Reading 32
This reading assumes familiarity with FIFO, LIFO, and average cost methods; computation of COGS, gross profit margin, and ending inventory under each; and adjustment using the LIFO reserve.
MODULE 32.1: INVENTORY MEASUREMENT
Describe the measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios.
IFRS — Lower of Cost or NRV
Under IFRS, inventory is reported at the lower of cost or net realizable value (NRV). NRV = expected sales price − estimated selling costs − completion costs. Write-downs go through I/S (separately or as part of COGS). If value recovers, the firm can write up — but only up to the original cost (cannot write up more than previously written down).
Write-downs/up are usually done through a valuation allowance (contra-asset account, similar to accumulated depreciation) — separates original cost from carrying value.
U.S. GAAP — Lower of Cost or NRV / Market
Companies using methods other than LIFO or the retail method report inventory at the lower of cost or NRV.
Companies using LIFO or the retail method report inventory at the lower of cost or market. "Market" is usually replacement cost, but constrained:
- Upper bound: NRV.
- Lower bound: NRV − normal profit margin.
If replacement cost > NRV → market = NRV. If replacement cost < NRV − normal profit margin → market = NRV − normal profit margin.
U.S. GAAP does not allow write-ups if value recovers. Market value becomes new cost basis.
Per unit: original cost $210; selling price $225; selling costs $22; NRV = 225 − 22 = $203; replacement cost $197; normal profit margin $12.
Lower of cost or NRV (IFRS or non-LIFO U.S. GAAP): NRV $203 < cost $210 → write down to $203; $7 loss recognized.
Lower of cost or market (LIFO U.S. GAAP): Market range = NRV − normal margin to NRV = [$191, $203]. Replacement cost $197 falls in range → market = $197 (replacement cost). Cost $210 > market $197 → write down to $197; $13 loss.
IFRS: Write up to $210 (original cost) — recognize $7 gain (limited to original write-down).
U.S. GAAP: No write-up; remains $197. Higher profit recognized when sold.
LIFO firms (under stable/rising prices) report lower ending inventory than FIFO firms, so they are less likely to recognize write-downs (cost is already below market).
Commodity exception (IFRS & U.S. GAAP): Producers/dealers of agricultural products, mineral ores, precious metals can report inventory at NRV with unrealized gains/losses in I/S (use quoted market price or recent transactions).
Effects of Write-Down to NRV (assuming reported through COGS)
- Decreases inventory, current assets, total assets.
- Current ratio decreases. Quick ratio unaffected (inventory not in numerator).
- Inventory turnover (COGS/avg inventory) increases; days of inventory on hand & CCC decrease.
- Lower total assets → asset turnover increases; debt-to-assets ratio increases.
- Equity decreases → debt-to-equity increases.
- Higher COGS → gross/operating/net margins decrease.
- NI decrease % > assets/equity decrease % → ROA and ROE decrease.
In subsequent periods, lower carrying values lead to lower COGS → higher NI → higher ROA/ROE.
IFRS：成本 vs NRV，取低者。NRV＝售價 − 售出成本 − 完工成本。減損透過 I/S（單列或併入 COGS），可沖回但不得超過原始成本。常用備抵存貨評價科目（與累積折舊類似）。
U.S. GAAP：非 LIFO／非零售法 → 成本 vs NRV 取低。LIFO 或零售法 → 成本 vs 市價取低。市價＝重置成本，但受限上下限：上限＝NRV、下限＝NRV − 正常利潤率。GAAP 一律禁止沖回。
例（Zoom）：成本 $210、售價 $225、銷售費 $22 → NRV $203；重置 $197；正常利潤 $12。
NRV 法：減 $7 至 $203；市價法：市價＝重置 $197（落在 $191～$203 區間），減 $13 至 $197。
沖回例：明年 NRV／重置都 +$10。IFRS：沖回到 $210（上限為原始成本），認 $7 利得；GAAP：不沖回，仍 $197。
LIFO 公司 ending inventory 已用較舊較低成本，較不易發生減損。
商品例外：農礦業／貴金屬商可用 NRV 並把未實現損益放 I/S。
減損當期影響：存貨／資產／權益↓；流動比↓、速動比不變；存貨周轉↑、DOH↓、CCC↓；資產周轉↑、債務比↑、D/E↑；毛利／營業／淨利率↓；ROA、ROE↓。後續期間因為帳面值低 → COGS↓、NI↑、ROA／ROE↑。
MODULE 32.2: INFLATION IMPACT ON FIFO AND LIFO
Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods.
During inflationary periods with stable or increasing inventory quantities:
- LIFO COGS > FIFO COGS (later/higher-cost units assumed sold first).
- LIFO gross profit < FIFO gross profit; LIFO NI < FIFO NI.
- LIFO ending inventory < FIFO ending inventory (older, lower-cost units left).
Deflationary periods: effects reversed. Stable prices: all methods yield same results. Average cost sits between LIFO and FIFO.
