Reading 29 - Inventories

Changing from FIFO to LIFO is a change in accounting principle that must be applied

Prospectively

Writedowns

A write-down of inventory to net realizable value is typically recognized as an increase in cost of goods sold in the period of the write-down. Consider the inventory equation: ending inventory = beginning inventory + purchases - cost of goods sold A write-down to NRV decreases ending inventory, with no effect on beginning inventory or purchases. For the inventory equation to hold, cost of goods sold must increase.

Required Inventory Disclosures

Cost Flow Method Total carrying Value Carrying Value of Inventories reported at fair value less selling costs Cost of inventory recognized as an expense (COGS) during the period. Amount of inventory write downs during the period>. - Carrying Value of inventories pledged as collateral

For a firm that uses the LIFO inventory cost method, a LIFO liquidation occurs if

LIFO liquidation occurs when the quantity of inventory decreases during a reporting period. In an increasing price environment this results in older, lower costs being included in COGS for the period.

Which accounting methods are preferable for income statements and balance sheets?

Last in, first out (LIFO) for income statements and first in, first out (FIFO) for the balance sheet. LIFO allocates the most recent prices to the cost of goods sold and provides a better measure of current income. For balance sheet purposes, inventories based on FIFO are preferable since these values most closely resemble current cost and economic value.

Low Inventory Turnover suggests:

Low inventory turnover (high number of days in inventory) may be a sign of slow-moving or obsolete inventory, especially when coupled with low or declining revenue growth compared to the industry. Low inventory value compared to cost of goods sold, however, implies a high inventory turnover ratio. This suggests much less risk of obsolescence.

Under U.S. GAAP, the LIFO reserve is a required financial statement disclosure:

Only firms that use the LIFO inventory cost method are required to disclose a LIFO reserve.

Whether prices are increasing or decreasing, LIFO cost of goods sold and FIFO inventory are preferred because they are the closest estimates of current costs. True or False.

True

A company purchased inventory on January 1, 20X2, for 600,000. On December 31, 20X2, the inventory had a net realizable value of 550,000 and a replacement cost of 525,000, which is also the NRV less the normal profit margin. What would be the carrying value of the inventory on the company's December 31, 20X2, balance sheet prepared under:

Under IFRS, inventories are carried at the lower of cost or net realizable value (NRV), which in this case is 550,000. Under U.S. GAAP, inventories are carried at the lower of cost or market. In this case, the replacement cost of 525,000 would be used as it is below NRV and equal to the NRV less the normal profit margin.

Work in process / Finished Goods Inventory

Work-in-process inventory increasing faster than finished goods inventory is a likely indicator that a firm expects demand to increase, which should increase future revenues and earnings. Finished goods inventory increasing faster than sales or work-in-process inventory may indicate that demand is decreasing. Analysts should refer to sources such as management's commentary to further examine the reasons for an increase in finished goods inventory.

The effect of an inventory writedown on a firm's return on assets (ROA) is most accurately described as:

Writing down inventory to net realizable value decreases both net income and total assets in the period of the writedown. Because net income is most likely less than assets, the result in the period is a decrease in ROA. In later periods, lower-valued inventory will decrease COGS and increase net income. Combined with a lower value of total assets, this will increase ROA.

An analyst is comparing a company that uses the LIFO inventory cost method to companies that use FIFO for inventories. The analyst should adjust the LIFO firm's cost of goods sold by subtracting the:

change in the LIFO reserve. FIFO cost of goods sold equals LIFO cost of goods sold minus the change in the LIFO reserve.

If a firm pledges inventories as collateral for a loan, the firm must:

disclose the carrying value of the pledged inventories.

Product costs

include purchase cost, conversion or manufacturing costs (including labor and overhead), and other costs to bring inventory to its present state and location.

Using the lower of cost or market principle under U.S. GAAP, if the market value of inventory falls below its historical cost, the minimum value at which the inventory can be reported in the financial statements is the:

market price minus selling costs minus normal profit margin. When inventory is written down to market, the replacement cost of the inventory is its market value, but the "market value" must fall between net realizable value (NRV) and NRV less normal profit margin. NRV is the market price of the inventory less selling costs. Therefore the minimum value is the market price minus selling costs minus normal profit margin.

A U.S. GAAP reporting firm changes its inventory cost flow assumption from average cost to LIFO. The firm must apply this change:

prospectively, with the carrying value as the first LIFO layer.

Period costs

recognized as expenses when incurred include abnormal waste, storage costs not required for production, selling costs, and administrative overhead.

LIFO Reserve

the difference between inventory under the LIFO cost method and inventory under the FIFO cost method.

The inventory turnover ratio and the number of days in inventory can be used to evaluate

the relative age of a firm's inventory as well as the effectiveness of a firm's inventory management.