Chapter 36 - Inventories

Chapter 36- Inventories

Cost of Sales (COS) in IFRS = COGS

COGS = Beginning Inventory + Purchases – Ending Inventory

Cost is the basis for most inventory valuation.

Cost of Inventories

Inventory costs are capitalized (made as assets) in the inventories account in BS. Expense recognition hence, is delayed until inventory is sold and revenue is recognized.

1. Purchase Cost (Cost of Purchase)

a. Purchase price

b. Import and tax related duties (Freight; exclude freight out to customers)

c. Transportation cost

d. Insurance during transport

e. Handling costs

f. Other costs (which results in acquisition of finished goods, material and services)

g. Reduce – Trade discounts, rebates

2. Conversion cost – Cost directly related to units produced

a. Direct labor

b. Fixed production Overhead Cost – Indirect cost of production, remains fixed regardless of volume of production

i. Depreciation

ii. Factory maintenance cost

iii. Factory management and administration

c. Variable production overhead cost – Indirect production cost, varies with volume of production

i. Indirect Labor

ii. Indirect Material

3. Other Cost (Necessary to bring the inventory to its present location and condition)

Including product related costs in inventory means they will not be recognized as an expense in IS until inventory is sold

Example – Which of the following is most likely to be included in a firm’s ending inventory?

· Storage costs of finished goods

· Variable production overhead

· Selling & administrative overhead

Answer – Storage cost is NOT related to production process. S&G costs are expensed as incurred. Variable production overhead is capitalized as a part of inventory.

Costs excluded from cost of inventories

Not all inventory costs are capitalized; some are treated as expense and recognized in IS in the period they are incurred.

1. Abnormal costs

a. Incurred due to waste of material, labor, production conversion inputs

2. Storage costs (Any)

a. Exclude only if required to be reported as part of production

3. All Administrative Overheads

4. Selling costs

Including costs in inventory will make them assets rather than expense (till the inventory is sold); hence, making the profitability go up in IS.

Inventory Valuation Methods (Inventory Cost Flow Method)

A company must use the same inventory valuation method for all items that have similar nature and use.

1. Specific Identification

a. Used for uniquely identifiable inventory. Ex – Gem Stones

b. Inventory items are NOT interchangeable

c. The method reflects actual cost incurred to purchase a particular inventory

2. FIFO

a. Oldest goods are sold first = Cost of Sales

b. Value of ending inventory = Most recent purchase price of inventory

c. When prices RISE

i. Ending inventory has high cost than COGS

ii. COGS is comparatively less, hence, profit is MORE

d. When prices FALL

i. COGS has high cost than cost of ending inventory

ii. COGS is comparatively more, hence, profit is LESS

3. Weighted Average

a. Assigns average cost to COGS (Inventory available for sales)

b. Total Cost / Total Units (Available for Sale in the accounting period)

c. The cost is always between LIFO & FIFO in rising and falling prices of inventory

4. LIFO

a. Permitted only in US GAAP; Not in IFRS

b. Newest goods are sold first = Cost of Sales

c. Oldest goods are ending inventory

d. Income Tax advantage in LIFO

i. When Prices rises – COGS (Last unit sold) is high priced – Profit is low – Tax to be paid is low (though cash flows are high as actual selling of inventory would differ from LIFO)

e. When prices FALL

i. Ending inventory has high cost than COGS

ii. COGS is comparatively less, hence, profit is MORE

f. When prices RISE

i. COGS has high cost than ending inventory

ii. COGS is comparatively more, hence, profit is LESS

5. Summary –

a. Prices RISE

i. FIFO Profit > LIFO Profit

1. Hence, FIFO Tax > LIFO Tax

2. Hence, FIFO Cash Flow < LIFO Cash Flow

ii. FIFO Current Ratio > LIFO Current Ratio

iii. FIFO Working Capital > LIFO Working Capital

b. Prices FALL

i. LIFO Profit > FIFO Profit

1. Hence, LIFO Tax > FIFO Tax

2. Hence, LIFO Cash Flow < FIFO Cash Flow

ii. LIFO Current Ratio > FIFO Current Ratio

iii. LIFO Working Capital > FIFO Working Capital

Reason for Tax and Cash Flow – Cash flow depends on actual sale but tax (or profit) will depend on what sort of method is used to report inventory cost.

