1. Presenter’s name Presenter’s title dd Month yyyy
Chapter 9 INVENTORIES
Presenter’s name
Presenter’s title
dd Month yyyy
LEARNING OUTCOMES
Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
Describe different inventory valuation methods (cost formulas).
Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Calculate and explain effects of inflation and deflation of inventory costs on the financial statements and ratios of companies that use different inventory valuation methods (cost formulas or cost flow assumptions).
Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Describe implications of valuing inventory at net realizable value for financial statements and ratios.
Describe the financial statement presentation of and disclosures relating to inventories.
Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information.
Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.

2. costs included in inventories
Costs included in Inventories and recognized as expenses when goods are sold:
Costs of purchase, e.g.
purchase price, net of discounts
import duties and taxes
transport and handling
insurance during transport
Costs of conversion
Other costs incurred in bringing the inventories to their present location and condition
Costs excluded from Inventories and recognized as expenses in period incurred:
Abnormal costs incurred as a result of waste of materials, labor or other production conversion inputs
Storage costs (unless required as part of the production process)
All administrative overhead and selling costs
LOS. Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
Pages
Under IFRS, the costs to include in inventories are “all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.” U.S. GAAP provide a similar description of the costs to be included in inventory.
The costs of purchase include the purchase price, import and tax-related duties, transport, insurance during transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Trade discounts, rebates, and similar items reduce the price paid and the costs of purchase.
The costs of conversion include costs directly related to the units produced, such as direct labor, and fixed and variable overhead costs.
To include these product-related costs in inventory (i.e., as an asset) means that they will not be recognized as an expense (i.e., as cost of sales) on the income statement until the inventory is sold.
The following costs are excluded from inventory. They are treated as expenses and recognized on the income statement in the period in which they are incurred:
abnormal costs incurred as a result of waste of materials, labor or other production conversion inputs;
any storage costs (unless required as part of the production process); and
all administrative overhead and selling costs.
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3. costs included in inventories: example
Assume that during a year, a table manufacturing company
produced 900,000 finished tables incurring
raw material costs of €9 million,
direct labour conversion costs of €18 million, and
production overhead costs of €1.8 million.
scrapped 1,000 tables (attributable to abnormal waste) incurring
raw material costs of €10,000 and
labor and overhead conversion costs of €20,000.
spent
€1 million for freight delivery charges on raw materials and
€500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at year end.
What costs should be expensed in the period incurred?
What costs should be included in inventory and expensed when the goods are sold?
LOS. Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
Pages
Including costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Therefore, including costs in inventory that should be expensed will overstate profitability on the income statement (because of the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet.
Slide presents Example 9-1 in the text.
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4. costs included in inventories: example
Assume that during a year, a table manufacturing company
produced 900,000 finished tables incurring
raw material costs of €9 million,
direct labour conversion costs of €18 million, and
production overhead costs of €1.8 million.
scrapped 1,000 tables (attributable to abnormal waste) incurring
raw material costs of €10,000 and
labor and overhead conversion costs of €20,000.
spent
€1 million for freight delivery charges on raw materials and
€500,000 for storing the finished goods as inventory.
What costs should be expensed in the period incurred?
Total costs that should be expensed
€30,000
500,000
€530,000
LOS. Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
Pages
Including costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Therefore, including costs in inventory that should be expensed will overstate profitability on the income statement (because of the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet.
Slide presents Example 9-1 in text.
Solution to Question 1. Total costs that should be expensed (not included in inventory) are as follows:
Abnormal waste of €30,000 (raw materials of €10,000 plus labor and overhead of €20,000)
Storage of finished goods as inventory €500,000
Total = €530,000
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5. costs included in inventories: example
Assume that during a year, a table manufacturing company
produced 900,000 finished tables incurring
raw material costs of €9 million,
direct labour conversion costs of €18 million, and
production overhead costs of €1.8 million.
scrapped 1,000 tables (attributable to abnormal waste) incurring
raw material costs of €10,000 and
labor and overhead conversion costs of €20,000.
spent
€1 million for freight delivery charges on raw materials and
€500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at year end.
What costs should be included in inventory and expensed when the goods are sold?
Total inventory costs €9,000,000
18,000,000
1,800,000
1,000,000
€29,800,000
LOS. Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
Pages
Including costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Therefore, including costs in inventory that should be expensed will overstate profitability on the income statement (because of the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet.
Slide presents Example 9-1 in text.
Solution to Question 2. Total inventory costs for 2009 are as follows:
Raw materials of €9,000,000
Direct labor of €18,000,000
Production overhead of €1,800,000
Transportation for raw materials of €1,000,000
Total inventory costs = €29,800,000
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6. Inventory cost flow Beginning Inventory Ending Inventory Goods
Available
For
Sale
Goods
Purchased
Cost of
Goods Sold
LOS. Describe different inventory valuation methods (cost formulas).
Pages
This slide illustrates the cost flow of inventory for a company that purchases inventory items for resale, for example a wholesaler or retailer.
