FR&A - Inventory

11:00 AM

Today we get to learn all about inventory!

Goal is to know how to convert between different cost flow assumptions

Remember cost flow is different than valuation.  Valuation is treated same regardless of cost flow assumption.  In valuation:

• IFRS - lower of cost or net realizable value
• GAAP - lower of cost or market.

COGS = beginning inventory + purchases - ending inventory

Ending inventory = beginning inventory + purchases - COGS (this is easiest to remember)

What is capitalized in to inventory:

• Purchase costs
• Conversion costs
• Allocations of fixed production OH based on normal capacity levels
• Other costs necessary to bring inventory to present location/condition (e.g. freight-in)

What is NOT capitalized:

• Unallocated portion of fixed production OH
• Abnormal waste of materials, labor, or OH
• Storage costs (unless required as part of production process)
• Admin OH
• Selling costs

Remember to only allocate the portion of OH that is allocated to production - if you only produce at 80%, only take 80% of the OH to inventory and expense the rest.

IFRS: Net realizable value = estimated sales price - estimated selling costs

• Inventory can be written down OR up
• Loss/gain is recognized in the income statement
• BUT amount of any gain is limited to the previous loss - cannot ever exceed original cost

GAAP: Lower of cost or market

• Market = replacement cost
• BUT market cannot be greater than NRV or less than NRV minus a normal profit margin
• Must fall within a window with size = normal profit margin
• If market > NRV, then market IS NRV
• If replacement cost is lower than NRV minus normal profit margin, market IS NRV minus normal profit margin
• If cost > market, inventory written down, loss recognized in balance sheet
• No subsequent writeup is allowed - mkt value is new cost basis
• You recover this in the form of higher profits in following years

Note - commodities and agriculture may report markups - inventory reported at NRV and unrealized gains/losses are reported in the income statement.  Use either active market prices or if not available use recent mkt transactions.

Cost Flow Methods

• IFRS allows specific id, FIFO, and wtd avg cost
• US GAAP allows all these PLUS LIFO
• Firm may use different assumption for different inventory, but must use same method for inventories of a similar nature/use

Specific Identification - each unit sold is matched with unit's actual cost.  Good for jewelry/autos.  Also appropriate for special orders/projects outside normal course of business.

FIFO

• First purchased is first sold.
• Advantage: ending inventory is based on most recent purchase of inventory, arguably best estimate of replacement cost
• When prices are rising, COGS will be understated compared to current replacement cost, thus earnings overstated

LIFO

• Last in first out
• When prices rising, LIFO COGS will be higher than FIFO
• Earnings will be lower as well - but this means lower income taxes and higher cash flows!
• When prices are rising, LIFO ending inventory is less than replacement value
• LIFO conformity
• Firms using LIFO for tax must also report performance in LIFO
• This is the rare situation where lower reported income is associated with higher cash from operations

Wtd Avg Cost Method

• Cost per unit = Total cost of goods available for sale (beginning + purchases) / quantity available for sale
• Whether prices are rising or falling wtd avg value will be between FIFO and LIFO

Usefulness of COGS and Inventory Data under each

• When prices stable, all three yield same result
• When prices moving, FIFO provides most useful measure of ending inventory
• LIFO is better for income statement information (FIFO for balance sheet)
• Inventory writedowns are LESS likely under LIFO
• They have a bunch of old inventory
• LIFO COGS is higher than FIFO COGS in rising price environment

Inventory turnover

• Turnover = cogs / avg inventory
• Days = 365 / inventory turnover
• Low turnover (coupled with slow sales) might mean slow moving inventory/obseleteness
• High turnover is preferred in places where obsolescence is a concern
• Also minimizes storage costs
• But if TOO high, you might be missing revenue opportunities
• High turnover with slow revenue growth e.g.
• Ratio is directly affected by LIFO/FIFO choice
• So are current ratio, debt/equity, and return on assets

Impact on other ratios (assuming rising prices)

• Profitability
• LIFO - higher cogs, lower profit
• Lower margins overall
• Liquidity
• LIFO = lower inventory
• Decreases current assets, so less liquid
• Quick ratio is not impacted because it excludes inventory
• Activity
• Inventory turnover = Higher for LIFO
• Solvency
• LIFO = lower total assets (inventory is lower)
• Debt ratio and debt/equity ratio are higher under LIFO than FIFO
• Because COGS is higher, net income lower, and equity lower

Converting LIFO to FIFO

• LIFO to FIFO is simple
• Firms using LIFO are required to disclose in footnotes the LIFO reserve
• LIFO reserve = FIFO inventory - LIFO inventory
• Remember FIFO is a better representation of economic value of inventory
• Once converted tho the balance sheet will not balance
• This is due to taxes
• Adjust liabilities for difference in taxes, and adjust equity by LIFO reserve net of tax
• Ex, say LIFO reserve is $150 and tax is 40%
• Increase assets by $150
• Increase liability (taxes) by $150 * 40% = 60
• Increase equity (retained earnings) by $90
• Must also convert COGS
• Difference equal to the CHANGE in the LIFO reserve
• FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve)
• Note that ideally we would want to convert FIFO cogs to LIFO cogs - because that is a better representation for the income statement actual cost - but this is beyond the test

When does LIFO reserve change

• LIFO reserve will increase each period when prices are increasing and inventory stable or increasing
• If firm is liquidating inventory, or prices falling, LIFO reserve declines
• LIFO liquidation - this is when a LIFO firm's inventory quantities are declining
• Now older, lower cost goods are included in COGS
• This means higher profit and higher taxes
• Higher profit though is phantom - not sustainable
• They are basically recognizing previously unrecognized gains in inventory value as income
• LIFO liquidations can result from strikes, recession or declining demand
• Firms categorizing in to narrow categories are likely to have some LIFO liquidations in certain products
• Pooling can help address this (clump items into inventory pools)
• Analyst should adjust COGS for the decline in LIFO reserve caused by a decline in inventory
• Firms must disclose LIFO liquidation in footnotes to facilitate adjustment

Last note - falling prices

• If prices falling, FIFO is now more accurate than LIFO in providing accurate estimate of economic value of inventory
• COGS is now higher under FIFO than LIFO
• Earlier, higher cost purchases are now reflected in COGS

End

12:30 pm

1.5 hrs