FIFO ending inventory best approximates current cost (most recent purchases). LIFO COGS best approximates current cost in the income statement (most recent purchases consumed).
| FIFO | LIFO | |
|---|---|---|
| Cost of sales | Lower | Higher |
| Ending inventory | Higher | Lower |
| Gross profit | Higher | Lower |
Effects on Ratios (Inflation, Rising Inventory)
- Profitability: FIFO higher gross/operating/net margins.
- Liquidity: FIFO higher inventory → higher current ratio & working capital.
- Activity: LIFO higher inventory turnover (higher COGS / lower inventory); FIFO has lower turnover, more days of inventory on hand.
- Solvency: FIFO higher assets and equity → lower debt ratio and lower D/E.
LIFO Liquidation
A LIFO liquidation occurs when a LIFO firm's inventory quantities decline → older, lower costs flow into COGS. Result: higher profit margins and higher taxes — inflating operating margins by recognizing historical inflationary gains as current income. Not sustainable.
Could be voluntary (drawdown to boost earnings or to suit market) or involuntary (supplier strikes, materials shortages). Analyst should examine LIFO reserve disclosure — a decrease may indicate a LIFO liquidation.
Prices inflate 5%/yr. Sales/purchase units and prices over 3 years:
| Year | 1 | 2 | 3 |
|---|---|---|---|
| Beginning inventory units | 0 | 4,000 | 7,000 |
| Purchases (units) | 14,000 | 15,000 | 10,000 |
| Ending inventory units | 4,000 | 7,000 | 1,000 |
| Units sold | 10,000 | 12,000 | 16,000 |
| Sales price | $100 | $105 | $110 |
| Purchase price | $80 | $84 | $88 |
| Year | 1 | 2 | 3 |
|---|---|---|---|
| Sales | $1,000,000 | $1,260,000 | $1,760,000 |
| COGS | 800,000 | 992,000 | 1,380,000 |
| Gross profit | $200,000 | $268,000 | $380,000 |
| Year | 1 | 2 | 3 |
|---|---|---|---|
| Sales | $1,000,000 | $1,260,000 | $1,760,000 |
| COGS | 800,000 | 1,008,000 | 1,372,000 |
| Gross profit | $200,000 | $252,000 | $388,000 |
| Year | 1 | 2 | 3 |
|---|---|---|---|
| FIFO | 20.00% | 21.27% | 21.59% |
| LIFO | 20.00% | 20.00% | 22.05% |
Year 2: rising prices + rising inventory → FIFO > LIFO gross margin (expected). Year 3: LIFO > FIFO gross margin — unusual! Caused by LIFO liquidation (units purchased 10,000 < units sold 16,000 → inventory dropped 7,000 → 1,000, releasing older lower costs into COGS).
通膨＋庫存穩或升：LIFO COGS > FIFO COGS（用最新較高成本）→ LIFO 毛利 < FIFO；LIFO 期末存貨 < FIFO（剩下舊低）。通縮反過來。穩定價格三者相同。平均居中。
FIFO 期末存貨近似當期成本（B/S 較準）；LIFO COGS 近似當期成本（I/S 較準）。
比率（通膨）：FIFO 毛利／營業／淨利率高；FIFO 流動比與工作資本高（存貨大）；LIFO 周轉率高、DOH 低；FIFO 資產與權益高 → D/E、Debt 比低。
LIFO 清算：LIFO 公司庫存下降時，舊（低）成本進 COGS → 毛利率提高（一次性、不可持續）、稅負增。看 LIFO reserve 揭露是否減少。可能自願（操弄盈餘）或被動（供應中斷）。
例（Willock）：三年通膨 5%，Y3 庫存從 7,000 跌到 1,000（買 10,000 < 賣 16,000）→ LIFO 毛利率反常 22.05% > FIFO 21.59%。
- A. $42.
- B. $43.
- C. $47.
- A. increase in cost of sales.
- B. decrease in depreciation charges.
- C. loss reported as other comprehensive income.
- A. Companies using FIFO should report inventory at the lower of cost or market value.
- B. Inventory can be written up, but not by more than it was previously written down.
- C. When establishing market value, net realizable value should be used as the upper limit if replacement cost exceeds NRV.
- A. Asset turnover will increase.
- B. The quick ratio will decrease.
- C. The debt-to-equity ratio will increase.
- A. First-in, first-out.
- B. Weighted average cost.
- C. Last-in, first-out.
- A. Lower.
- B. Higher.
- C. The same.
- A. inventory.
- B. accounts payable.
- C. operating profit margin.
MODULE 32.3: PRESENTATION AND DISCLOSURE
Describe the presentation and disclosures relating to inventories and explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information.
Required Disclosures (Similar IFRS & U.S. GAAP)
- Cost flow method (LIFO, FIFO, etc.)
- Total carrying value, with breakdown by classification (raw materials, WIP, finished goods) if appropriate
- Carrying value at fair value less selling costs
- Cost of inventory recognized as expense (COGS) during the period
- Amount of inventory write-downs during the period
- Reversals of write-downs during the period (IFRS only)
- Carrying value of inventories pledged as collateral
Inventory Signals
Merchandisers report one inventory account; manufacturers report three (raw materials, WIP, finished goods).
