Reading 17 Inventories: Implications for Financial Statements and Ratios Copyright FinQuiz.com. All rights reserved. 2 0 1 3 1. INTRODUCTION To evaluate a companys performance over time and relative to industry peers, analysts must clearly understand the various inventory valuation methods that companies use and their impact on financial statements and financial ratios. Inventory Cost Flow methods (cost formula) permitted in IFRS: 1) Specific Identification 2) First-in, first-out (FIFO) 3) Weighted Average cost Inventory Cost Flow methods (cost flow assumption) permitted in U.S. GAAP: 1) Specific Identification 2) First-in, first-out (FIFO) 3) Weighted Average cost 4) Last-in First-out (LIFO) 2. INVENTORY AND CHANGING PRICE LEVELS Ending inventory = beginning inventory + purchases COGS The choice of inventory cost flow method determines how the cost of goods available for sale during a period is allocated between inventory and cost of sales. Specific Identification In Specific Identification, cost of sales and inventory reflect the actual costs of the specific items sold and unsold (remaining in inventory). This method is most appropriate to use: For inventory items that are not interchangeable e.g. automobiles, jewelry etc. Special orders or projects that are not related to normal course of business. Goods and services segregated for specific projects. First-in, first-out (FIFO) First-in First-out (FIFO) assumes that the inventory items which are purchased or manufactured first are sold first. In periods of rising prices of inventory i.e. during inflation, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold. In periods of changing prices, ending inventory values in FIFO more closely reflect current costs than do the cost of sales. For balance sheet purposes, inventories based on FIFO are preferable since these values most closely represent current cost and economic value. Weighted Average cost Weighted Average cost assigns the average cost of the goods available for sale (beginning inventory + purchases, conversion and other costs) during the accounting period to the units that are sold as well as to the units in ending inventory. ? ? ? ? ? =Total Cost of goods available for sale Total units available for saleLast-in First-out (LIFO) Last-in, first-out (LIFO) assumes that the inventory items which are purchased or manufactured most recently are sold first. In periods of rising prices of inventory i.e. during inflation, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold. In periods of changing prices, cost of sales in LIFO more closely reflect current costs than do ending inventory values. Periodic Inventory System In periodic inventory system, inventory values and costs of sales are determined at the end of the accounting period. In periodic inventory system: Allocation of goods available for sale to cost of sales and ending inventory is the same under specific identification and FIFO. Allocation of goods available for sale to cost of sales and ending inventory is significantly different under weighted average cost method and FIFO. Perpetual Inventory System In perpetual inventory system, inventory values and costs of sales are continuously updated to reflect purchases and sales. In perpetual inventory system: Allocation of goods available for sale to cost of sales and ending inventory is the same under specific identification and FIFO. Allocation of goods available for sale to cost of sales and ending inventory is the same under weighted average cost method and FIFO. 1Reading 17 Inventories: Implications for Financial Statements and RatiosNOTE: Under either a perpetual or periodic inventory system, the use of LIFO method will result in significantly different allocations to cost of sales and ending inventory compared to other inventory valuation methods. 3. Using LIFO method in case of rising prices results in: Ending inventorys Carrying amounts NRV and Market cannot be NRVMarket is NRVIf Replacement cost NRV and Market cannot be growth of salesand the company has less cash and b) The cost of the item can be measured reliably. U.S. GAAP has similar rules. Examples of PPE include: Land Buildings Machinery Furniture Fixtures Vehicles Major spare parts that are expected to be used during more than one period. Major spare parts that can be used in connection with an item of PPE. Examples of Expenditures to get an asset ready for its intended use include: Purchase price Delivery Installation Intangible Assets: Intangible are assets which do not have physical substance. Requirements under IFRS rather they are tested for impairment. Practice: Example 4,