‘Fhe following ins review ofthe Financial Reporting and Analy principles deigned to aden the et forth by CEA Institute? This topic i lo covered in: learning ootcome statem INVENTORIES Study Session 9 EXAM Focus ‘This topic review discusses specific analytical processes for inventory. The complication in analyzing inventory is that firms can choose among different cost flow methods—FIFO, LIFO, and weighted average cost. You should know how to calculate inventory balances and COGS using all three methods and how to convert LIFO inventory and LIFO COGS to a FIFO basis for comparison. You must understand how the different cost flow methods affect the firm’ liquidity, profitability, activity and solvency ratios INVENTORY ACCOUNTING Merchandising firms, such as wholesalers and retailers, purchase inventory that is ready for sale, In chis case, inventory is reported in one account on the balance sheet. On the other hand, manufacturing firms normally report inventory using three separate accounts: raw materials, work-in-process, and finished goods. ‘The choice of inventory cost flow method affects the firm's income statement, balance sheet, and several important financial ratios, Additionally, che cost fow method can affect the firm’s income taxes and, thus, che firm's cash Bow, The inventory cost flow method should not be confused with the inventory valuation method as required by IFRS and U.S. GAAP. Generally, inventory is reported on the balance sheet ar cost and a writedown (loss) is recognized if ehe market value of inventory declines below cost. The valuation method (lower of cost or net realizable value for firms reporting under IFRS, and lower of cost or market for firms reporting under U.S. GAAD) is applied regardless of the cost fiowe method. Cost of goods sold is related to the beginning balance of inventory, purchases, and the ending balance of inventory. The relationship is summarized in the following equation: COGS = beginning inventory + purchases — ending inventory ‘This equation can be rearranged to solve for any of the four variables: purchases = ending inventory ~ beginning inventory + COGS beginning inventor COGS ~ purchases + ending inventory ending inventory = beginning inventory + purchases ~ COGS ©2009 Kaplan, Ine Page 173‘Study Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 Inventories Professor's Note: Many candidates find the inventory equation easiest to oe remember in this last form. If you start with beginning inventory, add the goods that came in (purchases), and subtract the goods that went out (COGS), the result must be ending inventory. LOS 36.a: Explain IFRS and U.S. GAAP rules for determining inventory cost, including which costs are capitalized and methods of allocating costs between. cost of goods sold and inventory. Cost is the basis for most inventory valuation. The main issue involves determining the amounts that should be included in cost. ‘The costs included in inventory ate similar under IFRS and U.S. GAAP. These costs, known as product costs, are capitalized in the Inventories account on the balance sheet and include: + Purchase cost. + Conversion costs. + Allocation of fixed production overhead based on normal capacity levels. + 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. Nor all inventory costs are capitalized; some are expensed in the period incurred. These costs, known as period costs, include: Unallocated portion of fixed production overhead. Abnormal waste of materials, labor, or overhead, Storage costs (unless required as part of the production process). Administrative overhead. Selling costs. Example: Costs included in inventory Vindaloo Company manufactures a single product. The following information has been caken from the company’s production and cost records for last year Noimal production capacity 5,000,000 units Units produced 4,000,000 unis Conversion cost for finished goods $20,000,000 Raw materials $15,000,000 Fixed ovethead $6,000,000 Freight-in $800,000 Storage cost for finished goods $500,000 Abnormal waste $100,000 ‘Assuming no units remain unfinished at year-end, calculate the capitalized cost of one Page 174 (©2009 Kaplan, Ine.Study Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 — Inventories Answer: (Cipitalized inventory cove includes the Convelsigh com Yaw veaicide cos, Reight toy ine the allocated fixed overhead. The allocation of fixed overhead is-based on the units: ‘produced relative to normal production capacity. Since Vindaloo operated at 80% of norinal production capacity last year (4,000,000-units produced / 5,000,000 units: normal capacity), 80% of the fixed overhead is capitalized. The remaining 2096 of fixed overhead is expensed. ae ¢ ‘ ‘Conyersion cost for finished goods, Raw materials” oe Allocied fined overhead Preighei ‘Total capitalived:cose ‘Units produced: ‘Capiralized cost per uni ABE Costs, abnormal vaste, Breed Jnshe pote azine LOS 36.b: Discuss how inventories are reported on the financial statements and how the lower of cost or net realizable value is used and applied. | Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value, Net realizable value is equal to the estimated sales price less the estimated selling costs. If net realizable value is less than the balance sheet cost, the inventory is “written down” to net realizable value and a loss is recognized in the income statement. IF there is a subsequent secovery in value, the inventory can be “written up” i and a gain is recognized in the income statement. However, the amount of any such gain is limited to the amount previously recognized as a loss. In other words, inventory cannot be reported on the balance sheet at an amount that exceeds original cost, Under U.S. GAAP, inventories are reported on the balance sheet at the lower of cost or market, Market is usually equal to replacement cost; however, market cannot be greater than rict cealizable value (NRV) of less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus 2 normal profit margin, then market is NRV minus a normal profit margin. Professors Note: Think of lower of cost or market, where “market” cannot be outside a range of values. The range is from net realizable value minus a normal profit margin to net realizable value. So the size of the range is the normal profit margin. “Net” means net of selling costs Tf cost exceeds market, the inventory is written down to market on the balance shect and a loss is recognized in the income statement. If vhere is a subsequent recovery