Inventory in the statement of financial position (balance sheet) is directly linked to
2023 Curriculum CFA Program Level I Financial Reporting and Analysis Show IntroductionMerchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories: raw materials, work in progress, and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements. Inventories and cost of sales (cost of goods sold) are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time. International Financial Reporting Standards (IFRS) permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost. US generally accepted accounting principles (US GAAP) allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last-in, first-out (LIFO). The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios. This reading is organized as follows: Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred. Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems. Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO. Section 5 describes the financial statement effects of a change in inventory valuation method. Section 6 discusses the measurement and reporting of inventory when its value changes. Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories. A summary and practice problems conclude the reading. Learning OutcomesThe member should be able to:
SummaryThe choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies. Key concepts in this reading are as follows:
What is inventory in statement of financial position?Inventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated.
What account on the income statement is linked to the inventory account on the balance sheet?Inventory is recorded and reported on a company's balance sheet at its cost. When an inventory item is sold, the item's cost is removed from inventory and the cost is reported on the company's income statement as the cost of goods sold. Cost of goods sold is likely the largest expense reported on the income statement.
Where is inventory on the balance sheet?Where is inventory on a balance sheet? Inventory should be near the top of your balance sheet since it's likely one of your company's most liquid assets. Whatever current asset is most easily converted into cash should be at the very top—and that's almost certainly cash and cash equivalents themselves.
What accounts are associated with inventory?Inventory and Credit
Both accounts payable, and inventory are listed on a business's balance sheet. Even though inventory is a cost, it falls under assets on the balance sheet. Accounts payable to purchase the inventory is shown as a liability on the balance sheet.
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