CHAPTER 9

INVENTORIES

Michael A. Broihahn, CFA

Pembroke Pines, FL, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.
• Describe different inventory valuation methods (cost formulas).
• Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using periodic and perpetual inventory systems.
• Calculate and explain effects of inflation and deflation of inventory costs on the financial statements and ratios of companies that use different inventory valuation methods (cost formulas or cost flow assumptions).
• Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.
• Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison.
• Describe implications of valuing inventory at net realizable value for financial statements and ratios.
• Describe the financial statement presentation of and disclosures relating to inventories.
• Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information.
• Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.

1. INTRODUCTION

Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories:1 raw materials, work in progress,2 and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements.

Inventories and cost of sales (cost of goods sold)3 are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time.

International Financial Reporting Standards (IFRS) permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost.4 U.S. generally accepted accounting principles (U.S. GAAP) allow the same three inventory valuation methods, referred to as cost flow assumptions in U.S. GAAP, but also include a fourth method called last-in, first-out (LIFO).5 The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios.

This reading is organized as follows: Section 2 discusses the costs that are included in inventory and the costs that are recognized as expenses in the period in which they are incurred. Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems. Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO. Section 5 describes the financial statement effects of a change in inventory valuation method. Section 6 discusses the measurement and reporting of inventory when its value changes. Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories. A summary and practice problems conclude the reading.

2. COST OF INVENTORIES

Under IFRS, the costs to include in inventories are “all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.”6 The costs of purchase include the purchase price, import and tax-related duties, transport, insurance during transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Trade discounts, rebates, and similar items reduce the price paid and the costs of purchase. The costs of conversion include costs directly related to the units produced, such as direct labor, and fixed and variable overhead costs.7 Including these product-related costs in inventory (i.e., as an asset) means that they will not be recognized as an expense (i.e., as cost of sales) on the income statement until the inventory is sold. U.S. GAAP provide a similar description of the costs to be included in inventory.8

Both IFRS and U.S. GAAP exclude the following costs from inventory: abnormal costs incurred as a result of waste of materials, labor or other production conversion inputs, any storage costs (unless required as part of the production process), and all administrative overhead and selling costs. These excluded costs are treated as expenses and recognized on the income statement in the period in which they are incurred. Including costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Therefore, including costs in inventory that should be expensed will overstate profitability on the income statement (because of the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet.

3. INVENTORY VALUATION METHODS

Generally, inventory purchase costs and manufacturing conversion costs change over time. As a result, the allocation of total inventory costs (i.e., cost of goods available for sale) between cost of sales on the income statement and inventory on the balance sheet will vary depending on the inventory valuation method used by the company. As mentioned in the introduction, inventory valuation methods are referred to as cost formulas and cost flow assumptions under IFRS and U.S. GAAP, respectively. If the choice of method results in more cost being allocated to cost of sales and less cost being allocated to inventory than would be the case with other methods, the chosen method will cause, in the current year, reported gross profit, net income, and inventory carrying amount to be lower than if alternative methods had been used. Accounting for inventory, and consequently the allocation of costs, thus has a direct impact on financial statements and their comparability.

Both IFRS and U.S. GAAP allow companies to use the following inventory valuation methods: specific identification; first-in, first-out (FIFO); and weighted average cost. U.S. GAAP allow companies to use an additional method: last-in, first-out (LIFO). A company must use the same inventory valuation method for all items that have a similar nature and use. For items with a different nature or use, a different inventory valuation method can be used.9 When items are sold, the carrying amount of the inventory is recognized as an expense (cost of sales) according to the cost formula (cost flow assumption) in use.

Specific identification is used for inventory items that are not ordinarily interchangeable, whereas FIFO, weighted average cost, and LIFO are typically used when there are large numbers of interchangeable items in inventory. Specific identification matches the actual historical costs of the specific inventory items to their physical flow; the costs remain in inventory until the actual identifiable inventory is sold. FIFO, weighted average cost, and LIFO are based on cost flow assumptions. Under these methods, companies must make certain assumptions about which goods are sold and which goods remain in ending inventory. As a result, the allocation of costs to the units sold and to the units in ending inventory can be different from the physical movement of the items.

The choice of inventory valuation method would be largely irrelevant if inventory costs remained constant or relatively constant over time. Given relatively constant prices, the allocation of costs between cost of goods sold and ending inventory would be very similar under each of the four methods. Given changing price levels, however, the choice of inventory valuation method can have a significant impact on the amount of reported cost of sales and inventory. And the reported cost of sales and inventory balances affect other items, such as gross profit, net income, current assets, and total assets.

3.1. Specific Identification

The specific identification method is used for inventory items that are not ordinarily interchangeable and for goods that have been produced and segregated for specific projects. This method is also commonly used for expensive goods that are uniquely identifiable, such as precious gemstones. Under this method, the cost of sales and the cost of ending inventory reflect the actual costs incurred to purchase (or manufacture) the items specifically identified as sold and the items specifically identified as remaining in inventory. Therefore, this method matches the physical flow of the specific items sold and remaining in inventory to their actual cost.

3.2. First-In, First-Out (FIFO)

FIFO assumes that the oldest goods purchased (or manufactured) are sold first and the newest goods purchased (or manufactured) remain in ending inventory. In other words, the first units included in inventory are assumed to be the first units sold from inventory. Therefore, cost of sales reflects the cost of goods in beginning inventory plus the cost of items purchased (or manufactured) earliest in the accounting period, and the value of ending inventory reflects the costs of goods purchased (or manufactured) more recently. In periods of rising prices, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold. Conversely, in periods of declining prices, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold.

3.3. Weighted Average Cost

Weighted average cost assigns the average cost of the goods available for sale (beginning inventory plus purchase, conversion, and other costs) during the accounting period to the units that are sold as well as to the units in ending inventory. In an accounting period, the weighted average cost per unit is calculated as the total cost of the units available for sale divided by the total number of units available for sale in the period (Total cost of goods available for sale/Total units available for sale).

3.4. Last-In, First-Out (LIFO)

LIFO is permitted only under U.S. GAAP. This method assumes that the newest goods purchased (or manufactured) are sold first and the oldest goods purchased (or manufactured), including beginning inventory, remain in ending inventory. In other words, the last units included in inventory are assumed to be the first units sold from inventory. Therefore, cost of sales reflects the cost of goods purchased (or manufactured) more recently, and the value of ending inventory reflects the cost of older goods. In periods of rising prices, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold. Conversely, in periods of declining prices, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold.

