CFA Level 1 (2009) - 3

Stud y Session ')

Cross-Reference to CFA Institute Assigned Reading 1135 - Invelllories

Projitfzbi!ity

As COll1f)alTd to FIFO, UFO [)J'oduces higher COCS in the income statcmelH and will result in lower earnings. Any profltability llle;mIre that iucludes coes will be lower ul\(kr UFO. For <:xamplc, higher coes will r<:stilt ill lower gross, opn;llillg, and net pro/it margins coml1ar<:d to FIFO.

Liquidity

As cOlllpared to FIFO, LIFO results in a lower invenrnry value on the halance shl'Cl. Since inventory (a currcl1l asser) is lower under UFO, the L'urrenr ratio, a popular measure of liquidity, is also lower under LIFO rhall under HH). Working capital is lower under LIFO as well, also because current assets are lower.

The quick Lllio is llnafTeC!ed by the firm's inventory COSt flow Illethod sincc invcntory is excluded from ilS nUllll'Lllor.

Inventory turnover (CUeS/average inventory) is higher for firms thar use LIFO comllared to nrms rhar usc FIFO. Uncler UFO, COGS is valued at more recenr, higher prices, while inventory is valued at older, lower prices. Number of days of inventory (3oS/inventory rurnover) is therefore lower uIlder LIFO compared to fIFO.

Solvency

LIFO resulrs in lower toral assers compared to FIFO, since LIFO inveIltory is lowel'. Lower LOta] assets under LIFO result in lower stockholders' equity (assers - liabilities). Since total assets and stockholders' equiry are lower under LIFO, rhe debr ratio and the debt-to-equity ratio are higher under LIFO compared to FIFO.

ProjCs.wl'S Note: Another way ofthin/.:ing fzbout the ilnpaC! oj'IJFO Oil stockhoLders' equity is that since LIFO COGS is higheJ; 1Iet income is Lower. Lower 1Iet income wiLL resuLt in Lower stockhoLders' equity (retained earnings) compared to fiFO stockhoLders' equity.

LOS 35.f: Calculate adjustments to reported nnanci:d statements related to inventory assumptions in order to aid in comparing and evaluating companies.

When prices are changing, LIFO and FIFO can result in significant differences in ending inventories and COGS, thereby making it difficulr to make comparisons across different firms. As pteviously discussed, there are also valuation problems with Lll;O

(understates inventory when prices are rising) that necessitate adjustment. Thus, for analytical and comparison purposes, ir is necessary to convert the UFO values to fIfO values.

Swdy Session 9

Cross-Rcference to CFA Institutc Assigned Reading #35 - Inventorics

o. --. Professor's Note: Usually, it is not neassary to (Ol/vat Fom weighted average cost to FIFO beullHe the diflere1lces ill COG,)' ami ending in'lJl'lItory under these two methods lue //Sually immaterial.

The: UFO ro HFO conversion is relatively simple be:cause a Erm using UFO is required ro disclose the LIFO rescrve: in the: foolnotes. The: UFO re:snve is the diFference he:lwecn LIFO invenrory and FIFO invcnrory:

LIFO re:serve = rlFO invenrory - LIFO invenLOry

FIFO invenrory = LIFO invenrory + LIFO reserve

Figure t\ illustrate:s that adding the UFO reservc to the LIFO inventory yields FIFO invenlory. Remember, FIFO invenrory is a bertel" represcntalion of the cconomic valuc of invenrory.

Figure 4: LIFO Reserve

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IN\TNTORY

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Once the LIFO invenrory is convened to FIFO inventory, the accounring equation (assets = liabilities + equilY) will be out of balance. To make the accounting equation balance, it is necessary to adjust liabilities for the difference in taxes Cl'eated by the conversion and to adjust stockholders' equity by the LIFO reserve, net of tax. The income tax adjustmenr is necessary because the LIFO firm pays lower taxes than the FIFO firm (when prices are rising). Stated differently, had the firm been using FIFO instead of LIFO, income taxes would have been higher. So, upon conversion, we include the taxes.

