Chapter 6: Analysis of Inventories

1

INVENTORY COST FLOW METHODS

Cost flow assumptions determine the cost of goods sold (COGS) and ending inventory. The main methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average.

Impact During Inflation (Rising Prices)

Metric	FIFO	LIFO	Weighted Average
Cost of Goods Sold (COGS)	Lowest	Highest	Between FIFO and LIFO
Net Income	Highest	Lowest	Between FIFO and LIFO
Income Taxes	Highest	Lowest	Between FIFO and LIFO
Ending Inventory	Highest	Lowest	Between FIFO and LIFO

Impact During Deflation (Falling Prices)

Metric	FIFO	LIFO	Weighted Average
Cost of Goods Sold (COGS)	Highest	Lowest	Between FIFO and LIFO
Net Income	Lowest	Highest	Between FIFO and LIFO
Income Taxes	Lowest	Highest	Between FIFO and LIFO
Ending Inventory	Lowest	Highest	Between FIFO and LIFO

Note on LIFO Liquidation: This occurs when sales exceed purchases, resulting in the sale of older, lower-priced inventory layers. This can inflate reported profits and is a red flag for analysts.

Note on Constant Prices: If prices remain constant, all cost flow methods yield identical financial results.

2

INVENTORY VALUATION

Inventory is reported on the balance sheet at the lower of cost or market value to avoid overstatement when inventory value declines.

Valuation Rules: IFRS vs. US GAAP

Standard	Valuation Rule	Reversal of Write-Downs
IFRS	Carried at the lower of cost and Net Realizable Value (NRV). NRV is the estimated selling price less selling and completion costs.	Allowed. Recovery in value allows for a write-up, limited to the original write-down amount.
US GAAP	For LIFO/retail methods, carried at the lower of cost or market. "Market" is replacement cost within an upper and lower bound. For other methods, it's the lower of cost or NRV.	Not allowed. After a write-down, the new lower value becomes the new cost basis.

Effects of Inventory Write-Downs

Reduces reported profit and the inventory carrying amount.
Negatively impacts profitability, liquidity, and solvency ratios.
Positively impacts activity ratios like inventory turnover, which may falsely suggest improved efficiency.

Key Valuation Concepts

This section breaks down the terms used in inventory valuation, especially the "Lower of Cost or Market" rule under US GAAP.

1. Lower of Cost or Market (LCM) - The Core Principle

This accounting rule dictates that inventory must be recorded at whichever value is lower: its original cost or its current market value. This prevents companies from overstating the value of their assets.

2. Net Realizable Value (NRV) - The "Ceiling"

NRV is the estimated selling price of an item, minus any costs required to complete and sell it. It represents the maximum value the inventory can be reported at (the ceiling).

NRV = Selling Price Costs to Sell

3. Market Value (US GAAP) - A Three-Step Process

Under US GAAP (for LIFO/retail methods), "market value" isn't just one number. It's determined by finding the middle value among three figures:

Ceiling: The Net Realizable Value (NRV).
Floor: The NRV minus a normal profit margin.
Replacement Cost: What it would cost to buy the item again today.

The designated market value is the middle value of these three amounts.

3

INVENTORY MANAGEMENT RATIOS

Inventory Turnover

Inventory Turnover = COGS / Average Inventory

This ratio indicates how many times inventory is sold and replaced during a period. A high ratio generally suggests efficient inventory management.

Days of Inventory on Hand (DOH)

DOH = 365 / Inventory Turnover Ratio

This measures the average number of days inventory is held before being sold. A lower DOH suggests efficiency but could risk stockouts. A higher DOH may indicate slow-moving inventory or strategic stockpiling.

Gross Profit Margin

Gross Profit Margin = Gross Profit / Revenue

This indicates profitability. Higher margins may suggest stronger pricing power or a less competitive market, while lower margins can indicate a highly competitive industry.

4

PRESENTATION AND DISCLOSURE REQUIREMENTS

IFRS and US GAAP have similar disclosure requirements, with a few key differences.

Disclosure Item	IFRS	US GAAP
Accounting Policies & Carrying Amounts	Required	Required
Inventory Recognized as Expense (COGS)	Required	Required
Write-Downs	Disclosure of write-downs to NRV is required.	Disclosure of write-downs is required.
Reversals of Write-Downs	Required to disclose reversals and the related circumstances.	Not applicable as reversals are not permitted.
LIFO Liquidation	Not applicable as LIFO is not permitted.	Disclosure of income from LIFO liquidation is mandatory.

5

LIFO FIFO CONVERSION

Use these rules to adjust Inventory and COGS when prices are increasing or decreasing. LIFO Reserve = FIFO Inventory LIFO Inventory.

Price Increasing (Inflation)

Item	LIFO (reported)	FIFO (conceptual)	Adjustment to Convert LIFO FIFO	Intuition
Inventory	Lower	Higher	Add LIFO Reserve	FIFO retains newer, more expensive layers higher carrying value.
COGS	Higher	Lower	Subtract Change in LIFO Reserve (Ending Beginning)	LIFO expensed recent costly purchases; FIFO expensed older cheaper layers lower COGS.
Gross Margin	Lower	Higher	—	Lower COGS under FIFO increases gross margin.
Net Income	Lower	Higher	Optional: adjust tax if you also restate equity	Higher gross margin flows to higher net income (before taxes).

