FSA 6 Analysis of Inventories

For merchandisers and manufacturers, inventory is the engine of sales and profit: units are bought or built, held, and then sold, and the reported result hinges on how the cost attached to those units is measured when they leave. The single most important accounting choice here is the cost formula, also called the cost flow assumption or the inventory valuation method. That choice decides how the pool of spending on goods gets divided between two places: the figure shown as cost of sales inside the income statement, and the amount that stays parked in ending inventory on the balance sheet.

Because that division touches cost of sales, gross profit, and net income on one side and inventories, current assets, and total assets on the other, it flows into a wide set of ratios. An analyst who compares one company with another, or one year with the next, has to keep the method firmly in view before drawing any conclusion about performance.

The four cost formulas

Specific identification tracks the actual cost of each physical item and is used for unique, high-value goods. First-in, first-out (FIFO) treats the oldest purchases as the first sold, so ending inventory holds the most recent costs. Weighted average cost spreads the total cost of goods available evenly across all units, giving the same per-unit figure to cost of sales and to ending inventory. Last-in, first-out (LIFO) treats the newest purchases as the first sold, leaving the oldest costs in inventory. A key jurisdictional point: LIFO is allowed under US GAAP but is prohibited under International Financial Reporting Standards (IFRS).

This lesson concentrates on the analysis of inventories rather than on the mechanics of the formulas themselves: measuring inventory at the lower of cost and net realizable value, tracing how rising or falling costs move through each method, reading the required disclosures, computing the standard inventory ratios, and restating a LIFO reporter onto a FIFO basis for comparison.

Holding inventory carries real financial risk. Goods can spoil, become obsolete, or lose value as selling prices fall, and once that happens the recorded cost may no longer be recoverable. Accounting standards respond by capping the balance sheet value.

The IFRS rule

Under IAS 2, inventories are carried at the lower of cost and net realizable value (NRV). NRV is the price a company expects to obtain in the ordinary course of business, reduced by the estimated costs needed to complete the item and the estimated costs to sell it. The test is usually applied item by item, or across groups of similar or related items.

When NRV drops below the carrying amount, the inventory is written down to NRV and the reduction is recognized as an expense, either inside cost of sales or reported on its own line. In practice, many companies do not credit inventory directly but instead build a valuation allowance (an obsolescence allowance) that is netted against the gross inventory account to produce the reported carrying amount.

IFRS also allows the story to reverse. Each later period brings a fresh NRV assessment, and if the value of previously written-down inventory recovers, the company reverses the earlier write-down. The reversal is capped at the amount originally written off, and it is recorded as a reduction in cost of sales.

The US GAAP rule

For fiscal years that start after 15 December 2016, inventories measured on any basis apart from LIFO or the retail method follow the lower of cost or net realizable value, which broadly matches IFRS with one decisive exception: US GAAP does not allow a write-down to be reversed. For inventories measured with LIFO or the retail method, the comparison uses market value, defined as current replacement cost but bounded. Market cannot rise above NRV (the ceiling) and cannot fall below NRV less a normal profit margin (the floor). Any resulting write-down is generally charged to cost of goods sold.

What a write-down does to the ratios

A write-down lowers both reported profit and the inventory carrying amount, so it drags down profitability, liquidity, and solvency measures. Activity ratios move the other way: because inventory (and total assets) shrink in the denominator while sales are unchanged and cost of sales rises, inventory turnover and total asset turnover actually improve. That mixed effect, together with the fact that a US GAAP write-down can never be reversed, makes some companies reluctant to record one unless the decline looks permanent.

An exception worth remembering

IAS 2 does not govern producers of agricultural and forest products, nor producers of minerals and mineral products, nor commodity broker-traders. Those inventories may be carried at net realizable value even when that exceeds cost, with changes in value taken straight to profit or loss. US GAAP takes a similar line, and mark-to-market accounting is permitted for bullion. One more pattern: companies on FIFO, weighted average cost, or specific identification are more exposed to write-downs than LIFO companies, because in a rising-cost setting LIFO already reports inventory at the oldest and lowest costs, so it is closer to any floor.

The split of the goods-available pool between cost of sales and ending inventory depends on the method chosen and on the direction of unit costs, assuming quantities are stable or growing. The reasoning is symmetric, so it is enough to fix the pattern under rising costs and then flip it for falling costs.

