Topic 6

Inventories
Juan Carlos Salinas Morris, CFA, FRM
Inventories
Amount purchased during the period:

Purchases = Cost of Sales + Increase in Inventory

Amount paid to suppliers:

Cash Paid to Suppliers = Cost of Sales + Increase in Inventory – Increase

in Accounts Payable
What is excluded from inventories?
Costs included in inventories:
Costs of goods including discounts
Transformation/production costs
Transportation costs needed to move the inventories to their current
location
Costs excluded from inventories:
Abnormal waste of material and labor
Storage costs (except for the storage needed within the production process)
Administrative costs / overhead
Costs needed to generate sales (marketing, etc.)
Inventories
Nestlé buys coffee beans to convert them into instant coffee.
The company produces a total of 5 million cans of instant coffee per week,
using 100 million kilograms of beans that cost $0.5 per kilogram. Additionally,
Nestlé has incurred transportation costs of $500,000 to transfer the grains
from the crops to the production facility. The production process is estimated
to cost $10 million, which includes labor income, depreciation of the
machinery, electricity and water bill, as well as the factory’s rent.
Once the whole production process is finished, the cans of instant coffee are
stored at an average cost of $0.01 per can. Finally, upon the final sale, Nestlé
estimates a total transportation cost of $200,000 to deliver the goods to the
consumers.
How much should Nestlé capitalize in the inventories account?
How much should Nestlé register as an expense?
Inventories
Specific identification: The company specifically identifies each item from the
inventory.
First-in, first-out (FIFO): the first item bought is assumed to be the first one to be
sold (makes sense for goods that cannot be stored for long periods of time)
Last-in, first-out (LIFO): the last item bought is assumed to be the first one to be
sold (makes sense for growing non-perishable inventories).
Weighted average cost

IFRS US GAAP
FIFO
FIFO
LIFO
Weighted Average
Weighted Average

These assumptions have nothing to do with the physical flow of the inventory!
Inventories
Cost of Sales Assets Tax expense

Higher with inflation

FIFO First item bought Last item bought
vs. LIFO

Lower with inflation

LIFO Last item bought First item bought
vs. FIFO

Weighted
Average cost Average cost Between FIFO & LIFO
Average
Inventory Systems
Periodic System: the value of inventories and COGS are determined at
the end of the accounting period.
Perpetual System: the value of inventories and COGS are adjusted
continuously.

When are they different?

FIFO, LIFO, Weighted Average, Specific Identification?
Inventory Systems
Calculate the final inventory level and COGS under each system for all
FIFO, LIFO and Weighted Average:

Date Purchase/Sale Units Cost

Sep 1 Purchase 3 3
Sep 10 Purchase 3 5
Sep 15 Sale 4
Sep 19 Purchase 3 6
Sep 30 Sale 2
 Inflation and growing
inventories
Inv. FIFO (High)
FIFO LIFO
Current Ratio (High)
Inventory COGS
WC (High)

FIFO LIFO
Inv. LIFO (Low)
COGS Inv.
Current Ratio (Low)
WC (Low)

IS FIFO: IS LIFO:
COGS (Low) COGS (High)
Taxes (High) Taxes (Low)
Net Income (High) Net Income (Low)
Cash Flow (Low) Cash Flow (High)
Inflation and growing inventories
LIFO FIFO