in value, no write-up is allowed under U.S, GAAP. In this case, the market value becomes the new cost basis. ©2009 Kaplan, Inc. Page 175,Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories Example: Inventory writedown Zoom, Inc. sells digital cameras. Per-unit cost information pertaining to Zoom’s inventory is as follows: Original cost $210 Estimated selling price $225 Estimated selling costs $22 Net realizable value $203 Replacement cost $197 Normal profic margin $12 ‘Whit are the per-unie carrying values of Zoom’s inventory under IFRS and under U.S. GAAP? Answer: Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. Since original cost of $210 exceeds net realizable value ($225 — $22 = $203), the inventory is written down to the net realizable value of $203 and a $7 loss ($203 net realizable value ~ $210 original cost) is reported in the income statement. Under U.S. GAB, inventory is reported at the lower of cost or market. In this case, market is equal to replacement cost of $197, since net realizable value of $203 is gxeater than replacement cost, and net realizable value minus a normal profit margin ($203 — $12 = $191) is less than replacement cost. Since original cost exceeds market (replacement cost), the inventory is written down to $197 and a $13 loss ($197 replacement cost ~ $210 original cost) is reported in the income statement. Example: Inventory wriee-up ‘Assume that in the year after che writedown in the previous example, net realizable value and replacement cost both increase by $10. What is the impact of the recovery under IERS and under [Link]? ‘Answer: Under IFRS, Zoom will write up inventory to $210 per unit and recognize a $7 gain in its income statement. The write-up (gain) is limited to the original writedown of $7. The carrying value cannot exceed original cost. Under U.S. GAAP, no write-up is allowed. The per-unit carrying value will remain at $197. Zoom will simply recognize higher profit when the inventory is sold. Reporting inventory above historical cost is permitted under IFRS and U.S. GAAP in certain industries. This exception applies mainly co producers and dealers of commodity- like products, such as agricultural and forest products, mineral ores, and precious metals Under this exception, inventory is reported at net realizable value and the unrealized gains and losses from changing market prices are recognized in the income starement. If Page 176 ©2009 Kaplan, Inc.Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 Inventories an active market exists for the commodity, the quored market price is used to value the inventory. Otherwise, recent market transactions are used. LOS 36.c: Compute ending inventory balances and cost of goods sold using the FIFO, weighted average cost, and LIFO methods to account for product inventory and explain the relationship among and the usefulness of inventory and cost of goods sold data provided by the FIFO, weighted average cost, and LIFO methods when prices are 1) stable, 2) decreasing, or 3) increasing. If che cost of inventory remains constant over time, determining the firm’s COGS and ‘ending inventory is simple. To compute COGS, simply multiply the number of units sold by the cost per unit. Similarly, co compute ending inventory, multiply the number of units remaining by the cost per unit. However, itis likely that, over time, the cost of purchasing or producing inventory will change. As a result, firms must select a cost flow method to allocate inventory cost for the period to the income statement (COGS) artd the balance sheet (ending inventory), Under IFRS, the permissible cost flow methods are: + Specific identification. + First-in, first-out (FIFO). + Weighted average cost. The same cost Now methods are also permissible under U.S. GAAP. However, U.S, GAAP also permits the use of the last-in, first-out (LIFO) method. LIFO is nor allowed under IFRS. Professor's Note: FIFO, LIFO and weighted average cost are sometimes referred e 10-45 “cost flow assumptions.” Since it may be impractical to specifically identify the actual cost of each unit of inventory, firms make assumptions about how inventory cost flows through the sytem. Within che firm, one or more cost flow methods may be used. However, the firm must employ the same cost flow method for inventories of a similar nature and use, Specific Identification Method Under the specific identification method, each unie sold is matched with the unit's actual cost. Specific identification is appropriate when inventory items are not interchangeable. Icis commonly used by firms with a small number of costly and easily distinguishable items in inventory, such as jewelry and automobiles. Specific identification is also appropriate for special orders or projects outside a firms normal course of business. FIFO Method Under the F1EO method, the first item purchased (the oldest inventory) is assumed to be the first item sold. The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current replacement cost. FIFO COGS is based on the earliest purchase costs. When prices are rising, COGS will (©2009 Kaplan, Ine Page 177Seudy Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories be understated compared to current replacement cost and, as a result, earnings will be overstated. LIFO Method Under the LIFO method, the item purchased most recently is assumed to be the first item sold, LIFO produces better matching in the income statement since COGS and sales revenue are both measured using recent prices. When prices ate rising, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the earliest costs. Therefore, when prices are rising, LIFO ending inventory is less than replacement value As discussed previously, LIFO is permitted under U.S. GAAP but is not allowed under IRS. The LIFO conformity rule of the U.S. tax code requires firms chat use LIFO for tax purposes to also use LIFO for financial reporting purposes. This is one area where conformity between financial reporting and tax reporting standards is required The income tax advantages of using LIFO explain its popularity among U.S. firms. Because of generally rising prices, using LIFO for tax reporting generates tax savings since LIFO carnings arc lower than FIFO earnings. This results in the peculiar situation where lower reported income is associated with higher cash flow from operations. Weighted Average Cost Method ‘Weighted-average cost is a simple and objective method. The average cost per unit of inventory is computed by