Example –

Inventory	Arriving Unit	Selling Unit	Unit Cost
A	100,000	100,000	110
B	200,000	180,000	100
C	300,000	240,000	90

Cost of Sales in -

· Specific Identification = (100,000*110 + 180,000*100 + 240,000*90)

· Weighted Average = (100,000 + 180,000 + 240,000) * Wt avg unit

§ where, weighted average unit equals

§ 96.667 = (100,000*110 + 180,000*100 + 240,000*90) / (100,000 + 180,000 + 240,000)

· FIFO = (100,000*110 + 200,000*100 + 220,000*90)

· LIFO = (20,000*110 + 200,000*100 + 300,000*90)

Periodic Vs Perpetual Inventory system

Cost of Sales will differ in LIFO and Weighted average cost in both systems

Periodic inventory system –

§ Inventory value (Beginning already known, ending manually noted from warehouses) and COGS are determined at the end of accounting period.

§ No detailed records of inventory are maintained, rather, inventory acquired during the period is reported in the ‘purchase account’.

§ At the end of the period, Purchases + Beginning Inventory gives cost of goods available for sale.

§ COGS (Actual Sold goods)= Goods available for Sale – Ending Inventory

§ Company determines the quantity of inventory on hand periodically

Perpetual Inventory system – Inventory value and COGS are updated continuously

§ Changes in inventory account are updated continuously

§ Carrying amount is calculated continuously which gives cost of ending inventory after each transaction by deducting cost of inventory sold from cost of (beginning inventory + Available for sale). LIFO and weighted average will give different result compared to periodic inventory system.

§ Carrying (book) Value – The net value of asset / liability on the balance sheet

§ Purchases and Sale of goods are recorded directly in inventory as and when they occur. Hence, purchase account is not necessary.

Value of ending inventory and COGS –

· SAME – For the FIFO and Specific identification method

· DIFFERENT – For LIFO and weighted average cost method

When price rises

FIFO

§ Oldest units are sold; price of old units are less

§ COGS = Units sold at lower price

§ Ending Inventory = Current replacement cost (Market cost) of inventory; Higher price

§ More profit as COGS is less

LIFO

§ Newest units are sold; price of new units are more

§ COGS = Current replacement cost (Market cost) of inventory; Higher price

§ Ending Inventory = Units held at lower price

§ Less profit as COGS is more

Which is Useful – FIFO or LIFO

Ending Inventory – Whether prices are rising or falling, FIFO provides useful measure of ending inventory (FIFO inventory is made up of most recent purchases).

COGS – LIFO COGS is based on most recent purchases, LIFO gives a better approximation of current cost in Income Statement.

Measurement of Inventory value

IFRS – Inventories are reported on the Balance sheet at the lower of cost (book Value / BS value of inventory, price at which inventory was bought) and net realizable value (price market is now willing to pay for inventory less cost in getting the inventory ready for sale; Expected Sales price – Selling Cost & Completion Cost)

If Net Realizable Value (NRV) < Balance Sheet value of inventory;

· Inventory is written down to NRV

· Loss is recognized in Income Statement

When value recovers,

· Inventory is written up

· Gain is recognized by increasing NRV - by bringing down the Selling cost & completion cost (COGS) by amount of recovery.

Written down and subsequent written up are accomplished through use of ‘Valuation allowance account’ (Contra account)

Question - Why inventory can’t be written up by more than it was previously written down?

Answer – Even if written up (recovery in inventory value) is more than written down (earlier loss in inventory value) value; it means Net Realizable value is now greater than BS value. But inventory is measured at lower value, which will be balance sheet value. Hence, the written up value only has significance till NRV is lower than BS value. As the NRV reaches BS value (which means written up value = written down value), the Balance sheet value takes over as Inventory value. Any further increase in NRV (by more written up), is not going to affect the Inventory value as Inventory value will be equal to the BS value.

US GAAP – inventory is reported on BS lower of cost (Balance sheet value) or market.

Market is least of (replacement cost) or (NRV – Normal profit margin)

If Cost > Market,

· Inventory written down in BS

· Loss is recognized in IS

If recovery is there,

· No written-up is allowed under US GAAP

· More conservative than IFRS

Example – Estimate the write down in both IFRS and US GAAP

Original Cost	$ 210
Estimated Selling Price	$ 225
Estimated Selling Cost (Cost incurred to bring the material in selling condition)	$ 22
NRV	$ 203 = $ 225-$ 22
Replacement Cost	$ 197
Normal Profit Margin	$ 12

Inventory Value in IFRS

· Is equal to NRV = $ 203

· Loss = $ 203 - $ 210 = $ 7

Inventory Value in US GAAP

· Is equal to $ 191

· Lower of Replacement Cost = $ 197 or NRV – Normal Profit margin = $ 203 - $ 12 = $ 191

Question – What happens if after above write down, NRV and replacement cost both increase by $ 10?

