1. The 4 Inventory Cost Systems
1. 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
first
4. weighted average cost method - takes the average
inventory cost and applies it to each sale.
Study Session 5, Reading 17

2. 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

3. LIFO Reserve, LIFO liquidation
LIFO Reserve – used to convert Financial statements prepared
under LIFO to FIFO
LIFO 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

4. Converting Financial Statements
from LIFO to FIFO
Formula(s) :
Study Session 5, Reading 17

5. 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

6. 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

7. 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

8. Capitalizing vs Expensing Costs
Capitalization increases the profits of the company
Higher profits result in higher retained earnings and increases
owner’s equity
Assets and owner’s equity will be higher when capitalizing
Due 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

9. Depreciation Methods
depreciation - allocation of the cost of the asset over its useful life.
 Straight Line Method - allocates the cost evenly over the life of the
asset
Formula:
 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 asset
Formula:
Study Session 5, Reading 17

10. Impairment and Revaluation
on Assets
Impairment on Assets
If 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 value
revaluation 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

11. Disclosure about Long Lived Assets
Expenses can be categorized:
 according to nature
 according to function
Formula: Depreciable Life
Study Session 5, Reading 18

12. Leasing vs Purchasing Assets
lease - contractual agreement between two parties to use an asset
Leases reduce the risk of obsolescence
Leases result in a tax reporting advantage
Lease sometimes have easier provisions than borrowing
Under a finance lease, the lessee effectively buys the asset
Under a finance lease, the asset is reported on the balance sheet
Higher profits are achieved in early years through leasing rather
than purchasing
Study Session 5, Reading 18

13. Finance and Operating Leases
Leases 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

14. Finance and Operating Leases
Leases 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