During the period in question, as the company purchases goods they are added to its beginning inventory. Beginning inventory plus purchases equals goods available for sale.
As the goods are sold and revenues are recognized, the cost of goods sold will be removed from inventory and recorded as an expense.
Any items not sold during the period remain in ending inventory.
The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales.
Balance Sheet
Income Statement
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7. Summary Table on Inventory valuation Methods
Description
Specific Identification
Actual costs of items specifically identified as sold allocated to COGS.
FIFO (First in-First out)
Assumes that earliest items purchased were sold first. First in to inventory = first out to COGS.
LIFO (Last In-First Out)*
Assumes most recent items purchased were sold first. Last in to inventory = first out to COGS.
Weighted Average Cost
Averages total costs over total units available.
LOS. Describe different inventory valuation methods (cost formulas).
Pages
The choice of the inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales.
Alternative methods of assigning inventory costs to cost of goods sold (COGS) and to ending inventory include:
Specific Identification: cost of sales and cost of ending inventory reflect the actual costs incurred to purchase (or manufacture) the items specifically identified as sold and those specifically identified as remaining in inventory.
First-In, First-Out (FIFO): assumes that the earliest goods purchased (or manufactured) are sold first and the most recent goods purchased (or manufactured) remain in ending inventory.
Last-In, First-Out (LIFO): assumes that the most recent goods purchased (or manufactured) are sold first and the oldest goods purchased (or manufactured), including beginning inventory, remain in ending inventory. In other words, the last units included in inventory are assumed to be the first units sold from inventory. LIFO is not permitted under IFRS.
Weighted Average Cost: assigns the average cost of the goods available for sale (beginning inventory plus purchase, conversion, and other costs) during the accounting period to the units that are sold as well as to the units in ending inventory. In an accounting period, the weighted average cost per unit is calculated as the total cost of the units available for sale divided by the total number of units available for sale in the period (Total cost of goods available for sale/Total units available for sale).
*LIFO not permitted under IFRS
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8. Inventory valuation Methods: Specific identification
Sales: 520 ¥240/kg
Cost of Goods Sold
Purchases
Goods Available
100 ¥110/kg
600 ¥58,000 total
100 ¥110/kg
180 ¥100/kg
240 ¥90/kg
520 ¥50,600
200 ¥100/kg
Total =
600 ¥58,000
Ending inventory (cost)
300 ¥90/kg
LOS. Describe different inventory valuation methods (cost formulas).
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Slide presents Example 9-2, beginning with specific identification.
Hypothetical distributor of consumer products, including bars of soap sold by the kilogram, began operations in The distributor
purchased and received initially 100,000 kg of soap at 110 ¥/kg, then 200,000 kg of soap at 100 ¥/kg, and finally 300,000 kg of soap at 90 ¥/kg.
sold 520,000 kg of soap at 240 ¥/kg.
stored the soap in its warehouse so that soap from each shipment received is readily identifiable. During the year, the entire 100,000 kg from the first shipment received, 180,000 kg of the second shipment received, and 240,000 kg of the final shipment received was sent to customers.
Under the specific identification method, the physical flow of the specific inventory items sold is matched to their actual cost.
Note that regardless of the segregation of inventory within the warehouse, it would be inappropriate to use specific identification for this inventory of interchangeable items.
Note that the sales amount is not affected by the choice of inventory valuation method as 520,000 × ¥240 = ¥124,800,000.
Note that COGS and inventory equal the total of goods available. Because the example is for the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ.
20 ¥100/kg
60 ¥90/kg
80 ¥7,400
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9. Inventory valuation Methods: weighted average cost
Sales: 520 ¥240/kg
Cost of Goods Sold
Purchases
Goods Available
100 ¥110/kg
600 ¥58,000 total. AVERAGE ¥96.667/kg
520 ¥96.667/kg
= ¥50,267
200 ¥100/kg
Total =
600 ¥58,000
Ending inventory (cost)
300 ¥90/kg
LOS. Describe different inventory valuation methods (cost formulas).
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Slide presents Example 9-2.
Under the weighted average cost method, costs are allocated to cost of sales and ending inventory by using a weighted average mix of the actual costs incurred for all inventory items. The weighted average cost per unit is determined by dividing the total cost of goods available for sale by the number of units available for sale.
Weighted average cost = [(100,000 × ¥110) + (200,000 × ¥100) + (300,000 × ¥90)]/600,000 = ¥/kg
Note that the sales amount is not affected by the choice of inventory valuation method. 520,000 × 240 = ¥124,800,000 .
Note that COGS and inventory equal the total of goods available. Because the example is for the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ.
80 ¥96.667/kg
= ¥7,733
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10. Inventory valuation Methods: fifo
Sales: 520 ¥240/kg
Cost of Goods Sold
Purchases
Goods Available
100 ¥110/kg
600 ¥58,000 total
100 ¥110/kg
200 ¥100/kg
220 ¥90/kg
520 ¥50,800
200 ¥100/kg
Total =
600 ¥58,000
Ending inventory (cost)
300 ¥90/kg
LOS. Describe different inventory valuation methods (cost formulas).