Answer – Under US GAAP, No Changes

Under IFRS,

· New NRV = $ 213

· Book Value / Original Cost = $ 210

· Inventory Value (Lower of BV or NRV)= $ 210

Question – Given, Replacement Cost = $ 55; Original Cost = $ 43; Current SP = $ 50; Normal Profit Margin = $ 10% of SP; Selling Cost = $ 3. Under US GAAP, find inventory value reported?

Answer –

· Lower of Replacement Cost or (NRV – Normal Profit Margin)

· Replacement Cost = $ 55

· NRV = Estimated SP – Estimated Selling Cost = $ (50 – 3) = $ 47

· NRV – Normal Profit Margin = $ (47 – 10%*50) = $ 42

Hence, answer is $ 42

LIFO Firms are LESS likely to recognize inventory write downs than the firms using FIFO or Weighted Average cost.

Reason – Inventory left with LIFO is old and in case of inflation, is less than current market price. Hence, even if write down is there in current market price, it won’t bring the price down below the old price, of which inventory is left. Hence, price write down has NO effect on LIFO inventory.

Exception

In certain industries, reporting of inventory above its historical cost (BV) is permitted under IFRS and US GAAP (Under normal circumstances, it is the LOWER value)

· Inventory is reported as NRV (& not BV).

· Any Gains or Loss because of changing market scenario, is recorded in Income Statement.

Producers and Dealers of commodity products like

· Agriculture and forest products

· Mineral Ores

· Precious Metals

Inventory Disclosures in FS

· Inventory valuation method used– LIFO, FIFO

· Total Carrying value of inventory (Raw Material, WIP, Finished Goods)

· Cost of inventory recognized as expense

· Amount of inventory write down

· Reversal of inventory write downs

· Carrying value of inventory pledged as collateral

· Carrying value of inventory reported at (Fair value – Selling cost)

When a firm wants to change inventory valuation method

· Under IFRS and US GAAP

§ Rare occasion

§ Changes are made retrospectively – prior financial statements (1-2 years old) are recast based on new valuation method

§ Cumulative effect of change is reported as an adjustment to the beginning retained earnings of the earliest year presented

· IFRS – Firm must demonstrate that change will provide more reliable or relevant information.

· US GAAP – Firm must explain why the change in valuation method is preferable / superior to the old method. Permission of IRS (Internal Revenue Service) is required.

· Exception to retrospective application –

§ When a firm changes to LIFO.

§ Changes are applied prospectively; no adjustments are made to the prior periods

§ Carrying value of inventory (old method) = First layer of inventory in LIFO

Effect on Ratios on inventory valuation when prices are rising

		LIFO
Profitability		Higher COGS - Lower Gross Profit - Operating Profit - Net Profit Margin
Liquidity	Current Ratio	Lower Inventory Value on BS - CA is low - CR is low - WC is low - Quick ratio remains unaffected (Inventory is not present in quick ratio)
Activity	Inventory Turnover ratio = (COGS / Average Inventory) …. Number of times inventory is sold in the year…. Lower is investment on carrying same inventory Inventory Days= (365/ITR) …. Days spent between inventory purchase and its sale	Inventory Turnover Ratio - High (COGS is high & Inventory value on hand is low) Inventory Days -Low
Solvency	Debt Ratio (DR) Debt to Equity Ratio (DER)	Low Inventory, Low CA, Low Equity (A-L; L being fixed); High DR and DER COGS is high; Profit is low; Retained earnings is low; Equity is low

Inventory Turnover (IT)

How quickly the firm is selling its inventory

Too Low Inventory Turnover

· Slow Selling

· Obsolete product

· High inventory on hand

§ Costly – Storage cost, insurance, inventory taxes

§ Cash is tied up which could have been used elsewhere

Too High Inventory Turnover

· Shortage of inventory

· Inventory write down might have occurred

· High IT with small sales growth – Shortage of inventory – Company may be losing Sales

Gross Profit Margin (GPM)

§ Gross Profit / Revenue = (Revenue – COGS) / Revenue

§ Low in highly competitive industry

§ High GPM = Product might be luxury product

ü Luxury product = Low inventory turnover ratio