MODULE 6: ANALYSIS OF INVENTORIES

Inventory Measurement

1. Manufacturers can report either separate inventory categories or one total on the balance sheet; if they report only one total, they must disclose raw materials, work in progress, and finished goods separately in the footnotes.
2. Cost: What you paid to get inventory ready for sale (purchase price + freight-in/shipping + import duties − discounts). Example: buy a jacket for $100, pay $8 shipping, get a $3 discount → cost = $105.
3. Inventory (Both IFRS and US GAAP) = only costs needed to make the product ready for sale. Anything inefficient, unnecessary, or not part of production → expense immediately. If you wrongly include them → profit looks higher now, but it’s fake (just delayed costs).

INVENTORY VALUATION

1. Methods allowed
   • IFRS → Specific ID, FIFO, WAC
   • US GAAP → Specific ID, FIFO, WAC + LIFO
     → Only difference = LIFO allowed in US GAAP
2. Core idea (what method does)
   • It decides which cost is assigned to goods sold
   • Physical flow ≠ accounting flow
3. Flow (how cost moves)
   • Purchase/produce → goes to Inventory (Balance Sheet)
   • Sell → moves to COGS (Income Statement)
   • Method decides → which layer of cost leaves first
4. Choice of inventory is irrelevant if prices remain the same.
5. Specific identification → track exact cost per item; sold item carries its own cost
   Example: buy 3 cars at 10k, 12k, 15k → sell the 15k car → cost of sales = 15k
6. First-in, first-out → oldest cost leaves first, newest stays
   Example: buy 100 units at 10, then 100 at 12 → sell 100 → cost of sales = 100×10, inventory = 100×12
7. Weighted average cost → average all costs, same cost for all units
   Example: buy 100 at 10 and 100 at 12 → average = 11 → sell 100 → cost of sales = 100×11, inventory = 100×11
8. Last-in, first-out (US GAAP only) → newest cost leaves first, oldest stays
   Example: buy 100 at 10, then 100 at 12 → sell 100 → cost of sales = 100×12, inventory = 100×10**
9. Net realizable value (NRV): Expected selling price minus costs to complete and sell. Example: expect to sell for $110, and it will cost $4 to finish/pack and $3 selling commission → NRV = $103.
10. Market (Replacement Cost): If you sold everything today at cost, what will you get.
11. Lower-of-cost-or-NRV rule: Carry inventory at the lower number. With cost $105 and NRV $103, carry at $103 and record a $2 write-down in income.
12. IFRS: Inventory at the lower of cost or net realizable value (NRV). NRV = expected sales price − selling and completion costs. Write-downs hit income (separate line or COGS). Subsequent write-ups allowed, but only up to the prior write-down (cannot exceed original cost).
13. U.S. GAAP: If not using LIFO/retail, measure at lower of cost or NRV. If using LIFO or the retail method, measure at lower of cost or market (LCM) where market = replacement cost, bounded by ceiling = NRV and floor = NRV − normal profit margin. No write-ups permitted under U.S. GAAP (applies to both LCNRV and LCM users).
14. Periodic = calculate inventory and cost of sales at the end. Perpetual = update inventory and cost of sales every transaction**. Always know inventory in real time.

1. Notes: With inflation, LIFO ending inventory reflects older/cheaper costs, so LIFO firms are less likely to trigger write-downs than FIFO/average cost users. Certain commodity inventories (e.g., agricultural, mineral, precious metals) may be reported at NRV with unrealized gains/losses recognized in income when active markets exist.

2. Disclosures — inventory (IFRS vs U.S. GAAP)

   • Both: accounting policy and cost formula (e.g., FIFO/LIFO/average); carrying amounts by category (raw materials, WIP, finished goods/merchandise); amount recognized as expense (COGS); inventory write-downs recognized; inventories pledged as collateral.
3. IFRS only: reversals of write-downs and the circumstances; carrying amount of any inventories measured at fair value less costs to sell.
4. U.S. GAAP only: LIFO reserve disclosure for LIFO users; no reversals permitted (so no reversal disclosure).

1. When inventory is written down:
   • Inventory is lower. Current assets are lower. Assets are lower.
   • Current Ratio: CA / CL goes down.
   • Inventory Turnover: COGS / Avg. Inventory rises. Days of Inventory: 365 / ITR falls.
   • Cash Conversion Cycle: DIO + DSO - DPO falls.
   • Total Asset turnover: Sales / Avg. Assets rises. Debt to Assets rises. Debt to Equity rises as equity falls, write-down losses hit equity.
   • Gross Margin: GP / Sales falls (COGS ↑). Operating Margin: EBIT / Sales falls (COGS ↑). Net Margin: PAT/ Sales (COGS ↑) falls.

Inflation Impact on FIFO and LIFO

1. First-in, first-out (FIFO) assumes the oldest costs go to cost of goods sold first. In inflation, old cheaper costs hit expense first, so profit and ending inventory look higher.
2. Last-in, first-out (LIFO) assumes the newest costs go to cost of goods sold first. In inflation, new expensive costs hit expense first, so profit and taxes look lower.
3. In deflation, flip the logic. First-in, first-out can produce lower profit than last-in, first-out because older costs are higher.
4. The LIFO reserve is the bridge between first-in, first-out inventory and last-in, first-out inventory. Analysts use it to compare companies.

Presentation and Disclosure

1. Inventory disclosures tell you the cost formula, carrying amount by category, write-downs, reversals, and inventory pledged as collateral.
2. The note matters because the balance sheet gives one inventory number. The note tells you whether the inventory is raw material, work in progress, finished goods, or merchandise.
3. If finished goods are piling up while sales are flat, the company may be producing more than customers want.
4. If inventory write-downs keep recurring, margins may have been too optimistic earlier.