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LM06 Analysis of Inventories 2025 Level I Notes © IFT. All rights reserved 1 LM06 Analysis of Inventories 1. Introduction ........................................................................................................................................................... 2 2. Inventory Valuation ............................................................................................................................................ 2 3. The Effects of Inflation and Deflation on Inventories, Costs of Sales, and Gross Margin ........ 2 4. Presentation and Disclosure ........................................................................................................................... 2 Summary ...................................................................................................................................................................... 3 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM06 Analysis of Inventories 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction Inventories are assets held by a company to produce finished goods for sale. They are shown as a current asset on the balance sheet; and can represent a significant part of the total assets for many companies. Manufacturing and merchandising companies (Ex: Nike, Caterpillar) generate sales and profit through the sale of inventory. An important measure in calculating profits is cost of goods sold, i.e., how much cost the company incurred from procuring raw materials to converting it to a finished product, and finally selling it. There is no universal inventory valuation method. The four inventory valuation methods used by companies are: First In First Out (FIFO)  The cost of the first item purchased is assumed to be the cost of the first item sold.  Ending inventory is based on the cost of the most recent purchases. Last In First Out (LIFO)  The cost of the last item purchased is assumed to be the cost of the first item sold.  Ending inventory is based on the cost of the earliest purchases. Weighted average cost  Each item in the inventory is valued using an average cost of all items in the inventory.  COGS and inventory values are between their FIFO and LIFO values. Specific identification  Each unit sold is matched with the unit’s actual cost.  This method is usually used for items that are unique in nature, for example, jewelry. All four methods are permitted under U.S. GAAP. However, IFRS does not permit LIFO method. 2. Inventory Valuation Holding inventory for a prolonged period results in the risk of spoilage, obsolescence, or decline in prices, and the cost of inventory may not be recoverable in such circumstances. We define some terms first before looking at the differences in how inventory is measured under IFRS and GAAP. Net realizable value: Estimated selling price under ordinary business conditions minus estimated costs necessary to get the inventory in condition for sale. NRV is from a seller’s perspective. Net realizable value = estimated sales price – estimated selling costs Market value: Current replacement cost subject to lower or upper limits. Market value has
LM06 Analysis of Inventories 2025 Level I Notes © IFT. All rights reserved 3 upper limit of net realizable value and lower limit of NRV less a normal profit margin. Market value is from a buyer’s perspective. Market value limits = (NRV - normal profit margin, NRV) The following table describes how inventory is measured under IFRS and GAAP: Inventory measurement under IFRS and US GAAP IFRS US GAAP Lower of cost or net realizable value. Lower of cost or market value. If NRV is less than the balance sheet cost, the inventory is “written down” to NRV. The loss in value is reflected in the income statement in cost of goods sold. Inventory write-down has a negative effect on profitability, liquidity, and solvency ratios and positive effect on activity ratios. If cost exceeds market, inventory is written down to market value on the balance sheet and the loss is recognized. If value recovers subsequently, inventory can be written up and gain is recognized in the income statement. The amount of gain is limited to loss previously recognized. If value recovers subsequently, no write up is allowed. There is no reversal of write- downs. This may motivate companies not to record inventory write-downs unless the decline is permanent as it affects profitability ratios. Commodities and agricultural goods prices can be reported above historical cost. Commodities and agricultural goods prices can be reported above historical cost. An inventory write-down reduces both profit and carrying amount of inventory on the balance sheet, which, in turn, affects the ratios. The following table shows the effect of inventory write-downs on various financial ratios: Ratio Effect Reason Liquidity ratios Current ratio Lower Current assets decrease due to lower inventory. Activity ratios Inventory turnover Higher COGS increases assuming inventory write- downs are reported as part of cost of sales. Average inventory decreases. Lower inventory carrying amounts make it appear as if the company is managing its inventory effectively, but write-downs reflect poor inventory management.
LM06 Analysis of Inventories 2025 Level I Notes © IFT. All rights reserved 4 Days of inventory on hand Lower Inventory turnover is higher. Profitability ratios Net profit margin Lower Cost of sales is higher. Sales stay the same. Gross profit margin Lower Cost of sales is higher. Sales stay the same. Companies that use weighted average, specific identification, and FIFO are more likely to have inventory write-downs than companies using the LIFO method. 3. The Effects of Inflation and Deflation on Inventories, Costs of Sales, and Gross Margin First In, First Out (FIFO) Under First In, First Out:  Oldest goods purchased or manufactured are assumed to be sold first.  Newest goods purchased or manufactured remain in ending inventory.  When prices are increasing or stable, cost assigned to items in inventory is higher than the cost of items sold. The following example illustrates how cost of goods sold and inventory are accounted for in each period: Assume you bought four pencils. The first two pencils were worth $1 each and the next two pencils were worth $2 each. Before you start selling, your inventory consists of four pencils. In period 1, you sell two pencils. The cost of pencils sold in period 1 is $2 (two pencils of $1 each). The pencils that were bought first are considered sold. Inventory at the end of period 1 is $4 and looks like this (2 pencils of $2 each): As you could see, cost of pencils sold in period 1 was $2 (cheaper pencils bought initially) whereas the cost of pencils in inventory was $4. In period 2, you again sell two pencils. The cost of pencils sold in period 2 is $4. Inventory at the end of period 2 is 0. Advantage of using FIFO is that it is less subject to manipulation. The ending inventory is valued based on most recent purchases. COGS is based on earliest purchase costs. Therefore, in an inflationary environment, FIFO results in higher net income. Weighted Average Cost Under weighted average cost method, each item in inventory is valued using an average cost