Under IFRS, whenever the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value and the loss recognized as an expense on the income statement.
It is important for analysts to consider the possibility of an inventory write-down because the impact on a company’s financial statements and ratios could be significant.
Implications of Valuing Inventory at Net Realizable Value
Write-downs reduce the value of inventory, and the loss in value (expense) is generally reflected in the income statement in cost of goods sold. An inventory write-down will also reduce both profit and the carrying amount of inventory on the balance sheet and will, therefore, have a negative effect on profitability, liquidity, and solvency ratios.
For example, net profit margin and gross profit margin will both be lower because of a higher cost of sales (assuming that the inventory write-downs are reported as part of cost of sales).
Activity ratios such as inventory turnover and total asset turnover will be positively affected because the asset base is reduced (due to a decrease in the average inventory balance), and the higher cost of sales.
If a company values its inventory at the net realizable value, this will:
A. improve the company’s profitability
B. decrease the company’s inventory turnover
C. will lead to any loss being recognized as an expense on the company’s income statement.
The correct answer is C.
When a company’s inventory carrying amount is written down to its net realizable value, the loss is recognized as an expense on the income statement. Choice A and B are incorrect; if a company values its inventory at the net realizable value, this will decrease the company’s profitability and increase the inventory turnover.
An inventory write-down reversal has a negative effect on:
A. Solvency ratios.
B. Activity ratios.
C. None of the above.
The correct answer is B.
An inventory write-down reversal would increase a company’s assets (inventory), which is the denominator of all the activity ratios. The increase of the denominator of a ratio decreases the value of that ratio.
Reading 28 LOS 28h:
Describe implications of valuing inventory at net realisable value for financial statements and ratios