3.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory

In periods of changing prices, the allocation of total inventory costs (i.e., cost of goods available for sale) between cost of sales on the income statement and inventory on the balance sheet will vary depending on the inventory valuation method used by the company. The following example illustrates how cost of sales, gross profit, and ending inventory differ based on the choice of inventory valuation method.

3.6. Periodic versus Perpetual Inventory Systems

Companies typically record changes to inventory using either a periodic inventory system or a perpetual inventory system. Under a periodic inventory system, inventory values and costs of sales are determined at the end of an accounting period. Purchases are recorded in a purchases account. The total of purchases and beginning inventory is the amount of goods available for sale during the period. The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory. Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales.

Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. This is not generally true for the weighted average cost method. Under a periodic inventory system, the amount of cost of goods available for sale allocated to cost of sales and ending inventory may be quite different using the FIFO method compared to the weighted average cost method. Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales. As a result, the amount of cost of goods available for sale allocated to cost of sales and ending inventory is similar under the FIFO and weighted average cost methods. Because of lack of disclosure and the dominance of perpetual inventory systems, analysts typically do not make adjustments when comparing a company using the weighted average cost method with a company using the FIFO method.

Using the LIFO method, the periodic and perpetual inventory systems will generally result in different allocations to cost of sales and ending inventory. Under either a perpetual or periodic inventory system, the use of the LIFO method will generally result in significantly different allocations to cost of sales and ending inventory compared to other inventory valuation methods. When inventory costs are increasing and inventory unit levels are stable or increasing, using the LIFO method will result in higher cost of sales and lower inventory carrying amounts than using the FIFO method. The higher cost of sales under LIFO will result in lower gross profit, operating income, income before taxes, and net income. Income tax expense will be lower under LIFO, causing the company’s net operating cash flow to be higher. On the balance sheet, the lower inventory carrying amount will result in lower reported current assets, working capital, and total assets. Analysts must carefully assess the financial statement implications of the choice of inventory valuation method when comparing companies that use the LIFO method with companies that use the FIFO method.

Example 9-3 illustrates the impact of the choice of system under LIFO.

3.7. Comparison of Inventory Valuation Methods

As shown in Example 9-2, the allocation of the total cost of goods available for sale to cost of sales on the income statement and to ending inventory on the balance sheet varies under the different inventory valuation methods. In an environment of declining inventory unit costs and constant or increasing inventory quantities, FIFO (in comparison with weighted average cost or LIFO) will allocate a higher amount of the total cost of goods available for sale to cost of sales on the income statement and a lower amount to ending inventory on the balance sheet. Accordingly, because cost of sales will be higher under FIFO, a company’s gross profit, operating profit, and income before taxes will be lower.

Conversely, in an environment of rising inventory unit costs and constant or increasing inventory quantities, FIFO (in comparison with weighted average cost or LIFO) will allocate a lower amount of the total cost of goods available for sale to cost of sales on the income statement and a higher amount to ending inventory on the balance sheet. Accordingly, because cost of sales will be lower under FIFO, a company’s gross profit, operating profit, and income before taxes will be higher.

The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items. The cost of sales under LIFO will more closely reflect current replacement value. LIFO ending inventory amounts are typically not reflective of current replacement value because the ending inventory is assumed to be the oldest inventory and costs are allocated accordingly. Example 9-4 illustrates the different results obtained by using either the FIFO or LIFO methods to account for inventory.

4. THE LIFO METHOD

In the United States, the LIFO method is widely used (approximately 36 percent of U.S. companies use the LIFO method). The potential income tax savings are a benefit of using the LIFO method when inventory costs are increasing. The higher cash flows due to lower income taxes may make the company more valuable because the value of a company is based on the present value of its future cash flows. Under the “LIFO conformity rule,” the U.S. tax code requires that companies using the LIFO method for tax purposes must also use the LIFO method for financial reporting. Under the LIFO method, ending inventory is assumed to consist of those units that have been held the longest. This generally results in ending inventories with carrying amounts lower than current replacement costs because inventory costs typically increase over time. Cost of sales will more closely reflect current replacement costs.

If the purchase prices (purchase costs) or production costs of inventory are increasing, the income statement consequences of using the LIFO method compared to other methods will include higher cost of sales, and lower gross profit, operating profit, income tax expense, and net income. The balance sheet consequences include lower ending inventory, working capital, total assets, retained earnings, and shareholders’ equity. The lower income tax paid will result in higher net cash flow from operating activities. Some of the financial ratio effects are a lower current ratio, higher debt-to-equity ratios, and lower profitability ratios.

If the purchase prices or production costs of inventory are decreasing, it is unlikely that a company will use the LIFO method for tax purposes (and therefore for financial reporting purposes due to the LIFO conformity rule) because this will result in lower cost of sales, and higher taxable income and income taxes. However, if the company had elected to use the LIFO method and cannot justify changing the inventory valuation method for tax and financial reporting purposes when inventory costs begin to decrease, the income statement, balance sheet, and ratio effects will be opposite to the effects during a period of increasing costs.

The U.S. Securities Exchange Commission (SEC) has proposed the full adoption of IFRS by all U.S. reporting companies beginning in 2014. An important consequence of this proposal would be the complete elimination of the LIFO inventory method for financial reporting and, due to the LIFO conformity rule, tax reporting by U.S. companies. As a consequence of the restatement of financial statements to the FIFO or weighted average cost method, significant immediate income tax liabilities may arise in the year of transition from the LIFO method to either the FIFO or weighted average cost method.

4.1. LIFO Reserve

For companies using the LIFO method, U.S. GAAP requires disclosure, in the notes to the financial statements or on the balance sheet, of the amount of the LIFO reserve. The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used (in other words, the FIFO inventory value less the LIFO inventory value). The disclosure provides the information that analysts need to adjust a company’s cost of sales (cost of goods sold) and ending inventory balance based on the LIFO method, to the FIFO method.

