CFA Level 1 · Module 04 Financial Statement Analysis · Chapter 6
Inventory is often the largest current asset a manufacturer or a retailer carries, and the way a company measures it flows straight through to two of the numbers analysts care about most: cost of goods sold on the income statement and the inventory balance on the balance sheet. The twist is that a company can choose among several accepted ways to assign cost to the goods it sells, and in a world where prices move, those choices produce genuinely different profit, different asset values, and different tax bills, even though the physical goods on the shelf are identical. Understanding inventory accounting is therefore less about bookkeeping and more about knowing how much of a reported margin is real and how much is an artifact of the method.
This reading builds the tools in order. First, the four cost formulas and how a periodic count differs from a perpetual record. Second, the central skill: tracing how FIFO, LIFO, and weighted average move cost of goods sold, gross profit, net income, ending inventory, and taxes when costs are rising, and how every one of those effects flips when costs are falling. Third, the LIFO reserve and the mechanics of restating a LIFO company onto a FIFO basis so it can be compared fairly, plus the trap of LIFO liquidation. Fourth, writing inventory down to the lower of cost and net realizable value, and the sharp difference between IFRS and US GAAP on reversing that write-down. Fifth, the inventory ratios and how method choice quietly distorts them. Every company and every number below is invented by MidhaFin to teach the mechanics; none is taken from the source curriculum or any prep provider. Concepts, definitions, and formulas are shared knowledge and are used freely.
When a company buys or makes identical units at different prices over a period, it needs a rule for deciding which cost attaches to the units it sells and which cost stays with the units still on hand. That rule is the cost formula, sometimes called the cost flow assumption. It does not have to match the physical movement of the goods; it is an accounting convention for splitting the total cost of goods available for sale between cost of goods sold and ending inventory. There are four accepted formulas.
Specific identification tracks the actual cost of each individual item and charges that exact cost to cost of goods sold when the item is sold. It is used for goods that are not interchangeable and are usually high value and low volume, such as custom machinery, real estate units, or serial-numbered vehicles. It is the most precise formula, but it is impractical when a business sells thousands of interchangeable units.
First-in first-out (FIFO) assumes the oldest units are sold first, so cost of goods sold is made up of the earliest costs and ending inventory is made up of the most recent costs. This means the balance sheet carries inventory at close to current replacement cost, which analysts generally regard as the more useful inventory figure.
Weighted average cost assigns the same average cost to every unit, computed by dividing the total cost of goods available for sale by the total number of units available. Both cost of goods sold and ending inventory are struck at this single blended rate, so the method smooths out the effect of price changes and always sits between the FIFO and LIFO results.
where total cost of goods available for sale is beginning inventory cost plus the cost of all purchases (or production) during the period, and total units available for sale is beginning units plus units purchased or produced. The same average rate is applied to units sold and to units remaining.
Last-in first-out (LIFO) assumes the newest units are sold first, so cost of goods sold is made up of the most recent costs and ending inventory is made up of the oldest costs. This is the mirror image of FIFO. The critical rule to memorize is that LIFO is permitted under US GAAP but is not permitted under IFRS. A company reporting under IFRS may use only specific identification, FIFO, or weighted average cost. This asymmetry is the reason so much of inventory analysis is about converting a US LIFO reporter onto a comparable FIFO basis.
The cost formula changes only how the total cost of goods available for sale is split between the income statement and the balance sheet. It never changes the total itself. Beginning inventory plus purchases equals cost of goods sold plus ending inventory under every method, so a higher cost of goods sold always means a lower ending inventory, and the reverse. Whenever you compute one, you can check it by confirming that the two add back to the same pool of cost.
