Presentations and Disclosures Relating to Inventories

Presentation and Disclosures Relating to Inventories

IFRS Disclosure Requirements:

Under IFRS, companies must include the following information in their financial statements regarding inventories:

• Accounting Policies: The accounting policies adopted for measuring inventories, including the cost formula (inventory valuation method) used.
• Total Carrying Amount: The total carrying amount of inventories and the carrying amount in classifications such as merchandise, raw materials, production supplies, work in progress, and finished goods.
• Fair Value Measurement: The carrying amount of inventories carried at fair value less costs to sell.
• Expense Recognition: The amount of inventories recognized as an expense during the period (cost of sales).
• Write-downs: The amount of any write-down of inventories recognized as an expense in the period.
• Reversals of Write-downs: The amount of any reversal of any write-down that is recognized as a reduction in the cost of sales in the period.
• Circumstances for Reversals: The circumstances or events that led to the reversal of a write-down of inventories.
• Pledged Inventories: The carrying amount of inventories pledged as security for liabilities.

US GAAP Disclosure Requirements

Inventory-related disclosures under US GAAP are similar to those under IFRS but have some differences:

• Significant Estimates: Disclosure of significant estimates applicable to inventories.
• LIFO Liquidation: Disclosure of any material amount of income resulting from the liquidation of LIFO inventory.
• Exclusions for Write-down Reversals: Unlike IFRS, US GAAP does not require disclosures related to the reversal of inventory write-downs, and as such, reversals are not permitted.

Issues Analysts Should Consider

Analysts should consider several key issues when examining a company’s inventory disclosures and other sources of information.

The choice of inventory valuation method (FIFO, LIFO, Weighted Average) affects several financial statement items, including cost of sales, gross profit, net income, inventories (current assets), total assets

Analysts should also consider the effect of inventory valuation on financial ratios: Inventory valuation methods impact financial ratios such as:

• Current ratio, since inventory is a component of current assets.
• Return on assets (ROA) because the cost of sales affects net income, and inventory is part of total assets.
• Gross profit margin, since gross profit is affected by the cost of sales.
• Inventory turnover since it measures how efficiently inventory is managed.

Note that adjustments of inventory carrying amounts to net realizable value or current replacement cost can also impact the above financial items and ratios.

Other Considerations

1. Inventory Size

Analysts should compare the company’s inventory turnover ratio with sales trends to determine the appropriate inventory size. A too-small inventory might lead to missed sales opportunities, while too much inventory can negatively impact financial ratios.

2. Composition of Inventory

The percentage change of different inventory categories (finished goods, raw materials, work in progress) can indicate management’s expectations about future demand. For example, an increase in finished goods might suggest slower future sales growth.

3. Inventory Growth vs. Sales Growth

Analysts should compare the growth rate of finished goods with the sales growth rate. If inventory growth outpaces sales, it could indicate potential future sales slowdowns or overstocking.

4. Other Sources of Information

Additional information can be found in the Management Discussion and Analysis (MD&A) section, as well as industry reports and economic data related to the industry. This can provide context and further insights into inventory management and future sales trends.

Inventory Ratios

Three key ratios often used to evaluate the efficiency and effectiveness of inventory management are the inventory turnover ratio, days of inventory on hand (DOH), and gross profit margin. These ratios are directly influenced by a company’s choice of inventory valuation method.

However, other financial ratios, such as the current ratio, return on assets (ROA), and debt-to-equity ratio, are less directly affected by the inventory valuation method.

Inventory Turnover Ratio

Measures how often a company sells and replaces its inventory over a period. It is calculated as:

\[\text{Inventory Turnover Ratio} = \frac{\text{COGS}}{\text{Average Inventory}}\]

A higher turnover ratio indicates more efficient inventory management, as it means the company sells its inventory more frequently, reducing the investment tied up in inventory. Conversely, a low inventory turnover ratio could signal poor inventory management or overstocking. Comparing this ratio to industry norms helps contextualize the company’s performance.

Days of Inventory on Hand (DOH)

Indicates the average number of days inventory is held before it is sold. It is inversely related to inventory turnover.

\[\text{Days of Inventory on Hand} = \frac{\text{365}}{\text{Inventory Turnover Ratio}}\]

Inventory turnover and DOH should be compared against industry norms and tracked over multiple periods to assess trends.

A high inventory turnover ratio and low DOH can indicate efficient inventory management. However, it could also suggest inadequate inventory levels or aggressive write-downs, potentially leading to lost sales or production issues. Analysts should compare the company’s inventory turnover and sales growth rates with industry averages to differentiate between these scenarios and review inventory-related disclosures.

Conversely, a low inventory turnover ratio and a high DOH relative to industry standards may signal slow-moving or obsolete inventory. Comparing sales growth with industry norms and examining financial statement disclosures can provide further insights into potential inventory issues.

Gross Profit Margin

Gross profit margin indicates the percentage of sales that exceeds the cost of goods sold, contributing to net income. It is calculated as:

\[\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Sales}}\]

Gross profit margin provides insight into a company’s financial health, indicating how much of each dollar of sales is retained as profit after accounting for the cost of goods sold.

Generally, companies in highly competitive markets typically have lower gross profit margins, while those selling luxury goods generally have higher margins. However, companies with higher margins might have lower inventory turnover rates than those selling staple goods.

Question 1

Which of the following financial statement items is not directly affected by the choice of inventory valuation method?

1. Revenue.
2. Net income.
3. Cost of sales.

Solution

The correct answer is A.

Revenue is not affected by the choice of inventory valuation method. Net income and cost of sales, on the other hand, are.

B is incorrect. Net income is affected by the inventory valuation method because it impacts the cost of sales.

C is incorrect. Cost of sales is directly affected by the inventory valuation method used.

Question 2

The financial disclosure information required by the IFRS, but not US GAAP, is:

1. Information related to inventory write-downs.
2. Information related to inventory write-down reversals.
3. Information related to the carrying amount of each inventory section.

Solution

The correct answer is B.

US GAAP does not require the disclosure of write-down reversals because it does not allow for the reversal of write-downs.

A is incorrect. Both IFRS and US GAAP require information related to inventory write-downs.

C is incorrect. Both IFRS and US GAAP require information related to the carrying amount of each inventory section.