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2022 Curriculum CFA Program Level I Financial Reporting and Analysis

Inventories

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Introduction

Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories: raw materials, work in progress, and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements.

Inventories and cost of sales (cost of goods sold) are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time.

International Financial Reporting Standards (IFRS) permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost. US generally accepted accounting principles (US GAAP) allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last-in, first-out (LIFO). The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios.

This reading is organized as follows: Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred. Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems. Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO. Section 5 describes the financial statement effects of a change in inventory valuation method. Section 6 discusses the measurement and reporting of inventory when its value changes. Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories. A summary and practice problems conclude the reading.

Learning Outcomes

The member should be able to:

  1. distinguish between costs included in inventories and costs recognised as expenses in the period in which they are incurred;

  2. describe different inventory valuation methods (cost formulas);

  3. calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems;

  4. calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods;

  5. explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios;

  6. convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison;

  7. describe the measurement of inventory at the lower of cost and net realisable value;

  8. describe implications of valuing inventory at net realisable value for financial statements and ratios;

  9. describe the financial statement presentation of and disclosures relating to inventories;

  10. explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information;

  11. calculate and compare ratios of companies, including companies that use different inventory methods;

  12. analyze and compare the financial statements of companies, including companies that use different inventory methods.

Summary

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.

  • The allowable inventory valuation methods implicitly involve different assumptions about cost flows. The choice of inventory valuation method determines how the cost of goods available for sale during the period is allocated between inventory and cost of sales.

  • 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. US GAAP allow the three methods above plus the last-in, first-out (LIFO) method. The LIFO method is widely used in the United States for both tax and financial reporting purposes because of potential income tax savings.

  • The choice of inventory method affects the financial statements and any financial ratios that are based on them. As a consequence, the analyst must carefully consider inventory valuation method differences when evaluating a company’s performance over time or in comparison to industry data or industry competitors.

  • 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.

  • Under US GAAP, companies that use the LIFO method must disclose in their financial notes the amount of the LIFO reserve or the amount that would have been reported in inventory if the FIFO method had been used. This information can be used to adjust reported LIFO inventory and cost of goods sold balances to the FIFO method for comparison purposes.

  • LIFO liquidation occurs when the number of units in ending inventory declines from the number of units that were present at the beginning of the year. If inventory unit costs have generally risen from year to year, this will produce an inventory-related increase in gross profits.

  • Consistency of inventory costing is required under both IFRS and US GAAP. If a company changes an accounting policy, the change must be justifiable and applied retrospectively to the financial statements. An exception to the retrospective restatement is when a company reporting under US GAAP changes to the LIFO method.

  • Under IFRS, inventories are measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Under US GAAP, inventories are measured at the lower of cost, market value, or net realisable value depending upon the inventory method used. 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 US GAAP.

  • Reversals of inventory write-downs may occur under IFRS but are not allowed under US GAAP.

  • Changes in the carrying amounts within inventory classifications (such as raw materials, work-in-process, and finished goods) may provide signals about a company’s future sales and profits. Relevant information with respect to inventory management and future sales may be found in the Management Discussion and Analysis or similar items within the annual or quarterly reports, industry news and publications, and industry economic data.

  • 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.

  • Inventory management may have a substantial impact on a company’s activity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends and management’s intentions.

  • 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.