dividing the total cost of goods available for sale (beginning inventory + purchases) by the total quantity available for sale. To compute COGS, the average cost per unit is multiplied by the number of units sold. Similarly, to compute ending inventory, the average cost per unit is multiplied by the number of units that ‘When prices are either increasing or decreasing over time, the weighted average cost method will produce an inventory value between those produced by FIFO and LIFO. Figure 1: Inventory Cost Flow Method Comparison Cost of Goods Sold Ending Inventory Method Anenption Consists of. Consist of. FIFO (US. and The items fist ‘frst purchased most recent IFRS) purchased are che fst purchases to be sod. LIFO (U-S. only) The items last last purchased earliest purchases purchased are che frst tobe sold. Weighted average cost Items sold are a mix average cost ofall average cost ofall (US. and IFRS) of purchases items items Page 178 (©2009 Kaplan, IncStudy Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories Let's look at an example of how to calculate COGS and ending inventory using the FIFO, LIFO, and average cost inventory valuation methods. Example: Inventory cost flow methods Use the inventory data in the following figure to calculate the cost of goods sold and ending inventory under the FIFO, LIFO, and weighted average cost methods. Inventory Data ‘January 1 (beginning inventory) 2 units @ $2 per unit $4 January 7 purchase 3 units @ $3 per unit $9 January 19 purchase 5 units @ $5 per unit = $25 Cost of goods available 10 units $38 Units sold during January Tunis Answer: FIFO cost of goods sold. Vaive the seven units sold at the unit cost of the first units purchased, Start with the earliest units purchased and work down, as illustrated in the following figure. FIFO COGS Calculation ‘rom beginning inventory 2 units @ $2 per unit = 4 From first purchase 3 units @ $3 per unit = $9 From second purchase 2 units @ $5 per unit = $10 FIFO cost of goods sold 7 units $23 inventory. 3 units @$5 = $15 LIFO cost of goods sold. Value the seven units sold at the unit cost of the last units purchased. Start with the most recently purchased units and work up, as illustrated in-the following figure . naman LIFO COGS Caleulation From second purchase 5 units @ $5 per unit 525 From first purchase @ $3 peru $6 LIFO cost of goods sold 7 units $31 Ending inventory units @$2 +1 unit @$3= $7 ©2009 Kaplan, Inc. Page 179)Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventor Average cost of goods sold. Value the seven units sold at the average unit cost of. goods available. ‘Weighted Average COGS Calculation ‘Average unit cost $38/10= $3.80 per unit Weighted average cost of goods sold 7 units @ $3.80 per unit $26.60 Ending inventory 3 units @ $3.80 per uni $11.40 Summary Inventory system coGs Ending Inventory FIFO $23.00 $15.00 LIFO $31.00 $7.00 Average Cost $2 $11.40 Note that prices and inventory levels were rising over the period and that purchases during the period were the same forall cost flow methods. During periods of rising prices and stable or increasing inventory quantities, LIFO COGS is higher than FIFO COGS. This is because the last units purchased have a higher cost than the first units purchased. Under LIFO, the more costly last units in are the first units out (to COGS). OF course, higher COGS will result in lower net income. Using similar logic, we can see that LIFO ending inventory is lower than FIFO ending inventory. Under LIFO, ending inventory is valued using older, lower costs During periods of falling prices and stable or increasing inventory quantities, the cost flow effects of using LIFO and FIFO will be reversed; that is, LIFO COGS will be lower and LIFO ending inventory will be higher. This makes sense because the most recent lower-cost purchases are sold first under LIFO, and the units in ending inventory are assumed to be the earliest purchases with higher costs. Consider the diagram in Figure 2 to help visualize the FIFO-LIFO difference during periods of rising prices and growing inventory levels Remember, it's not the older or newer physical inventory units that are reported in the income statement and balance sheet; rather, it is the costs that are assigned to the units sold and to the units remaining in inventory. Page 180 ©2009 Kaplan, Ine.Study Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 — Inventories igure 2: LIFO and FIFO Diagram—Rising Prices and Growing Inventory Balances INVENTORY IN, INVENTORY OUT IFO = Sma vcore CR-CAICL Small WO CA=CL= Sell INVENTORY INVENTORY | our IN FO Tocome Sime | IFO Income Sime SALES — COGS (Sia SALES COGS (ig) ‘Net Tacome (i) Ne Income (Sal Higher Tes Lower Tues Lower Ca Flaws Higher Cash lowe During periods of rising prices, the LIFO assumption results in higher COGS, lower ret income, and lower inventory levels. This decreases the current ratio (current assets / current liabilities) and increases inventory turnover (COGS / average inventory). Professor's Note: Be able to describe the effects of LIFO and FIFO, assuming inflation, in your sleep. When prices are falling, the effects are simply reversed. When you are finished with this reviews take the time to look at these graphs and relationships again to solidify the concepts in your mind. Usefulness of Inventory and Cost of Goods Sold Data Provided by the LIFO, FIFO, and Average Cost Methods Professor's Note: The presumption in this section is that inventory quantities are stable or increasing During periods of stable prices, all chree cost flow methods will yield the same results for inventory, COGS, and earnings. During periods of trending prices (up or down), the cost flow methods may result in significant differences. I is necessary to adjust for the differences when comparing firms that use different cost flow methods. Ending Inventory ‘When prices are trending up or down, FIFO provides the most useful measure of ending. inventory. This is a critical point. Recall that FIFO inventory is made up of the most recent purchases. These purchases can be viewed as an approximation of replacement cost, which represents economic value. (©2009 Kaplan, Ine. Page 181‘Study Session 9 Cross-Reference to CEA Institute Assigned Reading #36 ~ Inventories Page 182 On the other hand, LIFO inventory is made up of outdated costs that may have no relationship to today’s economic value. For analytical and comparative purposes, itis necessary to adjust LIFO inventory by converting it to a FIFO