Home > Accounting, CFA L2, fundamental analysis > Implications for Financial Statements & Ratios of Inventories

Implications for Financial Statements & Ratios of Inventories

Summary of new* chapter in 2011 – Inventories  & Implications for Financial Statements & Ratios (longish…)

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Chapter 21 in textbook

*(I am certain I have read this material before for CFA, don’t remember if it was Level 1 or 2)

—————–

Terminology & Formula:

  • Inventory Valuation Method = Cost Formula (IFRS) = Cost Flow Assumption (US GAAP)
  • Cost of Sales = Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
  • Inventory Turnover = Activity Ratio = COGS ÷ Ending Inventory (sometime Average Inventory)
  • Gross Profit Margin = Gross Profit ÷ Sales
  • LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value (needed to convert COGS under LIFO to FIFO)
  • Days of Inventory on Hand = # of Days in Period ÷ Inventory Turnover Ratio

Converting from LIFO to FIFO

  • Inventory in FIFO = Inventory in LIFO + LIFO Reserve
  • COGS in FIFO = COGS in LIFO – Change in LIFO Reserve
  • Total Assets in FIFO = Total Assets in LIFO + LIFO Reserve – Cash Paid for Additional Income Tax

———-

Table1: Allowed methods of Inventory Accounting under IFRS & US GAAP

Methods of Inventory Valuation IFRS, US GAAP or Both
FIFO (first-in first-out) Both
LIFO (last-in first-out) US GAAP only
WAC (Weighted Average Cost) Both
SI (Specific Identification) Both

Table 2: Financial Statement Items under LIFO & FIFO in an Inflationary Environment

Inflationary Environment
Item FIFO LIFO
Balance Sheet
Inventory Carrying Amount Higher Lower
Current Assets Higher Lower
Working Capital Higher Lower
Total Assets Higher Lower
Liabilities No impact No impact
Equity & Retained Earnings Higher Lower
Income Statement
Cost of Goods Sold Lower Higher
(Reflect Replacement Cost)
Gross Profit Higher Lower
Income Tax Higher Lower
Net Income Lower Higher
Cash Flow
Cash flow from Operations
(difference is only due to income taxes)
Lower Higher
Ratios
Current Ratio Higher Lower
Debt to Equity Lower Higher
Profitability Ratios Higher Lower
Inventory Turnover Lower Higher
Gross Profit Margin Higher Lower
Return on Assets
(more effect due to Net Income than Assets)
Higher Lower
(Net Income is Lower but Assets are not proportionally lower)
Summary
Profitability More Less
Liquidity More Less
Leverage Lower Higher

———

Changes to Inventory Valuation Methods:

  • Allowed under both IFRS & US GAAP
  • IFRS requires companies to restate financials using new method as far back as practical
  • US GAAP requires companies to restate financials if changing from LIFO but does not require restating if changing to LIFO

———-

LIFO Liquidation

Occurs when # of units in ending inventory is less than beginning inventory i.e. more units are sold from older inventory which is stated at lower cost, hence increasing profits.

If inventory unit costs have risen in general, this will trigger an inventory related increase in gross profits

———-

Inventory Adjustments: Applies to both IFRS & US GAAP

When inventory declines below the carrying amount on the balance sheet:

  • The balance sheet amount must be written down to its net realisable value &
  • The loss or reduction in value is recognised as an expense on the income statement, either as part of COGS or reported separately.

If inventory values subsequently increase, the increase is recognised as a reduction in COGS under IFRS. US GAAP does not reversal of write-downs.

Effect of write-downs on financial statements is similar to adjusting from FIFO to LIFO valuation method… why?

Items affected from FIFO to LIFO adjustment are:

  • Inventory is lower & Retained Earnings are lower on Balance Sheet
  • COGS is higher and Net Income is lower on Income Statement

The effect of inventory write-down is the same – reducing inventory  & increasing COGS by amount of write-down

Companies using LIFO are least likely to incur inventory write-downs (think about it, their inventory is already the lower, how much more lower can it go?!)

———-

Other Notes:

Cost of Sales reflect replacement cost under LIFO in inflationary

No adjustment necessary between FIFO & WAC methods

[category Accounting, cfa, fundamental analysis]

[tags cfa, deflation, inflation, fifo, lifo, inventories, cogs]

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