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CFA Level 1 - Effects of Misstated Inventory EFFECTS OF MISSTATED INVENTORY
Effects of Misstated Inventory
Overstating (O) or understanding (U) inventory has an effect not only on the balance sheet but also on reported income and cash flow. O and U occur when the purchase price and value of inventory change over time. Let's take, for example, a company that trades scrap steel.
The best way to illustrate O and U is to do it through an example.
Basic concept:
Formula 8.1
| COGS = beginning inventory + purchases – ending inventory |
If the price of a company's inputs (such as steel, lumber, etc.) is rising:
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.
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 would be higher.
- Assets would be understated and not reflective of its market value.
- Working capital and current ratio will be decreased.
Average-cost method
- Since it's an average, it would be in between LIFO and FIFO
Specific identification method
- If this method is used, it is extremely hard to tell, since each product has been accounted for individually.
The CFA institute focuses mostly on differences between LIFO and FIFO, hence our focus in this discussion. |
Next: CFA Level 1 - Inventory Valuation
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