A second choice sits alongside the cost formula: whether the company uses a periodic or a perpetual inventory system. Under a periodic system, inventory quantity is determined by a physical count at the end of the period, and cost of goods sold is derived as a residual (beginning inventory plus purchases minus ending inventory). Under a perpetual system, each purchase and each sale is recorded as it happens, so the inventory balance and cost of goods sold are known continuously. For FIFO and for specific identification the two systems give the same result. For LIFO and for weighted average they can differ, because the timing of when costs enter the average or which layer is treated as most recent depends on when the count is struck. For Level 1, know that the distinction exists and that it matters most for LIFO and weighted average.
| Formula | What it assumes | Ending inventory reflects | Allowed under |
|---|---|---|---|
| Specific identification | Actual cost of each individual item | Actual cost of the specific items left | IFRS and US GAAP |
| FIFO | Oldest units are sold first | Most recent (current) costs | IFRS and US GAAP |
| Weighted average | All units carry one blended cost | The average cost of the period | IFRS and US GAAP |
| LIFO | Newest units are sold first | Oldest (often outdated) costs | US GAAP only, not IFRS |
This is the heart of the reading. Because FIFO and LIFO pull cost of goods sold from opposite ends of the price history, they report different profit whenever costs are changing, even for a company that buys and sells exactly the same physical goods. The direction of the difference depends entirely on whether costs are rising or falling.
Start with a rising-cost environment, which is the more common case and the one exams default to. FIFO charges the oldest, cheapest units to cost of goods sold, so FIFO gives the lowest cost of goods sold, and therefore the highest gross profit, the highest net income, and the highest taxes. FIFO leaves the newest, most expensive units in ending inventory, so it also reports the highest ending inventory, and that figure is closest to current replacement cost. LIFO does the reverse on every line: it charges the newest, most expensive units to cost of goods sold, giving the highest cost of goods sold, the lowest gross profit and net income, and the lowest taxes, while leaving the oldest, cheapest units in a low ending inventory that can be badly out of date. Weighted average lands between the two on every measure. Let us put numbers on it.
Setup. Marigold Hardware, an invented company, starts the year with 100 units in inventory at a cost of 10 each. During the year, in a period of rising costs, it buys 200 units at 12 each and then 200 units at 13 each. It sells 300 units at a price of 20 each. There are no other expenses, and the tax rate is 25%. Compute cost of goods sold, ending inventory, gross profit, tax, and net income under FIFO, LIFO, and weighted average.
Answer: FIFO reports gross profit of 2,600 and net income of 1,950; LIFO reports gross profit of 2,200 and net income of 1,650; weighted average sits in the middle at 2,400 and 1,800. So what does this number mean? The physical business is identical under all three, yet FIFO makes it look 300 more profitable after tax than LIFO. FIFO reports the higher profit and the higher inventory (2,600, close to the current cost of 13), but it also pays the higher tax of 650. LIFO reports the lower profit and a stale inventory of 2,200, but it pays only 550 in tax, so it keeps 100 more cash. In rising costs, LIFO trades reported profit for a real cash tax saving.
| Line | FIFO | Weighted average | LIFO |
|---|---|---|---|
| Sales revenue | 6,000 | 6,000 | 6,000 |
| Cost of goods sold | 3,400 | 3,600 | 3,800 |
| Gross profit | 2,600 | 2,400 | 2,200 |
| Tax at 25% | 650 | 600 | 550 |
| Net income | 1,950 | 1,800 | 1,650 |
| Ending inventory | 2,600 | 2,400 | 2,200 |
Anchor the rising-cost result with one phrase: FIFO gives the higher inventory and the higher profit. Everything else follows. Higher profit means higher taxes, so LIFO, with the lower profit, gives the lower tax and the better cash flow where it is allowed. If you can recall that FIFO puts the newest and dearest costs into inventory and the oldest and cheapest into cost of goods sold, you can rebuild every line of the comparison under pressure without memorizing a table.
Now reverse the price direction. In a falling-cost (deflationary) environment every effect flips. FIFO now charges the oldest, more expensive units to cost of goods sold, so FIFO gives the higher cost of goods sold, the lower gross profit and net income, and the lower ending inventory. LIFO charges the newest, cheaper units to cost of goods sold, giving the lower cost of goods sold, the higher profit, and the higher ending inventory. The methods do not have a fixed ranking; the ranking is entirely a function of whether costs are moving up or down.
