Inventories Level I Financial Reporting and Analysis. IFT Notes for the CFA exam

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Inventories

2014 Level I Financial Reporting and Analysis

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1. Introduction

Inventories are assets held by a company to produce finished goods for sale. Such assets include raw materials, unfinished goods and finished goods. Inventory is shown as a current asset on the balance sheet; it can represent a significant part of the total assets for many companies.

Manufacturing and merchandising companies (eg: Nike, Caterpillar) generate sales and profit through the sale of inventory. An important measure in calculating profits is cost of goods sold i.e. how much cost the company incurred from procuring raw materials to converting it to a finished product, and finally selling it.

There is no universal inventory valuation method. IFRS and GAAP allow different identification methods to measure the cost of inventory such as specific identification, weighted average cost, first-in, first-out, and last-in, first-out.

2. Cost of Inventories

When a company spends money on inventory most of the costs are capitalized. Capitalizing means creating an asset on the balance sheet. Specifically the inventory costs that are capitalized include:

 Costs of purchase

 Costs of conversion (for converting raw material into finished product)

 All other costs necessary to bring inventories to its present location and condition

 Fixed production overhead under normal operating capacity The costs which are expensed in period incurred are:

 Abnormal wastage of materials

 Storage costs

 Administrative overheads

 Selling costs

 Unused portion of fixed production overhead

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Kayvee Corporation manufactures high-end tractors. The inventory related costs are shown below:

Raw materials $56,000

Direct labor $40,000

Abnormal wastage $6,000

Transportation of raw materials $10,000 Transportation of finished goods to showroom $1,000 Storage of finished product $18,000 What value of inventory is recorded?

Solution:

The value of inventory is based on the costs which are capitalized. These costs are: raw materials, direct labor, and transportation of raw materials: 56,000 + 40,000 + 10,000 = 106,000. Note that following costs: abnormal wastage, transportation of finished goods and storage of finished product are expensed in the period incurred.

3. Inventory Valuation Methods

Why do we need inventory valuation methods? Simply put, because of inflation. The cost of raw materials and the costs incurred to convert the raw materials to finished goods change over time (increase or decrease). As the inventory costs do not remain constant over this period of time, different valuation methods are used to allocate inventory costs between the cost of goods sold on the income statement and inventory on the balance sheet.

What inventory valuation method a company follows is of significant importance as it affects the costs of inventory, hence the financial statements and profitability of the company.

The four methods for accounting inventory are:

 Specific Identification

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 LIFO (Last-In, First Out)

3.1 Specific Identification

Specific identification is used when:

 Items are unique in nature and not interchangeable.

 Cost of inventory is high.

 Carried on the financial statements at actual cost – i.e. cost of sales and ending inventory costs reflect actual costs incurred.

 Every item in the inventory can be tracked individually.

Examples: Jewelry, expensive watches, highly valued art pieces, used cars

3.2 First-In, First-Out (FIFO)

Under First-In, First-Out:

 Oldest goods purchased or manufactured are assumed to be sold first.

 Newest goods purchased or manufactured remain in ending inventory.

 When prices are increasing or stable, costs assigned to items in inventory is higher than the cost of items sold.

The following example illustrates how cost of goods sold and inventory are accounted for each period:

Let’s assume you bought four pencils. The first two pencils were worth $1 each and the next two pencils were worth $2 each. Before you start selling, your inventory consists of four pencils.

In period 1, you sell two pencils. The cost of pencils sold in period 1 is $2 (two pencils of $1 each). The pencils that were first bought are considered sold. Inventory at the end of period 1 is $4 and looks like this (2 pencils of $2 each):

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As you could see, cost of pencils sold in period 1 was $2 (cheaper pencils bought initially) whereas the cost of pencils in inventory was $4. In period 2, you again sell two pencils. The cost of pencils sold in period 2 is $4. Inventory at the end of period 2 is 0.

Advantage of using FIFO is that it is less subject to manipulation. It results in higher income when prices are increasing.

3.3 Weighted Average Cost

Under weighted average cost method each item in inventory is valued using an average cost of all items in the inventory.