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. In addition, increase liabilities (taxes) by $60 ($150 LIFO reserve X 40% tax rate) and increase stockholders' equity (retained earnings) by $90 [$150 reserve X (l - 40% tax rate)], This will bring the accounting equation back into balance.

For comparison purposes it is also necessary to convert the LIFO firm'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

Study Session 9

Cross-Refercnce ro CFA Institutc Assigned Reading #35 - Inventorics

LIFO COCS makes intuitive sense. When prices are falling, we still subtract the Ichange in the UFO reserve to convert from LIFO COGS to I~IFO COCS. In this case, however, the change in the LIFO reserve is negative and subtracting it will result in

higher COGS. When prices arc falling, FIFO COCS are greater than LIFO COGS.

Professor's Nou: ideaLLy, we would prefer to COf/vert from FIFO COGS to

UFO COGS/or analytical purposes. UFO COGS is a better representatiof/

Id'ecof/omir costs since it is based on the most recent purchasl>s. }fowever, the

N FO to UFO 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 during 20X6 was $3,000. Convert 20X6 ending inventory and COGS to a FIFO basis.

Answer:

Inventory:

Inv r = InvL + LIFO reserve = $700 + $300 = $1,000

COGS:

COGS r = COGS L - (ending LIFO reserve - beginning LIFO reserve)

= $3,000 - ($300 - $200) = $2,900

We are now ready to usc the results from the conversion of LIFO to FIFO for analytical purposes. Let's take a look at a more comprehensive example.

Example: Converting from LIFO to FIFO

Sample balance sheets for 20X5 and 20X6 and an income statement for 20X6 are shown below. The sample balance sheets and income statement were prepared using the LIFO inventory cost flow 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.

Sample Income Statement

Footnote: The company uses the LIFO inve11lory cost flow assumption to account for inventories. As compared to FIFO, inventorie~ would have been $100 higher in 20XG and $90 higher in 20X5.

Study Session ')

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

Answer:

The firm's effective tax rate is neccssary [or several o[ the adjustments. The tax rate can be derived from the income statement by dividing tax expcnse by earnings before tax. The tax rate is $100 / $300 = 33%.

em'rent 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% rax rate = $33) are added to current liabiliries. Thus, under FIFO, the current ratio is ($620 + $100 LIFO reserve) / ($325 + $33 tax liability) = 2.0. The current ratio is higher under FIFO as ending inventory now approximates replacemcnt cost.

JllllClltmy tur/lOlier

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.

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 (l - 33%) = $67; The adjustment to stockholders' equity is necessary to make the accounting equation balance. The 20X6LIFO 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 it reflects the effects of bringing the LIFO reserve onto the balance sheet.

Study Session 9

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

Operating profit margin

The operating profit margin (operating profit I revenue) under LIFO is $350 I $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. Decreasing COGS by $10 increases operating profit by $10. Thus, under FIFO, operating profit margin is ($350 + $10 change in LIFO reserve) I $4,000 = 9.0%. Operating profit margin is higher under FIFO than under LIFO because COGS is lower under FIFO than under LIFO (assuming rising prices).

Professor's 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 increased by $6.10 [$10 change in reserve 33% tax rate)}.

LOS 35.g: Discuss the reasons that a Ll FO reserve might rise or decline durilli!- 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 arc rising and inventory quantities are stable or increasing. If the firm is liquidating its inventory, or if prices 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 Income.

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 strikes, recessions, or declining demand from customers.

If the firm classifies its inventories into narrow categories such as specific products, LIFO liquidations within some of these categories are more likely to occur. 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.

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.

Study Session ')

Cross-Reference to CFA Insti[lJtc Assigned Reading #35 - Inventories

Example: LIFO liquidation

At the beginning of 20X8, Big 4 Manufacturing Company had 560 units of inventory as follows:

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 that resulted from the liquidation of 1I1ventory.