Profitability Ratios

Liquidity Ratios

Turnover Ratios

Solvency Ratios
(Leverage)
Better Solvency
LIFO Reserve
Given the differences between LIFO and FIFO methodologies, firms that
publish financial statements under the LIFO methodology must present
an additional calculation known as “LIFO Reserve”.
LIFO Reserve: is the difference between the value of inventories under
FIFO & LIFO
Then, how do we adjust financial statements to make them comparable?
1. Add “LIFO Reserve” to the LIFO Inventories
2. Reduce the LIFO COGS by the variation of “LIFO Reserve”
3. Increase retained earnings by the “LIFO Reserve” x (1-t)
4. Reduce cash by “LIFO Reserve” x t -> the firm pays more taxes
LIFO Reserve
A firm reports financial statements under the LIFO inventory method,
and releases inventory balances of $1,000 and $1,500 in 2015 and 2016,
respectively. LIFO Reserves are $300 and $500 for each year (2015 and
2016).
How would you adjust the financial statements so that they reflect the
value of inventories and COGS under the FIFO inventory method?
LIFO Reserve
LIFO Liquidation: occurs when LIFO inventories fall
◦ Old inventories (with a low cost basis) are include in COGS
◦ Higher margins and earnings given the realization of previous inflationary gains
(increase in inventory prices)
◦ These gains in margins and earnings are not sustainable over time (the firm will
reach a point at which low cost inventories run out)
◦ Taxes increase due to greater margins
◦ CFO increase given the lower purchases (but may fall due to higher taxes)

Intentional Unintentional
Increase current period’s earnings Strikes or market changes
LIFO Reserve
At the start of 2015, ABC held the following inventory:
Production date Units Cost Total Cost
2011 120 10 1200
2012 140 11 1540
2013 140 12 1680
2014 160 13 2080

ABC was not able to produce any unit during 2015 as its employees went
on strike; however, the firm was still able to sell 440 units. Had the strike
not occurred, ABC would have produced 440 units at an average cost of
$14 per unit.
What is the additional gain attributable to the LIFO Liquidation?
Impairments – FIFO (IFRS, US GAAP)
Lower of cost or net realizable value (NRV) (selling price less any costs
incurred to generate the sale)
NRV < book value: write down inventories, creating a valuation
allowance (inventories contra-account) and loss is recognized in IS.
NRV > book value: write up inventories by the inverse of the procedure
described above but capped to the initial write-down (cannot exceed
the historical cost). Write up is not posible under US GAAP.
Test annually.
Impairments – LIFO (US GAAP only)
◦ Lower of cost or market value (MV)
◦ Market value = replacement cost. Cannot be greater than NRV and cannot be
lower than NRV less a “normal profit”.
◦ Market value < book value: write down by increasing COGS and creating a
valuation allowance (inventories contra-account)
◦ Write up is not posible under US GAAP.
◦ Test annually.
Market Value = Replacement Cost

Minimum Value: Maximum Value:

Net Realizable Value Net Realizable Value
- Normal Profit
Impairments
Nikon sells digital cameras and holds inventories that cost $210 per unit.
Additionally, you have the following information:
Estimated Selling Price 225
Selling expenses 22
Net Realisable Value 203
Replacement Cost 197
Normal Profit 12

How much would Nikon register in inventories under IFRS and using LIFO
under US GAAP?
What would happen if both the net realizable value and the replacement
cost subsequently increased in $10?
Example
Viper Corp produces bicycles and presents 20X6
its financial statements for 20X5 and 20X6. Revenue 4,000
These financial statements are prepared COGS 3,000
using the LIFO inventory methodology, and Gross Profit 1,000
report LIFO Reserves of $90 and $100 in
2015 and 20X6, respectively. Operating Expense 650
Operating Profit 350
The tax rate was 25% in the year 20X5 and
Interest Expense 50
increased to 30% by the end of 20X6.
Earnings before Tax 300
Calculate the following ratios for the Taxes 90
company under both LIFO and FIFO:
current ratio, inventory turnover, long-term Net Income 210
debt to equity, gross profit margin, net
profit margin, return on assets.
Common Dividends 60
Example
20X6 20X5 20X6 20X5
Assets Liabilities and Equity
Cash 115 95 Payables 110 90
Receivables 205 195 Short-Term Debt 215 185
Inventories 310 290 Current Liabilities 325 275
Total Current Assets 630 580 Long-Term Debt 715 785
Gross PP&E 1800 1700 Common Stock 300 300
Acc. Depreciation (360) (340) Additional capital 400 400
Net PP&E 1440 1360 Retained Earnings 330 180
Total Assets 2070 1940 Total Liabilities and Equity 2070 1940
Key concepts
FIFO
LIFO
Weighted average cost
LIFO reserve
LIFO liquidation
Inventory impairment
Net realizable value
Replacement cost