To compare companies using LIFO with companies not using LIFO, inventory is adjusted by adding the disclosed LIFO reserve to the inventory balance that is reported on the balance sheet. The reported inventory balance, using LIFO, plus the LIFO reserve equals the inventory that would have been reported under FIFO. Cost of sales is adjusted by subtracting the increase in the LIFO reserve during the period from the cost of sales amount that is reported on the income statement. If the LIFO reserve has declined during the period,10 the decrease in the reserve is added to the cost of sales amount that is reported on the income statement. The LIFO reserve disclosure can be used to adjust the financial statements of a U.S. company using the LIFO method to make them comparable with a similar company using the FIFO method.

4.2. LIFO Liquidations

In periods of rising inventory unit costs, the carrying amount of inventory under FIFO will always exceed the carrying amount of inventory under LIFO. The LIFO reserve may increase over time as the result of the increasing difference between the older costs used to value inventory under LIFO and the more recent costs used to value inventory under FIFO. Also, when the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase as the result of the addition of new LIFO layers (the quantity of inventory units is increasing and each increase in quantity creates a new LIFO layer).

When the number of units sold exceeds the number of units purchased or manufactured, the number of units in ending inventory is lower than the number of units in beginning inventory and a company using LIFO will experience a LIFO liquidation (some of the older units held in inventory are assumed to have been sold). If inventory unit costs have been rising from period to period and LIFO liquidation occurs, this will produce an inventory-related increase in gross profits. The increase in gross profits occurs because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for cost of sales and the sales are at the current prices. The gross profit on these units is higher than the gross profit that would be recognized using more current costs. These inventory profits caused by a LIFO liquidation, however, are one-time events and are not sustainable.

LIFO liquidations can occur for a variety of reasons. The reduction in inventory levels may be outside of management’s control; for example, labor strikes at a supplier may force a company to reduce inventory levels to meet customer demands. In periods of economic recession or when customer demand is declining, a company may choose to reduce existing inventory levels rather than invest in new inventory. Analysts should be aware that management can potentially manipulate and inflate their company’s reported gross profits and net income at critical times by intentionally reducing inventory quantities and liquidating older layers of LIFO inventory (selling some units of beginning inventory). During economic downturns, LIFO liquidation may result in higher gross profit than would otherwise be realized. If LIFO layers of inventory are temporarily depleted and not replaced by fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits. Therefore, it is imperative to review the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred. A decline in the LIFO reserve from the prior period may be indicative of LIFO liquidation.

5. INVENTORY METHOD CHANGES

Companies on rare occasion change inventory valuation methods. Under IFRS, a change in method is acceptable only if the change “results in the financial statements providing reliable and more relevant information about the effects of transactions, other events, or conditions on the business entity’s financial position, financial performance, or cash flows.”11 If the change is justifiable, then it is applied retrospectively.

This means that the change is applied to comparative information for prior periods as far back as is practicable. The cumulative amount of the adjustments relating to periods prior to those presented in the current financial statements is made to the opening balance of each affected component of equity (i.e., retained earnings or comprehensive income) of the earliest period presented. For example, if a company changes its inventory method in 2009 and it presents three years of comparative financial statements (2007, 2008, and 2009) in its annual report, it would retrospectively reflect this change as far back as possible. The change would be reflected in the three years of financial statements presented; the financial statements for 2007 and 2008 would be restated as if the new method had been used in these periods, and the cumulative effect of the change on periods prior to 2007 would be reflected in the 2007 opening balance of each affected component of equity. An exemption to the restatement applies when it is impracticable to determine either the period-specific effects or the cumulative effect of the change.

Under U.S. GAAP, the conditions to make a change in accounting policy and the accounting for a change in inventory policy are similar to IFRS.12 U.S. GAAP, however, requires companies to thoroughly explain why the newly adopted inventory accounting method is superior and preferable to the old method. If a company decides to change from LIFO to another inventory method, U.S. GAAP requires a retrospective restatement as described earlier. However, if a company decides to change to the LIFO method, it must do so on a prospective basis and retrospective adjustments are not made to the financial statements. The carrying amount of inventory under the old method becomes the initial LIFO layer in the year of LIFO adoption.

Analysts should carefully evaluate changes in inventory valuation methods. Although the stated reason for the inventory change may be to better match inventory costs with sales revenue (or some other plausible business explanation), the real underlying (and unstated) purpose may be to reduce income tax expense (if changing to LIFO from FIFO or average cost), or to increase reported profits (if changing from LIFO to FIFO or average cost). As always, the choice of inventory valuation method can have a significant impact on financial statements and the financial ratios that are derived from them. As a consequence, analysts must carefully consider the impact of the change in inventory valuation methods and the differences in inventory valuation methods when comparing a company’s performance with that of its industry or its competitors.

6. INVENTORY ADJUSTMENTS

Significant financial risk can result from the holding of inventory. The cost of inventory may not be recoverable due to spoilage, obsolescence, or declines in selling prices. IFRS state that inventories shall be measured (and carried on the balance sheet) at the lower of cost and net realizable value.13 Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale. The assessment of net realizable value is typically done item by item or by groups of similar or related items. In the event that the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value14 and the loss (reduction in value) recognized as an expense on the income statement. This expense may be included as part of cost of sales or reported separately.

In each subsequent period, a new assessment of net realizable value is made. Reversal (limited to the amount of the original write-down) is required for a subsequent increase in value of inventory previously written down. The reversal of any write-down of inventories is recognized as a reduction in cost of sales (reduction in the amount of inventories recognized as an expense).

U.S. GAAP specify the lower of cost or market to value inventories.15 This is broadly consistent with IFRS with one major difference: U.S. GAAP prohibit the reversal of write-downs. Market value is defined as current replacement cost subject to upper and lower limits. Market value cannot exceed net realizable value (selling price less reasonably estimated costs of completion and disposal). The lower limit of market value is net realizable value less a normal profit margin. Any write-down reduces the value of the inventory, and the loss in value (expense) is generally reflected in the income statement in cost of goods sold.

An inventory write-down reduces both profit and the carrying amount of inventory on the balance sheet and thus has a negative effect on profitability, liquidity, and solvency ratios. However, activity ratios (for example, inventory turnover and total asset turnover) will be positively affected by a write-down because the asset base (denominator) is reduced. The negative impact on some key ratios, due to the decrease in profit, may result in the reluctance by some companies to record inventory write-downs unless there is strong evidence that the decline in the value of inventory is permanent. This is especially true under U.S. GAAP where reversal of a write-down is prohibited.