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Slide presents Example 9-2.
Under the FIFO method, the earliest inventory units acquired are assumed to be the first units sold. Ending inventory, therefore, is assumed to consist of those inventory units most recently acquired.
Cost of sales = (100,000 × ¥110) + (200,000 × ¥100) + (220,000 × ¥90) = ¥50,800,000. This includes all of the first two purchases and 220,000 from the third purchase.
Ending inventory = 80,000 × ¥90 = ¥7,200,000 (all from the third purchase).
Note that the sales amount is not affected by the choice of inventory valuation method. 520,000 × ¥240 = ¥124,800,000.
Note that COGS and inventory equal the total of goods available. Because the example is for the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ.
80 ¥90/kg
80 ¥7,200
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11. Inventory valuation Methods: Lifo
Sales: 520 ¥240/kg
Cost of Goods Sold
Purchases
Goods Available
100 ¥110/kg
600 ¥58,000 total
20 ¥110/kg
200 ¥100/kg
300 ¥90/kg
520 ¥49,200
200 ¥100/kg
Total =
600 ¥58,000
Ending inventory (cost)
300 ¥90/kg
LOS. Describe different inventory valuation methods (cost formulas).
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Slide presents Example 9-2.
Under the LIFO method, the most recently-acquired inventory units are assumed to be the first units sold. Ending inventory, therefore, is assumed to consist of the earliest inventory units.
Cost of sales = (20,000 × ¥110) + (200,000 × ¥100) + (300,000 × ¥90) = ¥49,200,000. This includes all of the last two purchases and 20,000 kg from the first inventory purchased.
Ending inventory = 80,000 × ¥110 = ¥8,800,000, all from the first inventory purchased.
Note that the sales amount is not affected by the choice of inventory valuation method. 520,000 × ¥240 = ¥124,800,000 .
Note that COGS and inventory equal the total of goods available. Because the example is for the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ.
80 ¥110/kg
80 ¥8,800
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12. Inventory valuation Methods: summary
Specific ID
Weighted Average Cost
FIFO
LIFO
Cost of sales
50,600
50,267
50,800
49,200
Ending inventory
7,400
7,733
7,200
8,800
Goods available for sale
58,000
Gross profit
74,200
74,533
74,000
75,600
LOS. Describe different inventory valuation methods (cost formulas).
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
The table (in thousands of yuan) summarizes Example 9-2.
Shows cost of sales, the ending inventory, cost of goods available for sale, and gross profit (sales minus COGS) for each of the four inventory valuation methods. Also shown is the gross profit figure for each of the four methods.
Note that COGS and ending inventory equal the total of goods available for sale.
Because the example is for the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ.
Because the cost of a kg of soap declined over the period, LIFO had the highest ending inventory amount, the lowest cost of sales, and the highest gross profit. FIFO had the lowest ending inventory amount, the highest cost of sales, and the lowest gross profit.
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13. periodic and perpetual inventory systems
Periodic inventory system: inventory values and costs of sales are determined at the end of an accounting period.
Purchases are recorded in a purchases account.
The total of purchases and beginning inventory is the amount of goods available for sale during the period.
The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory.
Perpetual inventory system: inventory values and cost of sales are continuously updated to reflect purchases and sales.
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Companies typically record changes to inventory using either a periodic inventory system or a perpetual inventory system.
Under a periodic inventory system, the inventory values and costs of sales are determined at the end of an accounting period. Purchases are recorded in a purchases account. The total of purchases and beginning inventory is the amount of goods available for sale during the period. The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory.
Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales.
Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. However, this is not generally true for the weighted average cost method or LIFO.
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14. periodic and perpetual inventory systems: example
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Purchased
Sold
Remaining
Units
Cost
COGS - perpetual
Jan
100
$110
Apr 80 20
= $8,800
July
200
$100
220
Nov
120
= $10,000
COGS
=$8,800+$10,000=$18,800
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. This is not generally true for the weighted average cost method or LIFO.
This example uses two purchases and two sales over an entire year to illustrate the calculation under the perpetual inventory system vs. a periodic system.
This slide shows the perpetual system. The first 80 units sold have a cost per unit of $110 (from the most recent purchase which occurred in January). The next 100 units sold have a cost per unit of $100 (from the most recent purchase which occurred in July).
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15. periodic and perpetual inventory systems: example
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Purchased
Sold
Remaining
Units
Cost
COGS -periodic
Jan
100
$110
Apr 80 20 NA
July
200
$100
220
Nov
120
Goods available
= *$ *$100 =$31,000
Ending inventory
= 100 *$ *$100
= $13,000
COGS
= $31,000 - $13,000
= $18,000
LOS. Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
Pages
Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. This is not generally true for the weighted average cost method or LIFO.
This example uses two purchases and two sales over an entire year to illustrate the calculation under perpetual inventory system vs. a periodic inventory system.
This slide shows the periodic inventory system. When the units are sold during the period, no cost of goods sold is recorded (shown here as “NA”).
