Analysis of Inventories

For retailers, manufacturers and commodity companies, inventory is often the largest current asset and cost of goods sold the largest expense, so the way inventory is measured shapes margins, ratios, taxes and cash flows. This module covers which costs enter inventory, how FIFO, LIFO and weighted average cost allocate costs when prices change, how to use the LIFO reserve to compare LIFO and FIFO companies, how write-downs to net realizable value work under IFRS and US GAAP, and how to read inventory ratios and disclosures.

Start this lesson free Practice questions

What you will learn

1. Identify the costs included in inventory and calculate cost of goods sold and ending inventory under specific identification, FIFO, LIFO and weighted average cost, in periodic and perpetual systems.

Inventory cost = purchase + conversion + other costs to bring goods to their location and condition.
Abnormal waste, most storage, unrelated administrative overheads and selling costs are expensed.
Goods available for sale = beginning inventory + purchases = COGS + ending inventory.
IFRS permits specific identification, FIFO and weighted average; US GAAP also permits LIFO.
FIFO gives the same result in periodic and perpetual systems; LIFO and weighted average may not.

2. Explain how rising and falling inventory costs affect cost of goods sold, profit, inventory, taxes, cash flow and financial ratios under different cost formulas.

Rising costs: FIFO gives the lowest COGS, highest profit and highest inventory; LIFO the reverse.
Falling costs: all rankings reverse.
LIFO users pay less tax in rising-cost periods, so their operating cash flow is higher despite lower profit.
Rising costs: LIFO companies show lower margins and current ratio, higher inventory turnover and higher debt-to-equity than FIFO peers.
LIFO gives a more current income statement; FIFO gives a more current balance sheet.

3. Use the LIFO reserve to restate a LIFO company's financial statements to a FIFO basis, and explain the causes and effects of a LIFO liquidation.

Inventory (FIFO) = inventory (LIFO) + LIFO reserve.
COGS (FIFO) = COGS (LIFO) - change in the LIFO reserve; net income rises by the change x (1 - t).
Equity rises by the reserve x (1 - t); the reserve x t goes to deferred taxes (or reduces cash).
A LIFO liquidation releases old, cheap layers into COGS, temporarily inflating margins and taxes.
A sharp drop in the LIFO reserve when prices are not falling signals a liquidation.

4. Describe the measurement of inventory at the lower of cost and net realizable value under IFRS and US GAAP, including reversals, and explain the effects of write-downs on financial statements and ratios.

NRV = estimated selling price - costs of completion - costs to sell.
IFRS: lower of cost and NRV for all inventories; reversals allowed up to the original write-down.
US GAAP: lower of cost and NRV for FIFO and weighted average; lower of cost or market for LIFO and retail; no reversals.
A write-down lowers inventory, assets, margins and equity in the period recognized.
Large or repeated write-downs may signal weak demand forecasting or big-bath accounting.

5. Calculate and interpret inventory ratios, and evaluate inventory disclosures and other information when comparing companies.

Inventory turnover = COGS / average inventory; DOH = 365 / turnover.
Inventory growing much faster than sales often precedes markdowns and write-downs.
Restate LIFO companies to FIFO before comparing turnover and margins with FIFO or IFRS peers.
Disclosures: policies, category breakdown, amounts expensed, write-downs and reversals, LIFO reserve.
Rising finished goods with flat raw materials can signal slowing sales.

Module at a glance

Inventory cost includes purchase, conversion and costs to bring goods to their location and condition; abnormal waste, storage and selling costs are expensed.
FIFO, weighted average and specific identification are allowed under IFRS; LIFO only under US GAAP.
Rising costs: LIFO gives higher COGS, lower profit and inventory, lower taxes and higher CFO than FIFO; falling costs reverse this.
FIFO inventory = LIFO inventory + LIFO reserve; FIFO COGS = LIFO COGS - change in reserve.
LIFO liquidations release old, cheap costs into COGS and temporarily inflate margins.
Lower of cost and NRV; IFRS allows reversals up to the original write-down, US GAAP does not.
Inventory turnover = COGS / average inventory; inventory growing faster than sales is a warning sign.

This free module has 5 lessons, 15 practice questions with full explanations.

Start the lesson