IAS 2 [Inventories] does not apply to the inventories of producers of agricultural and forest products and minerals and mineral products, nor to commodity broker–traders. These inventories may be measured at net realizable value (fair value less costs to sell and complete) according to well-established industry practices. If an active market exists for these products, the quoted market price in that market is the appropriate basis for determining the fair value of that asset. If an active market does not exist, a company may use market determined prices or values (such as the most recent market transaction price) when available for determining fair value. Changes in the value of inventory (increase or decrease) are recognized in profit or loss in the period of the change. U.S. GAAP is similar to IFRS in its treatment of inventories of agricultural and forest products and mineral ores. Mark-to-market inventory accounting is allowed for bullion.

Analysts should consider the possibility of an inventory write-down because the impact on a company’s financial ratios may be substantial. The potential for inventory write-downs can be high for companies in industries where technological obsolescence of inventories is a significant risk. Analysts should carefully evaluate prospective inventory impairments (as well as other potential asset impairments) and their potential effects on the financial ratios when debt covenants include financial ratio requirements. The breaching of debt covenants can have a significant impact on a company.

Companies that use specific identification, weighted average cost, or FIFO methods are more likely to incur inventory write-downs than companies that use the LIFO method. Under the LIFO method, the oldest costs are reflected in the inventory carrying amount on the balance sheet. Given increasing inventory costs, the inventory carrying amounts under the LIFO method are already conservatively presented at the oldest and lowest costs. Thus, it is far less likely that inventory write-downs will occur under LIFO—and if a write-down does occur, it is likely to be of a lesser magnitude.

7. EVALUATION OF INVENTORY MANAGEMENT

The choice of inventory valuation method impacts the financial statements. The financial statement items impacted include cost of sales, gross profit, net income, inventories, current assets, and total assets. Therefore, the choice of inventory valuation method also affects financial ratios that contain these items. Ratios such as current ratio, return on assets, gross profit margin, and inventory turnover are impacted. As a consequence, analysts must carefully consider inventory valuation method differences when evaluating a company’s performance over time or when comparing its performance with the performance of the industry or industry competitors. Additionally, the financial statement items and ratios may be impacted by adjustments of inventory carrying amounts to net realizable value or current replacement cost.

7.1. Presentation and Disclosure

Disclosures are useful when analyzing a company. IFRS require the following financial statement disclosures concerning inventory:

Inventory-related disclosures under U.S. GAAP are very similar to the disclosures cited earlier, except that requirements (f) and (g) are not relevant because U.S. GAAP do not permit the reversal of prior-year inventory write-downs. U.S. GAAP also require disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.

7.2. Inventory Ratios

Three ratios often used to evaluate the efficiency and effectiveness of inventory management are inventory turnover, days of inventory on hand, and gross profit margin.17 These ratios are directly impacted by a company’s choice of inventory valuation method. Analysts should be aware, however, that many other ratios are also affected by the choice of inventory valuation method, although less directly. These include the current ratio, because inventory is a component of current assets; the return-on-assets ratio, because cost of sales is a key component in deriving net income and inventory is a component of total assets; and even the debt-to-equity ratio, because the cumulative measured net income from the inception of a business is an aggregate component of retained earnings.

The inventory turnover ratio measures the number of times during the year a company sells (i.e., turns over) its inventory. The higher the turnover ratio, the more times that inventory is sold during the year and the lower the relative investment of resources in inventory. Days of inventory on hand can be calculated as days in the period divided by inventory turnover. Thus, inventory turnover and days of inventory on hand are inversely related. It may be that inventory turnover, however, is calculated using average inventory in the year whereas days of inventory on hand is based on the ending inventory amount. In general, inventory turnover and the number of days of inventory on hand should be benchmarked against industry norms and compared across years.

A high inventory turnover ratio and a low number of days of inventory on hand might indicate highly effective inventory management. Alternatively, a high inventory ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. Inventory shortages could potentially result in lost sales or production problems in the case of the raw materials inventory of a manufacturer. To assess which explanation is more likely, analysts can compare the company’s inventory turnover and sales growth rate with those of the industry and review financial statement disclosures. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Write-downs of inventory could reflect poor inventory management. Minimal write-downs and sales growth rates at or above the industry’s growth rates would support the interpretation that the higher turnover reflects greater efficiency in managing inventory.

A low inventory turnover ratio and a high number of days of inventory on hand relative to industry norms could be an indicator of slow-moving or obsolete inventory. Again, comparing the company’s sales growth across years and with the industry and reviewing financial statement disclosures can provide additional insight.

The gross profit margin, the ratio of gross profit to sales, indicates the percentage of sales being contributed to net income as opposed to covering the cost of sales. Firms in highly competitive industries generally have lower gross profit margins than firms in industries with fewer competitors. A company’s gross profit margin may be a function of its type of product. A company selling luxury products will generally have higher gross profit margins than a company selling staple products. The inventory turnover of the company selling luxury products, however, is likely to be much lower than the inventory turnover of the company selling staple products.

7.3. Financial Analysis Illustrations

IFRS and U.S. GAAP require companies to disclose, either on the balance sheet or in the notes to the financial statements, the carrying amounts of inventories in classifications suitable to the company. For manufacturing companies, these classifications might include production supplies, raw materials, work in progress, and finished goods. For a retailer, these classifications might include significant categories of merchandise or the grouping of inventories with similar attributes. These disclosures may provide signals about a company’s future sales and profits.

For example, a significant increase (attributable to increases in unit volume rather than increases in unit cost) in raw materials and/or work-in-progress inventories may signal that the company expects an increase in demand for its products. This suggests an anticipated increase in sales and profit. However, a substantial increase in finished goods inventories while raw materials and work-in-progress inventories are declining may signal a decrease in demand for the company’s products and hence lower future sales and profit. This may also signal a potential future write-down of finished goods inventory. Irrespective of the signal, an analyst should thoroughly investigate the underlying reasons for any significant changes in a company’s raw materials, work-in-progress, and finished goods inventories.