At the end of the period, the ending inventory is determined and deducted from goods available.
Goods available: beginning inventory (here $0) plus purchases.
Ending inventory:
Under LIFO, the last units into inventory are the first units out to COGs, so the units remaining in inventory are from the earliest purchased. In other words, Last-in-First-Out implies First-in-Still-Here.
In this example, the goods remaining in ending inventory are assumed to be the 100 that were purchased in January at $110 each plus 20 that were purchased in July at $100 each.
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16. effects of inflation of inventory costs on the financial statements
FIFO
FIFO: Earlier, lower costs in COGS
FIFO: Later, higher costs in inventory
Costs
LOS. Calculate and explain effects of inflation and deflation of inventory costs on the financial statements and ratios of companies that use different inventory valuation methods (cost formulas or cost flow assumptions).
Pages
In an environment of rising inventory unit costs and constant or increasing inventory quantities:
Under FIFO, the earlier lower costs will be in cost of goods sold (COGS) and the later, higher costs will be in inventory.
In other words, of the total cost of goods available for sale, FIFO (compared with LIFO or weighted average cost) will allocate
a lower amount to cost of sales on the income statement. Accordingly, because cost of sales will be lower under FIFO, a company’s gross profit, operating profit, and income before taxes will be higher.
a higher amount to ending inventory on the balance sheet. Accordingly, a company would show a higher current ratio, all else equal.
Conversely, under LIFO, the earlier lower costs will be in inventory and the later, higher costs will be in COGS. In a period of rising prices, LIFO results in a higher cost of sales than FIFO (and thus a lower gross profit and operating profit).
Time
Period end
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17. Lifo reserve
LIFO reserve is the difference between inventory amount as reported using LIFO and the inventory amount that would have been reported using FIFO.
FIFO inventory value - LIFO inventory value = LIFO reserve.
Companies using the LIFO method must disclose the amount of the LIFO reserve.
An analyst can use the disclosure to adjust a company’s reported cost of goods sold and ending inventory from LIFO to FIFO.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
Recall that IFRS does not allow LIFO.
For companies using the LIFO method, U.S. GAAP requires disclosure in the notes to the financial statements or on the balance sheet, of the amount of the 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 (the FIFO inventory value less the LIFO inventory value).
An analyst can use the disclosure to adjust a company’s reported cost of goods sold and ending inventory from LIFO to FIFO. Adjusting the reported financials from LIFO to FIFO would permit comparison with another company that used FIFO.
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18. Lifo reserve example: disclosure
Inventories Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 70% of total inventories at December 31, 2008 and about 75% of total inventories at December 31, 2007 and If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,183 million, $2,617 million and $2,403 million higher than reported at December 31, 2008, 2007 and 2006, respectively. Caterpillar Inc Annual Report Note 1. D.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
Slide shows an excerpt from the Caterpillar annual report. The amount of LIFO reserve was $3,183 million at December 31, 2008.
Recall that IFRS does not allow LIFO.
For companies using the LIFO method, U.S. GAAP requires disclosure in the notes to the financial statements or on the balance sheet, of the amount of the 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 (the FIFO inventory value less the LIFO inventory value).
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19. Lifo reserve example: adjust inventory
Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,183 million, $2,617 million and $2,403 million higher than reported on December 31, 2008, 2007 and 2006, respectively.”
Caterpillar’s balance sheet shows inventories of $8,781 million, $7,204 million, and $6,351 million, at December 31, 2008, 2007, and 2006, respectively.
Adjust inventory from LIFO to FIFO by adding the amount of the LIFO reserve to the reported inventory.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages
Slide shows an excerpt from Caterpillar’s Annual report. The amount of LIFO reserve was $3,183 million, $2,617 million and $2,403 million at December 31, 2008, 2007 and 2006, respectively.
Adjusting inventory from LIFO to FIFO requires adding the amount of the LIFO reserve to the reported inventory.
With respect to the effect on ratios, the higher amount of inventories would result in a higher current ratio (all else being equal).
31 December ($ millions)
2008
2007
2006
Total inventories as reported (LIFO)
8,781
7,204
6,351
From Note 1. D disclosure (LIFO reserve)
3,183
2,617
2,403
Total inventories adjusted (FIFO)
11,964
9,821
8,754
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20. Lifo reserve example: adjust Cost of goods sold
Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,183 million, $2,617 million and $2,403 million higher than reported at December 31, 2008, 2007 and 2006, respectively.”
Caterpillar’s income statement shows Cost of Goods Sold of $38,415 million and $32,626 million for the years ending December 31, and 2007, respectively.
Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount of change in LIFO reserve.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages
Slide shows an excerpt from Caterpillar’s Annual report. The amount of LIFO reserve was $3,183 million, $2,617 million and $2,403 million at December 31, 2008, 2007 and 2006, respectively.
Adjusting cost of goods sold from LIFO to FIFO requires deducting the amount of the change in LIFO reserve.
