Financial Reporting Session 9 - Inventories

LIFO is not allowed under..

IFRS

COGS formula

Purchases = ending inventory - beginning inventory + COGS COGS = beginning inventory + purchases - ending inventory ending inventory = beginning inventory + purchases - COGS begging inventory = COGS - purchases + ending inventory

effects of LIFO COGS under periodic vs perpetual

LIFO COGS under periodic is more than LIFO COGS under perpetual

explain COGS under changing prices for FIFO and LIFO

LIFO cogs is based on the most recent purchases. as a result, when prices are rising, LIFO COGS will be higher than FIFO COGS. when prices are falling, LIFO COGS will be lower than FIFO COGS. because LIFO COGS is based on the most recent purchases, LIFO produces a better approximation of current cost in the income statement. when prices are changing, the weighted average cost method will produce values of COGS and ending inventory between those of LIFO and FIFO.

four relations hold when prices have been rising over relevant period

LIFO inventory < FIFO inventory LIFO COGS > FIFO COGS LIFO net income < FIFO net income LIFO tax < FIFO tax

effects of LIFO inventory for periodic vs perpetual

LIFO inventory under periodic is less than LIFO inventory under perpetual

example of inventory costs that are not capitalized (not on the balance sheet) but expensed on the income statement. these are called period costs

1. abnormal waste of materials, labor or overhead 2. storage costs (unless required as part of production) 3. administrative overhead 4. selling costs

to make financial statements prepared under LIFO comparable to those of FIFO firms, 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 LIFO reserve

manufacturers normally report inventory using three separate accounts

1. raw material 2. work in process 3. finished goods

under US GAAP the permissible methods are

1. specific identification 2. first in first out 3. last in first out 4. weighted average cost

under IFRS the permissable methods are

1. specific identification 2. first in, first out 3. weighted average cost LIFO IS NOT ALLOWED

COGS will also need to be converted from LIFO to FIFO. the different between LIFO COGS and FIFO COGS is equal to the change in the LIFO reserve for the period. to convert COGS from LIFO to FIFO, subtract ehc change in LIFO reserve: formula is

FIFO COGS = LIFO COGS (ending LIFO reserve - beginning LIFO reserve) assuming inflation,FIFO COGS is lower than LIFO COGS, so subtracting the change in the LIFO reserve from LIFO COGS makes intuitive sense. when prices are falling, we still subtract the change in the LIFO reserve to convert from LIFO COGS to FIFO COGS. in this case, however, the change in the LIFO reserve is negative and subtracting it will result in higher COGS. when prices are falling, FIFO COGS is greater than LIFO COGS.

explain effects on ending inventory under rising or falling prices under FIFO/LIFO

FIFO provides the most useful measure of ending inventory. FIFO is made up of the most recent purchases. these purchases can be viewed as a better approximation of current cost, and thus a better approximation of economic value. LIFO inventory, is based on older costs that may differ significantly from current economic value.

solvency ratios effects from LIFO and FIFO

adjusting to FIFO results in higher total assets because inventory is higher. higher total assets under FIFO result in higher stockholders' equity (assets - liabilities). because total asses ad stockholers' equity are higher under FIFO, the debt ratio and the debt to equity ratio are lower under FIFO compared to LIFO.

advantage of FIFO - first in first out

advantage of FIFO is ending inventory is valued based on the most recent purchases, arguably the best approximation of current cost. conversely, FIFO COGS is based on the earliest purchase costs.

profitability ratios effects from LIFO and FIFO

as compared to FIFO, LIFO produces higher COGS in the income statement and result in lower earnings. any profitability measure that includes COGS will be higher under FIFO. for example, reducing COGS will result in higher gross, operating, and net profit margins as compared to LIFO.

how is weighted average cost calculated?

average cost per unit of inventory is computed by dividing the total cost of goods available for sale by total quantity available for sale. to compute COGS, the average cost per unit is multiplied by the number of units sold. to compute ending inventory, the average cost per unit is multiplied by the number of units that remain.

explain gross profit under changing prices for FIFO and LIFO

because COGS is subtracted from revenue in calculating gross profit, gross profit is also affected by the choice of cost flow method. assuming inflation, higher COGS under LIFO will result in lower gross profit. in fact, all probability measures (gross profit, operating profit, income before taxes, and net income) will be affected by the choice of cost flow method.