basis. This adjustment will be demonstrated later in this topic review. Professor's Note: Remember that FIFO is always preferred from a balance sheet perspective since FIFO inventory is based on the most recent costs. LIFO provides better income statement information (COGS). The lower costs associated with LIFO inventory are less likely to exceed market value, thereby making inventory writedowns less likely under LIFO. Cost of Goods Sold Changing prices can also result in significant differences in COGS under LIFO and FIFO. Recall that 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. When prices are trending, the weighted-average cost method will produce values of COGS and ending inventory between those of FIFO and LIFO. Disclosure of a firm's cost fow method is found in the financial foornotes. This information allows the analyst to make adjustments to the financial statements as necessary for analytical and comparative purposes. LOS 36.d: Discuss and calculate ratios useful for evaluating inventory management. Inventory turnover and the number of days in inventory are popular inventory metrics. These ratios can be used to evaluate the age of a firm's inventory as well as the effectiveness of inventory management cost of goods sold inventory turnover average inventory number of days of inventory = ee oe Inventory ratios should not be viewed in isolation but, rather, should be compared to industry norms. Low inventory turnover (high number of days in inventory), coupled with low or declining revenue growth compared to the industry, may be a sign of slow-moving or obsolete inventory. This may necessitate a downward revaluation (writedown) of inventory. (©2009 Kaplan, IncSeudy Session 9 Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories High inventory turnover (low number of days in inventory) is usally preferred as ic reduces the risk of obsolescence and minimizes carrying costs such as storage, insurance, and handling. However, high inventory turnover may also be an indication of inadequate inventory levels. Too litle inventory may result in lost revenue when orders cannot be filled. High turnover, coupled with high or increasing revenue growth compared to the industry, is an indication of inventory management efficiency. High turnover and slower revenue growth may indicate insufficient inventory levels. Inventory ratios are directly affected by the firm's choice of cost flow method, as are other ratios such as the current ratio, the debt-to-equity ratio, and rerurn on assets. ‘When evaluating a firm's performance or when comparing the firm to industry peers, the analyst must understand the differences that result from the different cost fow methods Professor's Note: Calculating and interpreting the inventory turnover ratio and eo the number of days of inventory was discussed in the topic review of Financial Analysis Techniques and is covered again in the Study Session on corporate finance. LOS 36.e: Analyze the financial statements of companies using different inventory accounting methods by comparing and describing he effect of the different methods on cost of goods sold, inventory balances, and other financial statement items. Professor's Note: The presumption in this section is that prices are rising and inventory quantities are stable or increasing “The differences among LIFO and FIFO COGS, ending inventory, and other financial statement items are summarized in Figure 3. Values and ratios using the weighted average cost method will fall between the LIFO and FIFO values and ratios, Figure 3: LIFO and FIFO Comparison—Rising Prices and Stable or Increasing Inventories LIFO resules in FIFO resi higher COGS lower COGS lower taxes higher caxes lower net income (EBT and EAT) _ higher net income (EBT and EAT) lower inventory balances higher inventory balances lower working eapital (CA~ CL) higher working capital (CA ~ higher cash flows (ess taxes paid out) _ lower cash flows (more taxes paid out) (©2009 Kaplan, Inc. Page 183‘Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories LOS 36.f Compute and describe the effects of the choice of inventory method, on profitability, liquidity, activity, and solvency ratios. A firm's choice of inventory cost flow method can have a significant impact on profitability, liquidity, activity, and solvency. Later we will discuss the adjustments necessary to compare firms with different cost fow methods. Profitability ‘As compared to FIFO, LIFO produces higher COGS in the income statement and will result in lower earnings. Any profitability measure that includes COGS will be lower under LIFO. For example, higher COGS will result in lower gross, operating, and net profic margins compared to FIFO. Liguidity As compared to FIFO, LIFO results in a lower inventory value on the balance sheet. Since inventory (a current asset) is lower under LIFO, the current ratio, a popular measure of liquidity, is also lower under LIFO than under FIFO. Working capital is lower under LIFO as wel, also because current assets are lower. The quick ratio is unaffected by the firm's inventory cost ow method since invencory is excluded from its numerator. Activity 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 prices, while inventory is valued at older, lower prices. The number of days of inventory (365 / inventory turnover) is therefore lower under LIFO compared to FIFO. = Solvency LIFO results in lower total assets compared to FIFO, since LIFO inventory is lower. Lower toral assets under LIFO result in lower stockholders’ equity (assets — liabilities) Since total assets and stockholders’ equity are lower under LIFO, the debt ratio and the debe-to-equity ratio are higher under LIFO compared to FIFO. Professor's Note: Another way of thinking about the impact of LIFO on stockholders’ equity is shat because LIFO COGS is higher, net income is lower. Lower net income will result in lower stockholders’ equity (retained earnings) compared to FIFO stockholders’ equity Page 184 (©2009 Kaplan, IncSeudy Session 9 ‘Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories LOS 36.g: Calculate adjustments to reported financial statements related to inventory assumptions to aid in comparing and evaluating companies. When prices are changing, LIFO and FIFO can result in significane differences in ending inventories and COGS, thereby making ie difficult co make comparisons across different firms. As previously discussed, there are also valuation problems with LIFO (understates inventory