns, LIFO liquidation may result in higher gross profit than would otherwise be realised. If LIFO layers of inventory are temporarily depleted and not replaced by fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits. Therefore, it is imperative to review the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred. A decline in the LIFO reserve from the prior period may be indicative of LIFO liquidation.