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Subject 3. Presentation and Disclosure PDF Download

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.

Presentation and Disclosure

Consistency of inventory accounting policy is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively and there is no retrospective adjustment to the financial statements.

Inventory Ratios

Inventory turnover measures how fast a company moves its inventory through the system.

This ratio can be used to measure how well a firm manages its inventories. The lower the ratio, the longer the time between when the good is produced or purchased and when it is sold.

  • An abnormally high inventory turnover and a short processing time could mean either effective inventory management or inadequate inventory, which could lead to outages, backorders, and slow delivery to customers (which would adversely affect sales). Revenue growth should be compared with that of the industry to assess which explanation is more likely.
  • An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory. Again, the analyst should compare the firm's revenue growth with that of the industry to assess the situation.

Financial Analysis: FIFO versus LIFO

The advantages of LIFO are:

  • Matching. Current costs are matched against revenues and inventory profits are thereby reduced.
  • Tax benefits. These are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting."
  • Improved cash flow. This is related to tax benefits, because taxes must be paid in cash.
  • Future earnings hedge. With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline.

The disadvantages of LIFO:

  • Reduced earnings. Many managers would just rather have higher reported profits than lower taxes. However, non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street.
  • Inventory understated. LIFO may have a distorting effect on a company's balance sheet. It makes the working capital position of the company appear worse than it really is.
  • Physical flow. LIFO does not approximate the physical flow of the inventory items except in particular situations.
  • Current cost income not measured. LIFO falls short of measuring current cost (replacement cost) income, though not as far as FIFO. Using replacement cost is referred to as the next-in, first-out method; it is not acceptable for purposes of inventory valuation.
  • Inventory liquidation. If the base or layers of old costs are eliminated, strange results can occur, because old, irrelevant costs can be matched against current revenues. The income tax problem is particularly severe when involuntary liquidation results from a strike or a shortage of materials; in these situations, companies may incur high tax bills when they can least afford to pay taxes.
  • Poor buying habits. A company may attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.

The choice of inventory system or method affects financial numbers. For example, the following is the comparison between LIFO (Last In, First Out) and FIFO (First In, First Out):

LIFO Liquidations

So far, discussions have been based on the assumptions of rising prices and stable or growing inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO reserves can decline for either of the two reasons listed below. In either case, the COGS will be smaller and the reported income will be higher relative to what they would have been if the LIFO reserve had not declined. However, the implications of a decline in the LIFO reserve on financial analysis vary, depending on the reason for the decline.

  • Liquidation of inventories. When a firm reduces its inventory, the old assets flow into income. The COGS figure no longer reflects the current cost of inventory sold. This is called LIFO liquidation. Gross profit margin will be abnormally high and unsustainable ("phantom" gross profits). To defer taxes indefinitely, purchases must always be greater than or equal to sales. A LIFO liquidation may signal that a company is entering an extended period of decline (and needs the "profit" to show as income). Analysts should exclude this profit from recurring earnings, as it is not operating in nature; the reported COGS should be restated by adding back the decline in the LIFO reserve to remove the artificial boost to net income.

  • Price declines. The lower-cost current purchases enter reported LIFO COGS when purchase prices fall, reducing the cost differences between LIFO and FIFO ending inventories. As a result, the LIFO reserve declines. Such a decline is not considered a LIFO liquidation. Amounts on the balance sheet are still outdated but those on the income statement are still current. However, the tax benefits are lost under LIFO. For analytical purposes, no adjustment is required for declining prices, since price decreases are a normal business situation.

User Contributed Comments 10

User Comment
sarath If we use FIFO then ending inventory will cost higher then LIFO ...

so LIFO reserve = FIFO Inventory - LIFO Inventory
tqueiroz When inflation for a certain period is unknown, a proper measure of inflation can be found dividing the increase in LIFO reserve by beginning-of-year inventory (FIFO basis).
miiyeung FIFO COGS = LIFO COGS - change in LIFO reserve

FIFO COGS = LIFO COGS - (LIFO reserve END - LIFO reserve Beg)

AND

FIFO Inventory = LIFO Inventory + LIFO reserve
gulfa99 cogs is higher under lifo and lower under fifo
Cashflows are higher under lifo and lower under fifo
rest; higher under fifo and lower under lifo
johntan1979 Thank you miiyeung! Important formulas to remember.
johntan1979 And gulfa99, it's AFTER-TAX cashflows that is higher, not just in general.
shubhamk0 No adjustments are required in case of price decline since it is normal business situation
ravinram No adjustments required when prices fall. but suppose we are in a period of deflation, and Japan for eg, has been facing the problem of deflation for many years..
Kiniry Liquidity: The current ratio is lower under LIFO- BUT, the quick ratio will be higher under LIFO because of more cash (from lower taxes.)
mali97 Lifo liquidation just went over my head lmao
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