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CHAPTER 9 INVENTORIES Presenters name Presenters title dd Month yyyy.

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Presentation on theme: "CHAPTER 9 INVENTORIES Presenters name Presenters title dd Month yyyy."— Presentation transcript:

1 CHAPTER 9 INVENTORIES Presenters name Presenters title dd Month yyyy

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 Copyright © 2013 CFA Institute 2

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? Copyright © 2013 CFA Institute 3

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? Copyright © 2013 CFA Institute 4 Total costs that should be expensed 30, , ,000

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? Copyright © 2013 CFA Institute 5 Total inventory costs 9,000,000 18,000,000 1,800,000 1,000,000 29,800,000

6 INVENTORY COST FLOW Goods Purchased Beginning Inventory Goods Available For Sale Ending Inventory Cost of Goods Sold Balance SheetIncome Statement Copyright © 2013 CFA Institute 6

7 SUMMARY TABLE ON INVENTORY VALUATION METHODS Method 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 CostAverages total costs over total units available. Copyright © 2013 CFA Institute 7 *LIFO not permitted under IFRS

8 INVENTORY VALUATION METHODS: SPECIFIC IDENTIFICATION Copyright © 2013 CFA Institute ¥110/kg 200 ¥100/kg 300 ¥90/kg Purchases Goods Available 600 ¥58,000 total Sales: 520 ¥240/kg Cost of Goods Sold 100 ¥110/kg 180 ¥100/kg 240 ¥90/kg 520 ¥50, ¥100/kg 60 ¥90/kg 80 ¥7,400 Ending inventory (cost) Total = 600 ¥58,000

9 INVENTORY VALUATION METHODS: WEIGHTED AVERAGE COST Copyright © 2013 CFA Institute ¥110/kg 200 ¥100/kg 300 ¥90/kg Purchases Goods Available 600 ¥58,000 total. AVERAGE ¥96.667/kg Sales: 520 ¥240/kg Cost of Goods Sold 520 ¥96.667/kg = ¥50, ¥96.667/kg = ¥7,733 Ending inventory (cost) Total = 600 ¥58,000

10 INVENTORY VALUATION METHODS: FIFO Copyright © 2013 CFA Institute ¥110/kg 200 ¥100/kg 300 ¥90/kg Purchases Goods Available 600 ¥58,000 total Sales: 520 ¥240/kg Cost of Goods Sold 100 ¥110/kg 200 ¥100/kg 220 ¥90/kg 520 ¥50, ¥90/kg 80 ¥7,200 Ending inventory (cost) Total = 600 ¥58,000

11 INVENTORY VALUATION METHODS: LIFO Copyright © 2013 CFA Institute ¥110/kg 200 ¥100/kg 300 ¥90/kg Purchases Goods Available 600 ¥58,000 total Sales: 520 ¥240/kg Cost of Goods Sold 20 ¥110/kg 200 ¥100/kg 300 ¥90/kg 520 ¥49, ¥110/kg 80 ¥8,800 Ending inventory (cost) Total = 600 ¥58,000

12 INVENTORY VALUATION METHODS: SUMMARY Copyright © 2013 CFA Institute 12 Inventory Valuation Method Specific ID Weighted Average Cost FIFOLIFO Cost of sales50,60050,26750,80049,200 Ending inventory7,4007,7337,2008,800 Goods available for sale 58,000 Gross profit74,20074,53374,00075,600

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. Copyright © 2013 CFA Institute 13

14 PERIODIC AND PERPETUAL INVENTORY SYSTEMS: EXAMPLE PurchasedSoldRemaining UnitsCostUnits COGS - perpetual Jan100$ = $8,800 July200$ = $10,000 COGS =$8,800+$10,000=$18,800 Copyright © 2013 CFA Institute 14 Cost of Goods Sold Using LIFO valuation method Perpetual versus Periodic Inventory Systems

15 PERIODIC AND PERPETUAL INVENTORY SYSTEMS: EXAMPLE PurchasedSoldRemaining UnitsCostUnits COGS -periodic Jan100$ Apr8020NA July200$ Nov100120NA Goods available = *$ *$100 =$31,000 Ending inventory = 100 *$ *$100 = $13,000 COGS = $31,000 - $13,000 = $18,000 Copyright © 2013 CFA Institute 15 Cost of Goods Sold Using LIFO valuation method Perpetual versus Periodic Inventory Systems

16 EFFECTS OF INFLATION OF INVENTORY COSTS ON THE FINANCIAL STATEMENTS Copyright © 2013 CFA Institute 16 Time Costs FIFO: Earlier, lower costs in COGS FIFO: Later, higher costs in inventory Period end FIFO

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 companys reported cost of goods sold and ending inventory from LIFO to FIFO. Copyright © 2013 CFA Institute 17

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. Copyright © 2013 CFA Institute 18

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. Caterpillars balance sheet shows inventories of $8,781 million, $7,204 million, and $6,351 million, at December 31, 2008, 2007, and 2006, respectively. Adjust inventory from LIFO to FIFO by adding the amount of the LIFO reserve to the reported inventory. Copyright © 2013 CFA Institute December ($ millions) Total inventories as reported (LIFO)8,7817,2046,351 From Note 1. D disclosure (LIFO reserve)3,1832,6172,403 Total inventories adjusted (FIFO)11,9649,8218,754

