CFA Level 1 (2009) - 3

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

Proji'Hor's Note: MflflY candidates find the irllJentory equation 1'(Hiest to remember in this last form. Ifyou start with beginning inventory. add the goods that Cflme in (pllrc!}(I5eJ), alld sub/mct the goods thflt WCIlt out (COG:';), the result must be ending inventory.

ins Y5_a: Fxplain IFRS anel U.S. C;\AP rules for determining invcntory cost irlllllding which costs arc capitalil_cd and mcthods of allocating UlstS bL'lwl'L'1l cost or goods sold and invcntory.

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 arc similar under IFRS and U.S. GAAP. These costs, known as "product costs," are capitalized in the "lnvenrories" account on the balance _sheet and incl L1de:

Purchase cost.

•Conversion costs.

• Allocation of f-ixed 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.

Not all inventory costs arc capitalized; some are expensed in the period incurred. These costs, known as period costs, include:

•Administrative overhead.

•Selling costs.

Example: Costs included in inventory

Vindaloo Company manufactures a single product. The following information has been taken from the company's production and cost records for last year:

Assuming no units remain unfinished at year-end, calculate the capitalized cost of one unit.

Srudy Session 9

Cross-Rcference to CFA Institute Assigncd Reading #35 -Inventories

Answer:

Capitalized inventory cost includes the conversion cost, raw materials cost, freight-in, and 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 normal production capacity last year (4,000,000 units produced / 5,000,000 units normal capacity), 80% of the fixed overhead is capitalized. The remaining 20% of fixed overhead is expensed.

Storage costs, abnormal waste, and the remaining unallocated fixed overhead are expensed in the period incurred.

LOS Yi.b: Discuss how inventories are reported in the fina!lcial statements and how the lower or cost or llc.:t reali/,able vallie is llsed and applic.:d.

Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value. Net realizable vallie 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 "wrirren down" to net realizable value and a loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be "written up" 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 net realizable value (NRV) or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRY. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin.

Professor's Note: Think oflower ofcost or market, where "market" cannot o 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 ofthe range is the normal profit margin. "Net" means net ofselling costs.

If cost exceeds market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement. If there 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.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

Example: Inventory writedown

Zoom Incorporated sells digital cameras. Per-unit cosr inFormarion pertaining [Q

Zoom's invenlOry is as follows:

What are the per-unit carrying values of Zoom's invenrory under IFRS and under U.S. GAAP?

Answer:

Under [FRS, invcnrory is reponed on the balance sheet at rhe lower of cOst or ner realizable value. Sincc original cost of $210 excccds ncr realil.<lble valuc ($225 - $22 = $203), the invenrory is wrirren down [Q rhe net realizablc valuc of $203 and a $7 loss ($203 net realizable value - $210 original cost) is reported in the income statement.

Under U.S. GAAP, inventory is reponed at the lower of cost or market. In this case, marker is equal to replaceme11l cOst of $] 97, since net realizable value of $203 is grearer than replacemenr cost, and net realizable value minus a normal profit margin ($203 - $12 = $191) is less than replaceme11l cost. Since original cost exceeds marker (replacement cost), the invenrory is written down to $197 and a $13 loss ($197 replacemenr cost - $210 original cost) is reported in the income statemenr.

Example: Inventory write-up

Assume that in the year after the writedown in the previous example, ner realizable value and replacement cost both increase by $10. What is the impact of the recovery under JFRS and under U.S. GAAP?

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 cosr.

Under U.S. GAAP, no write-up is allowed. The pet-unit carrying value will remain at $] 97. Zoom will simply recognize higher profit when the inventory is sold.