when prices are rising) that necessitate adjustment. Thus, for analytical and comparison purposes, itis necessary to convert the LIFO values to FIFO values. Professor's Note: Usually, it is not necessary to convert from weighted average cost to FIFO because the differences in COGS and ending inventory under these swo methods are usually immaterial The LIFO to FIFO conversion is relatively simple because a firm using LIFO is required to disclose the LIFO reserve in che footnotes. The LIFO reserve is the difference between LIFO inventory and FIFO inventory: LIFO reserve = FIFO inventory ~ LIFO inventory FIFO inventory = LIFO inventory + LIFO reserve Figare 4 illustrates that adding the LIFO reserve to the LIFO inventory yields FIFO inventory. Remember, FIFO inventory is a better representation of the economic value of inventory. Figure 4: LIFO Reserve =] Once the LIFO inventory is converted to FIFO inventory, the accounting equation (assets = liabilities + equity) will be out of balance. To make the accounting equation balance, itis necessary to adjust liabilities for the difference in taxes created by the conversion and to adjust stockholders’ equity by the LIFO reserve, net of tax. The income tax adjustment is necessary because the LIFO firm pays lower taxes than the FIFO firm (when prices are rising). Stated differendly, had the firm been using FEO instead of LIFO, income taxes would have been higher. So, upon conversion, we include the taxes. FIFO. INVENTORY For example, say the LIFO reserve is $150 and the tax rate is 40%. To convert the balance sheet to FIFO, increase assets (inventory) by the $150 LIFO reserve. Jn addition, increase liabilities (caxes) by $60 ($150 LIPO reserve x 40% tax rate) and increase stockholders’ equity (retained earnings) by $90 [$150 reserve x (1 ~ 40% tax rate)]. This will bring the accounting equation back into balance. ©2009 Kaplan, Ine. Page 185Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories Page 186 For comparison purposes it is also necessary to convert the LIFO fiem’s COGS to FIFO COGS. The difference between LIFO COGS and FIFO COGS is equal to the change in. the LIFO reserve. So, to convert COGS from LIFO to FIFO, simply subtract the change in the LIFO reserve: FIFO COGS = LIFO COGS- (ending LIFO reserve beginning LIFO reserve) When prices are rising, FIFO COGS is lower than LIFO COGS, so subtracting the change in the LIFO reserve (the difference in COGS under the two methods) 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 resule in higher COGS. When prices are falling, FIFO COGS are greater than LIFO COGS. Professors Note: Idealy, we would prefer to convert from FIFO COGS to LIFO COGS for analytical purposes. LIFO COGS is a better representation of economic costs since itis based on the most recent purchases. However, the FIFO to LIFO conversion of COGS is beyond the scope of this topic review. ‘Example: Converting ending inventory and COGS from LIFO to FIFO Sipowitz Company, which uses LIFO, reported end-of-year inventory balances of $500 in 20X5 and $700 in 20X6. The LIFO reserve was $200 for 20X5 and $300 for 20X6. COGS duting 20X6 was $3,000. Convert 20X6 ending inventory and COGS 10:2 FIFO basis. + $3,000-- ($300 ~ $200) = $2,900 We are now ready to use the results from the conversion of LIFO to FIFO for analytical purposes. Ler's take a look at a more comprehensive example. Example: Converting from LIFO to FIFO Sample balance sheets for 20X5 and 20X6 and an iricoine statement for 20X6 are shown below. The sample balance sheets and income statement were prepared using the LIFO inventory cost How method. Calculate the current ratio, inventory turnover, long-term debt-to-equity ratio, and operating profit margin for 20X6 for LIFO and FIFO inventory valuation’methods. (©2009 Kaplan, IncStudy Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories Sample Balance Sheet Year 20X6___20X5 Assets Cash $105 $95 Receivables 205 195 Inventories 310 290 Total current assers 620 580 Gross property, plant, and equipment "$1,800 $1,700 Accumulaced depreciation 360 340 Net property, plant, and equipment _1,440___1,360 Total assets $2,060 $1,940 Liabilities and equity Payables $110) $90 Short-cerm debe 160 140 Current portion of long-term debe 55 45 Current liabilities $325 $275 Long-term debt $610 $690 Deferred taxes 105 95 ‘Common stock 300 300 ‘Additional paid in capical 400 400 Retained earnings 320 180 ‘Common shareholders equity 1,020 880 Total liabilities and equity $2,060 $1,940 Sample Income Stavement Year Sales Cost of goods sold Gross profit S100 Operating expenses 650 Operating profit 350 Incerest expense 50 Earnings before taxes 300 Taxes 100 Net income 200 Common dividends "$60, Footnote: The company uses the LIFO inventory cost flow assumption to account for inventories. As compared to FIFO, inventories would have been $100 higher in 20X6 and $90 higher in 20X5. ©2009 Kaplan, Inc, Page 187,Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 Inventories Page 188 Answer: ‘The firm's effective tax rate is necessary for several of the adjustments. The tax rate can, be derived from the income statement by dividing tax expense by earnings before tax. ‘The tax rate is $100 / $300 = 33%. Current Ratio ‘The current ratio (current assets / current liabilities) under LIFO is $620 / $325 = 1.9. To convert to FIFO, the 20X6 LIFO reserve of $100 is added to current assets, and taxes on the LIFO reserve ($100 LIFO reserve x 33% tax rate = $33) are added to current liabilities. Thus, under FIFO, the current ratio is ($620 + $100 LIFO reserve) 1'($325 + $33 tax liability) = 2.0. The current ratio is higher under FIFO as ending inventory now approximates replacement cost. Inventory Turnover The inventory turnover ratio (COGS / average inventory) for 20X6 under LIFO is {$3,000 / $300 = 10.0. To convert to FIFO COGS, it is necessary to subtract the change in the LIFO reserve from LIFO COGS. The change in the LIFO reserve is $100 ending reserve ~ $90, beginning reserve = $10. Also, the average LIFO reserve is added to average LIFO inventory: ($90 beginning reserve + $100 ending reserve) / 2 = $95. Alternatively, we can calculate average FIFO inventory by averaging the beginning and ending FIFO inventory: ($290 beginning LIFO inventory + $90 beginning LIFO reserve + $310 ending LIFO inventory + $100 ending LIFO reserve) / 2 = $395. ‘Thus, under FIFO, inventory turnover is ($3,000 ~ $10 change in LIFO reserve) / ($300 + $95 average LIFO reserve) = 