Analysts also should compare the growth rate of a company’s sales to the growth rate of its finished goods inventories, because this could also provide a signal about future sales and profits. For example, if the growth of inventories is greater than the growth of sales, this could indicate a decline in demand and a decrease in future earnings. The company may have to lower (mark down) the selling price of its products to reduce its inventory balances, or it may have to write down the value of its inventory because of obsolescence, both of which would negatively affect profits. Besides the potential for mark-downs or write-downs, having too much inventory on hand or the wrong type of inventory can have a negative financial effect on a company because it increases inventory-related expenses such as insurance, storage costs, and taxes. In addition, it means that the company has less cash and working capital available to use for other purposes.

Inventory write-downs may have a substantial impact on a company’s activity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends toward product obsolescence and to analyze the financial ratios for their sensitivity to potential inventory impairment. Companies can minimize the impact of inventory write-downs by better matching their inventory composition and growth with prospective customer demand. To obtain additional information about a company’s inventory and its future sales, a variety of sources of information are available. Analysts should consider the management’s discussion and analysis (MD&A) or similar sections of the company’s financial reports, industry-related news and publications, and industry economic data.

When conducting comparisons, differences in the choice of inventory valuation method can significantly affect the comparability of financial ratios between companies. A restatement from the LIFO method to the FIFO method is critical to make a valid comparison with companies using a method other than the LIFO method such as those companies reporting under IFRS. Analysts should seek out as much information as feasible when analyzing the performance of companies.

8. SUMMARY

The choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies. Key concepts in this reading are as follows:

• Inventories are a major factor in the analysis of merchandising and manufacturing companies. Such companies generate their sales and profits through inventory transactions on a regular basis. An important consideration in determining profits for these companies is measuring the cost of sales when inventories are sold.
• The total cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Storage costs of finished inventory and abnormal costs due to waste are typically treated as expenses in the period in which they occurred.
• The allowable inventory valuation methods implicitly involve different assumptions about cost flows. The choice of inventory valuation method determines how the cost of goods available for sale during the period is allocated between inventory and cost of sales.
• IFRS allow three inventory valuation methods (cost formulas): first-in, first-out (FIFO); weighted average cost; and specific identification. The specific identification method is used for inventories of items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects. U.S. GAAP allow these three methods plus the last-in, first-out (LIFO) method. The LIFO method is widely used in the United States for both tax and financial reporting purposes because of potential income tax savings.
• The choice of inventory method affects the financial statements and any financial ratios that are based on them. As a consequence, the analyst must carefully consider inventory valuation method differences when evaluating a company’s performance over time or in comparison to industry data or industry competitors.
• A company must use the same cost formula for all inventories having a similar nature and use to the entity.
• The inventory accounting system (perpetual or periodic) may result in different values for cost of sales and ending inventory when the weighted average cost or LIFO inventory valuation method is used.
• Under U.S. GAAP, companies that use the LIFO method must disclose in their financial notes the amount of the LIFO reserve or the amount that would have been reported in inventory if the FIFO method had been used. This information can be used to adjust reported LIFO inventory and cost of goods sold balances to the FIFO method for comparison purposes.
• LIFO liquidation occurs when the number of units in ending inventory declines from the number of units that were present at the beginning of the year. If inventory unit costs have generally risen from year to year, this will produce an inventory-related increase in gross profits.
• Consistency of inventory costing is required under both IFRS and U.S. GAAP. If a company changes an accounting policy, the change must be justifiable and applied retrospectively to the financial statements. An exception to the retrospective restatement is when a company reporting under U.S. GAAP changes to the LIFO method.
• Under IFRS, inventories are measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Under U.S. GAAP, inventories are measured at the lower of cost or market value. Market value is defined as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. Reversals of previous write-downs are permissible under IFRS but not under U.S. GAAP.
• Reversals of inventory write-downs may occur under IFRS but are not allowed under U.S. GAAP.
• Changes in the carrying amounts within inventory classifications (such as raw materials, work-in-process, and finished goods) may provide signals about a company’s future sales and profits. Relevant information with respect to inventory management and future sales may be found in the Management Discussion and Analysis or similar items within the annual or quarterly reports, industry news and publications, and industry economic data.
• The inventory turnover ratio, number of days of inventory ratio, and gross profit margin ratio are useful in evaluating the management of a company’s inventory.
• Inventory management may have a substantial impact on a company’s activity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends and management’s intentions.
• Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company’s inventory management.

PROBLEMS

1. Inventory cost is least likely to include:

A. production-related storage costs.

B. costs incurred as a result of normal waste of materials.

C. transportation costs of shipping inventory to customers.

2. Mustard Seed PLC adheres to IFRS. It recently purchased inventory for €100 million and spent €5 million for storage prior to selling the goods. The amount it charged to inventory expense (€ millions) was closest to:

A. €95.

B. €100.

C. €105.

3. Carrying inventory at a value above its historical cost would most likely be permitted if:

A. the inventory was held by a producer of agricultural products.

B. financial statements were prepared using U.S. GAAP.

C. the change resulted from a reversal of a previous write-down.

4. Eric’s Used Bookstore prepares its financial statements in accordance with IFRS. Inventory was purchased for £1 million and later marked down to £550,000. One of the books, however, was later discovered to be a rare collectible item, and the inventory is now worth an estimated £3 million. The inventory is most likely reported on the balance sheet at:

A. £550,000.

B. £1,000,000.

C. £3,000,000.

5. Fernando’s Pasta purchased inventory and later wrote it down. The current net realizable value is higher than the value when written down. Fernando’s inventory balance will most likely be:

A. higher if it complies with IFRS.

B. higher if it complies with U.S. GAAP.

C. the same under U.S. GAAP and IFRS.

For questions 6 through 17, assume the companies use a periodic inventory system.

