1. F-401: Financial Statement Analysis and Valuation Prepared By: Md Imran Hossain Assistant Professor Department of Finance University of Dhaka Email: imran@du.ac.bd 1 CFA Level 1: Financial Reporting and Analysis Reading 25: Inventories

2. Intro to Inventories Inventories, a component of current assets in B/S, are finished goods intended to sell, are in process of being produced to sell and are to be used in producing goods. Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Inventories and cost of sales (cost of goods sold) are significant items in the B/S and I/S respectively of many companies. Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Therefore, comparing the performance of different companies with different inventory valuation methods is challenging. 2

3. Cost of Inventories  Under IFRS and US GAAP, 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.”  The costs of purchase include the purchase price, import and tax-related duties, transport, insurance during transport etc. 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 labour, and fixed and variable overhead costs.  Including these product-related costs in inventory (i.e., as an asset) means that they will not be recognised as an expense (i.e., as cost of sales) on the income statement until the inventory is sold.  Both IFRS and US GAAP exclude the following costs from inventory: abnormal costs incurred as a result of waste of materials, labour or inputs, any storage costs and all administrative overhead and selling costs.  These excluded costs are treated as expenses and recognised on the I/S in the period in which they are incurred.  Self study: Example 1 3

4. Inventory valuation methods IFRS- Cost Formulas US GAAP- Cost flow assumptions 1. Specific Identification 2. First-In, First-Out (FIFO) 3. Weighted Average Cost 4. Last-In, First-Out (LIFO) 4 IFRS US GAAP

5. 1. Specific Identification  The specific identification method is used for inventory items that are not ordinarily interchangeable produced and segregated for specific projects expensive goods that are uniquely identifiable. The cost of sales and the cost of ending inventory reflect the actual costs incurred to purchase (or manufacture) the items specifically identified as sold and the items specifically identified as remaining in inventory. Therefore, this method matches the physical flow of the specific items sold and remaining in inventory to their actual cost. 5

6. 2. First-In, First-Out (FIFO) FIFO assumes that the oldest goods purchased (or manufactured) are sold first and the newest goods purchased (or manufactured) remain in ending inventory. Therefore, cost of sales reflects the cost of goods in beginning inventory plus the cost of items purchased (or manufactured) earliest in the accounting period, and the value of ending inventory reflects the costs of goods purchased (or manufactured) more recently. In periods of rising (declining) prices, the costs assigned to the units in ending inventory are higher (lower) than the costs assigned to the units sold. 6

7. 3. Weighted Average Cost 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. Weighted Average Cost per unit = (Total cost of goods available for sale / Total units available for sale) 7

8. 4. Last-In, First-Out (LIFO) LIFO is permitted only under US GAAP. This method assumes that the newest goods purchased (or manufactured) are sold first and the oldest goods purchased (or manufactured), including beginning inventory, remain in ending inventory. Therefore, cost of sales reflects the cost of goods purchased (or manufactured) more recently, and the value of ending inventory reflects the cost of older goods. In periods of rising (declining) prices, the costs assigned to the units in ending inventory are lower (higher) than the costs assigned to the units sold. The LIFO method is widely used in the United States for both tax and financial reporting purposes because of potential income tax savings. 8

9. Choice of Inventory Valuation Method The choice of inventory method affects the financial statements and any financial ratios that are based on them. Consequently, the analyst must carefully consider inventory valuation method differences when evaluating a company’s performance over time or in comparison to industry data or industry competitors. A company must use the same cost formula for all inventories having a similar nature and use to the entity. 9

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14. Recording changes to inventory: Periodic vs. Perpetual Inventory Systems  Under a 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.  Under a perpetual inventory system: Inventory values and cost of sales are continuously updated to reflect purchases and sales.  The inventory accounting system (perpetual or periodic) may result in different values for cost of sales and ending inventory when the weighted average cost or LIFO inventory valuation method is used. 14