7.6. Inventory turnover is lower under FIFO due to higher average inventory in the denominator and lower COGS in the numerator (assuming rising prices). Long-Term Debt to Equity ‘The long-term debt to equity ratio (long-term debt / stockholders’ equity) under LIFO is ($610 + $105) / $1,020 = 0.70. To convert to FIFO, the 20X6 LIFO reserve, net of tax, is added to stockholders’ equity: $100 x (1 - 3384) = $67. The adjustment to stockholders’ equity is necessary to make the accounting equation balance. The 20X6 LIFO reserve of $100 was added to total assets and $33 of taxes was added to current liabilities, so $67 is added to stockholders’ equity. Thus, under FIFO, long-term debt to equity is ($610 + $105) / ($1,020 + $67 ending LIFO reserve, net of tax) = 0.66. Long-term debt-to-equity is lower under FIFO (assuming rising prices) because stockholders’ equity is higher, since ic reflects the effects of bringing the LIFO reserve onto the balance sheet. ©2009 Kaplan, Inc.Study Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 - Inventories Professor's Note: In this example we treated deferred taxes as part of debt, The Se treatment of deferred taxes when calculating ratios varies among analysts, as twe will discuss in our topic review of Income Taxes. Operating Profit Margin ‘The operating profit margin (operating profit / revenue) under LIFO is $350 / $4,000 = 8.8%. “To convert to FIFO operating profit margin, the analyst should subtract the $10 change in the LIFO reserve from LIFO COGS to get FIFO COGS. Decreasing COGS by $10 increases operating profit by $10. Thus, under FIFO, operating profit margin is ($350 + $10 change in LIFO reserve) / $4,000 = 9.0%. The operating profit margin is greater under FIFO than under LIFO because COGS is less under FIFO than under LIFO (when prices are rising). Profesor’ Note: Had you been asked to adjust net profit margin, it would have been necessary to increase taxes by $3.30 ($10 change in reserve x 33% tax rate), Then, FIFO net income would have been greater than LIFO net income by $6.70 [$10 change in reserve x (1 - 33% tax rate)}. LOS 36.h: Discuss the reasons that a LIFO reserve might rise or decline during a given period and discuss the implications for financial analysis. Recall that the LIFO reserve is equal to the difference between LIFO inventory and FIFO inventory. The LIFO reserve will increase each period when prices are rising and inventory quantities are stable or increasing. Ifthe firm is liquidating its inventory, or if peices are falling, the LIFO reserve will decline. A LIFO liquidation occurs when a LIFO firm's inventory quantities are declining. In this situation, the older, lower costs are now included in COGS. The result is higher profit margins and higher income taxes. Note, however, that the higher profit is artificial (phantom) because it is not sustainable. The firm cannot liquidate its inventory indefinitely, because it will eventually run out of goods to sell. You can think of a LIFO liquidation as recognizing previously unrecognized gains in inventory value in operating Obviously, firms can increase earnings by simply liquidating the older, lower cost inventory rather than purchasing new inventory. However, LIFO liquidations can also result from sitikes, recessions, or declining demand from customers. If che firm classifies its inventories into narrow categories such as specific products, LIFO liquidations within some of these categories are more likely to oceus. Firms can reduce the likelihood of LIFO liquidations and phantom profits by pooling inventory into broader categories for financial reporting. Within a pool, a decrease in the inventory of one item can be offset by increases in inventories of other items. ©2009 Kaplan, Ine. Page 189Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories Page 190 The analyst should adjust COGS for the decline in the LIFO reserve caused by a decline in inventory. Firms must disclose a LIFO liquidation in the financial statement footnotes to facilitate the adjustment, Example: LIFO liquidation At the beginning of 20X8, Big 4 Manufacturing Company had 560 units of inventory as follows: Year Purchased Number of Units Cost Per Unit___Toal 20X4 120 $10 $1,200 20K5 40 0 11540 206 M40 2 1.680 20X7 160 13, 2,080 6085 500 Due to a strike, no units were produced during 20X8. During 20X8, Big 4 sold 440 units. Absent the strike, Big 4 would have had a cost of $14 for each unit produced. Compute the artificial (phantom) profit thar resulted from the liquidation of inventory. Answer: Because of the LIFO liquidation, actual COGS was $5,300 as follows: Unin Cast Beginning Inventory $60—_‘$6,500 + Purchases a. o- ~ Ending Inventory 220-1200 ($10 « 120 uni) = COGS (Actual) 440 $5300 Had Big 4 replaced the 440 units sold, COGS would have been $6,160 as follows: Units Got : as 6,160 ($14 x 440 unies) = Ending Inventory 6,500 = COGS (IF replaced) $6,160 Due to the LIFO liquidation, COGS was lower by $860 (86,160 — $5,300); thus, pretax profit was higher by $860. The higher profit is unsustainable because Big 4 will eventually run ou of inventory. Falling prices. If prices are falling, the value of inventory under FIFO is lower compared to LIFO inventory since che most recent costs are lower than the costs of goods purchased earlier. In this case, FIFO still provides the more accurate estimate of the economic value of inventory. COGS under FIFO is higher than COGS under LIFO since the earlier, higher-cost purchases are reflected in FIFO COGS. ©2009 Kaplan, Ine,Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories K LOS 36.2 Costs included in inventory on the balance sheet include purchase cost, conversion cost, allocation of fixed production overhead based on normal capacity levels, and other costs necessary to bring the inventory to its present location and condition. All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or co ending inventory Period costs, such as unallocated overhead, abaormal waste, most storage costs, administrative costs, and selling costs, are expensed LOS 36.b Under IFRS, inventories are valued at the lower of cost or net realizable value, Inventory “write-up” is allowed, but only to the extent chat a previous writedown to net realizable value was recorded. Under U.S. GAAP, inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but cannot exceed net realizable value or be less than net realizable value minus a normal profit margin. No subsequent “write-up” is allowed. LOS 36. Inventory