during an inflationary or deflationary period, the weighted average cost method will produce an inventory value....

between those produced by FIFO and LIFO.

liquidity ratios effects from LIFO and FIFO

compared to FIFO, LIFO results in a lower inventory value on the balance sheet. because inventory (a current asset) is higher under FIFO, the current ratio, a popular measure of liqudiity is also higher under FIFO. working capital is higher under FIFO as well, because current assets are higher. the quick ratio is unaffected by the firm's inventory cost flow method because inventory is excluded from its numerator.

firms must select a cost flow method to allocate the inventory cost to the income statement (COGS) and the balance sheet (ending inventory) because it is likely that the cost of purchasing or producing inventory will change over time.

cost flow assumption under US GAAP cost flow formula under IFRS

what are product costs and how are they treated under IFRS and US GAAP?

costs included in inventory are similar under IFRS ad US GAAP they are capitalized in the inventories account on the balance sheet 1. purchase cost less trade discounts and rebates 2. conversion (manufacturing) costs including labor and overhead 3. other costs necessary to bring the inventory to its present location and condition by capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold and revenue is recognized.

what is special identification and when is special identification method used?

each unit sold is matched with the unit's actual cost. it is appropriate when inventory items are not interchangeable and is commonly used by firms with a small number of costly and easily distinguishable items such as jewlery.

what is LIFO reserve?

firms that report under LIFO must also report a LIFO reserve. it is the amount by which LIFO inventory is less than FIFO inventory.

when does periodic and perpetual inventory differ?

for FIFO and specific identification methods, ending inventory values and COGS are the same whether a periodic or perpetual system is used. however, periodic and perpetual inventory systems can produce different values for inventory and COGS under the LIFO ad weighed average cost methods.

assuming increasing prices and stable or increasing inventory levels, COGS under LIFO is (higher/lower) than FIFO

higher

assuming increasing prices and stable or increasing inventory levels, ending inventory under FIFO is (higher/lower) than LIFO

higher

assuming increasing prices and stable or increasing inventory levels, gross profit under FIFO is (higher/lower) than LIFO

higher

during inflationary periods with stable or increasing inventory quantities, LIFO COGS is (higher/lower) than FIFO COGS

higher this is because the last unit purchased have a higher cost than the first units purchased.

what is a periodic inventory system?

in a periodic inventory system, inventory values and COGS are determined at the end of the accounting period. no detailed records of inventory are maintained; rather inventory acquired during the period is reported in a purchase account. at the end of the period purchases are added to beginning inventory to arrive at cost of goods available for sale. to calculate COGS, ending inventory is subtracted from good available for sale.

activity ratios effects from LIFO and FIFO

inventory turnover (COGS/ average inventory) is higher for firms that use LIFO compared to firms that use FIFO. under LIFO, COGS is valued at more recent higher costs (higher numerator), while inventory is valued at older, lower costs (lower denominator). adjusting to FIFO values will result in lower turnover and higher days of inventory on hand (365/ inventory turnover).

what is a perpetual inventory system?

inventory values and COGS are updated continuously. inventory purchased and sold is recorded directly in inventory when the transactions occur. no purchase account is necessary.

assuming increasing prices and stable or increasing inventory levels, COGS under FIFO is (higher/lower) than LIFO

lower

assuming increasing prices and stable or increasing inventory levels, ending inventory under LIFO is (higher/lower) than FIFO

lower

assuming increasing prices and stable or increasing inventory levels, gross profit under LIFO is (higher/lower) than FIFO

lower

when prices are rising, firms that report inventory under LIFO will report (higher/lower) inventory values and (higher/lower) cost of goods sold than firms that report under FIFO

lower/ higher

effects of FIFO for periodic vs perpetual

no change - same under both methods

effects of FIFO inventory for periodic vs perpetual

no change - same under both methods

l. st in first out LIFO

only under US GAAP in an inflationary enviornment, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. lower earnings translate into lower income taxes, which increase cash flow. ending inventory on the balance sheet is valued using the earliest costs. in an inflationary enviornment, LIFO ending inventory is less than current cost