Reading 29 LOS's

Question 1

LOS 29a: Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred

Answer 1

IFRA and US GAAP suggest a similar treatment of various expenses in the determination of inventory costs. The following items are cpitalized inventory costs, which are included in the cost or carrying valye of inventories on the balance sheet

• Costs of purchase, which include the purchase price, import duties, taxes, insurance, and other costs that are directly attributable to the acquisition of finished goods, trade discounts, which include direct labor and other direct overheads
• Costs of conversion, which include direct labor and other direct overheads

Capitalization of these costs results in a buildup or asset balances and delays recognition of these costs until inventory is old

The following items are not capitalized as inventory costs, they are expensed on the income statement as incurred :

• Abnormal costs from material wastage
• Abnormal costs of labor or wastage of other production inpits
• storage costs that are not a part of the normal prodcution process
• administrative expenses
• selling and marketing costs

Capitalization of costs that should be expensed results in an overstatement of net income fo the year and an overstatement of inventory value

Question 2

LOS 29b: Describe different inventory valuation methods (cost formulas)

LOS 29c: Calculate cost of sales and ending inventory using different inventory valuation methods and explain the effect of the inventory valuation method choice on gross profit

LOS 29e: Compare cost of sales, ending inventory, and gross profit using different inventory valuation methods

Answer 2

Inventory Valuation Methods (Cost Formulas)

Seperate Indentification

• COGS reflects actual costs incurred to purchase or manufacture the specific units that have been sold over the period
• Ending Inventory (EI) reflects actual costs incurred to purchase or manufacture the specific units that still remain in inventory at the end of the period
• This method is used for items that are not interchangable and for goods produced for specific projects

First In, First Out (FIFO)

• olders units purchased or manufactured are assumed to be the first ones sold
• Newest units purchased or manufactures are assumed to remain in EI
• COGS is composed of units valued at oldest prices
• EI is composed of units valued at most recent prices

Weighted Average Cost (AVCO)

• This method allocates the total costs of goods available for sale evenly across all units available for sale
• COGS and EI are composed of units valued at average prices

Last in, First out ( LIFO)

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

IFRS accepts all but LIFO where as US GAAP accepts all forms

Balance Sheet Information: Inventory Account

It does not matter whether prices are rising or falling, FIFO will always give a better reflection of the current economic value of inventory because the units currently in stock are valued at the most recent prices

• If prices are rising, LIFO and AVCO will understate ending inventory
• If prices are falling , LIFO and AVCO will overstate ending inventory

Income Statement Information: Cost Of Goods Sold

COGS should ideally relect the replacement of inventory. It does not matter whether price are rising or falling, LIFO will always offer a closer relfection of replacement costs in COGS because it allocates recent prices to COGS.

• If prices are rising, FIFO and AVCO will understate replacement costs in COGS and overstate profits
• if prices are falling, FIFO and AVCO will overstate replacement costs in COGS and understate profits

Question 3

LOS 29d: Calculate and compare cost of sales, gross proft, and ending inventory using perpetual and periodic inventory systems

Answer 3

Periodic vs Perpetual Inventory Systems

Periodic inventory system: Under this system, the quantity of inventory on hand is calculated periodically. The cost of goods for sale during the period is calculated as beginning inventory plus purchases over the period. Ending inventory amount is then deducted from cost of goods available for sale to determine COGS

Perpetual inventory system: Under this system changes in the inventory account are updated continuously. Purchases and sales are recorded directly in the inventory account as they occur. THe best way to understand how the perpetual system works is through example.

Question 4

LOS 29f: Describe the measurement of inventory at the lower of cost and net realizable value

Answer 4

Under IFRS, inventory must be stated at the lower of cost or net realizable value (NRV). NRV is calculated as:

• estimated selling price minus estimated selling costs.

If NRV falls below carrying value, the company must record a loss and change the value of their inventory on the balance sheet. If there is an increase in NRV, inventory can increase but is limited to the total write-down that had previously been recorded

Under US GAAP, invenotry requires the application of LCM ( lower of cost or market). Market value is defined as current replacement cost, where this cost must lie within a range of NRV minus normal profit margin to NRV. If replacement costs is higher than NRV, it must be brought down to NRV, and if replacement cost is lower than NRV minus normaly profit margin, then it must be brought up. This adjusted replacement cost is then compared to carrying value, and the lower of the two is used to value inventory.

Question 5

LOS 29g: Describe the financial statement presentation of and disclosures relating to inventories

Answer 5

Presentation and Disclosure

IFRS requires companies to make the following disclosures relating to inventory:

1. The accounting policies used to value inventory
2. The cost formula used to inventory valuation
3. The total carrying value of inventories and the carrying value of differnt classifications
4. The value of inventories carried at fair value less selling cost
5. Amount of inventory-related expenses for the period (cost of sales)
6. The amount of any write-downs recognized during the period
7. The amount of reversal recognized on any previous write-downs
8. Description of the circumstances that led to reversal
9. the carring amount of inventories pledged as collateral for liabilities

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

Inventory Method Changes

Consistency in the inventory costing method is required under US GAAP and IFRS

Under IFRS, a change in policy is acceptable only if the change results in the provision of more reliable and relevant information in the financial statements

• changes in inventory accounting policy are applied retrospectively
• Information for all periods presented in the financial report is restated
• Adjustmentsfor periods priod to the earliest year presented in the financial report are reflected in the begininng balance of retained earnings for the earliest year presented in the report

US GAAP has a similar requirement for changes in invetory accounting policies

• However, a company must thoroughly explain how the newly adopted inventory accounting method is superior and preferable to the old one
• The company may be required top seek permission from the IRS
• if inventory-related accounting policies are modified, the changes to the financial statements must be made retrospecitvely, unless the LIFO method is being adopted (which is applied prospectively)

Question 6

LOS 29h: Calculate and interpret ratios used to evaluate inventory management

Answer 6

the three most important ratios used in the evaluation of a company’s inventory management are:

• Inventory Turnover = COGS/Average Inventory
• No. of days of inventory = 365/ inventory turnover
• Gross profit margin = Gross profit/ sales revenue

If a company has a higher inventory turnover ratio and a lower number of days of inventory than the industry average, it can mean one of three things:

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

To determine which explination holds true, analysts should compare the firm’s revenue growth with that of the industry and examine the company’s financial statement disclosures. A low sale growth would imply that the company is losing out on sale with low inventory

A firm whose inventory turnover is lower and number of days of inventory higher than industry average, could have a problem with slow-moving or obsolete inventory. Again a comparison with industry sales growth would provide further information

The gross profit margin indicates the percentage of sales that is contributing to net income as opposed to covering the cost of sales

• Firms in relatively competitive industries have lower gross profit margins
• Firms selling luxury products tend to have lower volumes and higher gross profits