IFT Notes for Level I CFA® Program Show
Part 39. Inventory Method ChangesCompanies occasionally change their inventory valuation method. The change is acceptable if it results in the financial statements providing reliable and more relevant information. If the change is justified, then it must be applied retrospectively. Analysts must carefully analyze why a company is actually changing the inventory valuation method. Often, the company might be trying to reduce taxes or increase reported net income. 10. Inventory AdjustmentsHolding inventory for a prolonged period results in the risk of spoilage, obsolescence or decline in prices, and the cost of inventory may not be recoverable in such circumstances. We define some terms first before looking at the differences in how inventory is measured under IFRS and GAAP. Net realizable value: Estimated selling price under ordinary business conditions minus estimated costs necessary to get the inventory in condition for sale. NRV is from a seller’s perspective. Net realizable value = estimated sales price – estimated selling costs Market value: Current replacement cost subject to lower or upper limits. Market value has upper limit of net realizable value and lower limit of NRV less a normal profit margin. Market value is from a buyer’s perspective. Market value limits = (NRV – normal profit margin, NRV) The following table describes how inventory is measured under IFRS and GAAP:
An inventory write-down reduces both profit and carrying amount of inventory on the balance sheet, which in turn, affects the ratios. The following table shows the effect of inventory write-downs on various financial ratios:
Companies that use weighted average, specific identification and FIFO are more likely to have inventory write-downs than companies using the LIFO method. 11. Evaluation of Inventory Management: Disclosures & RatiosThe efficiency and effectiveness of inventory management can be evaluated using the following ratios:
An analyst must understand that the choice of inventory valuation method can impact several financial ratios and make comparisons between two firms difficult. He needs to be particularly careful when comparing an IFRS and US GAAP firm. 11.1 Presentation and DisclosureIFRS requires the following financial statement disclosures concerning inventory:
Disclosures under U.S. GAAP are similar to IFRS except that it does not permit reversal of write down of inventories. In addition, any income from liquidation of LIFO inventory must be disclosed. 11.2 Inventory RatiosThe choice of inventory valuation method impacts various components of the financial statements such as cost of goods sold, net income, current assets and total assets. As a result, it affects the financial ratios containing these items. Analysts must consider the differences in valuation methods when evaluating a company’s performance over time or in comparison to other companies. The table below summarizes the impact of valuation method on inventory-related ratios in an inflationary environment:
The ratios that are important in evaluating a company’s management of inventory are inventory turnover, number of days of inventory, and gross profit margin. A high inventory turnover implies that a company is utilizing inventory efficiently. 12 &13. Illustrations of Inventory AnalysisRetailers normally report inventory in a single account. Whereas, manufacturing companies usually classify inventory into three separate accounts: raw materials, work in progress, and finished goods. These classifications can provide insights into a company’s future sales and profits. For example, a significant increase in the raw materials or work in progress inventory may be considered as a sign of increased demand, and higher future sales and profits. On the other hand, a significant increase in the finished goods inventory may be considered as a sign of slowing demand, and lower future sales and profits. Analysts should also compare the growth rate of finished good inventory to the growth rate of sales. For example, if growth of inventories is greater than the growth of sales, this could indicate slowing demand. How do you account for inventory under IFRS?Under IFRS, inventories are measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale.
Why is inventory written down to the lower of cost or its net realizable value?The value of a good can shift over time. This holds significance, because if the price at which the inventory can be sold falls below the net realizable value of the item, thus triggering a loss for the company, then the lower of cost or market method can be employed to record the loss.
When Should inventories be written down from cost to net realizable value?Net realizable value is the expected selling price of something in the ordinary course of business, less the costs of completion, selling, and transportation. Thus, if inventory is stated in the accounting records at an amount higher than its net realizable value, it should be written down to its net realizable value.
What happens when inventory is written down?An inventory write-down impacts both the income statement and the balance sheet. A write-down is treated as an expense, which means net income and tax liability is reduced. A reduction in net income thereby decreases a business's retained earnings, which would then decrease the shareholder' equity on the balance sheet.
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