6. Cinnamon Corp. started business in 2007 and uses the weighted average cost method. During 2007, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2008, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2008 cost of sales (€ thousands) was closest to:

A. €490.

B. €491.

C. €495.

7. Zimt AG started business in 2007 and uses the FIFO method. During 2007, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2008, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2008 ending inventory balance (€ thousands) was closest to:

A. €105.

B. €109.

C. €110.

8. Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by:

A. Zimt is too low.

B. Nutmeg is too low.

C. Nutmeg is too high.

9. Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices the ending inventory balance reported by:

A. Zimt is too high.

B. Nutmeg is too low.

C. Nutmeg is too high.

10. Like many technology companies, TechnoTools operates in an environment of declining prices. Its reported profits will tend to be highest if it accounts for inventory using the:

A. FIFO method.

B. LIFO method.

C. weighted average cost method.

11. Compared to using the weighted average cost method to account for inventory, during a period in which prices are generally rising, the current ratio of a company using the FIFO method would most likely be:

A. lower.

B. higher.

C. dependent upon the interaction with accounts payable.

12. Zimt AG wrote down the value of its inventory in 2007 and reversed the write-down in 2008. Compared to the ratios that would have been calculated if the write-down had never occurred, Zimt’s reported 2007:

A. current ratio was too high.

B. gross margin was too high.

C. inventory turnover was too high.

13. Zimt AG wrote down the value of its inventory in 2007 and reversed the write-down in 2008. Compared to the results the company would have reported if the write-down had never occurred, Zimt’s reported 2008:

A. profit was overstated.

B. cash flow from operations was overstated.

C. year-end inventory balance was overstated.

14. Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more:

A. liquid.

B. efficient.

C. profitable.

15. Nutmeg Inc. uses the LIFO method to account for inventory. During years in which inventory unit costs are generally rising and in which the company purchases more inventory than it sells to customers, its reported gross profit margin will most likely be:

A. lower than it would be if the company used the FIFO method.

B. higher than it would be if the company used the FIFO method.

C. about the same as it would be if the company used the FIFO method.

16. Compared to using the FIFO method to account for inventory, during periods of rising prices, a company using the LIFO method is most likely to report higher:

A. net income.

B. cost of sales.

C. income taxes.

17. Carey Company adheres to U.S. GAAP, whereas Jonathan Company adheres to IFRS. It is least likely that:

A. Carey has reversed an inventory write-down.

B. Jonathan has reversed an inventory write-down.

C. Jonathan and Carey both use the FIFO inventory accounting method.

The following information relates to Questions 18 through 25.20

Hans Annan, CFA, a food and beverage analyst, is reviewing Century Chocolate’s inventory policies as part of his evaluation of the company. Century Chocolate, based in Switzerland, manufactures chocolate products and purchases and resells other confectionery products to complement its chocolate line. Annan visited Century Chocolate’s manufacturing facility last year. He learned that cacao beans, imported from Brazil, represent the most significant raw material and that the work-in-progress inventory consists primarily of three items: roasted cacao beans, a thick paste produced from the beans (called chocolate liquor), and a sweetened mixture that needs to be “conched” to produce chocolate. On the tour, Annan learned that the conching process ranges from a few hours for lower-quality products to six days for the highest-quality chocolates. While there, Annan saw the facility’s climate-controlled area where manufactured finished products (cocoa and chocolate) and purchased finished goods are stored prior to shipment to customers. After touring the facility, Annan had a discussion with Century Chocolate’s CFO regarding the types of costs that were included in each inventory category.

Annan has asked his assistant, Joanna Kern, to gather some preliminary information regarding Century Chocolate’s financial statements and inventories. He also asked Kern to calculate the inventory turnover ratios for Century Chocolate and another chocolate manufacturer for the most recent five years. Annan does not know Century Chocolate’s most direct competitor, so he asks Kern to do some research and select the most appropriate company for the ratio comparison.

Kern reports back that Century Chocolate prepares its financial statements in accordance with IFRS. She tells Annan that the policy footnote states that raw materials and purchased finished goods are valued at purchase cost whereas work in progress and manufactured finished goods are valued at production cost. Raw material inventories and purchased finished goods are accounted for using the FIFO (first-in, first-out) method, and the weighted average cost method is used for other inventories. An allowance is established when the net realizable value of any inventory item is lower than the value calculated.

Kern provides Annan with the selected financial statements and inventory data for Century Chocolate shown in Exhibits A through E. The ratio exhibit Kern prepared compares Century Chocolate’s inventory turnover ratios to those of Gordon’s Goodies, a U.S.-based company. Annan returns the exhibit and tells Kern to select a different competitor that reports using IFRS rather than U.S. GAAP. During this initial review, Annan asks Kern why she has not indicated whether Century Chocolate uses a perpetual or a periodic inventory system. Kern replies that she learned that Century Chocolate uses a perpetual system but did not include this information in her report because inventory values would be the same under either a perpetual or periodic inventory system. Annan tells Kern she is wrong and directs her to research the matter.

EXHIBIT A Century Chocolate Income Statements (CHF millions)

For Years Ended 31 December	2009	2008
Sales	95,290	93,248
Cost of sales	−41,043	−39,047
Marketing, administration, and other expenses	−35,318	−42,481
Profit before taxes	18,929	11,720
Taxes	−3,283	−2,962
Profit for the period	15,646	8,758

EXHIBIT B Century Chocolate Balance Sheets (CHF millions)

For Years Ended 31 December	2009	2008
Cash, cash equivalents, and short-term investments	6,190	8,252
Trade receivables and related accounts, net	11,654	12,910
Inventories, net	8,100	7,039
Other current assets	2,709	2,812
Total current assets	28,653	31,013
Property, plant, and equipment, net	18,291	19,130
Other noncurrent assets	45,144	49,875
Total assets	92,088	100,018
Trade and other payables	10,931	12,299
Other current liabilities	17,873	25,265
Total current liabilities	28,804	37,564
Noncurrent liabilities	15,672	14,963
Total liabilities	44,476	52,527
Equity
Share capital	332	341
Retained earnings and other reserves	47,280	47,150
Total equity	47,612	47,491
Total liabilities and shareholders’ equity	92,088	100,018

EXHIBIT C Century Chocolate Supplementary Footnote Disclosures: Inventories (CHF millions)

For Years Ended 31 December	2009	2008
Raw Materials	2,154	1,585
Work in Progress	1,061	1,027
Finished Goods	5,116	4,665
Total inventories before allowance	8,331	7,277
Allowance for write-downs to net realizable value	−231	−238
Total inventories net of allowance	8,100	7,039

EXHIBIT D Century Chocolate Inventory Record for Purchased Lemon Drops

EXHIBIT E Century Chocolate Net Realizable Value Information for Black Licorice Jelly Beans

	2009	2008
FIFO cost of inventory at 31 December (CHF)	314,890	374,870
Ending inventory at 31 December (kilograms)	77,750	92,560
Cost per kilogram (CHF)	4.05	4.05
Net realizable value (CHF per kilogram)	4.20	3.95

While Kern is revising her analysis, Annan reviews the most recent month’s Cocoa Market Review from the International Cocoa Organization. He is drawn to the statement that “the ICCO daily price, averaging prices in both futures markets, reached a 29-year high in US$ terms and a 23-year high in SDRs terms (the SDR unit comprises a basket of major currencies used in international trade: US$, Euro, Pound Sterling and Yen).” Annan makes a note that he will need to factor the potential continuation of this trend into his analysis.

