Inventories

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Topics

• Introduction
• Inventory Valuation
• The Effects of Inflation and Deflation on Inventories, Costs of Sales, and Gross Margin
• Presentation and Disclosure
  • Presentation and Disclosure
  • Inventory Ratios

Table of Contents

Introduction

Inventories are assets held by a company to produce finished goods for sale. They are shown as a current asset on the balance sheet; and can represent a significant part of the total assets for many companies.

Manufacturing and merchandising companies (Ex: Nike, Caterpillar) generate sales and profit through the sale of inventory. An important measure in calculating profits is cost of goods sold, i.e., how much cost the company incurred from procuring raw materials to converting it to a finished product, and finally selling it.

The four inventory valuation methods used by companies are:

• First In First Out (FIFO)
  • The cost of the first item purchased is assumed to be the cost of the first item sold.
  • Ending inventory is based on the cost of the most recent purchases.
• Last In First Out (LIFO)
  • The cost of the last item purchased is assumed to be the cost of the first item sold.
  • Ending inventory is based on the cost of the earliest purchases.
• Weighted Average Cost
  • Each item in the inventory is valued using an average cost of all items in the inventory.
  • COGS and inventory values are between their FIFO and LIFO values.
• Specific Identification
  • Each unit sold is matched with the unit’s actual cost.
  • This method is usually used for items that are unique in nature, for example, jewelry.
    All four methods are permitted under U.S. GAAP.

Inventory Valuation

Holding inventory for a prolonged period results in the risk of spoilage, obsolescence, or decline in prices, and the cost of inventory may not be recoverable in such circumstances.

Net realizable value: Estimated selling price under ordinary business conditions minus estimated costs necessary to get the inventory in condition for sale. NRV is from a seller’s perspective. $$\text{Net Realizable Value = Estimated Sales Price – Estimated Selling Costs }$$Market value: Current replacement cost subject to lower or upper limits. Market value has upper limit of net realizable value and lower limit of NRV less a normal profit margin. Market value is from a buyer’s perspective.

Companies that use weighted average, specific identification, and FIFO are more likely to have inventory write-downs than companies using the LIFO method.

The Effects of Inflation and Deflation on Inventories, Costs of Sales, and Gross Margin

First In, First Out (FIFO)

• Oldest goods purchased or manufactured are assumed to be sold first.
• Newest goods purchased or manufactured remain in ending inventory.
• When prices are increasing or stable, cost assigned to items in inventory is higher than the cost of items sold.

Advantage of using FIFO is that it is less subject to manipulation. The ending inventory is valued based on most recent purchases. COGS is based on earliest purchase costs. Therefore, in an inflationary environment, FIFO results in higher net income.

Weighted Average Cost

Under weighted average cost method, each item in inventory is valued using an average cost of all items in the inventory.

Last In, First Out (LIFO)

• Newest items purchased or manufactured are assumed to be sold first.
• Oldest goods purchased or manufactured remain in ending inventory.
• The cost of goods sold reflects the cost of goods purchased or manufactured recently; the value of inventory reflects the cost of older goods purchased.

Companies use LIFO during inflation to reduce taxes as cost of goods sold (COGS) is high. Under LIFO, ending inventory is valued using earliest purchase costs. Therefore, in an inflationary environment, LIFO ending inventory will be less than current costs. Also, LIFO COGS will be higher than FIFO COGS leading to a lower net income.

Calculation of Cost of Sales, Gross Profit, and Ending Inventory

Based on the inventory valuation method used by a company, the allocation of inventory costs between cost of goods sold on the income statement and inventory on the balance sheet varies in periods of changing prices.

• The total gross profit and COGS for all the periods combined is the same under each of the methods.
• As the prices of pencils were increasing, the ending inventory was highest and COGS was lowest under FIFO.
• Similarly, the ending inventory was lowest and COGS was highest under LIFO.

The Effects of Inflation and Deflation

The allocation of total cost of goods available for sale to COGS and ending inventory varies under different inventory valuation methods. The following table compares LIFO vs. FIFO for different parameters when prices are rising and inventory levels are stable.

1. FIFO is the opposite of LIFO.
2. Cash flow (after tax) is higher under LIFO as taxes paid are lower.
3. Companies following US GAAP prefer LIFO because the taxes paid are lower.
4. LIFO gives a better income statement and FIFO a better balance sheet as they reflect economic reality or recent costs.
5. Under LIFO, cost of goods sold in income statement shows the most recent costs reflecting better quality. Similarly, under FIFO ending inventory on the balance sheet shows the most recent costs, reflecting better quality.

LIFO Reserve

The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used instead.

The equation for LIFO reserve is given by: $$\text{LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value}$$

LIFO Liquidation

In periods of rising inventory, the carrying amount of inventory under FIFO will exceed the carrying amount of inventory under LIFO.

LIFO reserve may increase for two reasons:

• The number of inventory units manufactured or purchased exceeds the number of units sold.
• Increasing difference between the older costs used to value inventory under LIFO and the more recent costs used to value inventory under FIFO.

If a firm is liquidating its inventory or if the prices are declining, the LIFO reserve will decline.

When the number of units sold in a period exceeds the number of units purchased/manufactured, it is called ‘LIFO liquidation’.

In LIFO liquidation, the costs from older LIFO layers will flow to COGS and it can be used by the management to manipulate earnings and margins. The gross profits increase because the older inventory carrying amounts are used for COGS while sales are at current prices. An increase in gross profit accompanied by a decrease in LIFO reserve must be used as a warning sign.

Presentation and Disclosure

The efficiency and effectiveness of inventory management can be evaluated using the following ratios:

• Inventory Turnover
• Days of Inventory on Hand
• Gross Profit Margin

An analyst must understand that the choice of inventory valuation method can impact several financial ratios and make comparisons between two firms difficult. He needs to be particularly careful when comparing an IFRS and US GAAP firm.

Presentation and Disclosure

IFRS requires the following financial statement disclosures concerning inventory:

• The accounting policies used to measure inventory, including the cost formula.
• The total carrying amount of inventories and the carrying amount in classification (for example, merchandise, raw materials, production supplies, work in progress, and finished goods appropriate to entity).
• The carrying amount of inventories carried at fair value less costs to sell.
• The amount of inventories recognized as an expense in the period (cost of sales).
• The amount of any reversal of any write-down recognized as a reduction in cost of sales in the period.
• What led to the reversal of a write-down in the inventories?
• Carrying amount of inventories pledged as a security for liabilities.

Inventory Ratios

The choice of inventory valuation method impacts various components of the financial statements such as cost of goods sold, net income, current assets, and total assets. As a result, it affects the financial ratios containing these items.

Analysts must consider the differences in valuation methods when evaluating a company’s performance over time or in comparison to other companies.

A high inventory turnover implies that a company is utilizing inventory efficiently.

Inventory Analysis

Retailers normally report inventory in a single account. Whereas, manufacturing companies usually classify inventory into three separate accounts: raw materials, work in progress, and finished goods. These classifications can provide insights into a company’s future sales and profits.

For example, a significant increase in the raw materials or work in progress inventory may be considered as a sign of increased demand, and higher future sales and profits. On the other hand, a significant increase in the finished goods inventory may be considered as a sign of slowing demand, and lower future sales and profits.

Analysts should also compare the growth rate of finished goods inventory to the growth rate of sales. For example, if growth of inventories is greater than the growth of sales, this could indicate slowing demand.