Setup. Cedar Components, an invented company, faces falling costs. It begins with 100 units at 15 each, then buys 200 units at 13 each and 200 units at 12 each. It sells 300 units. Compute cost of goods sold and ending inventory under FIFO, LIFO, and weighted average, and confirm the direction of the effect has reversed relative to Worked Example 1.
Answer: with falling costs, FIFO now reports the higher cost of goods sold (4,100) and the lower inventory (2,400), while LIFO reports the lower cost of goods sold (3,700) and the higher inventory (2,800). So what does this number mean? This is the exact opposite of the rising-cost case, where FIFO gave the lower cost of goods sold. The lesson is that no method is permanently the conservative one; the price trend decides. An analyst must always ask which way costs moved before predicting which method reports the higher profit.
| When costs are rising, FIFO gives the | When costs are falling, FIFO gives the |
|---|---|
| Lower cost of goods sold | Higher cost of goods sold |
| Higher gross profit and net income | Lower gross profit and net income |
| Higher ending inventory (near current cost) | Lower ending inventory |
| Higher income taxes | Lower income taxes |
In every row above, LIFO does the reverse of FIFO, and weighted average falls between the two. Read the table as FIFO versus LIFO; the weighted-average result is always the compromise.
Do not assume LIFO always means lower profit. That is true only while costs are rising, which is the usual textbook setting, but it is not a law. If a company operates in a market of falling input costs, such as many technology components, LIFO will report the higher profit and FIFO the lower. Memorizing the rising-cost outcome as if it were universal is one of the most common errors on this reading. Tie the outcome to the price direction, not to the method name.
Because LIFO is allowed under US GAAP but banned under IFRS, an analyst comparing a US LIFO reporter with an IFRS FIFO reporter is comparing figures that are not on the same basis. US GAAP solves half of the problem by requiring LIFO companies to disclose the LIFO reserve, which is the difference between what inventory would be under FIFO and what it is under LIFO. That single disclosed number is the bridge that lets you restate the whole company onto a FIFO basis.
Rearranged for conversion: FIFO inventory = LIFO inventory + LIFO reserve. And on the income statement, FIFO cost of goods sold = LIFO cost of goods sold − (the increase in the LIFO reserve during the period). Equity is adjusted upward by the after-tax amount of the LIFO reserve, because the extra inventory would have been taxed.
The logic of the cost of goods sold adjustment is worth pausing on. In rising costs, LIFO cost of goods sold is higher than FIFO cost of goods sold, and the gap for the year is exactly the amount by which the LIFO reserve grew. So to move from LIFO cost of goods sold to FIFO cost of goods sold, you subtract the increase in the reserve. On the balance sheet, you add the full reserve to inventory to reach FIFO inventory. On the equity side, you add only the after-tax portion of the reserve to retained earnings, because if the company had reported the higher FIFO profits it would also have paid tax on them; the tax that would have been due is recorded as a deferred tax liability.
Setup. Basalt Industrial, an invented US company, reports on LIFO. Its ending inventory under LIFO is 2,200 and its beginning inventory under LIFO was 1,800. It discloses a LIFO reserve of 900 at the end of the year and 700 at the start. Reported LIFO cost of goods sold for the year is 8,000, and the tax rate is 25%. Restate ending inventory, cost of goods sold, and the equity adjustment onto a FIFO basis.
Answer: on a FIFO basis, inventory rises to 3,100, cost of goods sold falls to 7,800, and equity rises by 675. So what does this number mean? The reserve of 900 is the cumulative amount by which LIFO has held inventory below current cost since the company adopted it, so adding it back restores the balance sheet to current-cost thinking. The current year cost of goods sold falls by only 200, the amount the reserve grew this year, which lifts pretax profit by 200. Only 675 of the reserve belongs to shareholders because 225 of it would have gone to the tax authority.