Weighted average cost = Total cost of units available for sale / total units available for sale

Let’s use the pencils example again to illustrate how inventory is calculated using the WAC method.

Total cost of pencils available for sales = $6 Total number of pencils available for sale = 4 Weighted average cost per pencil = 6/4 = 1.5

WAC Method

Item WAC (in $)

Cost of 2 pencils sold in period 1 3

Inventory for 2 pencils at the end of period 1 3

Inventory at the end of period 2 0

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Under Last-In, First-Out method:

 Newest goods purchased or manufactured are assumed to be sold first.

 Oldest goods purchased or manufactured remain in ending inventory.

 Cost of goods sold reflects cost of goods purchased or manufactured recently; value of inventory reflects cost of older goods purchased.

We will continue with the pencils example to see how inventory is accounted for in LIFO: Unlike FIFO, at the end of period 1, LIFO inventory consists of the first two pencils:

LIFO Method

Item LIFO (in $)

Inventory for 2 pencils at the end of period 1 2

Inventory at the end of period 2 0

LIFO is not allowed under IFRS; it is allowed only under U.S. GAAP.

Companies use LIFO during inflation to reduce taxes as cost of goods sold (COGS) is high.

3.5 Calculation of cost of sales, gross profit, and ending inventory

Assume each of the pencils in the example above was sold for $5. The table below summarizes the cost of goods sold, inventory ending value and gross profit under each of the methods:

Inventory Accounting under Various Methods

Item FIFO (in $) LIFO (in $) WAC (in $)

COGS for period 1 2 4 3

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Gross profit for period 1 8 6 7

Inventory at end of period 1 4 2 3

COGS for period 2 4 2 3

Gross profit for period 2 6 8 7

Inventory at end of period 2 0 0 0

Some points to be noted:

 The total gross profit and COGS for all the periods combined is the same under each of the methods.

 As the prices of pencils were increasing, the ending inventory was highest and COGS was lowest under FIFO.

 Similarly, the ending inventory was lowest and COGS was highest under LIFO. A summary of the three methods:

Inventory Accounting

FIFO Weighted average cost LIFO

IFRS/GAAP Allowed under both Allowed under both Only US GAAP Item Purchased first to be

sold first

No segregation. Contains both earliest and latest purchases

Recently purchased to be sold first

COGS First purchased or

manufactured

Average cost Recently purchased or manufactured

Ending inventory Recent purchases Average cost First purchased

Worked Example 2:

A company bought 400 generators at a price of $400 each on January 5. 300 of these generators were sold at a price of $450 each by the end of March. On April 10, 250 more generators were bought at a price of $325 each. By May 31, 225 generators were sold at a price of $500 each. For the period ending June 30, what is the ending inventory using FIFO?

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Purchased 400

Sold (300)

Remainder as at March 2012 100

Purchased further 250

Sold (100 old + 125 new) (225)

Remainder (new) 125

First in first our means that the items bought first are being sold first. Inventory amount is based on the items which are left. Hence, inventory cost = 125 * 325 = $40,625.

3.6 Periodic Vs. perpetual inventory systems

The two types of inventory systems used to keep track of changes in the inventory are:

 Periodic system

 Perpetual system

Periodic system: The company measures the quantity of inventory on hand periodically. It is not

a continuous process unlike the perpetual system. Purchases are recorded in a purchases account. Ending inventory is determined through a physical count of the units in inventory.

Cost of goods sold (COGS) = Beginning Inventory + Purchases – Ending Inventory

The formula above can be rearranged to determine the value of any of the items. For example:

Ending Inventory = Beginning Inventory + Purchases – COGS

Perpetual system: As the name implies, inventory and COGS are continuously updated in this

system. Purchases and sale of units are directly recorded in the inventory as and when they occur.

Important point to be noted:

Specific Identification and FIFO: Periodic and perpetual systems give the same values for

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ending inventory.