- RM or WIP increasing → expecting demand increase → higher future revenue.
- Finished goods increasing while RM/WIP decreasing → declining demand → possible write-downs.
- Finished goods growing faster than sales → declining demand, potential obsolete inventory.
Inventory carrying costs: storage, insurance, taxes, opportunity cost of capital.
Inventory Turnover Analysis
High inventory turnover is generally good, but too high may mean inadequate stock and lost sales. Combine with sales-growth context:
- High turnover + low sales growth (vs industry) → may indicate inadequate inventory, lost sales.
- High turnover + sales growth at/above industry → reflects efficiency.
| 20X6 | 20X7 | |
|---|---|---|
| Inventory turnover | 3.71 | 6.83 |
| Days of inventory on hand | 98 | 53 |
| Gross profit margin | 52.73% | 45.33% |
| Sales growth | 3.77% | 36.36% |
| Current ratio | 4.24 | 3.98 |
| Quick ratio | 3.20 | 3.78 |
Inventory dropped from $900K → $300K. Raw materials and WIP did not decline proportionally relative to finished goods (RM was 20%/22%; WIP 10%/10%) → demand doesn't appear to be falling. Valuation allowance on finished goods decreased (10.7% → 7.7%) — not consistent with obsolescence. Sales growth surged to 36%. Gross margin fell (53% → 45%) suggests raw material/production costs rose.
Likely cause: supply-side shocks, not falling demand. Current ratio fell (inventory shrank) but quick ratio rose (cash and receivables rose) → liquidity moderately improved on the quick measure. Analyst should consult MD&A, conference calls, industry reports.
必要揭露：方法（LIFO/FIFO 等）；總帳面值（原料/WIP/成品分項）；以公允價減售出成本列示者；當期入 COGS 金額；當期減損；沖回（僅 IFRS）；做擔保的存貨帳面值。
訊號：RM／WIP↑＝預期需求增；成品↑而 RM／WIP↓＝可能需求下滑、未來可能減損；成品成長超過銷售＝過剩／過時，可能要減損。庫存有持有成本（倉儲、保險、稅、機會成本）。
周轉率分析：高周轉＋業內銷售成長慢 → 可能存貨不足、流失銷售；高周轉＋業內銷售成長快 → 效率高。
例（Hyzer）：20X7 存貨從 $900K 跌到 $300K，但 RM/WIP 比例未失衡、成品評價備抵反降、銷售卻成長 36%、毛利率下降 → 應是供應端衝擊（成本飆升），不是需求下滑。流動比下降但速動比上升 → 流動性實質改善。
- A. The amount of loss reversals, from previously written-down inventory, recognized during the period.
- B. The carrying value of inventories that collateralize a short-term loan.
- C. The separate carrying values of raw materials, work in progress, and finished goods computed under the LIFO cost flow method.
- A. has an increasing inventory turnover ratio.
- B. anticipates declining demand for its products.
- C. might be losing sales due to inadequate inventory.
- A. managing its inventory effectively.
- B. may have obsolete inventory that requires a write-down.
- C. may be losing sales by not carrying enough inventory.
- A. lower gross margin.
- B. higher current ratio.
- C. higher asset turnover.
IFRS: lower of cost or NRV. Write-ups allowed only to extent of prior write-down.
U.S. GAAP: lower of cost or NRV (FIFO/average/SI); lower of cost or market (LIFO/retail). Market = replacement cost bounded by [NRV − normal margin, NRV]. No write-ups.
Write-down to NRV: decreases inventory, assets, equity; increases asset turnover, D/A, D/E; decreases NI, margins, ROA, ROE.
Inflation, stable/rising inventory: FIFO has highest ending inventory and lowest COGS; LIFO has lowest ending inventory and highest COGS. Avg cost between. FIFO yields higher profitability and liquidity, lower turnover, lower solvency ratios.
LIFO liquidation: distorts profit margins upward (older, lower costs flow into COGS) — unsustainable.
Required disclosures: cost flow, carrying value (by classification), FV less selling costs, COGS, write-downs, reversals (IFRS only), pledged inventory. Examine RM/WIP/finished-goods composition vs sales for demand signals. Inventory turnover too high may indicate lost sales or write-downs.
32.a：IFRS 成本／NRV 取低、可沖回；GAAP 非 LIFO：cost/NRV；LIFO：cost/market（市價＝重置成本，受 NRV±正常利潤夾住），不可沖回。減損增加 turnover、D/A、D/E；降低 margin、ROA、ROE。
32.b：通膨＋穩升庫存：FIFO 期末高、COGS 低、毛利高、流動比高、周轉率低、D/E 低；LIFO 反之。LIFO 清算釋出舊低成本入 COGS，毛利率短暫飆升。
32.c：揭露＋訊號分析：RM／WIP 升＝需求增；成品快過銷售＝可能過時；高周轉＋低銷售成長＝可能流失銷售。