Accounting Adjustments
- Inventory valuation and impact on
Financial Statements
1
Objective
• Understand different cost formulas used for
valuing inventories
• Understand how to adjust a company’s
reported financial statements from LIFO to
FIFO for purposes of peer comparison
• Perpetual vs. periodic inventory method
• Understand the concepts of LIFO reserve and
LIFO liquidation and their effects on financial
statements and ratios
2
Method of valuing inventory and Cost
flow assumptions/cost formulas
• Inventories are valued at lower of
– Cost or
– Net realisable value
• “The cost of inventories shall comprise all costs of
purchase, direct labour, costs of conversion,
variable and fixed production overheads and other
costs incurred in bringing the inventories to their
present location and condition”
• Net realisable value is the estimated selling price in
the ordinary course of business less the estimated
costs of completion and the estimated costs
necessary to make the sale.
3
Method of valuing inventory and Cost
flow assumptions/cost formula
• IFRS, US GAAP as well as IND AS exclude the following costs
from inventory:
– abnormal costs incurred as a result of waste of materials,
labour or other production conversion inputs,
– any storage costs (unless required as part of the production
process or unless those costs are necessary in the production
process before a further production stage) and
– administrative overheads that do not contribute to bringing
inventories to their present location and condition; and
– Selling Costs
• These excluded costs are treated as expenses and
recognised on the income statement in the period in which
they are incurred.
4
Method of valuing inventory and Cost
flow assumptions/cost formulas
• 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.
• The practice of writing down inventories below cost to net
realisable value is consistent with the view that assets should not
be carried in excess of amounts expected to be realized from their
sale or use
• Inventory valuation follows “Conservatism” principle of accounting
since it recognizes
– Losses or declines in market value are recognized as they occur
– Profits are reported only when inventory is sold
5
Example - Treatment of InventoryRelated Cost
Acme Enterprises, a manufacturer tables, prepares its financial
statements in accordance with IFRS. In 2019, the factory
produced 900,000 finished tables and scrapped 1,000 tables. For
the finished tables, raw material costs were €9 million, direct
labour conversion costs were €18 million, and production
overhead costs were €1.8 million. The 1,000 scrapped tables
(attributable to abnormal waste) had a total production cost of
€30,000 (€10,000 raw material costs and €20,000 conversion
costs; these costs are not included in the €9 million raw material
and €19.8 million total conversion costs of the finished tables).
During the year, Acme spent €1 million for freight delivery
charges on raw materials and €500,000 for storing finished goods
inventory. Acme does not have any work-in-progress inventory at
the end of the year.
1 What costs should be included in inventory in 2019?
2 What costs should be expensed in 2019?
Source: CFA level 1 FSA
6
Solution
• Total inventory costs for 2019 are as follows:
Raw materials
€9,000,000
Direct labour
18,000,000
Production overhead
1,800,000
Transportation for RM
1,000,000
Total inventory costs
€29,800,000
• Total costs that should be expensed (not included in
inventory) are as follows:
Abnormal waste
€30,000
Storage of finished goods inventory
500,000
Total
€530,000
7
Cost formulas
• Cost formulas for measuring cost of inventories
and that charged to COGS are
– Specific identification
– FIFO
– LIFO (Not permitted as per IND AS-2 and IFRS and
many other GAAP, US GAAP still has the provision)
– Weighted average cost
• Lookup disclosures on Inventories in annual
reports -“Inventories” for Titan, Kalyan Jewelers
and Tata Motors
8
Inventory and COGS Formula
Beginning Inventory (BI)
Purchases / (Purchases + conversion) (P)
Cost of Goods Sold (COGS)
Ending Inventory (EI)
Equation –
BI + P = COGS + EI
Preparation of income statement and Balance sheet
requires allocation of these costs (BI + P) between
COGS and ending inventory
9
First-in, First-out (FIFO)
• Expenses costs of oldest purchases first i.e.
costs of items purchased first are deemed to
be costs of items sold first and enter the COGS
• Costs of most recently purchased goods are in
the inventory on the balance sheet
– Likely but not necessary to follow actual flow of
goods
– Ending inventory under FIFO method
approximates current cost of goods
10
LIFO
• Expenses cost of recent purchases first i.e.