Reponing inventory above historical cost is permitted under IFRS and U.S. GAAP in certain industries. This exception applies mainly [Q producers and dealers of commoditylike products, such as agricultural and forest products, mineral ores, and precious metals. Under th is exception, inventory is reported at net real inble value and the unrealized gains and losses from changing market prices are recognized in the income statement. If an active market exists for the cornmodiry, rhe quoted market price is used to value the inventory. Otherwise, recent marker transactions are llsed.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

LOS J5.c: Computc cnding invcntory balances and cost of goods sold using thc FI H), wcightcd averagc cost, and 1.1 FO nlcthods to account for product invcntory and cxplain the relationship anlOng and the uscfnlncss of invcnlory and cosl of goods sold daul providcd by thc FIFO, wcighted avcra!-',c cost, and Ll FO methods whcn priccs arc 1) stahle, 2) dccreasing, or .')) inCl'casing.

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If lhc cost of inventory remains constant over time, dctermining the flrm's COGS and cnding inventory is simple. To compute COGS, simply multiply the number of units sold by the cost per unit. Similarly, to compute ending inventory, multiply the number of units remaining by the cost per unit.

However, it is likely [hat, ovcr lime, the cost of purchasing or producing inventory will change. As a result, firms mus[ select a cost How method to allocate inventory cost for the period to the income statemcnt (COCS) and thc balance sheet (ending inventory).

Under J FRS, the permissible cost flow mClhods are:

Specific idenli/lcation.

First-in, first-out (Fll;O).

•Weighted average cost.

The same cost flow 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 not allowed under IFRS.

Professor's Note: FIFO, LIFO and weighted average cost are sometimes referred to as "cost flow assumptions. " Since it ma)' be impractical to specifically identifJ' the ({ctual cost ofeach unit of inventory, firms make assumptions about how inventOty cos/flows through the spum.

Within the 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 unit sold is matched with the unit's actual cost. Specific identification is appropriate when inventory items are not interchangeable. It is 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 firm's normal course of business.

FIFO Method

Under the FIFO 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 be understated compared to current replacemen t cost and, as a result, earnings will be overstated.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

LIFO Method

Under the LIFO method, the item purchased most n:cenrly is assumed to be the hrst item sold. LIfO produces bener matching in the income sUtemeIH since COGS and sales revenue arc both measured using recenr prices. When prices are rising, LIFO COCS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash Row. 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 replacemelH value.

As discussed previously, LIFO is permitted under U.S. GAAP bur is not allowed under IFRS. The LIFO conformity rule of the U.S. tax code requires hrms that use LIFO for tax purposes to also usc LIFO for hnancial reponing purposes. This is one area where conformity between hnancial reporting and tax reporting standards is required.

'fhe income tax advanrages of using LIFO explain its popularity al1long U.S. hrms. Because of generally rising prices, using LIFO for tax reponing generates tJX savings since LIFO earnings Jre lower than FIFO earnings. This results in the peculiar situation where lower report('d income is associated with higher cash flow ftom 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 invenrory, the average cost per unit is multiplied by the number of units that remall1.

When prices arc 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

Let's look at an example of how to calculate COGS and ending inventory using the

FIFO, LIFO, and average cost inventory valuation methods.

S[lIdy Session ')

Cross-Reference to CFA Institute Assigned Rcading #35 - Invcntorics

Example: Inventory Cost Flow Methods

Usc the invenrorydata 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

Answer:

Value rhe 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

LIFO cost ofgoods 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.

LIFO COGS Calculation

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

Average cost ofgoods sold. Value the seven units sold at the average unit cost of goods available.

Weighted Average COGS Calculation

Note that prices and inventory levels were rising over the period and that purchases during the period were the same For all cost Row methods.

During periods of rising prices and stable or increasing inventory quanrities, 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 arc 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 Row 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 he the eJrliest 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 reponed 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.

Study Session ')

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

Figure 2: LIFO and FIFO Diagram-Rising Prices and Growing Inventory Balances

During periods of rising prices, the LIFO assumption results in higher COGS, lower net 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 review, take the time to Look at these graphs and reLationships again to soLidifY the concepts ill your mind.