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18. Comparison of Inventory Valuation Methods: Impact on Financial Statements In an environment of declining (rising) inventory unit costs and constant or increasing inventory quantities, compared to weighted average cost or LIFO, FIFO will allocate a higher (lower) amount to cost of sales on the I/S and a lower (higher) amount to ending inventory on the B/S. Accordingly, because cost of sales will be higher (lower) under FIFO, a company’s gross profit, operating profit, income before taxes and net income will be lower (higher). SCF Accordingly, because income tax expense will be lower (higher) under FIFO, a company’s net operating cash flows in the SCF will be higher (lower). Accordingly, because ending inventory will be lower (higher) under FIFO, a company’s current assets and total assets will be lower (higher). The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories consist of the most recently purchased items, unlike LIFO. The cost of sales under LIFO will more closely reflect current replacement value, unlike FIFO. 18

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23. LIFO Reserve For companies using the LIFO method, US GAAP requires disclosure of the amount of LIFO reserve in the notes to the financial statements or on the B/S. 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 LIFO reserve = FIFO inventory value - LIFO inventory value To compare companies using LIFO with companies not using LIFO: – Inventory is adjusted by adding the disclosed LIFO reserve to the inventory balance reported on the B/S. – Cost of sales is adjusted by subtracting (adding) the increase (decrease) in the LIFO reserve during the period from the cost of sales reported on the I/S. The LIFO reserve disclosure can be useful to financial analysts to adjust the financial statements of a US company using LIFO to make them comparable with a similar company using FIFO. 23

24. LIFO Liquidations A company using LIFO will experience a LIFO liquidation when the number of units sold exceeds the number of units purchased or manufactured, indicating some older units from beginning inventory have been sold. LIFO liquidation occurs when the number of units in ending inventory declines from the number of units that were present at the beginning of the year. In addition, a decline in the LIFO reserve from the prior period may be indicative of LIFO liquidation. If inventory unit costs have been rising from period to period and LIFO liquidation occurs, this will result in higher gross profits because lower inventory carrying amounts of the liquidated units are used for cost of sales whereas the sales are at the current prices. LIFO liquidations can occur for a variety of reasons: The reduction in inventory levels may be outside of management’s control (Ex: labour strikes at a supplier firm, economic recession or declining customer demand). Management can potentially manipulate and inflate gross profits and net income at critical times by intentionally reducing inventory quantities and liquidating older layers of LIFO inventory. 24

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32. 32 Solution to 8: DIY from book Example 6: DIY from book

33. Inventory Method Changes Consistency of inventory costing is required under both IFRS and US GAAP. If a company changes an accounting policy, the change must be justifiable and applied retrospectively to the financial statements’ comparative information for prior periods as far back as is practicable. However, In US GAAP, if a company decides to change from other methods to the LIFO method, it must do so on a prospective basis, no retrospective adjustments are required. Analysts should carefully evaluate changes in inventory valuation methods. The real underlying (and unstated) purpose may be to – reduce income tax expense (if changing to LIFO from FIFO or average cost), or – increase reported profits (if changing from LIFO to FIFO or average cost). 33

34. Inventory Adjustments Under IFRS, inventories are measured at the lower of cost and net realizable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Under US GAAP, inventories are measured at the lower of cost, market value, or net realisable value depending upon the inventory method used. Market value is defined as current replacement cost which is subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. However, an exception is for inventories of producers of agricultural and forest products and mineral products where inventories are measured at net realizable value. Reversals of previous write-downs are permissible under IFRS but not under US GAAP. Self study: Example 7 34

35. Evaluation of Inventory Management: Presentation and Disclosure 35

36. Three ratios often used to evaluate the efficiency and effectiveness of inventory management are: inventory turnover, days of inventory on hand, and gross profit margin. These ratios are directly impacted by a company’s choice of inventory valuation method. Analysts should be aware that many other ratios are also indirectly affected by the choice of inventory valuation method: current ratio, return-on-assets (ROA) debt-to-equity ratio etc. 36 Evaluation of Inventory Management: Inventory Ratios Examples 8, 9 & 10: Not mandatory for all, rather only for those can try by themselves

37. Advice Please practice suggested Examples inside the chapter as well as relevant chapter-end questions and problems to master yourself and become SUPERMAN!!! 37

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