From Exhibit 9-3, Note 1. D, the increase in LIFO reserve for 2008 is $566 million ($3,183 – $2,617) and for 2007 is $214 million ($2,617 – $2,403).
31 December ($ millions)
2008
2007
Cost of goods sold as reported (LIFO)
38,415
32,626
Less: Increase in LIFO reserve*
−566
−214
Cost of goods sold as adjusted (FIFO)
37,849
32,412
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21. Lifo reserve example: adjust net income
Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,183 million, $2,617 million and $2,403 million higher than reported at December 31, 2008, 2007 and 2006, respectively.”
Caterpillar’s income statement shows net Income of $3,557 million and $32,626 million for the years ending December 31, 2008 and 2007, respectively.
Caterpillar’s effective tax rates were approximately 20% for 2008 and 30% for and earlier.
Adjust net income from LIFO to FIFO by incorporating the adjustment in Cost of Goods Sold (COGS), on an after-tax basis.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages
Slide shows an excerpt from Caterpillar’s Annual report. The amount of LIFO reserve was $3,183 million, $2,617 million and $2,403 million at December 31, 2008, 2007 and 2006, respectively.
Adjusting the net income from LIFO to FIFO requires incorporating the adjustment in COGS on an after-tax basis. In this example, the reduction in COGS resulted in an increase in operating profit.
Caterpillar’s effective tax rates were approximately 20% for 2008, and 30% for 2007 and earlier.
The taxes on the increased operating profit are assumed to be $113 ($566 × 20%) for 2008 and $64 ($214 × 30%) for 2007.
31 December ($millions )
2008
2007
Net income as reported (LIFO)
3,557
3,541
Reduction in COGS (increase in operating profit)
566
214
Taxes on increased operating profit
−113
−64
Net income as adjusted (FIFO)
4,010
3,691
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22. Lifo reserve example: adjust liabilities and equity
Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use, inventories would have been $3,183 million, $2,617 million and $2,403 million higher than reported at December 31, 2008, 2007 and 2006, respectively.”
Caterpillar’s December 31, 2008 balance sheet shows total liabilities of $61,171 million, and total equity of $6,087 million.
Caterpillar’s effective tax rates were approximately 20% for 2008 and 30% for 2007 and earlier.
Adjust liabilities from LIFO to FIFO by incorporating a tax liability for the amount of accumulated tax savings over the years. Adjust equity by including the cumulative after-tax gross profits.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages
Slide shows an excerpt from Caterpillar’s Annual report. The amount of LIFO reserve was $3,183 million, $2,617 million and $2,403 million at December 31, 2008, 2007 and 2006, respectively.
Caterpillar’s effective tax rates were approximately 20% for 2008 and 30% for 2007 and earlier.
Adjusting liabilities from LIFO to FIFO requires adjusting liabilities to show a tax liability for the amount of accumulated tax savings over the years.
Assuming tax rates of 20% for 2008 and 30% for earlier years, the cumulative amount of income tax savings that Caterpillar has generated by using the LIFO method instead of FIFO is approximately $898 million ($566 × 20% + $2,617 × 30%). This calculation is based on the disclosed LIFO reserve of $2,617 million at the end of 2007 and an increase in the LIFO reserve of $566 million in Therefore, under the FIFO method, cumulative gross profits would have been $2,617 million higher as of the end of 2007 and an additional $566 million higher as of the end of The estimated tax savings would be higher (lower) if income tax rates were assumed to be higher (lower).
The amount that would be added to Caterpillar’s equity (retained earnings) is $2,285 million,
derived as the total increase in assets minus the increase in liabilities ($3,183 – $898), or
equivalently derived as the cumulative after-tax increase in profits ($566 × 80% + $2,617 × 70%).
The increase to equity represents the cumulative increase in profit due to the decrease in cost of goods sold (LIFO reserve of $3,183 million) less the assumed taxes on that profit ($898 million).
31 December ($millions )
2008
Liabilities as reported (LIFO)
$61,171
Accumulated deferred taxes
$898
Liabilities as adjusted (FIFO)
$62,069
31 December ($millions )
2008
Equity as reported (LIFO)
$6,087
Retained earnings
$2,285
Equity as adjusted (FIFO)
$8,372
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23. Comparative ratios
Calculate Caterpillar’s Inventory Turnover, Gross Profit margin, and Net Profit margin for 2008 under the LIFO and FIFO methods.
Caterpillar’s 2008 revenues were $48,044 million from machinery sales and $3,280 from financial products.
LIFO
FIFO
Inventory turnover
4.81
3.47
= 38,415 ÷
[(8, ,204) ÷ 2]
= 37,849 ÷
[(11, ,821) ÷ 2]
Gross profit margin
20.04%
21.22%
= [(48,044 – 38,415) ÷ 48,044]
= [(48,044 – 37,849) ÷ 48,044]
Net profit margin
6.93%
7.81%
= (3,557 ÷ 51,324)
= (4,010 ÷ 51,324]
LOS. Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages ,
Inventory turnover ratio = Cost of goods sold ÷ Average inventory
LIFO = 4.81 = 38,415 ÷ [(8, ,204) ÷ 2]
FIFO = 3.47 = 37,849 ÷ [(11, ,821) ÷ 2]
There is a higher ratio under LIFO because, given rising inventory costs, cost of goods sold will be higher and inventory carrying amounts will be lower under LIFO. Without an adjustment for the difference in inventory methods, it might appear that a company using the LIFO method manages its inventory more effectively.