3.7 Comparison of Inventory Valuation Methods

The following table compares LIFO vs. FIFO for different parameters when prices are rising and inventory levels are stable:

LIFO vs. FIFO with rising prices and stable inventory levels

LIFO FIFO

COGS Higher Lower

Taxes Lower Higher

Earnings before taxes (EBT) Lower Higher

Earnings after taxes (Net Income)

Lower Higher

Ending inventory Lower Higher

Working capital (CA-CL) Lower Higher

Cash flow (after tax) Higher Lower

Note: Weighted average costs provide results between FIFO and LIFO Tips for remembering the table above:

1. Remember the pencils example of $1, $1, $2 and $2. Deducing the LIFO values from this example for COGS, net income, ending inventory becomes simpler.

2. FIFO is the opposite of LIFO. Other important points:

3. Cash flow (after tax) is higher under LIFO as taxes paid are lower.

4. Companies following U.S GAAP prefer LIFO because the taxes paid are lower

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4. Measurement of Inventory Value

Holding inventory for a prolonged period results in the risk of spoilage, obsolescence or decline in prices. We define some terms first before looking at the differences in how inventory is measured under IFRS and GAAP.

Net realizable value: Estimated selling price under ordinary business conditions minus

estimated costs necessary to get the inventory in condition for sale. NRV is from a seller’s perspective.

Market value: Current replacement cost subject to lower or upper limits. Market value has

upper limit of net realizable value and lower limit of NRV less a normal profit margin. Market value is from a buyer’s perspective.

Net realizable value = estimated sales price – estimated selling costs Market value limits = (NRV - normal profit margin, NRV)

The following table describes how inventory is measured under IFRS and GAAP:

Inventory measurement under IFRS and GAAP

IFRS GAAP

Lower of cost or net realizable value Lower of cost or market value If NRV is less than the balance sheet cost, the

inventory is “written down” to NRV and the loss is recognized.

If cost exceeds market, inventory is written down to market on balance sheet and the loss is

recognized. If value recovers subsequently, inventory can be

written up and gain is recognized in income statement. The amount of gain is limited to loss previously recognized.

If value recovers subsequently, no write up is allowed.

Commodities and agricultural goods prices can be reported above historical cost.

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In 2010, the inventory balance is 52 but the net realizable value is 49. The current replacement cost is 47. The figure exceeds the net realizable value less a normal profit margin. In 2011, the NRV was 5 greater than the carrying amount. Show the inventory values in 2010 and 2011 according to IFRS.

Solution:

2010: inventory balance = 52; NRV = 49. Since NRV is lower than the balance sheet cost of 52, inventory is written down to 49. Loss recognized on income statement = 3.

2011: NRV = 54 as it is 5 greater than the carrying value of 49. Inventory value written up to 52. Reversal of loss in income statement limited to 3.

Worked Example 4 (for measurement of inventory under GAAP):

In 2010, the inventory balance is 52 but the net realizable value is 49. The current replacement cost is 47. The figure exceeds the net realizable value less a normal profit margin. In 2011, the NRV was 5 greater than the carrying amount. Show the inventory values in 2010 and 2011 according to GAAP.

Solution:

Here replacement cost is the market value. According to U.S, GAAP, inventory is written down to lower of cost or market value, i.e. 47 for 2010. However, you need to ensure that this number 47 is within the limits for market value (NRV and NRV- normal profit margin). 47 is less than the upper limit - i.e. 49 (net realizable value). It is also greater than the lower limit as the statement, “the figure exceeds the net realizable value less a normal profit margin” confirms. Inventory value for 2010 = 47. For 2011, net realizable value = 52. Inventory value for 2011 stays at 47 as writing up is not permitted under U.S GAAP.

5. Presentation Disclosure

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that must be presented – carrying amount, write down, write up, how it was measure and accounting policies.

IFRS requires the following financial statement disclosures concerning inventory:

 The accounting policies used to measure inventory, including the cost formula

 The total carrying amount of inventories and the carrying amount in classification (for example, merchandise, raw materials, production supplies, work in progress, and finished goods appropriate to entity)

 The carrying amount of inventories carried at fair value less costs to sell

 The amount of inventories recognized as an expense in the period (cost of sales)

 The amount of any reversal of any write-down recognized as a reduction in cost of sales in the period

 What led to the reversal of a write-down in the inventories

 Carrying amount of inventories pledged as a security for liabilities

Disclosures under U.S. GAAP are similar to IFRS except that it does not permit reversal of write down of inventories. In addition, any income from liquidation of LIFO inventory must be disclosed.

