Com 4FK3

1. Com 4FK3 Financial Statement Analysis Week 4, 2012 Inventory Valuation and Cost Flows

2. 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

3. Types of Cost Flow • FIFO • First in, first out • Weighted Average • LIFO • Last in, first out

4. 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.

5. 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

6. 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 • Can lead to recognizing expenses for CGS that are several years out of date

7. 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?

8. Cost Flow Example

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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 • LIFO can defer taxes This is the only case where financial reporting choices affect taxation

15. 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

16. 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

17. 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

18. LIFO Reserve Example

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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