Answer:

Because of the LIFO liquidation, actual COGS was $5,300 as follows:

Had Big 4 replaced the 440 units sold, COGS would have been $6,160 as follows:

Due to the LIFO liquidation, COGS was lower by $860 ($6,160 - $5,300); thus, pretax profit was higher by $860. The higher profit is unsustainable because Big 4 will eventually run out of inventory.

Falling prices. If prices are falling, the value of inventory under FIFO is lower compared to LIFO inventory since the 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.

Sl uJy Session ')

Cl"Oss-Rcfcrcncc to CFA Institute Assigned Reading #35 - Inventories

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KEy CONCEPTS

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LOS 35.a

COSlS included in inventory on the b:.dance sheet include purchase cost, conversion cost, JllocJtion of fixed production ovcrheJd based on normal cJpacity levels, and other costs necessary to bring the inventory to its presem location and condition. All of these costs for inventory acquired or produced in the current period arc added to beginning inventory value and then allocated either ro cost of goods sold for the period or to ending inventory.

Period costs, such as unallocated overhead, abnormal waste, most storage coSts, administrative costs, and selling costs, are expensed.

LOS 35.b

Under IrRS, invcntories arl' valued at the lower of cost 01' net realizable value. Invenlory "write-up" is allowed, but only to the extent thar a previous writedown [() net rcalii.able value was n:corded.

Under U.S. GAAP, inventories are valued at the lower of cost or marker. Market is usually equal to replacemem 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 35.c

Inventory cost flow methods:

•HFO - 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, thereby approximating replacement cost.

•LIfO - 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 lower and COGS is higher compared to FIFO. Higher COGS results in lower taxes and, thus, higher cash flow. LII~O is prohibited under IfRS.

•Weighted average cost - COGS and inventory values are between their HFO and UFO values.

•Specific identification - Each item of inventory is valued at cost and that is the cost when that item is sold.

LOS 35.d

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 inventory) is preferred, but if inventory turnover is too high, sales may be lost because inventory is too low. Low turnover (high days in inventory) may indicate inventory is too high and may be a sign of obsolescence and potential writedowns in future periods.

Study Session 9

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

1.Which of the folJowing is most like~y included in a firm's ending inventory'

A.Storage costs of finished goods.

B.Fixed production overhead.

C.Selling and administrative costs.

2.Which of the following sU.temenrs best describes the treatmeIH 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. GMP but is not recognized under IfRS.

C.The carrying value of inventory can never exceed original cost under IFRS or U.S. GMP

.1. Kamjl, Inc. sells specialized bicycle shoes. At year-end, due to a sudden increase in manufacturing costs, [he replacement COSt per pair of shoes is $5'1.

The historical cost is $43, and the curreIH selling price is S50. The normal profit margin is 10% of the selling price, and the selling costs are $3 per pair. According to U.S. GAAP, which of the following amounts should each pair of shoes be recorded on Kamp's year-end balance sheet?

A.$42.

13.$43.

C.$47.

4.From an analyst's perspective, inventory balances based on:

A.LIFO are preferable since they reAen historical cost.

13.FIFO are preferable since they reAect current cost.

C.weighted averages are preferable since they reAect normal results.

5.During periods of rising prices and stable or increasing inventory levels:

A.LIFO COGS> weighted average COGS> FIFO COGS.

B.LIFO COGS < weighted average COGS < FIFO COGS,

C.LIfO COGS = weighted average COGS = FIFO COGS.

6.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.

7.In periods of rising prices and stable or increasing invenwry quantities, UFO (as compared to FIFO) results in:

A.lower COGS, higher taxes, lower invenrory, and lower cash flows.

B.lower COGS, higher taxes, lower invenrory, and higher cash flows. e. higher COGS, lower taxes, lower inventory, and higher cash flows.