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. Caterpillars income statement shows Cost of Goods Sold of $38,415 million and $32,626 million for the years ending December 31, 2008 and 2007, respectively. Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount of change in LIFO reserve. Copyright © 2013 CFA Institute December ($ millions) Cost of goods sold as reported (LIFO)38,41532,626 Less: Increase in LIFO reserve* Cost of goods sold as adjusted (FIFO)37,84932,412

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. Caterpillars income statement shows net Income of $3,557 million and $32,626 million for the years ending December 31, 2008 and 2007, respectively. Caterpillars effective tax rates were approximately 20% for 2008 and 30% for 2007 and earlier. Adjust net income from LIFO to FIFO by incorporating the adjustment in Cost of Goods Sold (COGS), on an after-tax basis. Copyright © 2013 CFA Institute December ($millions ) Net income as reported (LIFO)3,5573,541 Reduction in COGS (increase in operating profit) Taxes on increased operating profit11364 Net income as adjusted (FIFO)4,0103,691

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. Caterpillars December 31, 2008 balance sheet shows total liabilities of $61,171 million, and total equity of $6,087 million. Caterpillars effective tax rates were approximately 20% for 2008 and 30% for 2007 and earlier. Adjust liabilities from LIFO to FIFO by incorporating a tax liability for the amount of accumulated tax savings over the years. Adjust equity by including the cumulative after-tax gross profits. Copyright © 2013 CFA Institute December ($millions )2008 Liabilities as reported (LIFO)$61,171 Accumulated deferred taxes$898 Liabilities as adjusted (FIFO)$62, December ($millions )2008 Equity as reported (LIFO)$6,087 Retained earnings$2,285 Equity as adjusted (FIFO)$8,372

23 COMPARATIVE RATIOS LIFOFIFO Inventory turnover = 38,415 ÷ [(8, ,204) ÷ 2] = 37,849 ÷ [(11, ,821) ÷ 2 ] Gross profit margin20.04%21.22% = [(48,044 – 38,415) ÷ 48,044] = [(48,044 – 37,849) ÷ 48,044] Net profit margin6.93%7.81% = (3,557 ÷ 51,324)= (4,010 ÷ 51,324] Copyright © 2013 CFA Institute 23 Calculate Caterpillars Inventory Turnover, Gross Profit margin, and Net Profit margin for 2008 under the LIFO and FIFO methods. Caterpillars 2008 revenues were $48,044 million from machinery sales and $3,280 from financial products.

24 COMPARATIVE RATIOS LIFOFIFO Current ratio = (31,633 ÷ 26,069) = [(31, ,183) ÷ 26,069] Total liabilities-to-equity ratio = (61,171 ÷ 6,087) = [(61, ) ÷ (6, ,285)] Copyright © 2013 CFA Institute 24 Calculate Caterpillars 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.

25 LIFO LIQUIDATION Copyright © 2013 CFA Institute 25 Units in to inventory: Purchase or Manufacture Units out of inventory: Sales 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. Inventory

26 LIFO LIQUIDATION Copyright © 2013 CFA Institute 26 Units in to inventory: Purchase or Manufacture Units out of inventory: Sales 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. Inventory

27 EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION Assume a three year scenario during which a companys 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. Copyright © 2013 CFA Institute 27

28 EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION 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. Copyright © 2013 CFA Institute 28

29 EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION In Year 3, the old layers at $5 from Year 1 and $6 from Year 2 flow to cost of goods sold UnitsCost per unitTotal costs Beginning inventory0 Units purchased 10,000$5$50,000 Units sold9,000$5$45,000 Ending inventory Year 1 1,000$5,000 Beginning inventory Year 2 1,000 - $ 5,000 Units purchased10,000$6$60,000 Units sold9,000$6$54,000 Ending inventory Year 22,000$11,000 Beginning inventory Year 32,000$11,000 Units purchased8,000$7$56,000 Units sold10,000$67,000 Ending inventory Year 300 Copyright © 2013 CFA Institute 29

30 EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION Copyright © 2013 CFA Institute 30 Year Revenue per unitTotal revenueCOGS Gross profit Gross margin 1$10$ 90,000 $ 45,000 50% 2$12 $ 108,000 $ 54,000 50% 3$14 $ 140,000 $ 67,000 $ 73,00052%

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 Copyright © 2013 CFA Institute 31

32 INVENTORY ADJUSTMENTS Copyright © 2013 CFA Institute 32 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.

33 INVENTORY ADJUSTMENTS Copyright © 2013 CFA Institute 33 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]

34 INVENTORY DISCLOSURES: ANALYTICAL CONSIDERATIONS Examine changes in inventory ratios relative to sales growth. -High turnover + sales growth slower than industry: Is the companys 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 Copyright © 2013 CFA Institute 34

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. Copyright © 2013 CFA Institute 35


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