costs/price of items latest purchased are assumed
to be costs of items sold first and enter the COGS
• Ending inventory is made up of earliest cost
incurred
• Impact of its use in the income statement
– Enhanced measurement of periodic income results as
it is a better matching of current sales prices with
current costs
– Conversely, the balance sheet’s distortion of the
current value of inventory produces a measurement of
inventory and current assets which is understated
under inflationary conditions
11
LIFO
• Firms often adopt the LIFO approach for the tax benefits
during periods of high inflation
• Studies indicate that firms with the following characteristics
are more likely to adopt LIFO –
– Rising prices for raw materials and labor
– An absence carry forward of other tax losses
• When firms switch from FIFO to LIFO in valuing inventory,
there is likely to be a drop in net income and a concurrent
increase in cash flows (because of the tax savings). The
reverse will apply when firms switch from LIFO to FIFO
• Given the income and cash flow effects of inventory
valuation methods, it is often difficult to compare firms
that use different methods
12
Example
• Use the inventory data in the following figure
to calculate the cost of goods sold and ending
inventory under the FIFO, LIFO, and weighted
average cost methods. 7 units sold for Rs. 40
Date
Particulars
Amount
1, January
2 units @ $2/unit
4
10, January
3 units @ $3/unit
9
20, January
5 units @ $5/unit
25
Units sold on 25,
January
7 units
13
Choice of Inventory method and its
impacts on operating results
Give effect as Higher or lower under each of the
method when prices are increasing
Particulars
LIFO
FIFO
COGS
Income before taxes
Income taxes
Net income
Inventory balance (B/S)
Working Capital
Current ratio
Inventory turnover ratio
14
Choice of Inventory method affects
operating results
• In
the period of rising prices (inflationary trend) and
stable or increasing inventory quantities
Particulars
LIFO
FIFO
COGS
Higher
Lower
Income before taxes
Lower
Higher
Income taxes
Lower
Higher
Net income
Lower
Higher
Inventory balance (B/s)
Lower
Higher
Working Capital
Lower
Higher
Current ratio
Lower
Higher
Inventory turnover ratio
Higher
Lower
15
Example 2
Global Sales, Inc. (GSI) is a distributor of consumer products, including bars
of violet essence soap. The soap is sold by the kilogram. GSI began
operations in 2019, during which it purchased and received initially 100,000
kg of soap at 110 yuan/kg, then 200,000 kg of soap at 100 yuan/kg, and
finally 300,000 kg of soap at 90 yuan/kg. GSI sold 520,000 kg of soap at 240
yuan/kg. GSI stores its soap in its warehouse so that soap from each
shipment received is readily identifiable. During 2019, the entire 100,000 kg
from the first shipment received, 180,000 kg of the second shipment
received, and 240,000 kg of the final shipment received was sent to
customers. Answers to the following questions should be rounded to the
nearest 1,000 yuan.
1 What are the reported cost of sales, gross profit, and ending inventory
balances for 2019 under the specific identification method?
2 What are the reported cost of sales, gross profit, and ending inventory
balances for 2019 under the weighted average cost method?
3 What are the reported cost of sales, gross profit, and ending inventory
balances for 2019 under the FIFO method?
4 What are the reported cost of sales, gross profit, and ending inventory
balances for 2019 under the LIFO method?
Source: CFA level 1 FSA
16
Example 2 sol. (in ‘000 yuan)
Solved in Excel sheet as well
17
Weighted Average
• Under the weighted average approach, both
inventory and the cost of goods sold are based
upon the average cost of all units purchased
during the period.
18
Perpetual Vs. Periodic Inventory
System - Example
• The periodic inventory system is a method of
inventory valuation for financial reporting
purposes in which a physical count of the
inventory is performed at specific intervals,
usually the end of the reporting year
• A perpetual inventory system keeps continual
track of your inventory balances. Updates are
automatically made when you receive or sell
inventory. Purchases and returns are immediately
recorded in your inventory accounts.
19
Perpetual Vs. Periodic Inventory
System - Example
20
Solution
Refer to Excel sheet for solution
21
LIFO Reserve
• To adjust these differences and study companies on same footing,
firms that choose to use the LIFO approach to value inventories have to
specify in a footnote (I.e., in notes to the accounts), the difference in
inventory valuation between FIFO and LIFO, and this difference is
termed as LIFO reserve.
• This can be used to adjust the beginning and ending inventories, and
consequently the cost of goods sold, and to restate income based upon
FIFO valuation
• Since 1972, SEC made it mandatory for publicly traded companies, to
disclose the excess of current cost or replacement cost of inventory
over the LIFO values stated on the balance sheet when these
differences are material.
• LIFO Reserves are also termed as “Excess of current cost over LIFO
cost/Replacement cost of inventory”
• Large LIFO reserves signal to the market an inflationary environment
• The LIFO reserve serves as a direct indicator of the materiality of the
balance sheet distortions which may result from LIFO use over a period
of time
22
Adjusting LIFO to FIFO
•
Balance sheet adjustment
–
–
–
–
•
Add LIFO Reserve to Inventory (as reported under LIFO)
Equity is increased by LIFO Reserve (after tax) (LIFO reserve *(1-tax rate)
Adjust deferred tax liability by adding the income taxes on the LIFO reserve (LIFO Reserve * tax rate)
Thus the accounting equation matches
Income statement adjustment
– COGS as per FIFO = Reported COGS as per LIFO Less change in LIFO Reserve
– Tax adjustment = Reported Tax as per LIFO Add (Change in LIFO reserve * Effective tax rate)
– Net Profit = Net Profit reported as per LIFO Add (Change in LIFO reserve * (1-effective tax rate)
•
•
Income statement i.e. COGS is generally not adjusted to FIFO as the LIFO method results in
costs of goods sold that are more indicative of replacement-cost values, and the best
matching to revenues. While it might be desirable to adjust for those companies that use
FIFO or average costs methods, the data generally are unavailable
When a company using the LIFO method has inventory balances that decrease over a
period of time, LIFO liquidation may result and hence following adjustment
– Adjustment to COGS; COGSL less change in LIFO reserve from previous year end
– COGS = COGSL – (LIFO Reserve ending balance- LIFO Reserve beginning balance )
– Add the income taxes on the change in the LIFO reserve to income tax expense (Change in LIFO
reserve*tax rate)
23
LIFO Liquidation
• LIFO liquidation occurs when inventory levels are reduced below their
beginning balance i.e., when more goods are sold than are
purchased/manufactured in a given year.