18. The costs least likely to be included by the CFO as inventory are:

A. storage costs for the chocolate liquor.

B. excise taxes paid to the government of Brazil for the cacao beans.

C. storage costs for chocolate and purchased finished goods awaiting shipment to customers.

19. What is the most likely justification for Century Chocolate’s choice of inventory valuation method for its finished goods?

A. It is the preferred method under IFRS.

B. It allocates the same per unit cost to both cost of sales and inventory.

C. Ending inventory reflects the cost of goods purchased most recently.

20. In Kern’s comparative ratio analysis, the 2009 inventory turnover ratio for Century Chocolate is closest to:

A. 5.07.

B. 5.42.

C. 5.55.

21. The most accurate statement regarding Annan’s reasoning for requiring Kern to select a competitor that reports under IFRS for comparative purposes is that under U.S. GAAP:

A. fair values are used to value inventory.

B. the LIFO method is permitted to value inventory.

C. the specific identification method is permitted to value inventory.

22. Annan’s statement regarding the perpetual and periodic inventory systems is most significant when which of the following costing systems is used?

A. LIFO.

B. FIFO.

C. Specific identification.

23. Using the inventory record for purchased lemon drops shown in Exhibit D, the cost of sales for 2009 will be closest to:

A. CHF 3,550.

B. CHF 4,550.

C. CHF 4,850.

24. Ignoring any tax effect, the 2009 net realizable value reassessment for the black licorice jelly beans will most likely result in:

A. an increase in gross profit of CHF 9,256.

B. an increase in gross profit of CHF 11,670.

C. no impact on cost of sales because under IFRS, write-downs cannot be reversed.

25. If the trend noted in the ICCO report continues and Century Chocolate plans to maintain constant or increasing inventory quantities, the most likely impact on Century Chocolate’s financial statements related to its raw materials inventory will be:

A. a cost of sales that more closely reflects current replacement values.

B. a higher allocation of the total cost of goods available for sale to cost of sales.

C. a higher allocation of the total cost of goods available for sale to ending inventory.

The following information relates to Questions 26 through 31.21

John Martinson, CFA, is an equity analyst with a large pension fund. His supervisor, Linda Packard, asks him to write a report on Karp Inc. Karp prepares its financial statements in accordance with U.S. GAAP. Packard is particularly interested in the effects of the company’s use of the LIFO method to account for its inventory. For this purpose, Martinson collects the financial data presented in Exhibits F and G.

EXHIBIT F Balance Sheet Information (US$ millions)

As of 31 December	2009	2008
Cash and cash equivalents	172	157
Accounts receivable	626	458
Inventories	620	539
Other current assets	125	65
Total current assets	1,543	1,219
Property and equipment, net	3,035	2,972
Total assets	4,578	4,191
Total current liabilities	1,495	1,395
Long-term debt	644	604
Total liabilities	2,139	1,999
Common stock and paid in capital	1,652	1,652
Retained earnings	787	540
Total shareholders’ equity	2,439	2,192
Total liabilities and shareholders’ equity	4,578	4,191

EXHIBIT G Income Statement Information (US$ millions)

For Years Ended 31 December	2009	2008
Sales	4,346	4,161
Cost of goods sold	2,211	2,147
Depreciation and amortization expense	139	119
Selling, general, and administrative expense	1,656	1,637
Interest expense	31	18
Income tax expense	62	48
Net income	247	192

Martinson finds the following information in the notes to the financial statements:

• The LIFO reserves as of 31 December 2009 and 2008 are $155 million and $117 million respectively; and
• The effective income tax rate applicable to Karp for 2009 and earlier periods is 20%.

26. If Karp had used FIFO instead of LIFO, the amount of inventory reported as of 31 December 2009 would have been closest to:

A. $465 million.

B. $658 million.

C. $775 million.

27. If Karp had used FIFO instead of LIFO, the amount of cost of goods sold reported by Karp for the year ended 31 December 2009 would have been closest to:

A. $2,056 million.

B. $2,173 million.

C. $2,249 million.

28. If Karp had used FIFO instead of LIFO, its reported net income for the year ended 31 December 2009 would have been higher by an amount closest to:

A. $30 million.

B. $38 million.

C. $155 million.

29. If Karp had used FIFO instead of LIFO, Karp’s retained earnings as of 31 December 2009 would have been higher by an amount closest to:

A. $117 million.

B. $124 million.

C. $155 million.

30. If Karp had used FIFO instead of LIFO, which of the following ratios computed as of 31 December 2009 would most likely have been lower?

A. cash ratio

B. current ratio

C. gross profit margin

31. If Karp had used FIFO instead of LIFO, its debt to equity ratio computed as of 31 December 2009 would have:

A. increased.

B. decreased.

C. remained unchanged.

The following information relates to Questions 32 through 37.22

Robert Groff, an equity analyst, is preparing a report on Crux Corp. As part of his report, Groff makes a comparative financial analysis between Crux and its two main competitors, Rolby Corp. and Mikko Inc. Crux and Mikko report under U.S. GAAP and Rolby reports under IFRS.

Groff gathers information on Crux, Rolby, and Mikko. The relevant financial information he compiles is in Exhibit H. Some information on the industry is in Exhibit I.

EXHIBIT H Selected Financial Information (US$ millions)

EXHIBIT I Industry Information

To compare the financial performance of the three companies, Groff decides to convert LIFO figures into FIFO figures, and adjust figures to assume no valuation allowance is recognized by any company.

