Transcript Business F768 - McMaster University

Com 4FK3
Financial Statement Analysis
Week 4, 2012
Inventory Valuation and Cost Flows
Introduction
• For most firms, the cost of goods sold is the
largest single expense
• Inventory is one of the most active accounts
• Many inventory items are indistinguishable
from each other, so tracking actual costs is
difficult or expensive
• Cost flow assumptions used
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Types of Cost Flow
• FIFO
 First
in, first out
• Weighted Average
• LIFO
 Last
in, first out
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FIFO
• As goods are received, the price paid and
quantity is recorded
• As goods are processed, the price of the first
shipment is used until the number of units
received has been expensed
• After that, the price paid for the second
shipment is used… etc.
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Weighted Average
• As goods are received, the price per unit is
multiplied by the quantity
• This is added to the current inventory value
 current
average price x number of units
• Total value divided by number of units in
inventory is the amount expensed for every
unit sold/used
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LIFO
• As goods are received, the price paid and quantity
received is recorded
• As goods are processed, the price of the most
recent shipment is used until the number of units
received has been expensed or another shipment
arrives
• After the current invoice is expensed, the price
paid for the non-fully expensed second most
recent shipment is used… etc.
• Can lead to recognizing expenses for CGS that are
several years out of date
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Cost Flow Example
• MGD Inc. receives 4 orders of parts
 100
@ $1.25 in January
 75 @ $1.33 in February
 90 @ $1.30 in March
 60 @ $1.45 in April
• MGD uses 80 units of parts per month
• What are CGS and ending inventory?
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Cost Flow Example
Order
1
2
3
4
Number
100
75
90
60
Cost
1.25
1.33
1.30
1.45
Month
Jan
Feb
Mar
Apr
FIFO
100.00
104.80
104.45
112.25
CGS
WA
100.00
105.05
104.15
112.51
Total
421.50
421.72
WA
1.2500
1.3132
1.3019
1.4064
LIFO
100.00
106.00
104.00
112.50
422.50
Cum
125.00
224.75
341.75
428.75
FIFO
25.00
19.95
32.50
7.25
EI
WA
25.00
19.70
32.55
7.03
LIFO
25.00
18.75
31.75
6.25
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Physical Flow ≠ Cost Flow
• Just because goods move through the
system in a certain way does not affect the
choice of cost flow for accounting
 FIFO;
convenience store milk fridge
 Weighted average: gasoline
 LIFO; newspapers or photocopy paper
• All of these could use any cost flow method
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Cost Flow Considerations
• FIFO; most accurate valuation of inventory
but cost of goods sold may not reflect the
replacement costs
• LIFO; cost of goods sold most closely
reflects replacement costs (except if LIFO
liquidation happens), but inventory value
may become meaningless
• Weighted Average; somewhere between
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Inventory Value
• Is inventory value significant?
 1,000
L at 1.40 vs. 0.50
 Due to timing of purchases
 No economic difference
• For some companies FIFO inventory value
is more than double LIFO value
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LIFO Liquidation
• If the company uses more physical units of
inventory in a given period than it purchases
then some of the cost of goods sold will be
based on prices recorded in previous
accounting periods
 e.g.
a gas station has had at least 1,000 L in its
storage tank since 2003, it empties the tank for
maintenance… and reports a large profit
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Cash Flow Effect of Liquidation
• Two cash flow effects are likely
 Cash
inflow due to reducing the level of
purchase of inventory
 Cash outflow due to reporting higher profits
and taxes due to expensing cost of goods sold at
significantly lower historic costs
• Can cause abnormal price reactions when
such liquidations are reported
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Why Use LIFO?
• Most accounting standards boards do not
consider LIFO acceptable
• If prices are rising, LIFO reports the lowest
net income
• US tax laws allow the use of LIFO for tax
reporting if the company also uses LIFO for
financial reporting
This is the only case
• LIFO can defer taxes where financial reporting
choices affect taxation
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Who Uses LIFO?
• Firms expecting increasing input costs
• Firms with highly variable inventory growth
 LIFO
has a smoothing effect on margins
• Firms looking for tax saving opportunities
• Firms in certain industries
• Large firms
 LIFO
increases record keeping costs, if the tax
savings are not big enough it isn’t worthwhile
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Paradox
• LIFO has been shown to provide higher
quality of earnings on the income statement
• FIFO provides a much higher quality of
assets on the balance sheet
• Fixed assets at cost; quality?
