Inventories

also referred to as cost of sales (COS) under IFRS, is related to the beginning balance of inventory, purchases, and the ending balance of inventory.

COGS = beginning inventory + purchases – ending inventory

are capitalized in the Inventories account on the balance sheet and include:

Purchase cost less trade discounts and rebates.
Conversion (manufacturing) costs including labor and overhead.
Other costs necessary to bring the inventory to its present location and condition.

Not all inventory costs are capitalized; some costs are expensed in the period incurred. These costs, known as period costs, include

Abnormal waste of materials, labor, or overhead
Storage costs (unless required as part of production)
Administrative overhead
Selling costs

Specific identification.
First-in, first-out.
Weighted average cost.

Specific identification.
First-in, first-out.
Weighted average cost.
Last in, first out

method, each unit sold is matched with the unit's actual cost. Specific identification is appropriate when inventory items are not interchangeable and is commonly used by firms with a small number of costly and easily distinguishable items such as jewelry. Specific identification is also appropriate for special orders or projects outside a firm's normal course of business.

Under the first-in, first-out (FIFO) method, the first item purchased is assumed to be the first item sold. The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current cost. Conversely, FIFO COGS is based on the earliest purchase costs. In an inflationary environment, COGS will be understated compared to current cost. As a result, earnings will be overstated.

Under the last-in, first-out (LIFO) method, the item purchased most recently is assumed to be the first item sold. In an inflationary environment, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the earliest costs. Therefore, in an inflationary environment, LIFO ending inventory is less than current cost.

Weighted average cost is a simple and objective method. The average cost per unit of inventory is computed by dividing the total cost of goods available for sale (beginning inventory + purchases) by the total quantity available for sale. To compute COGS, the average cost per unit is multiplied by the number of units sold. Similarly, to compute ending inventory, the average cost per unit is multiplied by the number of units that remain.

inventory values and COGS are determined at the end of the accounting period.

No detailed records of inventory are maintained; rather, inventory acquired during the period is reported in a Purchases account. At the end of the period, purchases are added to beginning inventory to arrive at cost of goods available for sale. To calculate COGS, ending inventory is subtracted from goods available for sale.

In a perpetual inventory system, inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur.

Thus, a Purchases account is not necessary.

When prices are rising or falling, FIFO provides the most useful measure of ending inventory. This is a critical point. Recall that FIFO inventory is made up of the most recent purchases. These purchase costs can be viewed as a better approximation of current cost, and thus a better approximation of economic value. LIFO inventory, by contrast, is based on older costs that may differ significantly from current economic value

Changing prices can also produce significant differences between COGS under LIFO and FIFO. Recall that LIFO COGS is based on the most recent purchases. As a result, when prices are rising, LIFO COGS will be higher than FIFO COGS. When prices are falling, LIFO COGS will be lower than FIFO COGS. Because LIFO COGS is based on the most recent purchases, LIFO produces a better approximation of current cost in the income statement

Because COGS is subtracted from revenue in calculating gross profit, gross profit is also affected by the choice of cost flow method. Assuming inflation, higher COGS under LIFO will result in lower gross profit. In fact, all profitability measures (gross profit, operating profit, income before taxes, and net income) will be affected by the choice of cost flow method.

LIFO inventory < FIFO inventory.
LIFO COGS > FIFO COGS.
LIFO net income < FIFO net income.
LIFO tax < FIFO tax.

Firms that report under LIFO must also report a LIFO reserve, the amount by which LIFO inventory is less than FIFO inventory.

add the LIFO reserve to LIFO inventory on the balance sheet.
increase the retained earnings component of shareholders' equity by the LIFO reserve.

FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)

As compared to FIFO, LIFO produces higher COGS in the income statement and results in lower earnings. Any profitability measure that includes COGS will be higher under FIFO. For example, reducing COGS will result in higher gross, operating, and net profit margins as compared to LIFO

Compared to FIFO, LIFO results in a lower inventory value on the balance sheet. Because inventory (a current asset) is higher under FIFO, the current ratio, a popular measure of liquidity, is also higher under FIFO. Working capital is higher under FIFO as well, because current assets are higher

Inventory turnover (COGS / average inventory) is higher for firms that use LIFO compared to firms that use FIFO. Under LIFO, COGS is valued at more recent, higher costs (higher numerator), while inventory is valued at older, lower costs (lower denominator). Adjusting to FIFO values will result in lower turnover and higher days of inventory on hand (365 / inventory turnover)

Adjusting to FIFO results in higher total assets because inventory is higher. Higher total assets under FIFO result in higher stockholders' equity (assets − liabilities). Because total assets and stockholders' equity are higher under FIFO, the debt ratio and the debt-to-equity ratio are lower under FIFO compared to LIFO

A LIFO liquidation occurs when a LIFO firm's inventory quantities decline. Older, lower costs are included in COGS compared to a situation in which inventory quantities are not declining. LIFO liquidation results in higher profit margins and higher income taxes compared to what they would be if inventory quantities were not declining

(NRV) is equal to the expected sales price less the estimated selling costs and completion costs

For companies using LIFO or the retail method, inventory is reported on the balance sheet at the lower of cost or market. Market is usually equal to replacement cost, but cannot be greater than NRV or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin.

As inventory is part of current assets, an inventory write-down decreases both current and total assets.
Current ratio (CA/CL) decreases. However, the quick ratio is unaffected because inventories are not included in the numerator of the quick ratio.
Inventory turnover (COGS/average inventory) is increased, which decreases days' inventory on hand and the cash conversion cycle.
The decrease in total assets increases total asset turnover and increases the debt-to-assets ratio.
Equity is decreased, increasing the debt-to-equity ratio.
The increase in COGS reduces gross margin, operating margin, and net margin.
The percentage decrease in net income can be expected to be greater than the percentage decrease assets or equity. As a result, both ROA and ROE are decreased.

usually found in the financial statement footnotes, are useful in evaluating the firm's inventory management. The disclosures are also useful in making adjustments to facilitate comparisons with other firms in the industry

The cost flow method (LIFO, FIFO, etc.) used.
Total carrying value of inventory, with carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate.
Carrying value of inventories reported at fair value less selling costs.
The cost of inventory recognized as an expense (COGS) during the period.
Amount of inventory write-downs during the period.
Reversals of inventory write-downs during the period, including a discussion of the circumstances of reversal (IFRS only because U.S. GAAP does not allow reversals).
Carrying value of inventories pledged as collateral.