CFA Level 1

Assets - Inventory Analysis


Computing Inventory Balances
In computing ending inventory balances under the various methods we will use the following example.

Example:

Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:


1. Average-cost method - Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry large amount of units.

Total cost: $130
Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

2. First in first out - Under this inventory method, the units that were first purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 101 and 102)
Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65 = $235

3. Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)
Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

Usefulness of Inventory Data When Prices Are Stable or Changing
If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO, LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort the reported income, cash flow and inventory.

I. Rising Price (Inflationary) Environment

FIFO method

  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).
LIFO method
  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax and cash flow will be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).
Average-cost method
  • Since it's an average, it would be in between LIFO and FIFO.

II. Decreasing Price (Deflation) Environment

FIFO method
  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax, and cash flow would be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).
LIFO method
  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).
Look Out!

Make sure you understand this concept very well. It can make or break an entire sample set if you reverse the effects conceptually
Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation".

Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their general-purpose statements.

Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods
When comparing two companies, one must ensure that they are comparing apples with apples. If the first company uses the FIFO method and the other the LIFO method, then there is a problem. To make the comparison relevant, one must convert LIFO to FIFO or FIFO to LIFO.



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