1. Cost of Sales and Inventories Basics [52 minutes]

2. LIFO Liquidation and LIFO Reserve Reversals [14 minutes]

3. Inventory Impairments [27 minutes]

Take-aways:

• Perpetual and periodic inventory systems are two ways to record the cost of sold goods to inventories: In perpetual systems, cost of sales is updated each time there is a sale. In periodic systems, cost of sales is updated at the end of each reporting period.

• FIFO cost of sales and ending inventories are the same under perpetual and periodic systems because the FIFO ordering is not affected by updating cost of sales during the period.

• Weighted average cost of sales and ending inventories generally do differ for perpetual and periodic systems because weighted average costs are affected by updating cost of sales.

• Under US GAAP, LIFO cost of sales and ending inventories generally do differ for perpetual and periodic systems because LIFO orderings are affected by updating cost of sales. These differences are likely considerably smaller for most companies than differences between LIFO and FIFO cost of sales and inventories.

• Under US GAAP, LIFO layers are the building blocks behind LIFO inventories: New LIFO layers are added to inventories during periods when companies acquire or produce more units than they sell. Old LIFO layers are eliminated (liquidated or decremented) during periods when companies sell more units than they acquire or produce. Older LIFO layers have lower unit costs when input prices are increasing and these layers can stay in inventories indefinitely. As a result, LIFO inventories can be valued much lower than they would be at replacement costs.

• Under US GAAP, LIFO reserves connect LIFO and FIFO measures at balance sheet dates: FIFO inventory equals LIFO inventory plus the LIFO reserve.  The increase in the LIFO reserve during a reporting period connects LIFO and FIFO period measures: FIFO cost of sales equals LIFO cost of sales less the increase in the LIFO reserve.

• Under US GAAP, LIFO reserve reversals are decreases on the LIFO reserve. They often occur when LIFO layers are liquidated and have the opposite effects on LIFO-FIFO comparisons to LIFO reserve increases: FIFO cost of sales is greater than LIFO cost of sales.

• Under US GAAP, concerned that LIFO liquidation profits can distort users’ predictions regarding future profits and companies can manipulate profits by intentionally liquidating LIFO layers, the SEC mandates that companies disclose LIFO liquidation profits in footnotes.

• Under IFRS, inventories are impaired or written down when their net realizable values are less than their costs, where costs are based on FIFO or weighted average and net realizable value is the estimated selling price less completion and disposal costs. Impairments can be reversed if there is clear evidence the net realizable value has increased, but only up to the pre-impairment cost.

• Under US GAAP, inventories are impaired or written down when their market values are less than their cost, where costs are typically based on LIFO, FIFO, weighted average, or a variation of these methods and market is: Replacement cost, providing the replacement cost is less than the net realizable value and greater than the net realizable value less a normal profit; Net realizable value if the replacement cost is greater than the net realizable value; or Net realizable value less a normal profit when the replacement cost is less than the net realizable value less a normal profit. Impairments aren’t reversed under US GAAP.

Key terms:

• Average cost method-  Accounting method where the unit cost assigned to both inventory and cost of sales is the weighted average cost per unit. Average cost is determined by dividing total cost of inventory by the number of units in inventory. Also called weighted average cost method.

• FIFO- First-in-first-out- Accounting method where the first costs assigned to inventory are the first assigned to cost of sales.

• LIFO- Last-in-first-out- Accounting method where the last costs assigned to inventory are the first assigned to cost of sales.

• LIFO layer- Under LIFO cost method, the quantity of units added to ending inventory when inventory purchases exceed sales. The quantity of inventory when a company starts using LIFO is the “base layer”.  Subsequently, LIFO layers are added during reporting periods when the number of units produced or acquired is more than the units sold.

• LIFO liquidations- LIFO layers are partially or fully liquidated during reporting periods when the number of units sold exceeds the number of units produced or acquired. As a result, costs from previous periods are assigned to cost of sales, which decreases LIFO layers recorded in previous years. Synonyms: LIFO layer eliminations, LIFO layer decrements.

• LIFO reserve- The difference between inventories valued under FIFO versus LIFO costing methods. A contra asset for the excess of FIFO over LIFO inventory costs.

• LIFO reserve reversals- Decrease in the LIFO reserve that often occurs when LIFO layers are liquidated. However, LIFO layers can be liquidated without LIFO reserve reversals and LIFO reserve reversals can occur without LIFO liquidations.

• Inventory impairments- Inventory is impaired or written down when its net realizable value, under IFRS, or market value, under US GAAP, is less than its cost. The impairment is the excess of the cost over the net realizable value( IFRS) or market value(US GAAP).

• Inventory impairment reversals- Under IFRS, inventory impairments can be reversed when the conditions that gave rise to them no longer exist or there is evidence of an increase in net realizable value. However, inventory can’t be stated above its pre-impairment cost.      Paragraphs 33, IASB 2

• Lower of cost or net realizable value- Under IFRS, inventory is stated at the lower of cost or net realizable value, where cost is determined using FIFO or weighted average and net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.     Paragraphs 6 and 25, IASB 2

• Periodic inventory costing system- cost of sales is updated at the end of each reporting period.

• Perpetual inventory costing system- cost of sales is updated each time there is a sale.