A different and more dangerous distortion is LIFO liquidation. Under LIFO, inventory is thought of as stacked layers, with old low-cost layers at the bottom and recent high-cost layers on top. In a normal year the company sells roughly what it buys, so it draws only on the recent top layer and cost of goods sold reflects current costs. But if inventory quantities fall, because the company sells more than it buys or produces, it digs into the old bottom layers, and those decades-old low costs flow into cost of goods sold. Cost of goods sold is then artificially low, gross profit is artificially high, and the boost is a one-time event that cannot be repeated once the cheap layer is gone.
Setup. Quarry Metals, an invented LIFO company, sells 2,000 units this year. It purchased only 1,500 units during the year, all at the current cost of 14 each. To meet the extra demand it liquidated 500 units from an old LIFO layer carried at just 8 each. Show the effect on cost of goods sold and gross profit compared with a year in which all units were bought at current cost.
Answer: the liquidation of the old cheap layer cut cost of goods sold by 3,000 and inflated pretax profit by the same 3,000. So what does this number mean? Quarry Metals looks 3,000 more profitable this year, but the gain came from selling inventory bought long ago at 8, not from any improvement in the business. It cannot happen again once that layer is exhausted, so an analyst must remove the 3,000 before judging the trend, and should be suspicious whenever a LIFO company reports a jump in margin at the same time its inventory quantities are shrinking.
Do not read rising LIFO margins as good news without checking inventory quantities. A LIFO liquidation can make a declining business look like it is improving, because shrinking inventory is exactly what pushes the old cheap costs into cost of goods sold. The tell is the combination of higher gross margin and falling unit inventory. Restating to FIFO, or backing out the disclosed liquidation effect, removes the illusion.
Cost is not the end of the story. Inventory can become damaged, obsolete, or simply worth less than the company paid, and accounting does not let a company carry an asset above the amount it can recover from selling it. Under IFRS, inventory is measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business minus the estimated costs to complete the item and the estimated costs to sell it.
If net realizable value is below cost, inventory is written down to net realizable value and the write-down is recognized as an expense (usually within cost of goods sold) in the period. If net realizable value is at or above cost, inventory stays at cost and no gain is recognized.
A write-down lowers the carrying value of inventory on the balance sheet and reduces net income in the period it is taken, which in turn lowers assets and equity. Because it shrinks both inventory and profit, it also moves the ratios: the lower inventory raises inventory turnover, the lower profit cuts margins, and both assets and equity fall. The treatment of a later recovery in value is where the two frameworks part company. Under IFRS, if the net realizable value of previously written-down inventory recovers, the earlier write-down is reversed, but only up to the amount of the original write-down, so the carrying value can never exceed the original cost. Under US GAAP, reversal of a write-down is generally prohibited: once written down, the reduced amount becomes the new cost basis and cannot be written back up. (Note also that US GAAP companies using LIFO or the retail method apply lower of cost or market rather than lower of cost and net realizable value, a related but distinct rule.)
Setup. Saffron Apparel, an invented IFRS company, holds a line of coats recorded at a cost of 5,000. At year end it estimates it can sell them for 5,600 but must spend 900 on alterations and selling costs to do so. Compute net realizable value and any write-down. Then, in the following year, the estimated net realizable value recovers to 4,950. Show the treatment under IFRS and note the US GAAP difference.
Answer: the write-down is 300 (inventory to 4,700); under IFRS a later recovery restores 250 (inventory to 4,950), while under US GAAP inventory remains at 4,700. So what does this number mean? The write-down immediately reduced Saffron’s profit and asset base by 300. Under IFRS the partial recovery is allowed to flow back through income, so reported results can rebound; under US GAAP the loss is locked in and only unwinds later as the goods are sold at their reduced basis, which can make a US firm look less volatile but also understate the true value of its inventory after a recovery.
The reversal rule is a favorite exam point because the two frameworks give opposite answers. Fix it as a pair: IFRS reverses (up to original cost), US GAAP does not. When you compare an IFRS company with a US GAAP company after a period of write-downs and recoveries, the IFRS firm can report higher inventory and higher recent profit for the identical goods, purely because it was permitted to write the value back up.