Rising unit costs

When costs are climbing, FIFO sends the oldest and cheapest purchases to cost of sales and leaves the newest and dearest ones in ending inventory. Compared with weighted average cost or LIFO, FIFO therefore reports a lower cost of sales, a higher ending inventory, and higher gross profit, operating profit, and pre-tax income. LIFO does the reverse: the newest, most expensive purchases hit cost of sales, so cost of sales is higher and profit lower, while ending inventory holds stale old costs.

Each method is faithful in a different place. FIFO ending inventory tracks current replacement value closely because it holds recent purchases, which makes the FIFO balance sheet more current. LIFO cost of sales tracks current replacement value closely because it expenses recent purchases, which makes the LIFO income statement more current. LIFO ending inventory, built from old layers, can drift far from replacement cost.

Falling unit costs

With declining costs the conclusions invert. FIFO now expenses the oldest, most expensive units, so FIFO reports a higher cost of sales and lower profit than LIFO, and a lower ending inventory. This is why a firm operating in a deflationary product market, such as many technology businesses, tends to report its highest profit under LIFO.

LIFO liquidation

If a LIFO company sells more units than it buys in a period, inventory falls and old, low-cost layers are drawn into cost of sales. This is LIFO liquidation. Because those layers carry unusually low costs, cost of sales is understated and gross profit is temporarily inflated, a distortion an analyst should strip out rather than read as genuine margin improvement.

Because the cost formula reaches cost of sales, gross profit, and net income, along with inventories, current assets, and total assets, it also reaches every ratio built from those figures, among them return on assets, the current ratio, inventory turnover, and gross profit margin. Adjustments to net realizable value or replacement cost move the same items. Disclosures are what let an analyst see the method and its footprints.

Required disclosures

IFRS asks a company to disclose the accounting policy and cost formula used; the total carrying amount and the amounts in each classification such as raw materials, work in progress, and finished goods; any inventory held at fair value less costs to sell; the amount of inventory recognized as an expense (cost of sales); the amount of any write-down expensed in the period; the amount of any reversal and the circumstances that caused it; and the carrying amount of inventory pledged as security. US GAAP disclosures are similar, except that the reversal items fall away (reversals are not allowed), and US GAAP additionally calls for disclosure of significant inventory estimates and of any material income arising from a LIFO liquidation.

The three core ratios

Inventory turnover counts how many times a year a company works through its inventory; a higher figure means less capital tied up per unit of sales. Days of inventory on hand converts that into an average holding period, so the two measures are inverses. Gross profit margin shows the share of sales left after covering the cost of the goods sold.

The numbers rarely speak for themselves. High turnover with few days on hand can mean tight, effective management, but it can equally flag an inventory that is too thin to support sales or one that has been written down. Low turnover with many days on hand can point to slow-moving or obsolete stock. The way to tell these apart is to benchmark against industry norms, track the trend across years, compare the sales growth rate, and read the disclosures. Margins carry their own context: firms in fiercely competitive markets usually run thinner gross margins, and a luxury seller tends to post a high margin with low turnover, while a staples seller shows the opposite mix.

Because LIFO is a US GAAP option that IFRS forbids, an analyst comparing a LIFO reporter with FIFO peers has to put them on a common footing. US GAAP requires LIFO companies to disclose the LIFO reserve, the gap between what inventory would be under FIFO (or current cost) and what it is under LIFO. That single disclosed number is the bridge between the two methods.

The conversion

To move a balance sheet from LIFO to FIFO, add the reserve to LIFO inventory. To move the income statement, subtract the change in the reserve from LIFO cost of sales, because an increase in the reserve measures how much larger LIFO cost of sales was than FIFO cost of sales in the period. Equity rises too: retained earnings under FIFO are higher by the after-tax amount of the reserve.

When the aim is also to strip out write-down distortions, an analyst removes the valuation-allowance charges from cost of sales (and adds them back, after tax, to income and equity). A rising reserve signals that LIFO cost of sales ran above FIFO, the normal picture when costs climb and layers build. A falling reserve can signal a LIFO liquidation, in which old low-cost layers are consumed, or simply a period of falling prices, and it deserves a closer look before turnover or margin is trusted.