Inventories Merchandisers Manufacturers Inventory Cost Formula and Cost Flow Assumptions : IFRS: US GAAP: 4. LIFO

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1 Inventories Merchandisers Manufacturers - finished goods inventory - raw materials, work-in-process, finished goods inventory - may report separate carrying values or choose to report total inventory value Inventory Cost Formula and Cost Flow Assumptions : IFRS: US GAAP: 1. specific identification 1. specific identification 2. weighted average 2. weighted average 3. FIFO 3. FIFO 4. LIFO Determination of Inventory Cost IFRS and US GAAP: What can be Capitalized: 1. Cost of purchase 2. Conversion costs 3. Transportation costs 4. Portion of fixed overhead What must be Expensed: 1. Abnormal waste 2. Labor 3. Storage costs 4. All administrative and selling overhead Capitalizing inventory costs - overstates profitability and overstates inventory IFRS: Inventory reported at lower of cost and net realizable value Net realizable value is equal to the estimated selling price in the ordinary course of business less the estimated costs required to make the sale US GAAP: Inventory reported at lower of cost and market value Market value is equal to the current replacement cost (within certain limits) Reversals of previous write-downs are allowed under IFRS, but not under US GAAP Exam Preparation & Investment Sales Training 1 info@examsuccess.ca

2 LIFO/FIFO Comparison: In periods of rising prices and stable or increasing inventory levels: LIFO results in: Higher COGS Lower Taxes Lower Net Income Lower Inventory Balances Lower Working Capital Higher Cash Flows FIFO results in: Lower COGS Higher Taxes Higher Net Income Higher Inventory Balances Higher Working Capital Lower Cash Flows Think in terms of how accounting choices affect the financial ratios: FIFO LIFO Total Current Assets Higher Lower Current Ratio Higher Lower Debt to Equity Ratio Lower Higher Inventory Turnover Lower Higher ROE Higher Lower Balance Sheet & Income Statement Adjustments Income Statement Adjustments: 1. Decrease COGS FIFO COGS = LIFO COGS - (END LIFO RES - BEG LIFO RES) 2. Increase Net Income FIFO NI = LIFO NI + (END LIFO RES - BEG LIFO RES)(1-tax rate) Balance Sheet Adjustments: 1. Increase Inventory, (Asset) FIFO INV = LIFO INV + LIFO RESERVE 2. Increase Deferred Taxes, (Liability) FIFO DT = LIFO DT + LIFORES (tax rate) 3. Increase Retained Earnings, (Equity) FIFO RE = LIFO RE + LIFO RES (1-tax rate) Exam Preparation & Investment Sales Training 2 info@examsuccess.ca

3 Financial Statement Effects of Capitalization Capitalization vs. Expensing Income Variability Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income Firms that expense costs as incurred have greater variance in reported income, variance declines as the firm matures and is lower for larger firms Profitability In the Early Years, expensing lowers profitability In later years, expensing firms report lower asset and equity levels and higher ROA, ROE Cash Flow from Operations Reported net cash flow is the same for both expensing and/or capitalizing (ignoring income tax effects) Expenditures for capitalized assets are included in CFI Firms that expense, include costs in CFO CFO higher for capitalizing firm "Capitalization of long-lived assets results in a permanent shift of expenditures from CFO to CFI" Leverage Ratios Expensing firms show lower asset and equity balances Debt to Equity, Debt to Assets will appear worse for expensing firm Capitalizing Expensing Income Variability Lower Higher Early ROA & ROE Higher Lower Late ROA & ROE Lower Higher Total CF Same Same CFO Higher Lower CFI Lower Higher D/E & D/A Lower Higher Current NI Greater Smaller Future NI: Costs Greater Smaller Future NI: Costs Smaller Greater Exam Preparation & Investment Sales Training 3 info@examsuccess.ca

4 Analysis of Leases Must Classify as Finance (Capitalize) Lease if any of the following terms exist: 1) if title is transferred at lease end 2) if a bargain purchase option 3) if lease period greater than 75% of economic life of the asset 4) Present Value of the lease payments are equal to or greater than 90% of the FMV of the asset Income Statement Effects Operating Lease is considered an operating expense Finance Lease, reported lease expense has two components, interest expense and depreciation In the early years, Finance Lease Expense > Operating Lease Expense Cash Flows Effects Operating Lease an expense classified as CFO Finance Lease expense has two components, interest expense and principle repayment, which are classified as CFO and CFF Balance Sheet Effects Capitalized lease reports increase in fixed assets (PP&E) and current liabilities increase by current portion of lease debt and LTD increases by the remaining debt. Ratios Finance (Capital) Lease Operating Lease Current CA/CL Lower Higher WC CA - CL Lower Higher AT S/TA Lower Higher ROA EAT/TA Lower Higher ROE EAT/E Lower Higher D/E Higher Lower Assets Higher Lower Liabilities Higher Lower NI(early years) Lower Higher CFO Higher Lower CFF Lower Higher Total CF Same Same Exam Preparation & Investment Sales Training 4 info@examsuccess.ca

5 Accounting for Leases Examples: Lease Example 1: Turner Corp. is a lessee in a new noncancelable leasing agreement to finance farming equipment. The discounted present value of the lease payments is $6,144,000 using an interest rate of 10%. The annual payment will be $1,000,000. Assume the lease term is for 10 years and Turner uses straight line depreciation for its capital assets. Calculate the impact of the lease, from an analytic point of view, on the appropriate B/S, I/S and Statement of Cash Flow accounts. Exam Preparation & Investment Sales Training 5 info@examsuccess.ca