Gross profit margin = Gross profit ÷ Total revenue
LIFO = percent = [(48,044 – 38,415) ÷ 48,044]
FIFO = percent = [(48,044 – 37,849) ÷ 48,044]
The company’s revenue on financial products is excluded from the calculation of gross profit. Gross profit is sales of machinery and engines less cost of goods sold. The gross profit margin is lower under LIFO because the cost of goods sold is higher given rising inventory costs.
Net profit margin = Net income ÷ Total revenue
LIFO = 6.93 percent = (3,557 ÷ 51,324)
FIFO = 7.81 percent = (4,010 ÷ 51,324]
The company appears to be less profitable under LIFO. The calculation includes total revenue (revenue from machinery sales and revenue from financial products).
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24. Comparative ratios
Calculate Caterpillar’s Current Ratio and Total liabilities-to-equity for 2008 under the LIFO and FIFO methods.
In 2008, Caterpillar reported $31,633 million current assets, $26,069 million current liabilities, 61,171 million total liabilities, and $6,087 million total equity.
LIFO
FIFO
Current ratio
1.21
1.34
= (31,633 ÷ 26,069)
= [(31, ,183) ÷ 26,069]
Total liabilities-to-equity ratio
10.05
7.41
= (61,171 ÷ 6,087)
= [(61, ) ÷ (6, ,285)]
LOS. Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.
LOS. Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
Pages ,
Current ratio = Current assets ÷ Current liabilities
LIFO = 1.21 = (31,633 ÷ 26,069)
FIFO = 1.34 = [(31, ,183) ÷ 26,069]
The current ratio is lower under LIFO primarily because of the lower inventory carrying amount. The company appears to be less liquid under LIFO.
Total liabilities-to-equity ratio = Total liabilities ÷ Total shareholders’ equity
LIFO = = (61,171 ÷ 6,087)
FIFO = 7.41 = [(61, ) ÷ (6, ,285)]
The ratio is higher under LIFO because the addition to retained earnings under FIFO reduces the ratio. The company appears to be more highly leveraged under LIFO.
In summary, the company appears to be less profitable, less liquid, and more highly leveraged under LIFO. Yet, because a company’s value is based on the present value of future cash flows, LIFO will increase the company’s value because the cash flows are higher in earlier years due to lower taxes. LIFO is primarily used for the tax benefits it provides.
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25. LIFO liquidation Inventory
Units in to inventory:
Purchase or Manufacture
Units out of inventory:
Sales
Inventory
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
When the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase as the result of the addition of new LIFO layers (the quantity of inventory units is increasing and each increase in quantity creates a new LIFO layer).
However, when the number of units sold in a period exceeds the number of units purchased or manufactured, the costs from older LIFO layers will flow to COGS (some of the older units held in inventory are assumed to have been sold), called “LIFO liquidation.”
If inventory unit costs have been rising from period to period, a LIFO liquidation will produce an inventory-related increase in gross profits because the older, lower inventory carrying amounts are used for cost of sales while sales are at current prices.
Inventory profits caused by a LIFO liquidation, however, are one-time events and are not sustainable.
LIFO liquidations can occur for a variety of reasons, for example labor strikes, economic recession or other causes of declining customer demand which may cause companies to reduce existing inventory levels. Alternatively, management can intentionally inflate their company’s reported profits by reducing inventory quantities and liquidating older layers of LIFO inventory (selling some units of beginning inventory).
When the number of inventory units manufactured or purchased in a period exceeds the number of units sold, the LIFO reserve may increase with each increase in quantity creating a new LIFO “layer.”
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26. LIFO liquidation Inventory
Units in to inventory:
Purchase or Manufacture
Units out of inventory:
Sales
Inventory
When the number of units sold in a period exceeds the number of units purchased or manufactured, the costs from older LIFO layers will flow to COGS (some of the older units held in inventory are assumed to have been sold), called “LIFO liquidation.”
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
When the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase as the result of the addition of new LIFO layers (the quantity of inventory units is increasing and each increase in quantity creates a new LIFO layer).
However, when the number of units sold in a period exceeds the number of units purchased or manufactured, the costs from older LIFO layers will flow to COGS (some of the older units held in inventory are assumed to have been sold), called “LIFO liquidation.”
If inventory unit costs have been rising from period to period, a LIFO liquidation will produce an inventory-related increase in gross profits because the older, lower inventory carrying amounts are used for cost of sales while sales are at current prices.
Inventory profits caused by a LIFO liquidation, however, are one-time events and are not sustainable.