5.1 Changes in Inventory Valuation Method

A company may decide to change its inventory valuation method say from LIFO to FIFO. IFRS and U.S. GAAP stipulate certain guidelines to make such a change acceptable.

 If a company changes its accounting policy, the reason for the change must be justifiable. For instance, one valid reason is that the change results in the financial statements providing more reliable and reliant information.

 Consistency of inventory costing is required under both IFRS and GAAP.

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effect of the change. Under U.S. GAAP, when a company changes from FIFO to LIFO, retrospective adjustments are not needed. Changes will be accounted only on a prospective basis.

6. Evaluation of Inventory Management

The choice of inventory valuation method impacts various components of the financial statements such as cost of goods sold, net income, current assets and total assets. As a result, it affects the financial ratios containing these items. The table below summarizes the impact of valuation method on inventory-related ratios:

Ratio Numerator Denominator Impact on ratio

Inventory turnover Cost of goods sold is higher under LIFO

Average inventory is lower LIFO

Higher under LIFO

Days of inventory No. of days are the same Higher under LIFO Lower under LIFO Total asset turnover Revenue is the same Lower average total assets

under LIFO

Higher under LIFO

Current ratio Ending inventory is lower under LIFO so current assets lower

Current liabilities are the same

Lower under LIFO

Gross profit margin Gross profit lower under LIFO as COGS is higher

Revenue is the same Lower under LIFO

Return on assets Net income lower under LIFO as COGS is higher

Lower average total assets under LIFO

Lower under LIFO

Debt to equity Debt is the same Lower equity under LIFO. Equity = assets – liabilities. Total assets under LIFO are lower as ending inventory is lower.

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Summary

Note: This summary has been adapted from the CFA Program curriculum.

The choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies.

Key concepts in this reading are as follows:

 Inventories are a major factor in the analysis of merchandising and manufacturing companies. Such companies generate their sales and profits through inventory transactions on a regular basis. An important consideration in determining profits for these companies is measuring the cost of sales when inventories are sold.

 The total cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Storage costs of finished inventory and abnormal costs due to waste are typically treated as expenses in the period in which they occurred.

 IFRS allow three inventory valuation methods (cost formulas): first-in, first- out (FIFO); weighted average cost; and specific identification. The specific identification method is used for inventories of items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects. U.S. GAAP allow the three methods above plus the last-in, first-out (LIFO) method.

 A company must use the same cost formula for all inventories having a similar nature and use to the entity.

 The inventory accounting system (perpetual or periodic) may result in different values for cost of sales and ending inventory when the weighted average cost or LIFO inventory valuation method is used.

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estimated costs necessary to make the sale. Under U.S. GAAP, inventories are measured at the lower of cost or market value. Market value is defined as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. Reversals of previous write-downs are permissible under IFRS but not under U.S. GAAP.

 Consistency of inventory accounting policies is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements are accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively, and there is no retrospective adjustment to the financial statements.

 The choice of inventory valuation method affects a number of items on the financial statements and any financial ratios that include inventory or cost of sales, whether directly or indirectly. As a consequence, the analyst must carefully consider differences in inventory valuation methods when evaluating a company’s performance in comparison to industry performance or industry competitors’ performance.

 The inventory turnover ratio, number of days of inventory ratio, and gross profit margin ratio are useful in evaluating the management of a company’s inventory.

 Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company’s inventory management.

Next Steps

 Work through the examples in the curriculum.

 Solve the practice problems in the curriculum.

 Solve the IFT Practice Questions associated with this reading.

Inventories Level I Financial Reporting and Analysis. IFT Notes for the CFA exam

Inventories

2014 Level I Financial Reporting and Analysis

Contents

1. Introduction

2. Cost of Inventories

3. Inventory Valuation Methods

4. Measurement of Inventory Value

5. Presentation Disclosure

6. Evaluation of Inventory Management

Summary

Next Steps