Inventory appears as a single current-asset line on the face of the balance sheet, but the notes carry the detail an analyst actually uses. Required disclosures typically include the accounting policy and the cost formula adopted, the total carrying amount and the carrying amount by classification (for a manufacturer, raw materials, work in progress, and finished goods), the amount of inventory recognized as an expense during the period (essentially cost of goods sold), the amount of any write-down recognized, and, under IFRS, the amount of any reversal of a write-down together with the circumstances that led to it. A US GAAP company that uses LIFO must also disclose the LIFO reserve, which, as the previous section showed, is the key to restating it onto a FIFO basis.
These disclosures are not box-ticking. The cost formula tells you whether the reported inventory is close to current cost (FIFO) or potentially stale (LIFO). The breakdown by category is an early read on operations: a build-up of finished goods relative to sales can signal weakening demand, while a jump in raw materials may signal a planned increase in production. The write-down disclosure quantifies how much value has already been impaired, and the LIFO reserve disclosure is the single number that makes cross-company comparison possible. An analyst who skips the inventory note is throwing away most of what inventory accounting reveals.
Watch the mix inside inventory, not just the total. A rising total inventory balance can be benign if it is raw materials ahead of a genuine production ramp, but the same rise concentrated in finished goods, especially when it is growing faster than sales, is a classic early warning of an inventory glut and future write-downs. The category disclosure is what lets you tell a healthy build-up from a warning one.
The final skill is turning inventory figures into ratios and knowing how the accounting choices above distort them. Three measures matter most. Inventory turnover counts how many times a company sold and replaced its inventory during the period. Days of inventory on hand converts that into an average number of days a unit sits in stock. Gross profit margin measures the profit left after the cost of the goods themselves.
where average inventory is usually (beginning inventory + ending inventory) ÷ 2. A higher turnover, and therefore fewer days on hand, means inventory is moving quickly; a very high turnover can also signal that inventory is too lean and stockouts are being risked.
where a higher margin means more of each unit of sales survives after the direct cost of the goods. Because cost of goods sold is the numerator that method choice changes most, gross profit margin is directly sensitive to whether a firm uses FIFO or LIFO.
Setup. Verdant Foods, an invented company, reports net revenue of 10,000,000 and cost of goods sold of 7,300,000. Beginning inventory was 900,000 and ending inventory was 1,100,000. Compute inventory turnover, days of inventory on hand, and gross profit margin.
Answer: turnover is 7.3 times, days of inventory on hand is 50 days, and gross profit margin is 27%. So what does this number mean? Verdant sells and replaces its entire inventory 7.3 times a year, so an average item sits on the shelf about 50 days before it is sold, and after paying for the goods the company keeps 27 cents of every revenue unit as gross profit. For a food business those are reasonable figures, but they only become a judgement once compared with the company’s own past and with peers on the same accounting basis.
Now the analytical sting. Every one of these ratios is distorted by method choice and by write-downs, so comparing two firms at face value can mislead. Consider inventory turnover for a US LIFO firm in rising costs. Its inventory (the denominator) is understated because LIFO holds the oldest, cheapest costs, and its cost of goods sold (the numerator) is at current cost. Both effects push turnover up, so the LIFO firm looks like it manages inventory far more tightly than a FIFO peer, when the gap is largely an accounting artifact. The fix is to restate the LIFO firm to FIFO using the LIFO reserve before comparing.
Setup. Ironwood Supply, an invented US LIFO company, reports cost of goods sold of 8,000,000, ending LIFO inventory of 1,000,000, and beginning LIFO inventory of 800,000. Its LIFO reserve is 400,000 at year end and 300,000 at the start. Compute its inventory turnover as reported, then restate it to FIFO to compare fairly with its FIFO peer Cedarstone Supply.
