Inventory Accounting | CFA Level I FSA

In this lesson, we’ll focus on inventory accounting within the Financial Statement Analysis section of the CFA Level 1 curriculum. We’ll start with the inventory equation and discuss the costs that should be capitalized and expensed. Lastly, we’ll cover inventory adjustments when the valuation falls below cost.

Inventory Equation and Accounts

Both merchandising and manufacturing firms generate revenues and profits through the sale of inventory. Merchandising firms like retailers and wholesalers purchase inventory that is ready for sale, often reported in just one account as inventory on the balance sheet. Manufacturing firms report inventory using three separate accounts: raw materials, work-in-process, and finished goods.

The inventory account starts the accounting period with the beginning inventory. Throughout the accounting period, new purchases are made, adding to the inventory account. At the same time, inventory is sold to customers, and the cost of these inventories must be subtracted from the inventory account. This gives us the inventory equation:

Ending Inventory = Beginning Inventory + Purchases – Cost of Goods Sold

We can rearrange this equation to find any of the unknowns.

Capitalizing and Expensing Inventory Costs

In the course of building up inventory, several costs may be incurred. Which of these costs should be capitalized as inventory in the balance sheet, and which should be expensed as operating expenses in the income statement? Both IFRS and US GAAP provide guidance on this:

• Product costs: The purchase cost of the inventory, less trade discounts and rebates, conversion or manufacturing costs, including labor and overhead, and any other costs necessary to bring the inventory to its present location. These costs should be capitalized as an asset in the balance sheet.
• Period costs: Abnormal waste of materials, labor or overhead, storage costs, administrative overhead, and selling costs are considered period costs. These should be expensed in the period they are incurred.

Inventory Revaluation and Adjustments

Both IFRS and US GAAP allow for the revaluation of inventory value:

• IFRS: Inventory value is reported at the lower of cost or net realizable value (NRV). If the NRV falls below the cost, the inventory should be written down to the NRV. Reversal of write-downs is allowed under IFRS.
• US GAAP: Inventory value is reported at the lower of cost, or market. The market is equal to the replacement cost but cannot exceed the net realizable value (NRV) or be less than the NRV minus a normal profit margin. Write-downs are allowed, but unlike IFRS, reversal of write-downs is not allowed under US GAAP.

A write-down of inventory to NRV or market affects the financial statements and ratios in several ways:

• As inventory is part of current assets, an inventory write-down decreases both current and total assets in the balance sheet. Equity is decreased due to the reduction in retained earnings.
• In the income statement, the increase in cost of goods sold as a result of the write-down decreases the gross profit, operating profit, and net income.
• All the changes affect the ratios in different ways:
  • Current ratio decreases as the current assets decrease. However, the quick ratio and cash ratio are unaffected because inventories are not included in the numerator.
  • Inventory turnover is increased as the cost of goods sold increased, and average inventory decreased. This decreases the days of inventory on hand and subsequently the cash conversion cycle.
  • The decrease in total assets increases total asset turnover.
  • The debt-to-assets ratio is also increased due to the reduction in average total assets.
  • The decrease in total equity causes the debt-to-equity ratio to increase.
  • The decrease in profits reduces gross margin, operating margin, and net margin.
  • The percentage decrease in net income can be expected to be greater than the percentage decrease in assets or equity. As a result, both return on assets (ROA) and return on equity (ROE) are decreased.

For periods subsequent to a write-down of inventory, cost of goods sold may be decreased by lower inventory carrying values. This means that profits may increase in subsequent periods. Together with the decreases in assets and equity from the prior-period write-down, this increase in net income will increase reported ROA and ROE in subsequent periods.

That concludes this lesson on inventory accounting. In the next lesson, we’ll learn the methods to account for the cost of the inventory that was sold.