Inventories

Question 1

What is capitalized costs?

Answer 1

They are included in the cost or carrying value of inventories on the BS.

Question 2

Which items are capitalized costs?

Answer 2

• Cost of purchase: purchase price, import duties, taxes, insurance, and other costs that are directly attributable to the acquisition of finished goods, trade discounts, and other rebates that reduce costs of purchase.
• Cost of conversion: DL and other (fixed and variable) direct overheads.

Question 3

Which items are expensed in the income statement (not capitalized)?

Answer 3

• Abnormal costs from material wastage
• Abnormal costs of labor or wastage of other production inputs
• Storage costs that are not a part of the normal production process
• Administration expenses
• Selling and marketing costs

Question 4

Describe the First in, first out (FIFO) method.

Answer 4

• Oldest units purchased or manufactured are the first ones sold.
• Newest units purchased or manufactured remain in ending inventory.
• COGS is composed of units valued at the oldest prices.
• EI is composed of units valued at the most recent prices.

Question 5

Describe the Last in, first out (LIFO) method.

Answer 5

• Newest units purchased or manufactured are the first ones sold.
• Oldest units purchased or manufactured remain in EI.
• COGS is composed of units valued at the most recent prices.
• EI is composed of units valued at the most recent prices.

Question 6

Why is FIFO a good method and what happens to LIFO and AVCO when prices are rising, falling, and stable?

Answer 6

FIFO will always give a better reflection of the economic value of inventory.
- Prices are rising: LIFO & AVCO will understate EI value.
- Prices are falling: LIFO & AVCO will overstate EI value.
- Prices are stable: the three methods will value inventory the same.

Question 7

Why is LIFO a good method and what happens to FIFO and AVCO when prices are rising, falling, and stable?

Answer 7

LIFO will always offer a closer reflection of replacement cost in COGS.
- Prices are rising: FIFO and AVCO will understate COGS.
- Prices are falling: FIFO and AVCO will overstate COGS.
- Prices are stable: the three methods will value inventory the same.

Question 8

What is the periodic inventory system?

Answer 8

• It is the quantity of inventory on hand calculated periodically
• OI + purchases = Goods available for sale
• Goods available for sale = EI + COGS

Question 9

What is the perpetual inventory system?

Answer 9

• It is the changes in the inventory account updated continuously.
• Purchases and sales are recorded directly in the inventory account as they occur.

Question 10

What is the impact on the company value under LIFO?

Answer 10

• It will appear less profitable, less liquid, and more highly leveragedé
• It will have a higher company value as the PV of its expected future cash flows would be higher.

Question 11

What are the two reasons for a decline in the LIFO reserve? Describe them.

Answer 11

• LIFO liquidation: it occurs when a firm that uses LIFO sells more units during a given period than it purchases over the period.
• Declining prices: It occurs when prices of the firm’s products fall over a given period.

Question 12

What are the inventory method changes under IFRS?

Answer 12

A change in policy is acceptable only if the change results in the provision of more reliable and relevant information:
- Changes in inventory accounting policy are applied retrospectively
- Information for all periods presented in the financial report is restated
- Adjustments for periods prior to the earliest year presented.

Question 13

What are the inventory method changes under US GAAP?

Answer 13

Similar to IFRS, but the company:
- Must explain how the adopted inventory accounting method is superior.
- May be required to seek permission from the internal revenue service.
- The changes to the financial statement must be made retrospectively.

Question 14

What is the measurement of inventory requirements under IFRS?

Answer 14

• Inventory must be stated at the lower cost or net realizable value (NRV)
• Reversals of any write-downs are required

Question 15

What is the measurement of inventory requirements under US GAAP?

Answer 15

• Requires the application of the cost or LCM
• Reversal of any write-down is prohibited

Question 16

What is the range of replacement cost of market value, and how is it defined?

Answer 16

• Replacement cost must lie within: (NRV-normal profit margin) and NRV.
• If the replacement cost is higher than NRV, it must be brought down to NRV.
• If replacement cost is lower than (NRV-normal profit margin), it must be brought to (NRV-normal profit margin)

Question 17

What are the exceptions for valuing inventory under IFRS and US GAAP?

Answer 17

In agriculture, forest products, and mining, companies can value inventory at NRV even when it exceeds the historical cost.

Question 18

What are the disclosure of inventory under IFRS that need to appear?

Answer 18

• The accounting policies used to value inventory.
• The cost formula used for inventory valuation.
  -The total carrying value of inventories and the carrying value of different classifications.
• The value of inventories carried at fair value, less selling costs.
• Amount of inventory-related expenses for the period (cost of sales).
• The number of write-downs recognized during the period.
• The amount of reversal recognized on any previous write-down.
• Description of the circumstances that led to the reversal.
• The carrying amount of inventories pledged as collateral for liabilities.

Question 19

What are the disclosure of inventory under US GAAP that need to appear?

Answer 19

• It does not permit the reversal of prior-year inventory write-downs.
• It also requires disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.

Question 20

What do a higher inventory turnover ratio and a lower number of days of inventory that the industry could mean?

Answer 20

• It could indicate that the company is more efficient in inventory management, as fewer resources are tied up in inventory.
• It could also suggest that the company does not carry enough inventory at any point in time, which could hurt sales.
• It could also mean that the company might have written down the value of its inventory.

Question 21

What can lower inventory turnover and a higher number of days of inventory than average cause on companies with obsolete inventory?

Answer 21

The gross profit margin (GPM) indicates the percentage of sales that contribute to NI:
- Firms in relatively competitive industries have lower GPM
- Luxury products tend to have lower quantities and higher GPM

Question 22

What are the inventories classification for carrying amounts disclosure that is required under IFRS and US GAAP?

Answer 22

• A significant increase in unit volumes of raw materials and/or WIP inventory may suggest that the company expects an increase in demand for its products.
• An increase in FGI with declining raw materials and WIP inventory may signal a decrease in demand for the company’s products.
• If growth in inventories is greater than the growth in sales, it could indicate a decrease in demand.