LIFO liquidations can occur for a variety of reasons, for example labor strikes, economic recession or other causes of declining customer demand which may cause companies to reduce existing inventory levels. Alternatively, management can intentionally inflate their company’s reported profits by reducing inventory quantities and liquidating older layers of LIFO inventory (selling some units of beginning inventory).
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27. Example: LIFO layers and LIFO liquidation
Assume a three year scenario during which a company’s
cost of goods increased by $1 per unit each year from $5 to $6 to $7.
priced its goods to achieve a 50% gross profit per unit (i.e. 100% markup).
In years 1 and 2, the company buys 10,000 units but sells only 9,000 units. In year 3, the company buys 8,000 units, sells 10,000.
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
Slide presents a simple example in which a company bought more units than it sold in years 1 and 2, so we see LIFO layers created. Then in year 3, the company sold more units than it bought, causing a liquidation of the LIFO layers.
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28. Example: LIFO layers and LIFO liquidation
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
In this example, the company bought more units than it sold in years 1 and 2, so we see LIFO layers created.
The ending inventory has one layer of 1,000 from the units purchased in year 1 for $5 and another layer of 1,000 from the units purchased in year 2 for $6.
Note that this does not assume that the actual units are still in inventory, only the costs associated with the units.
The ending inventory includes a “layer” of old costs at $5 per unit x 1,000 units and another “layer” of costs at $6 per unit x 1,000.
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29. Example: LIFO layers and LIFO liquidation
Units
Cost per unit
Total costs
Beginning inventory
Units purchased
10,000 $5
$50,000
Units sold
9,000
$45,000
Ending inventory Year 1
1,000
$5,000
Beginning inventory Year 2 -
$ 5,000 $6
$60,000
$54,000
Ending inventory Year 2
2,000
$11,000
Beginning inventory Year 3
8,000 $7
$56,000
$67,000
Ending inventory Year 3
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
The inventory at the beginning of Year 3 has one layer of 1,000 from the units purchased in Year 1 for $5 and another layer of 1,000 from the units purchased in Year 2 for $6.
Note that this does not assume that the actual units are still in inventory, only that the costs associated with the units are.
In Year 3, the company sells all the units in its inventory, 8,000 of which are at $7 and the other 2,000 from the earlier years.
In Year 3, the old layers at $5 from Year 1 and $6 from Year 2 flow to cost of goods sold
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30. Example: LIFO layers and LIFO liquidation
Year
Revenue per unit
Total revenue
COGS
Gross profit
Gross margin 1
$10
$ 90,000
$ 45,000
50% 2
$12
$ 108,000
$ 54,000 3
$14
$ 140,000
$ 67,000
$ 73,000
52%
LOS. Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
Pages
The company prices its goods to achieve a 50% gross profit per unit (i.e. 100% markup).
The gross margin in Year 3 is higher because the COGS has the lower per-unit costs from the purchases in earlier years.
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31. Inventory adjustments
Inventory is measured and carried on the balance sheet at the lower of cost of market.
IFRS:
Lower of cost or net realizable value
Subsequent reversals allowed
U.S. GAAP:
Lower of cost or market, defined as current replacement cost subject to upper and lower limits
Upper limit of market: net realizable value
Lower limit of market: net realizable value less a normal profit margin
Subsequent reversals prohibited
LOS. Describe implications of valuing inventory at net realizable value for financial statements and ratios.
Pages
Under IFRS, inventories are measured (and carried on the balance sheet) at the lower of cost or net realizable value.
Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale.
Assessment of net realizable value is typically done item by item or by groups of similar or related items.
In the event that the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value and the loss (reduction in value) recognized as an expense on the income statement. This expense may be included as part of cost of sales or reported separately.
In each subsequent period, a new assessment of net realizable value is made.
Reversal (limited to the amount of the original write-down) is required for a subsequent increase in value of inventory previously written down.
The reversal of any write-down of inventories is recognized as a reduction in cost of sales (reduction in the amount of inventories recognized as an expense). Frequently, rather than writing inventory down directly, an inventory valuation allowance account is used. The allowance account is netted with the inventory accounts to arrive at the carrying amount that appears on the balance sheet.
U.S. GAAP specify the lower of cost or market to value inventories.
Unlike IFRS, U.S. GAAP prohibit the reversal of write-downs.
Market value is defined as current replacement cost subject to upper and lower limits.
Upper limit is the net realizable value (selling price less reasonably estimated costs of completion and disposal).
Lower limit is the net realizable value less a normal profit margin.
Any write-down reduces the value of the inventory, and the loss in value (expense) is generally reflected in the income statement in cost of goods sold.
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32. Inventory adjustments
The Volvo Group reported:
Total inventories (net of allowance) at year end 2008 and 2007, respectively, as reported on Balance Sheet: SEK 55,045 million and SEK 43,645 million.
Cost of sales for 2008, as reported on Income Statement: SEK 237,578
Allowance for inventory obsolescence at year end 2008 and 2007, respectively, as disclosed in footnote: SEK 3,522 million and SEK 2,837 million
Compare inventory turnover
Using numbers reported
Assuming all past inventory write downs were reversed in 2008.