cost flow methods: + FIEO—The cost of the first item purchased is the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases, chereby approximating replacement cost. + LIEO—The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. When prices are rising, ending inventory is smaller and COGS is larger compared co those calculated using FIFO. Higher COGS results in lower taxes and, thus, higher cash flow. LIFO is prohibited under IFR: + Weighted average cost LIFO values. + Specific identification—Each item of inventory is valued at cost, and that is the cost when chat specific item is sold COGS and inventory values are between their FIFO and ‘When prices are stable, the cost flow assumption has no effect on ending inventory. ‘When prices are rising, COGS is greater under LIFO than under FIFO and ending inventory is les. Under the average cost method, COGS and ending inventory are beeween thei FIFO and LIFO values. LOS 36.4 Inventory ratios can be used to evaluate inventory management and should be viewed relative to industry norms. These inventory ratios are affected by the choice of inventory cost flow method (FIFO, LIFO, weighted average). High turnover (low days in invencory) is preferred, but if inventory turnover is too high, sales may be lost because inventory is too low. Low curnover (high days in inventory) may indicate inventory is too high and may be a sign of obsolescence and potential writedowns in future periods (©2009 Kaplan, Ine. Page 191Study Session 9 Cross-Reference to CEA Institute Assigned Reading #36 ~ Inventories Page 192, LOS 36, "When prices are rising and inventory quantities are stable or increasing: LIEO results in: FIFO results in higher COGS lower COGS lower taxes higher taxes lower net income higher net income lower inventory balances higher inventory balances higher cash lows {less taxes paid out) lower cash flows (more taxes paid our) The weighted average cost method results in values between those of LIFO and FIFO. LOS 36. When prices are rising and inventory quantities are stable or increasing: LIEO results in: PLEO results in: lower net and gross margins higher net and gross margins lower current ratio higher current ratio higher inventory turnover lower inventory turnover higher D/A and D/E lower D/A and DIE The weighted average cost method results in values between those of LIFO and FIFO. LOS 36.g For analytical and comparison purposes, LIFO inventory should be converted to FIFO inventory by adding the LIFO reserve to current assets, adding income taxes on the LIFO reserve to current liabilities, and adding the LIFO reserve, net of tax, to stockholders’ equity, so that the accounting equation balances. LIFO COGS can. be converted to FIFO COGS by subtracting che change in the LIFO reserve over the period. LOS 36.h The LIFO reserve can decline because of either a LIFO liquidation or falling prices. ALLIFO liquidation (inventory quantity decreases) will result in lower COGS and an increase in profit as older, lower-cost inventory is (assumed co be) sold. However, the increase in profit is artificial (phantom) because it is not sustainable once the current inventory is depleted. Whea prices are decreasing, inventory value is higher under LIFO than under FIFO, so the LIFO reserve declines. ©2009 Kaplan, Inc.Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories 6 Which of the following is most likely included in a firm's ending inventory? A. Storage costs of finished goods. B, Fixed production overhead. C. Selling and administrative costs ‘Which of the following statements best describes the treatment of inventory on the balance sheet? A. Inventory is carried at the lower of cost or net realizable value under IFRS and the lower of cost or market under U.S. GAAP. B. Once an inventory writedown occurs, a subsequent recovery in value is recognized under U.S. GAAP but is not recognized under IFRS. C. The carrying value of inventory can never exceed original cost under IFRS or US. GAAP. Kamp. Inc. sells specialized bicycle shoes. At year-end, due to a sudden increase in manufacturing costs, the replacement cost per pair of shoes is $55. ‘The historical cose is $43, and the current selling price is $50. The normal profit margin is 10% of che selling price, and the selling costs are $3 pez pair. According to U.S. GAAP, which of the following amounts should eack pair of shoes be recorded on Kamp's year-end halance sheet? A. $42 B. $43. c. $47. From an analyst's perspective, inventory balances based on: A. LIFO are preferable since they reflect historical cost. B. FIFO are preferable since they reflect current cost. C. weighted averages are preferable since they reflect normal results. During periods of rising prices and stable or increasing inventory levels: ‘A. LIFO COGS > weighted average COG: 3S. B. LIFO COGS < weighted average COGS < FIFO COGS, C. LIFO COGS « weighted average COGS « FIFO COGS, During periods of falling prices: A. LIFO income > weighted average income > FIFO income. B. LIFO income < weighted average income < FIFO income, C. LIFO income = weighted average income = FIFO income. In periods of rising prices and stable or increasing inventory quantities, LIFO (as compared to FIFO) results in ‘A. lower COGS, higher taxes, lower inventory, and lower cash flows. B. lower COGS, higher taxes, lower inventory, and higher cash flows, C. higher COGS, lower taxes, lower inventory, and higher cash flows. ©2009 Kaplan, Inc Page 193,Study Session 9 (Cross-Reference to CFA Institute Assigned Reading #36 ~ Inventories 8. 10. 