Study Session 5, Reading 17

The 4 Inventory Cost Systems1. Specific identification - used for non-interchangeable items.2. FIFO - assumes that the items bought first are sold first. 3. LIFO - assumes that the items bought most recently are sold

first4. weighted average cost method - takes the average

inventory cost and applies it to each sale.

Study Session 5, Reading 17

Effects of Inventory Costs on Ratios

Inventory turnover ratio will be higher under the LIFO Days of inventory on hand is lower under LIFO The gross profit margin and net profit margin are lower

under LIFO Lower net income also results in lower return on assets Lower inventory values result in a lower current ratio. Total liabilities to equity ratio is higher under LIFO

Study Session 5, Reading 17

LIFO Reserve, LIFO liquidation LIFO Reserve – used to convert Financial statements prepared

under LIFO to FIFOLIFO liquidation - occurs when a company using the LIFO (Last

In, First Out) method of inventory costing liquidates their older LIFO inventory

Formula(s) used in LIFO Reserve:

Study Session 5, Reading 17

Converting Financial Statements from LIFO to FIFO

Formula(s) :

Study Session 5, Reading 17

Implications of Valuing Inventory at Net Realizable Value

Inventory valuation methods - used to determine the carrying amount on the balance sheet

Formula: Net Realizable Value of inventory

If NRV is less than carrying value, the book value of inventory is written down and the loss is recognized in the income statement.

Study Session 5, Reading 17

Analysis and Comparison of Financial Statements and Ratios Between Companies

LIFO often results in a higher cost of goods sold reported compared to FIFO.

Higher COGS result in lower gross profit and lower operating income for the companies using LIFO.

Companies using LIFO have lower tax expense vs companies using FIFO.

Study Session 5, Reading 17

Issues Concerning Inventory Disclosures

IFRS and GAAP require companies to include disclosures about the carrying value of inventory in the financial statements.

Industry news and the Management Discussion and Analysis section can also give information about inventory and future sales.

Study Session 5, Reading 17

Capitalizing vs Expensing Costs

Capitalization increases the profits of the companyHigher profits result in higher retained earnings and increases

owner’s equityAssets and owner’s equity will be higher when capitalizingDue to lower cash outflow from operations, capitalization

results in higher operating cash flows.An asset is recorded on the balance sheet under

capitalisation, but no asset is recorded on the balance sheet under expensing

Study Session 5, Reading 17

Depreciation Methodsdepreciation - allocation of the cost of the asset over its useful life. Straight Line Method - allocates the cost evenly over the life of the assetFormula:

Accelerated Depreciation - charge higher depreciation in the early years and lower in subsequent years

Formula:

Units of Production Method - Based on the usage of the assetFormula:

Study Session 5, Reading 18

Impairment and Revaluationon Assets

Impairment on AssetsIf the carrying amount of the asset is less than the recoverable

amount, an impairment loss can be recognized.Companies need to assess the assets for impairment at least once a

year.

Revaluation of Assets - used to report the assets at fair valuerevaluation surplus - the value of the asset is more than the carrying

value, then the gain goes straight to the other comprehensive income

Study Session 5, Reading 18

Disclosure about Long Lived Assets

Expenses can be categorized:according to natureaccording to function

Formula: Depreciable Life

Study Session 5, Reading 18

Leasing vs Purchasing Assets

lease - contractual agreement between two parties to use an asset

Leases reduce the risk of obsolescenceLeases result in a tax reporting advantageLease sometimes have easier provisions than borrowingUnder a finance lease, the lessee effectively buys the assetUnder a finance lease, the asset is reported on the balance sheetHigher profits are achieved in early years through leasing rather

than purchasing

Study Session 5, Reading 18

Finance and Operating LeasesLeases can be classified as either Finance Leases or Operating

Leases. Have different financial statement implications for lessee and

lessor in both types of lease. Operating lease allows the company to avoid a balance sheet

liability. Finance lease appears as a liability on the balance sheet of the

lessee.

Study Session 5, Reading 18

Finance and Operating LeasesLeases can be classified as either Finance Leases or Operating

Leases. Have different financial statement implications for lessee and

lessor in both types of lease. Operating lease allows the company to avoid a balance sheet

liability. Finance lease appears as a liability on the balance sheet of the

lessee.