LOS. Describe implications of valuing inventory at net realizable value for financial statements and ratios.
Pages
SEK (Swedish Krona).
Example follows Example 9-9, page 443, in text.
The Volvo Group (OMX Nordic Exchange: VOLV B), based in Göteborg, Sweden, is a leading supplier of commercial transport products such as construction equipment, trucks, busses, and drive systems for marine and industrial applications as well as aircraft engine components. (The Volvo line of automobiles is not under the control and management of the Volvo Group.)
Inventory Turnover = Cost of Goods Sold/Average Inventory
Days inventory held = Days in period/Inventory Turnover
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33. Inventory adjustments
The Volvo Group reported:
Total inventories (net of allowance) at year end 2008 and 2007, respectively, as reported on Balance Sheet: SEK 55,045 million and SEK 43,645 million.
Cost of sales for 2008, as reported on Income Statement: SEK 237,578
Allowance for inventory obsolescence at year end 2008 and 2007, respectively, as disclosed in footnote: SEK 3,522 million and SEK 2,837 million
Compare inventory turnover
Inventory Turnover = Cost of Goods Sold/ Average Inventory
Using numbers reported, 4.81 = 237,578 ÷ [(55, ,645) ÷ 2]
Assuming all past inventory write downs were reversed, using adjusted numbers = 4.51 = 236,893 ÷ [(58, ,482) ÷ 2]
LOS. Describe implications of valuing inventory at net realizable value for financial statements and ratios.
Pages
SEK (Swedish Krona)
Example follows Example 9-9, page 443, in text.
The Volvo Group (OMX Nordic Exchange: VOLV B), based in Göteborg, Sweden, is a leading supplier of commercial transport products such as construction equipment, trucks, busses, and drive systems for marine and industrial applications as well as aircraft engine components. (The Volvo line of automobiles is not under the control and management of the Volvo Group.)
Inventory Turnover = Cost of Goods Sold/Average Inventory
Inventory turnover ratio = Cost of sales ÷ Average inventory
With allowance (as reported) = 4.81 = 237,578 ÷ [(55, ,645) ÷ 2]
Without allowance (adjusted) = 4.51 = 236,893 ÷ [(58, ,482) ÷ 2]
Explanation: Cost of Sales is adjusted for the increase in allowance for obsolescence; for 2008, Cost of Sales is reduced by 685 (3,522 – 2,837), giving an adjusted cost of sales of 236,893.
Inventory in each of the two years is increased by the amount of the allowance.
Inventory turnover is higher based on the numbers as reported because cost of sales will be higher (assuming inventory write-downs are reported as part of cost of sales) and inventory carrying amounts will be lower with an allowance for inventory obsolescence.
Inventory write-downs give the appearance of a company having managed its inventory more efficiently, but write-downs of inventory can reflect poor inventory management.
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34. inventory disclosures: analytical considerations
Examine changes in inventory ratios relative to sales growth.
High turnover + sales growth slower than industry: Is the company’s level of inventory adequate?
High turnover + sales growth same or faster than industry: Probably indicates efficient inventory management
Examine changes in inventory components relative to other components and relative to sales growth.
Significant increase in finished goods inventories while raw materials and work-in-progress inventories are declining could signify a possible decline in demand
Growth of finished goods inventory higher than sales growth could also signify a possible decline in demand
LOS. Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information.
Pages
Changes in inventory ratios: Does a high inventory turnover ratio and a low number of days of inventory on hand indicate highly effective inventory management? Or does it indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. If the explanation is the latter, inventory shortages could potentially result in lost sales or production problems in the case of the raw materials inventory of a manufacturer.
To assess which explanation is more likely, analysts can compare the company’s inventory turnover and sales growth rate with those of the industry and review financial statement disclosures.
Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Write-downs of inventory could reflect poor inventory management. Minimal write-downs and sales growth rates at or above the industry’s growth rates would support the interpretation that the higher turnover reflects greater efficiency in managing inventory.
Examine changes in inventory components relative to other components. An increase in finished goods inventories while raw materials and work-in-progress inventories are declining may signal a decrease in demand for the company’s products and hence lower future sales and profit.
Analysts also should compare the growth rate of a company’s sales to the growth rate of its finished goods inventories. For example, growth of inventories greater than sales growth could indicate a decline in demand. In future, the company may have to lower the selling price of its products to reduce its inventory balances, or it may have to write down the value of its inventory because of obsolescence, both of which would negatively affect profits.
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35. Summary
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.
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. It affects the financial statements and any financial ratios that are based on them.
IFRS allow three inventory valuation methods (cost formulas): first-in, first- out (FIFO); weighted average cost; and specific identification.
U.S. GAAP allow the three methods above plus the last-in, first-out (LIFO) method.
Companies that use the LIFO method must disclose in their financial notes the amount of the LIFO reserve. This information can be used to adjust reported LIFO inventory and cost of goods sold balances to the FIFO method for comparison purposes.
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