12, Page 194 In periods of falling prices, compared to using LIFO, firms using FIFO will report: A. higher earnings. B. lower earnings C. identical earnings. If prices are rising and swo firms are identical except for inventory methods, the firm using FIFO will have: ‘A. higher net income. B. lower inventory. C. higher roral cash low. In periods of rising prices and stable or increasing inventory levels, compared to FIFO accounting for inventories, LIFO accounting will give: A. lower profitability ratios B. higher inventory values. C. a higher current ratio All else equal, in periods of rising prices and inventory levels, which of the following statements is most accurate? A. FIFO firms have higher debe-ro-equity ratios chan otherwise identical LIFO firms. B. LIFO fisms have higher gross profic margins than otherwise identical FIFO firms. C. FIFO firms will have greater stockholders’ equity than otherwise identical LIFO firms. ‘A firm uses LIFO for inventory accounting and reports the following + CcoGs $125,000 + Beginning inventory $25,000 + Ending inventory $27,000 Footnotes «0 the financial statements reveal a beginning LIFO reserve of $12,000 and an ending LIFO reserve of $15,000, COGS on a FIFO basis is: A. $122,000. B. $125,000 C. $128,000. ‘A firm's financial statements are prepared using LIFO. Ignoring income taxes, which of the following accounts should an analyst mose likely adjust before compating this fiem’s financial statement ratios to those of a firm that uses FIFO? A. Stockholders’ equity. B. Accounts receivable, C. Long-term debr. ALIFO liquidation will most likely resule in an increase in: |A. gross profit margin. B. inventory C. accounts payable. ©2009 Kaplan, Ine,Study Session 9 Cross-Reference ro CFA Institute Assigned Reading #36 - Inventories 15. Assuming no LIFO liquidation, a LIFO firm reports higher net income than an otherwise identical FIFO firm. Prices must be: A steady. B. rising, C. falling. 1 AA firm with a beginning inventory of zero made the following purchases and sales: Quarter Purchases Sales Q 40 units at $3013 units ac $35 @ 20 units at $40 35 units ar $45 @ 90 units ac $50 60 units at $60 A. Calculate the firms inventory value at the end of the period using the FIFO, LIFO, and weighted average inventory cost low assumptions. B. Calculate the firm’s gross profit at the end of the period using FIFO, LIFO, and weighted average inventory cost flow assumptions. 2. Acompany’s LIFO reserve is $50,000 at the beginning of a period and $60,000 at the end of the period. The firm’s tax rate is 40%. What adjustments, if any, should an analyse make to the company’s financial statements to: A. adjust end-of-period LIFO inventory to FIFO inventory? B. calculate the debt-to-equity ratio on a FIFO basis? C. adjust end-of-period accounts payable from a LIFO basis to a FIFO basis? D. adjust COGS from a LIFO basis to a FIFO basis? (©2009 Kaplan, Inc Page 195‘Study Session 9 Cross-Reference to CEA Institute Assigned Reading #36 — Inventories 1. B_ Aportion of fixed production overhead based on normal capacity is capitalized ssinventory. Storage costs nor related to the production process, and selling and administrative costs, are expensed as incureed 2. A- Inventory is reported at the lower of cost or net realizable value under IFRS and the lower of cost of marker under U.S. GAAP. In some cases, inventories can be cartied at an amoune chat is greater than cost (eg., precious metals, agriculrural and forest produces) 3. B_ Marker is equal co the replacemene cost subject fo replacement cost being wishin a specific range. The upper bound is net realizable value (NRV}, which i equal (0 selling price ($50) les selling costs ($3) for an NRV of $47. The lower bound is NRV (847) less normal profit (10% of selling price = $5) fora net amount of $42. Since replacement cost ($55) is greater than NRV ($47), market equals NRV ($47). Additionally, we have «0 use the lower of cose ($43) or market ($47) principle, so the shoes should be recorded at the cost of $43, 4. B_ Under FIFO, older inventory is assumed co be sold frst, so current inventory cost isa bercer indication of inventory replacement cast. 5. A. Weighted average COGS will always be berween FIFO and LIFO whether prices are rising or falling. Ifprices are rising, LIFO COGS will be the highest because the most recent production costs are included in COGS. 6. A LIFO COGS will be the lowest of the thrce methods when prices are falling. That means LIEO income will be che highest 7. C With rising prices, LIFO results in higher COGS. Higher COGS means lower income, lower income means lower taxes, std lower taxes mean higher cash flow. 8, B_ Filling prices for a firm using FIFO mean older, more expensive goods are going to ‘COGS, thus lowering ner income compared to LIFO. 9. A. Firms using FIFO will have lower COGS, which means they will have higher net income when compared co a firm using LIFO when prices are rising, 10, A Wich cising prices, LIFO wil resule in higher COGS. Higher COGS will esule in lower profiabilty as compared to FIFO. Inventory values, and thetefore the curzent ratio, ace lower using LIFO than using FIFO. 11, C All else equal, the FIFO firm has a higher level of assets due to higher inventory. Since liabilities are assumed so be equal, the FIFO firm muse have higher equity co finance those asexs 12. A FIFO COGS « LIFO COGS ~ (ending LIFO reserve ~ beginning LIFO reserve) = $125,000 ~ ($15,000 ~ $12,000) = $122,000. 13. A__Restaring LIFO inventory on a FIFO basis would increase inventory and therefore asses, which means equity would need to increase to keep the accounting equation in balance 14. A COGS per unit decline and profit margins increase. 15. CIF the LIFO firm is reporting higher net income, prices must be falling. Page 196 (©2009 Kaplan, Inc1 A Study Session 9 Cross-Reference to CFA Institute Assigned Reading #36 — Inventories COMPREHENSIVE PROBLE 108 units were sold (13 + 35 + 60), and 150 units were available for sale (beginning inventory of 0 plus purchases of 40 + 20 + 90), so there are 150 ~ 108 = 42 unies in ending inventory. Under FIFO, 42 units from the last purchase would remain in inventory: 42 x $50 = $2,100, ‘Under LIFO, the frst 42 units purchased would remain in inventory: (40 « $30) + (2 x $40) = $1,280. The average cost of inventory is [(40 x $30) + (20 x $40) + (90 x $50)] / (40 + 20 + 90) += $43.33. Invemory value under the weighted average cost method is $43.33 = 42 units = $1,820. Revenue = (13 « $35) + (35 x $45) + (60 x $60) = $5,630. Purchases = (40 x $30) + (20 x $40) + (90 « $50) = $6,500. Under LIFO, COGS = purchases + beginning inventory ~ ending inventory = 6,500 + 0 ~ 1,280 = $5,220 Gross profic = $5,630 ~ $5,220 = 410. Under FIFO: COGS = purchases + beginning inventory ~ ending inventory = 6,500 + 0~ 2,100 = $4,400. Gross profit = $5,630 ~ $4,400 1,230. Under weighted average cost: COGS = 43.33 x 108 = 4,680, Gross profit = $5,630 ~ $4,680 = $950. To adjust end-of-period LIFO inventory to FIFO inventory, the analyst should add the LIFO reserve of $60,000 to LIFO inventory Retained earnings must be increased by the LIFO reserve ner of tax, or $60,000 x (1-04) = $36,000. No adjustment is needed. Accounts payable are nor affected by inventory accounting, methods To adjust COGS from a LIFO basis to a FIFO basis, the analyst should decrease LIFO COGS by the $10,000 change in the LIFO reserve ©2009 Kaplan, Inc Page 197