After reading Groff’s draft report, his supervisor, Rachel Borghi, asks him the following questions:

32. Crux’s inventory turnover ratio computed as of 31 December 2009, after the adjustments suggested by Groff, is closest to:

A. 5.67.

B. 5.83.

C. 6.13.

33. Rolby’s net profit margin for the year ended 31 December 2009, after the adjustments suggested by Groff, is closest to:

A. 6.01%.

B. 6.20%.

C. 6.28%.

34. Compared with its unadjusted debt-to-equity ratio, Mikko’s debt-to-equity ratio as of 31 December 2009, after the adjustments suggested by Groff, is:

A. lower.

B. higher.

C. the same.

35. The best answer to Borghi’s Question 1 is:

A. Crux’s.

B. Rolby’s.

C. Mikko’s.

36. The best answer to Borghi’s Question 2 is:

A. stable.

B. inflationary.

C. deflationary.

37. The best answer to Borghi’s Question 3 is:

A. Activity ratios.

B. Solvency ratios.

C. Profitability ratios.

The following information relates to Questions 38 through 45.23

ZP Corporation is a (hypothetical) multinational corporation headquartered in Japan that trades on numerous stock exchanges. ZP prepares its consolidated financial statements in accordance with U.S. GAAP. Excerpts from ZP’s 2009 annual report are shown in Exhibits J–L.

EXHIBIT J Consolidated Balance Sheets (¥ millions)

Year Ended 31 December	2008	2009
Current assets
Cash and cash equivalents	¥542,849	¥814,760
⋮	⋮	⋮
Inventories	608,572	486,465
⋮	⋮	⋮
Total current assets	4,028,742	3,766,309
⋮	⋮	⋮
Total assets	¥10,819,440	¥9,687,346
⋮	⋮	⋮
Total current liabilities	¥3,980,247	¥3,529,765
⋮	⋮	⋮
Total long-term liabilities	2,663,795	2,624,002
Minority interest in consolidated subsidiaries	218,889	179,843
Total shareholders’ equity	3,956,509	3,353,736
Total liabilities and shareholders’ equity	¥10,819,440	¥9,687,346

EXHIBIT K Consolidated Statements of Income (¥ millions)

38. The MD&A indicated that the prices of raw material, other production materials, and parts increased. Based on the inventory valuation methods described in Note 2, which inventory classification would least accurately reflect current prices?

A. Raw materials

B. Finished goods

C. Work in process

39. The 2008 inventory value as reported on the 2009 consolidated balance sheet if the company had used the FIFO inventory valuation method instead of the LIFO inventory valuation method for a portion of its inventory would be closest to:

A. ¥104,698 million.

B. ¥506,125 million.

C. ¥618,692 million.

40. What is the least likely reason why ZP may need to change its accounting policies regarding inventory at some point after 2009?

A. The U.S. SEC is likely to require companies to use the same inventory valuation method for all inventories.

B. The U.S. SEC is likely to prohibit the use of one of the methods ZP currently uses for inventory valuation.

C. One of the inventory valuation methods used for U.S. tax purposes may be repealed as an acceptable method.

41. If ZP had prepared its financial statement in accordance with IFRS, the inventory turnover ratio (using average inventory) for 2009 would be:

A. lower.

B. higher.

C. the same.

42. Inventory levels decreased from 2008 to 2009 for all of the following reasons except:

A. LIFO liquidation.

B. sales volume decreased.

C. fluctuations in foreign currency translation rates.

43. Which observation is most likely a result of looking only at the information reported in Note 9?

A. Increased competition has led to lower unit sales.

B. There have been significant price increases in supplies.

C. Management expects a further downturn in sales during 2010.

44. Note 2 indicates that, “Inventories valued on the LIFO basis totaled ¥94,578 million and ¥50,037 million at 31 December 2008 and 2009, respectively.” Based on this, the LIFO reserve should most likely:

A. increase.

B. decrease.

C. remain the same.

45. The Industry and Business Risk excerpt states that, “Increased competition may lead to lower unit sales and excess production capacity and excess inventory. This may result in a further downward price pressure.” The downward price pressure could lead to inventory that is valued above current market prices or net realizable value. Any write-downs of inventory are least likely to have a significant effect on the inventory valued using:

A. weighted average cost.

B. first-in, first-out (FIFO).

C. last-in, first-out (LIFO).

1Other classifications are possible. Inventory classifications should be appropriate to the entity.

2This category is commonly referred to as work in process under U.S. GAAP.

3Typically, cost of sales is IFRS terminology and cost of goods sold is U.S. GAAP terminology.

4International Accounting Standard (IAS) 2 [Inventories].

5Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 330 [Inventory].

6International Accounting Standard (IAS) 2 [Inventories].

7Fixed production overhead costs (depreciation, factory maintenance, and factory management and administration) represent indirect costs of production that remain relatively constant regardless of the volume of production. Variable production overhead costs are indirect production costs (indirect labor and materials) that vary with the volume of production.

8FASB Accounting Standards Codification™ (ASC) Topic 330 [Inventory].

9For example, if a clothing manufacturer produces both a retail line and one-of-a-kind designer garments, the retail line might be valued using FIFO and the designer garments using specific identification.

10This typically results from a reduction in inventory units and is referred to as LIFO liquidation. LIFO liquidation is discussed in Section 4.2.

11IAS 8 [Accounting Policies, Changes in Accounting Estimates and Errors].

12FASB ASC Topic 250 [Accounting Changes and Error Corrections].

13IAS 2 paragraphs 28–33 [Inventories − Net realizable value].

14Frequently, rather than writing inventory down directly, an inventory valuation allowance account is used. The allowance account is netted with the inventory accounts to arrive at the carrying amount that appears on the balance sheet.

15FASB ASC Section 330-10-35 [Inventory − Overall − Subsequent Measurement].

16As of this writing, the Volvo line of automobiles is not under the control and management of the Volvo Group.

17 Days of inventory on hand is also referred to as days in inventory and average inventory days outstanding.

18This reduction is often referred to as a charge. An accounting charge is the recognition of a loss or expense. In this case, the charge is attributable to the impairment of assets.

19 Cost approximates cost on a first-in, first-out basis.

20Item set developed by Karen Rubsam, CFA (Fountain Hills, Arizona, USA).

21Item set developed by Rodrigo Ribeiro, CFA (Montevideo, Uruguay).

22Item set developed by Rodrigo Ribeiro, CFA (Montevideo, Uruguay).

23Item set developed by Karen O’Connor Rubsam, CFA (Fountain Hills, Arizona, U.S.A.).