Usefulness of Inventory and Cost of Goods Sold Data Provided by the LIFO, FIFO, and Average Cost Methods

~ Proftssor's Note: The presumption in this section is that inventory quantities ~~ are stable or increasing.

During periods of stable prices, all three 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. Ir is necessary to adjust for the differences when comparing firms rhat use different cost flow methods.

Ending Inventory

When prices are trending up or down, FIFO provides the most use(ul 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.

Study Session l)

Cross-Reference to CfA Institute Assigned Reading #35 - Inventories

On thc othcr hand, LIFO inventory is madc up of outdated costs that may have no relationship to today's economic valuc. For analytical and compar:1tive purposcs, it is necessary to adjust LIFO inventory by converting it to a fiFO basis. 'I'his adjustment will be demonstrated later in this topic review.

I'roji'ssor's NOll': Remember tiM I PI FO is always pnji'/"In! jimn (l ualalla s!Jeet penpertil}e since FIFO illlJentory is based 011 t!Jt' JilOJt reallt rosts. IjFO proIJides btUer income statement illformatioll (COGS).

The lower costs associated with LIH) inventory are less likely to exceed market value, thereby making inventory writedowns less likcly under LIFO.

Cost of Goods Sold

Changing prices can also result in significant differences in COGS under UFO and FIFO. Rec:111 that LIFO coes is based on Ihe most recent purchases. As a result, whcll prices are rising, LIFO COGS will be higher than FIFO COGS, Whcn prices are falling, LIFO COGS will be lower thall 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 How method is found in the financial foornotes. This information allows the analyst to make adjustments to the financial statcments as necessary for analytical and comparative purposes.

LOS .h.d: ;, >;;,,'\1'.'; ralios tlseflll for (~Vah:alillg 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

Il1velltory turnover =

average Il1ventory

365 number of days of inventory = --------

inventory turnover

Inventory ratios should not be viewed in isolation but, rather, should be compared ro 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.

Study Session ')

Cmss-Refercnce to CFA Institute Assigned Reading #35 - InventOl·ies

High invenlOry turnover (low number of days in inventory) is usually preferred as it reduces the risk of obsolescence and minimizes carrying costS stICh as storage, insurance, and handling. However, high invelllory turnover may also be an indication of inadequate inventory levels. Too lillie invelHory may result in lost revenue whcn orders cannot be

fi lied.

High turnovcr, coupled with high or increasing revcnue growth compared to the industry, is an indication of invelllory Illanagemelll efficicncy. High rurnover and slower rcvenue growth may indicate insufficiclll inventory levels.

Inventory ratios are directly affected by the firm's choice of cost How method, as are other ratios such as the current ratio, the debt-to-equity ratio, and return on assets. When evaluating a firm's performance or when comparing the firm to industry peers, the analyst must understand the differcnccs that result from the difCercnr cost Row methods.

Professor:r Not£': C({!m!({ting ({tid intrrprl'ting the i,I1Ji'lItOl)' lum01ler rrtlio ({nd the Ilil/liber ofdays ofilllll'lItOI)' wil! be di.ruused ill the topic review 1111

Fillrltlcird Alia/pis 7;'c!miques in the next Study SI's.rioll ,/lid ({gain in thl' ,<;tudy

Session 011 COIp0rflte finanei'.

LOS .-3'5.e: Analyze the financial statements of companies lIsing different inventory accounting methods to compare and describe the effect 01' the different methods on cost of goods sold, inventory balances, and other

financial statement items; and compute and describe the effects of the choice or inventory nrethod on profitability, liquidity, activity, and solvency ratios.

~. Professor~-Note: The presumptioll ill this section is that prices are rising and ~ inllentOl) quantities are stable or increasing.

The differences among LIFO and FIFO COGS, ending inventory, and other financial statement items arc summarized in Figure 3. Values and ratios using the weighted average cost method will fall between the LIro and FIFO values and ratios.

Figure 3: LIFO and FIFO Comparison-Rising Prices and Stable or Increasing

Inventories

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 flow methods.