Price Decreasing (Deflation)

Item	LIFO (reported)	FIFO (conceptual)	Adjustment to Convert LIFO FIFO	Intuition
Inventory	Higher	Lower	Subtract LIFO Reserve	FIFO retains newer, cheaper layers lower carrying value.
COGS	Lower	Higher	Add Change in LIFO Reserve (Ending Beginning)	LIFO expensed recent cheap purchases; FIFO expensed older, pricier layers higher COGS.
Gross Margin	Higher	Lower	—	Higher COGS under FIFO reduces gross margin.
Net Income	Higher	Lower	Optional: adjust tax if you also restate equity	Lower gross margin flows to lower net income (before taxes).

Formula Recap

Inventory (LIFO FIFO): FIFO Inventory = LIFO Inventory + LIFO Reserve (add under rising prices; subtract under falling prices)
COGS (LIFO FIFO): FIFO COGS = LIFO COGS - Δ LIFO Reserve (Δ = Ending Beginning)
Equity (optional): Adjusted Equity = Reported Equity + LIFO Reserve × (1 Tax Rate)
Inventory Turnover: COGS / Average Inventory (FIFO)

Rule of thumb: In rising prices, FIFO Inventory ↑, FIFO COGS ↓. In falling prices, FIFO Inventory ↓, FIFO COGS ↑.

For exams: always specify whether you're converting LIFO FIFO (most common for comparability) and remember to use average FIFO inventory for turnover ratios.

6

IAS 40 VS IAS 16 CHEAT SHEET

1. Investment Property Fair Value Model

Under IAS 40, companies can choose Cost Model or Fair Value Model.

When a company does not use the cost model for investment properties, the Fair Value Model is used.

Fair Value Model rule:

Re-measure at fair value every year.
Gains/losses go to Profit or Loss affects net income.

2. Plant Revaluation Model

Plant is Property, Plant & Equipment, so IAS 16 applies.

IAS 16 allows Cost Model or Revaluation Model.

When a company does not use the cost model for PPE, the Revaluation Model is used.

Revaluation Model rule:

Re-measure at fair value.
Gains go to OCI (Revaluation Surplus) NOT net income.

Why Plant Gain Doesn't Hit Net Income

Because IAS 16 sends revaluation gains to equity (OCI), not the income statement.

Quick Reference:

IAS 40 Fair Value Model Profit or Loss
IAS 16 Revaluation Model OCI

7

EXAM FOCUS & KEY FORMULAS

High-Yield Topics

Focus your study time on these key areas:

LIFO reserve adjustments and LIFO to FIFO conversions - expect 2-4 questions
Inventory turnover and DOH calculations
LIFO liquidation effects on financial statements
Lower of cost or market/NRV rules (IFRS vs US GAAP)
Impact of inventory methods during inflation/deflation
COGS adjustments for comparability

ESSENTIAL FORMULAS

1. LIFO Reserve (Definition)

LIFO Reserve = FIFO Inventory LIFO Inventory

Always positive in rising price environment; disclosed in notes

2. Convert LIFO Inventory to FIFO

FIFO Inventory = LIFO Inventory + LIFO Reserve

3. Convert LIFO COGS to FIFO COGS

FIFO COGS = LIFO COGS - Δ LIFO Reserve

Δ LIFO Reserve = Ending LIFO Reserve Beginning LIFO Reserve

4. Adjust Retained Earnings

FIFO Retained Earnings = LIFO RE + LIFO Reserve × (1 Tax Rate)

5. Inventory Turnover

Inventory Turnover = COGS / Average Inventory

Higher turnover = more efficient; compare within same industry

6. Days of Inventory on Hand (DOH)

DOH = 365 / Inventory Turnover

Or: DOH = (Average Inventory / COGS) × 365

7. Gross Profit Margin

Gross Profit Margin = (Revenue COGS) / Revenue

Affected by inventory method choice in inflationary periods

COMMON EXAM PITFALLS

Pitfall 1: Wrong Sign on COGS Adjustment

To convert LIFO COGS to FIFO: SUBTRACT the change in LIFO reserve, not add. If reserve increases, FIFO COGS is LOWER than LIFO COGS (in rising prices).

Pitfall 2: Forgetting Tax Effects on Equity

When adjusting retained earnings, multiply LIFO reserve by (1 Tax Rate). The full reserve doesn't flow to equity; some went to taxes.

Pitfall 3: Using Ending Instead of Average Inventory

Inventory turnover requires average inventory (Beginning + Ending) / 2. Using only ending inventory is wrong and gives incorrect turnover.

Pitfall 4: Confusing LIFO Liquidation with LIFO Reserve

LIFO liquidation occurs when sales > purchases, selling old cheaper inventory and inflating profits. LIFO reserve is the difference between FIFO and LIFO inventory values. Different concepts!

Pitfall 5: Reversing Inflation Effects

In rising prices: LIFO has lower inventory, higher COGS, lower net income. In falling prices: effects reverse. Don't mix them up!

            Exam Success Tips
            Build a Quick Reference Table: Create a 2×2 table showing LIFO vs FIFO effects under rising and falling prices. Include effects on COGS, Net Income, Inventory, and Taxes.
Practice Sign Discipline: The most common error is getting the sign wrong on COGS adjustments. Remember: subtract the INCREASE in LIFO reserve to get FIFO COGS.
Master the Three-Step Conversion: (1) Convert inventory, (2) Convert COGS, (3) Convert equity. Practice doing all three steps together.
Understand LIFO Liquidation Red Flags: Know when to spot it: declining inventory levels, improving margins at LIFO companies, disclosure in footnotes.
Link to Ratio Analysis: Understand how inventory method choice affects liquidity ratios (current ratio), activity ratios (turnover), and profitability ratios (gross margin, ROA).
Remember Geographic Restrictions: LIFO is US GAAP only. IFRS companies always use FIFO or weighted average. This helps eliminate wrong answers on multi-jurisdictional questions.

          