• No cost flow assumption can meet both
requirements at the same time
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The LIFO Reserve
• SEC regulations require firms that use LIFO
to add a note in their financial statements to
state the difference between inventory value
under LIFO or FIFO
• In effect, the company has to keep track of
the inventory costs using both methods
• This allows the analyst to convert from
LIFO to FIFO cost flow assumptions
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LIFO Reserve Example
December 31
Bethlehem Steel Company
Annual Report Excerpts
(in millions)
Year 8
Year 9
Inventories at FIFO cost
Excess of FIFO cost over LIFO cost
899.10
-530.10
972.80
-562.50
Inventories at LIFO cost
369.00
410.30
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Balance Sheet Conversion
• Add the Excess of FIFO Cost Over LIFO
Cost line from the notes to the inventories
• Reduce Cash by the cumulative value of
extra income tax that the firm would have
paid if it had reported using FIFO
• Increase Retained Earnings by the increase
in inventories net of the tax effect
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Effect on Ratios
• The inventory account is part of current
assets, so the cost flow assumption can have
a major impact on the current ratio
• Add the after-tax increase in inventories to
current assets (or use revised balance sheet)
• For Bethlehem Steel the current ratio is
 1.71
under LIFO
 2.15 under FIFO
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Income Statement Conversion
• LIFO to FIFO
 Subtract
the increase in the LIFO reserve from
the cost of goods sold
 Increase the tax expense
 Increase net income
• Note: in some cases the increase will
actually be a decrease due to LIFO
layer liquidation or falling prices
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Cash Flow Conversion
• Most accounting adjustments don’t affect
the statement of cash flows, but cost flow
does due to the income tax effects
• Adjust net income for the decrease in CGS
net of taxes and adjust change in inventory
 In
most cases CFO will decrease under FIFO
since the increased income will flow into the
inventory account
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Effect on Stock Price
• If a company switches to LIFO they signal
 Potential
tax savings (+)
 Expectation of factor price increases (-)
 Lower reported income in future periods (-)
• Mixed results from empirical evidence
• Note: managers in adopting firms have a
lower earnings component in compensation
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Inventory Turnover
• With high inventory turnover (4 times per
year or more) and reasonable price stability
the CGS is not strongly affected by the
choice of cost flow assumption
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Liquidation of LIFO Layers
• Firms that do experience a LIFO liquidation
are required to report the effect of that event
in the notes to the financial statements
• Dipping into old LIFO layers reduces the
quality of earnings advantage of LIFO
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Obsolete or Damaged Inventory
• Firms are required to write down inventory
to the lower of cost or market
• Typically the analyst has to rely on the
managers and auditors
• Some industry signals may allow the
analyst to independently estimate the
economic value of the firm’s inventory
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Inventory Financing
• Some financing arrangements can shift
some of the inventory and related accounts
payable off the balance sheet
• Significant purchase commitments may
appear in the notes in that case, at which
point the analyst should add those
commitments to both inventory and A/P
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John Deere
• Purchase obligations,
due in less than one
year are “off balance
sheet” financing
• Here they amount to
almost $3 billion
• Inventory reported,
just over $3 billion,
$4.4 B under FIFO
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Effect of Purchase Obligations
• Consider a company with $100 of current
assets, $60 in inventory and $60 in current
liabilities. What is the effect on the current
and quick ratios of moving $30 to P.O.?
 Current;
100/60=1.67 with P.O. 70/30=2.33
 Quick; 40/60=0.67 with P.O. 40/30=1.33
• No tax effects, inventory purchase is not a
taxable event
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XBRL, As a side note
• Extensible Business Reporting Language
• Sunday, 22 January 2006, Emily Chasan
 has been around for about eight years and is touted as
a development as important for financial reporting as
the bar code was for retail pricing
 XBRL's backers, which include Microsoft Corp.,
Morgan Stanley and Reuters Group Plc
 Booth said the SEC raised a lot of interest after it
offered incentives to participate, but investor demand is
really what will make XBRL a success
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