Answer: on its reported LIFO figures Ironwood turns inventory 8.89 times a year (41 days on hand), but restated to FIFO it turns only 6.32 times (58 days). So what does this number mean? Roughly seventeen of Ironwood’s apparent forty-one days were an accounting illusion created by LIFO understating inventory. If an analyst compared the raw LIFO turnover of 8.89 with Cedarstone’s FIFO turnover, Ironwood would look far more efficient than it really is. Only after restating both firms to the same FIFO basis does the comparison mean anything, and on that basis Ironwood at 58 days should be measured against Cedarstone’s own FIFO days.
When a question hands you a LIFO firm and a FIFO firm and asks which manages inventory better, the trap is to compare the reported ratios directly. Always convert the LIFO firm first: add the reserve to inventory, subtract the increase in the reserve from cost of goods sold, then recompute turnover and days. A write-down is the mirror-image trap: it cuts the inventory denominator and lifts turnover, so a firm can appear to speed up inventory management in the very period it is impairing stock it cannot sell.
Under IFRS, which inventory cost formulas may a company use, and which is prohibited?
Under IFRS a company may use specific identification, first-in first-out (FIFO), or weighted average cost. LIFO is prohibited under IFRS. LIFO is permitted only under US GAAP, which is why analysts must often restate a US LIFO reporter onto a FIFO basis before comparing it with an IFRS company.
In a period of rising costs, which method reports the highest ending inventory and which reports the highest cost of goods sold?
FIFO reports the highest ending inventory, because it leaves the newest and most expensive units on the balance sheet, close to current cost. LIFO reports the highest cost of goods sold, because it charges the newest and most expensive units to the income statement. As a result FIFO shows the higher profit and the higher tax, while LIFO shows the lower profit, the lower tax, and a stale, low inventory figure.
A US LIFO firm reports LIFO inventory of 600,000 and a LIFO reserve of 150,000. What is its inventory on a FIFO basis, and by how much would equity rise if the tax rate is 20%?
FIFO inventory = LIFO inventory + LIFO reserve = 600,000 + 150,000 = 750,000. Equity rises by the after-tax reserve = 150,000 × (1 − 0.20) = 120,000, with the remaining 30,000 recorded as a deferred tax liability. Inventory is raised by the full reserve, but only the after-tax portion belongs to shareholders.
A LIFO firm reports a LIFO reserve of 500,000 at the start of the year and 560,000 at the end, with reported LIFO cost of goods sold of 4,000,000. What is FIFO cost of goods sold?
3,940,000. The increase in the LIFO reserve is 560,000 − 500,000 = 60,000. FIFO cost of goods sold equals LIFO cost of goods sold minus that increase: 4,000,000 − 60,000 = 3,940,000. Because the reserve grew, LIFO cost of goods sold was higher than FIFO cost of goods sold by exactly the amount of the growth.
Inventory is recorded at a cost of 8,000. Its estimated selling price is 8,500, estimated completion costs are 400, and estimated selling costs are 600. Is a write-down required, and if so, how much?
Net realizable value = 8,500 − 400 − 600 = 7,500. Because net realizable value of 7,500 is below the cost of 8,000, a write-down of 500 is required, reducing inventory to 7,500 and reducing net income by 500 before tax. If net realizable value had been at or above 8,000, no write-down would be taken.
A previously written-down item recovers in value. How does the treatment differ between IFRS and US GAAP?
Under IFRS the earlier write-down is reversed, but only up to the original cost, so the carrying value rises again (never above original cost) and a gain is recognized. Under US GAAP reversal is generally prohibited: the written-down amount becomes the new cost basis and inventory cannot be written back up, so the recovery is never reflected until the goods are sold.
A company reports cost of goods sold of 5,400,000, beginning inventory of 850,000, and ending inventory of 950,000. Compute inventory turnover and days of inventory on hand.
Average inventory = (850,000 + 950,000) ÷ 2 = 900,000. Inventory turnover = 5,400,000 ÷ 900,000 = 6.0 times. Days of inventory on hand = 365 ÷ 6.0 = 60.8 days. On average a unit sits in inventory about 61 days before it is sold, a figure that becomes meaningful only against the company’s history and its peers.