– Lifo liquidation is also called as “inventory gains due to combined effects of LIFO
inventory accumulations and drawdowns”, (Refer to exxon mobil AR 2020 page 75)
– This could occur when companies face strikes, recession or declining demand for a
particular product line, or purposely resorts to for momentary gain
• Matches previous periods’ costs against current period’s revenues i.e. older,
less-recent layers of inventory are turned into cost of goods sold
• As LIFO liquidation gains are non-operating and artificial in nature and report
more income than is sustainable over time; they should be excluded from
earnings for the purpose of analysis
– Assuming an inflationary environment, cost of goods sold is reduced by LIFO
liquidation, and as a result, income increases
– LIFO Liquidation gain = (Current cost of replacing the inventory- LIFO layer cost) X
Quantity Liquidated (i.e. no. of units utilized from earlier layers)
– To capture the true sustainable profitability of a company, the gains generated from
LIFO liquidation generally are excluded from current profitability measures and
ratios
24
Case
• Exxon Mobil Corporation (AR_2011)
• Colgate Palmolive (AR_2011)
25
Example-Exxon Mobil Corporation
• AR_2020, Pg 75
26
Adjustment of FIFO and Average COGS
to LIFO
• Generally the FIFO and weighted average methods are
criticized as they do not book the recent cost of goods sold
against revenue
• However to adjust COGS as per this method no information is
made available in the foot notes
• One approximation that can be made is
– Adjusting FIFO COGS to LIFO
• COGS Lifo = COGS FIFO +(Cost of Beginning inventory under FIFO X r)
• r = specific inflation rate appropriate for the product in which the firm
deals
– Adjusting Weighted average cost to LIFO
• COGS LIFO = COGS weighted average + (cost of Beginning inventory under
weighted average method X r/2)
• Balance sheet adjustment is not required as FIFO gives better
replacement cost valuation for inventory than LIFO
27
Issues that Analysts Should Consider
in inventory disclosures
•
Change in the method of inventory valuation
– Company may change to LIFO to reduce the tax burden
– Company may change to FIFO to inflate the reported profits
•
•
•
•
•
•
Inventories can provide signal about a firms future revenues and earnings
An increase in raw materials and/or work-in-process inventory may be an indication of
an expected increase in demand. Higher demand should result in higher revenues and
earnings. (How would you determine if this is the right way to think?)
Conversely, an increase in finished goods inventory, while raw materials and work-inprocess are decreasing, may be an indication of decreasing demand and potential
inventory write-downs in the future
Finished goods inventory growing faster than sales may indicate declining demand and
excessive or potentially obsolete inventory.
Although high inventory turnover is considered good and desirable, a very high turnover
ratio might indicate that the company is not carrying sufficient inventory to meet
customer demand. If the trend has changed over the years, it may also indicate that the
company has outsourced its manufacture and has limited stock rm and wip inventory
To further assess the explanation for high inventory turnover, we can look at inventory
turnover relative to sales growth within the firm and industry.
– High turnover with slower growth may be an indication of inadequate inventory quantities.
– Alternatively, sales growth at or above the industry average supports the conclusion that high
inventory turnover reflects greater efficiency.
28
Funding of current assets
• Current assets are to be
financed using
– Current liabilities
– Working capital facilities from
banks
– Excess of long-term sources
(term-liabilities)
• Banks generally fund only the
working capital gap after
taking into account the Net
working capital from longterm source
29
Funding of current assets
• Current liabilities are more than current
assets and a part of short-term funds
(current liabilities) have been diverted to
finance fixed assets
• Here the company is not being able to
provide any Net working capital or fund
from long-term sources towards financing
of current assets
• Current ratio < 1
• This should be examined as it signals
diversion of funds as part of current
liabilities are used to finance fixed assets
30
MPBF – Inventories play a major role
• Studies on assessment of working capital needs
were conducted by different committees
nominated by RBI from time to time
– Tandon Committee ( 3 methods for computation of
PBF)
– Nayak Committee recommended the Turnover
method (generally for SSI units requiring Working
capital up to 5 crores)
– Kannan committee recommended the cash budget
method for WC appraisal
31