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)

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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

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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

Inflation… still no chance

Couple months ago I posted a chart on inflation in Canada… even though interest rates have risen since the QE2 announcement, this hasn’t changed inflation expectations dramatically…

Here is the updated long-term chart of inflation expectations as implied by Real-Return bonds…

And here is the above data since the formal QE2 announcement (3-Nov-2010)… the green line is flat implying inflation expectations haven’t changed in Canada…

…although your daily bills (grocery, gas, insurance, etc) have only gone up! How does that add up? Paul Krugman does an excellent job of explaining core inflation (excluding food & energy) vs total inflation.

Update [7-Jan-2010]: Paul Amery at SeekingAlpha talks about (non-existent) inflation expectations globally

Rising Interest Rates – thanks to QE?

If you haven’t already heard so…interest rates have reversed their downward trend to dramatically move up since the November Federal Reserve meeting, Quantitative Easing (QE2) announcement… QE2 is supposed keep US interest rates low… would you have thought that it would affect rates elsewhere?

Year-to-Date chart of Canadian interest rates…

As marked on the chart, interest rates in Canada have risen significantly over the last 6 weeks… especially the medium to long term rates in the 2-10 year terms. The 5-year rate is at 2.56%, same as in mid-July.

Here is the term chart or the Canadian yield curve… see the parallel shift in yield across all terms!

This means, borrowing costs will increase in proportion… yes, including mortgage rates, particularly fixed rates.

The 5-year fixed rates are as low as they have ever been… but they will be rising shortly; see this

The Bank of Canada hasn’t indicated any shift in monetary policy since the last rate hike in Sep-2010… so why are rates in Canada rising? Possible reasons:

· Higher inflation expectation

· Better than expected economic growth

· Bond markets are overbought

· Rising risk of default (!)

Stay tuned… I will explore each of these possibilities in the coming days…

No Chance of Inflation in Canada – Long Term

Do you really think we are in inflation? When was the last time you paid for something that costs less than it did a year ago?… Never, that’s right… here is Canada’s historical inflation rate

If you want to know whether the bond market expects inflation or deflation, you don’t need to be a rocket scientist to figure out… it is very simple.

The implied or expected inflation rate is the difference between the yield on a nominal Government of Canada bond and the equivalent maturity real-return (see definition below) Government of Canada bond. The chart below clearly shows that markets expect inflation to hover in the 2% range in the long-term.

Real-return bonds are Government of Canada bonds on which the principal and coupon are adjusted based on the inflation rate as measured by the Consumer Price Index. If inflation is increasing, then the coupon and principal on a real-return bond increases proportionally.

Deflation means persistent negative year-over-year change in Consumer Price Index… from a historical perspective, Canada had 2 bouts of deflation – both during the Great Depression of the 1920s/30s.

When was the last time you heard unions striking because of lower wage demands from employers?!?!

Loblaw Co. workers in Ontario have overwhelmingly voted to give their union a strike mandate if Canada’s largest grocery chain doesn’t back down from concession demands that it says are necessary to remain competitive against its non-unionized rivals.

via Mish’s Global Economic Trend Analysis: Deflationary Wage Pressures Hit Canada; Attitudes and Wal-Mart, the 800-Pound Gorillas.