Because when purchase costs change during the period, the formula decides which costs are charged to cost of goods sold and which stay in ending inventory, and that split changes reported gross profit, net income, the inventory balance, and the tax bill. FIFO charges the oldest costs to the income statement and leaves the newest in inventory, while LIFO does the opposite, so in rising costs FIFO reports higher profit and higher inventory and LIFO reports lower profit and lower taxes. The physical business is the same under every method; only the accounting result differs, which is why an analyst must know the method before trusting the margin.
No. LIFO is not permitted under IFRS. An IFRS company may use specific identification, first-in first-out (FIFO), or weighted average cost, but not last-in first-out. LIFO is permitted only under US GAAP. This difference is the reason analysts often have to convert a US LIFO reporter onto a FIFO basis, using the disclosed LIFO reserve, before comparing it with an IFRS company that reports on FIFO or weighted average.
In a rising-cost environment LIFO charges the newest and most expensive units to cost of goods sold, which makes cost of goods sold higher and pretax profit lower than under FIFO. A lower pretax profit produces a lower income tax bill, and because tax is a real cash outflow, paying less tax leaves the company with more cash. This is the core reason many US companies elect LIFO where it is allowed: it is a legitimate way to defer tax while costs keep rising. The trade-off is a lower reported profit and an inventory figure on the balance sheet that can be badly out of date.
The LIFO reserve is the difference between what inventory would be under FIFO and what it is under LIFO, and US GAAP requires LIFO companies to disclose it. To restate to FIFO, add the reserve to reported LIFO inventory to get FIFO inventory, subtract the increase in the reserve during the year from LIFO cost of goods sold to get FIFO cost of goods sold, and raise equity by the after-tax amount of the reserve, recording the tax portion as a deferred tax liability. These three adjustments put a LIFO firm on the same basis as a FIFO peer so their inventory, margins, and turnover can be compared.
LIFO liquidation happens when a LIFO company sells more units than it buys or produces, so inventory quantities fall and the sale reaches down into old cost layers carried at prices from years ago. Those old low costs flow into cost of goods sold, which is then artificially low, so gross profit is artificially high. The problem is that the gain is a one-time event that cannot repeat once the cheap layer is used up, and it often appears precisely when a business is shrinking. An analyst must remove the liquidation effect before judging profitability, and should be alert whenever a LIFO firm reports rising margins alongside falling unit inventory.
Net realizable value is the estimated selling price of inventory in the ordinary course of business minus the estimated costs to complete the item and the estimated costs to sell it. Under IFRS, inventory is carried at the lower of cost and net realizable value, so whenever net realizable value falls below cost, the inventory is written down to net realizable value and the reduction is recognized as an expense in that period. The write-down lowers the inventory balance, net income, assets, and equity, and it also raises inventory turnover because the denominator shrinks, which an analyst should keep in mind when comparing periods.
It depends on the framework. Under IFRS, if the net realizable value of previously written-down inventory recovers, the earlier write-down is reversed, but only up to the original cost, so the carrying value can rise again yet never exceed what the goods originally cost. Under US GAAP, reversal is generally prohibited: once inventory is written down, the reduced figure becomes its new cost basis and it cannot be written back up. This means that after a write-down and a recovery, an IFRS company can report higher inventory and higher recent profit than a US GAAP company holding identical goods.
Inventory turnover is cost of goods sold divided by average inventory, and in rising costs LIFO pushes both parts of that fraction in the direction of a higher ratio: it understates inventory in the denominator, because inventory carries old cheap costs, while cost of goods sold in the numerator reflects current costs. The result is that a LIFO firm can appear to turn its inventory much faster than a FIFO peer even when the two manage inventory identically. Before comparing, restate the LIFO firm to FIFO by adding the reserve to inventory and subtracting the increase in the reserve from cost of goods sold, then recompute turnover and days of inventory on hand.
Loading comments...
Add your Thoughts: