Last Revised: 08/25/2023

2024 Level 1 - Financial Statement Analysis

Prerequisite Readings Page

Introduction to Financial Reporting 2

Income Statements 8

Balance Sheets 15

Cash Flow Statements 21

Inventories 24

Long-Lived Assets 32

Income Taxes 40

Non-Current (Long-Term) Liabilities 45

Applications of Financial Statement Analysis 49

This document should be used in conjunction with the corresponding prerequisite readings in the 2024 Level 1 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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 Last Revised: 08/25/2023

Introduction to Financial Reporting

a. describe the objective of financial reporting and the importance of financial

reporting standards in security analysis and valuation

b. describe the roles of financial reporting standard-setting bodies and regulatory

authorities in establishing and enforcing reporting standards

c. describe the International Accounting Standards Board’s conceptual

framework, including qualitative characteristics of financial reports, constraints
on financial reports, and required reporting elements

d. describe general requirements for financial statements under International

Financial Reporting Standards (IFRS)

e. describe the roles of the statement of financial position, statement of

comprehensive income, statement of changes in equity, and statement of
cash flows in evaluating a company’s performance and financial position

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Financial Reporting
Page 1
➞ Accounting Standards ➞ provide principles for preparing LOS a
financial reports and determine the types and - describe
amounts of information that must be provided to users

IASB – International Accounting Standards Board: objective of

financial reporting is to provide financial information that
is useful to users in making decisions about providing resources
to the entity invest, lend, work for, extend credit, etc.

➞ Since financial reporting requires the use of judgments (estimates),

Standards try to limit the range of judgment to increase
consistency

Page 2
Standard Setting Bodies vs. Regulatory Authorities LOS b
e.g./ IASB/FASB e.g. SEC - describe

- private sector SROs that - recognize, require and

set standards enforce standards
➞ Accounting Standards Boards/ - typically independent, private, not-for-profit orgs.
1/ IASB ➞ standard setting body for IFRS
➞ principle objective ➞ develop/promote the use and adoption of
a single set of standards transparent
comparable information
decision-useful
+ promote convergence of
standards

2/ FASB ➞ standard setting body for U.S. GAAP

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Page 3
Regulatory Authorities/ gov’t. entities with legal authority LOS b
to enforce requirements - describe

1/ IOSCO – International Organization of Securities Commissions

- made up of the regulators of different markets
- do not develop the regulations, but establish objectives/
principles to guide regulation
protect investors
3 core objectives of regulation
ensure that markets are fair,
reduce systemic risk efficient and
transparent
2/ SEC – Securities and Exchange Commission (U.S.)
- any company issuing securities in the U.S. is subject to
the rules/regulations of the SEC
- companies must submit filings to comply (standardized forms)
electronically - EDGAR

Page 4
➞ Conceptual Framework/ LOS c
objective ➞ provide financial information useful in - describe
making decisions about providing resources to the entity
Qualitative characteristics of financial reports/
Fundamental
1/ Relevance – info. is relevant if it would affect or make a difference
- material info. is relevant in user’s decisions

omission/misstatement could influence user’s decisions

2/ Faithful representation – info. is complete, neutral, free from error
Enhancing without bias
Comparability
Verifiability - involves trade offs ➞ estimates are not verifiable
Timeliness ➞ available prior to making a decision
Understandability ➞ clear and concise presentation

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Page 5
➞ Conceptual Framework/ LOS c
Constraints/ Cost of providing information – benefits should - describe

example #1/ outweigh costs

Elements/ measurement of financial position
1/ Assets – an economic resource controlled by the entity (what a
company owns)
2/ Liabilities – an obligation of the entity to transfer an
economic resource (what a company owes)

3/ Equity – Assets – Liabilities

- measurement of performance
4/ Income – increases in assets, decreases in liabilities that result in
increases in equity (revenue + gains)
5/ Expenses – decreases in assets, increases in liabilities that result in
decreases in equity (costs + losses)

Page 7
➞ Conceptual Framework/ LOS c
Underlying Assumptions/ - describe
1/ Accrual accounting – matching principle, revenue recognized as
2/ Going concern – company will continue to operate earned

Measurement of Elements – monetary amounts to recognize

historical cost – amount originally paid
amortized cost – historical cost – Dep./Am.
current cost – amount required today for replacement
realizable value – amount realized from a sale of an asset
- called ‘settlement’ value for a liability
present value – discounted value of future net cash inflows
fair value – amount realized in a sale (normal markets)

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Page 8
➞ General Requirements/ LOS d
1/ Required Financial Statements/ - describe
Statement of financial position ➞ Balance Sheet
Statement of Comprehensive Income ➞ single statement or/
Statement of changes in Equity IS + comp. Inc.
Statement of cash flows
Notes to financial statements
2/ General features of financial statements/
fair presentation – faithful representation of the effects of
transactions
going concern – unless intention is different
accrual basis – matching principle, revenue recognized when earned
materiality & aggregation – similar items are aggregated, presented
separately from dissimilar items

Page 9
Primary Financial Statements/ periodic (unaudited) LOS e
annual (audited) - describe

- prepared in accordance with applicable accounting standards

1) Balance Sheet (Statement of Financial Position)
Assets = Liabilities + Owner’s Equity (accounting
equation)
resources the obligations to excess of
company controls lenders/creditors assets over liabilities

Assets Liabilities
most
Current Assets Current Liabilities IFRS specifies
liquid
categories but
Long-Lived Assets least Non-Current Liabilities not format
liquid Equity ∴ ordering by
Total Assets $ Total L + E $ liquidity may
differ
for a point in time

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Page 10
2) Income Statement (Statement of Comprehensive LOS e
single statement Income) - describe
IFRS
2 statements Income St. consolidated
St. of C.I. (begins with N.I.) ( > 50%)
➞ covers a period of time
Income – Expenses = Net Income/loss ➞ expressed as
Basic and
(Revenue + Other Income) Diluted EPS
➞ Other Comprehensive Income (OCI): all items that impact
owner’s equity but are not the results of
transactions with shareowners unrealized gains/losses
foreign currency translations
NI + OCI = TCI
pension actuarial g/L
3) Statement of Changes in Owner’s Equity/
for each equity account : Beg. balance + Inc. – Dec. = Ending
(paid-in capital, retained earnings, etc.) balance

Page11
4) Cash Flow Statement LOS e
➞ Sources and uses of cash from: Operations - CFO - describe

Investing
Financing

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Income Statements

a. describe the components of the income statement and alternative presentation

formats of that statement

b. describe general principles of revenue recognition and accounting standards for

revenue recognition

c. calculate revenue given information that might influence the choice of revenue
recognition method

d. describe general principles of expense recognition, specific expense recognition

applications, and implications of expense recognition choices for financial
analysis

e. contrast operating and non-operating components of the income statement

f. formulate income statements into common-size income statements

g. evaluate a company’s financial performance using common-size income

statements and financial ratios based on the income statement

h. describe, calculate, and interpret comprehensive income

i. describe other comprehensive income and identify major types of items

included in it

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Understanding Income Statements

Page 1
- presents a company’s financial results over a period of time LOS a
- describe
Revenue – expenses = Net
Income

· IFRS/GAAP ➞ may be presented as a separate statement (IS) followed

by a Statement of Comprehensive Income (CI)
or/ a single statement of CI with a separate section for P/L
➞ Components of the IS/
Revenue – first line ➞ amounts charged for g/s in the ordinary activities
(net) of the business
➞ reported as a ‘net’ figure (i.e. less estimated
returns, rebates, discounts, etc…)

Expenses – outflows, depletion of assets, incurrences of liabilities in

the ordinary course of the business
- may be grouped by nature or function

Page 2
➞ Components of the IS/ LOS a
Expenses ➞ grouping by ➞ nature e.g. depreciation - describe
➞ function e.g. COGS – RM, DL, MOH
SG&A – DL, OH
Gains/Losses ➞ typically non-operating e.g. gain/loss on sale of assets
unrealized gain/loss on financial
assets
➞ Multi-step IS: Gross Profit/Margin Rev. $ 100%
($) (%) - COGS ($) x %
profit $ (100 - x)% - margin

Operating Profit/Margin Gross profit - not affected by

- may or may not include - Operating Exp. capital structure
non-operating Inc./Exp.
- income from associates
- discontinued operations
(EBIT – 1 – T = NI)
Net Income/Margin bottom line

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Page 3
➞ Revenue Recognition/ LOS b
accrual basis – revenue is recognized when it is earned - describe
- may or may not be at the same time payment is received
- payment after delivery ➞ Accounts Receivable
- payment before delivery ➞ Unearned Revenue

· Accounting Standards/ IASB/FASB

core principle ➞ rev. recognized to reflect the transfer of
g/s to customers in an amount that reflects
the consideration to be received
5 Steps:
1/ Identify the contract(s) with a customer
2/ Identify the separate/distinct performance obligations in
the contract
3/ Determine the transaction price
4/ Allocate the price to the performance obligations
5/ Recognize revenue when a performance obl. is satisfied

Page 4
➞ Revenue Recognition/ LOS b
· Accounting Standards/ contract – agreement between parties - describe
- establishes obligations and rights
(e.g. delivery of g/s for payment)
- contract only exists if collectability is probable
IFRS: more likely than not GAAP: likely to occur

- performance obligations
➞ distinct g/s ➞ customer can benefit from it on its own
➞ promise to transfer g/s can be
separated from other g/s in contract

- obligation satisfied, and revenue recognized, when:

1/ company has a right to payment
2/ customer has legal title
3/ customer has physical possession
4/ customer has significant risks/rewards of ownership
5/ customer has accepted the asset (Exhibit #5)
LOSc - calculate

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Page 5
➞ Expense Recognition/ LOS d
IASB/ · expenses are decreases in economic benefits in - describe
the form of: · outflows expenses
· depletion of assets +
· incurrences of liabilities losses
that result in decreases in equity

· General Principle/ · matching principle (concept) ➞ matching costs with

- product costs ➞ COGS – directly related to Revenue revenues
- period costs ➞ Admin., Depreciation ➞ related to operations
regardless of the level of Revenue

Page 6
➞ Expense Recognition/ LOS d
· Doubtful accounts – matching principle ➞ estimate amount that - describe
- expensed on IS would be uncollectible (typically derived from
for reporting purposes past exp.)

- direct write-off method (tax purposes)

- take charge only when default occurs

· Warranties – estimate expense based on level of sales and past exp.

- expensed on IS for reporting purposes

· Depreciation/Amortization – costs of long-lived assets are allocated

over the period of time during which they provide economic
(except for land and intangibles with indefinite lives) benefits
- physical assets ➞ Depreciation (building, equipment)
- Intangible assets ➞ Amortization (copyright, patent)

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Page 7
➞ Expense Recognition/ LOS d
· Depreciation/Amortization – 2 methods under IFRS - describe
(not widely
1/ Cost model 2/ Revaluation model
used)
IS/ IS/ 𝚫𝐅𝐕 − 𝐮𝐧𝐫𝐞𝐚𝐥𝐢𝐳𝐞𝐝 𝐠𝐚𝐢𝐧𝐬/𝐥𝐨𝐬𝐬𝐞𝐬
𝐂𝐨𝐬𝐭 − 𝐬𝐚𝐥𝐯𝐚𝐠𝐞 𝐯𝐚𝐥𝐮𝐞
𝐃𝐞𝐩. = (𝐅𝐕𝐭 − 𝐅𝐕𝐭"𝟏 )
𝐔𝐬𝐞𝐟𝐮𝐥 𝐥𝐢𝐟𝐞

BS/ 𝐁𝐕 = 𝐂𝐨𝐬𝐭 − 𝐀𝐜𝐜𝐮𝐦. 𝐃𝐞𝐩. BS/ 𝐂𝐚𝐫𝐫𝐲𝐢𝐧𝐠 𝐯𝐚𝐥𝐮𝐞 = 𝐟𝐚𝐢𝐫 𝐯𝐚𝐥𝐮𝐞

· IFRS requires each component of not permitted under GAAP

an asset to be depreciated separately
· also requires an annual review of salvage
value and useful life
- choice of depreciation method should match the asset’s pattern of use

· Straight-Line (S.L.) no pattern ➞ then use S.L.

𝐂𝐨𝐬𝐭 − 𝐬𝐚𝐥𝐯𝐚𝐠𝐞 𝐯𝐚𝐥𝐮𝐞 estimate
𝐔𝐬𝐞𝐟𝐮𝐥 𝐥𝐢𝐟𝐞 estimate (Example #3)

Page 8
➞ Expense Recognition/ LOS d
· Depreciation/Amortization - describe

· Accelerated methods - greater proportion of the cost to early yrs.

- referred to as
e.g. 2x declining (example #4)
conservative
Dep. exp. Early years 2x > S.L. higher NI with S.L.
Later years 2x < S.L. higher NI with 2x
· amortization ➞ typically S.L.
➞ indefinite lives (e.g. Goodwill), no amortization but tested
annually for impairment
➞ Implications ➞ choice of methods and estimates will affect Net Income
and thus, comparability (found in Notes of Statements)
- are changes valid?
- are differences valid?

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Page 9
➞ Non-Operating Items/ LOS e
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 - contrast
− 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐄𝐱𝐩.
= 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐈𝐧𝐜𝐨𝐦𝐞
typically + Non-operating gains/Inc. typically amounts earned
reported - Non-operating losses/Exp. through investing or
separately financing activities
may be disclosed on a ‘Net’ basis
e.g. Net Interest Expense = Interest Expense – Interest Inc.

Page 10
➞ Common size analysis/ LOS f
Sales 100% - formulate
- COGS x %
· each line as a
= gross profit (100 - x) % gross margin %’age of Revenue
- SG&A - y1%
- R&D - y2%
- Advertising - y3%
= Operating profit (100% - x% - y1% - y2% - y3%) - op. profit margin
- Taxes - T% ➞ 𝐓D𝐨𝐩. 𝐩𝐫𝐨𝐟𝐢𝐭 ➞ not Sales (effective tax rate)
= Net Income = NI% - net income margin E𝐍𝐈D𝐒𝐚𝐥𝐞𝐬I

· removes size effect

· facilitate comparison across time periods (time series analysis)
· facilitate comparison across companies (cross sectional analysis)
(Exhibit #15, 16)

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Page 11
➞ Ratios/ LOS g
𝐠𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭D - evaluate
· 𝐠𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = 𝐒𝐚𝐥𝐞𝐬
- measures effectiveness at manufacturing or purchasing
- lower margins over time = competitive pressures
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭D
· 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = 𝐒𝐚𝐥𝐞𝐬
- measures effectiveness at operations
- higher margins as size grows = economies of scale

· 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 𝐦𝐚𝐫𝐠𝐢𝐧 = 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞D𝐒𝐚𝐥𝐞𝐬

- measures overall effectiveness
(Exhibit #17)

Page 12
➞ Comprehensive Income LOS h, i
OCI – Other Comprehensive Income - describe
- calculate
TCI – Total Comprehensive Income – change in
- interpret
equity during a period resulting from transactions
(IFRS/GAAP) and other events, other than those changes resulting

from transactions with owners

TCI = NI + 0CI
other revenue/expense items NOT included in NI
e.g./ · foreign currency translation adjustments
· unrealized g/L on derivatives accounted for as hedges
· unrealized g/L on certain financial assets (AFS ➞ GAAP,
· certain DBPP costs FVOCI ➞ IFRS)
+ IFRS ➞ revaluation model results
(Example #14)

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Balance Sheets

a. describe the elements of the balance sheet: assets, liabilities, and equity

b. describe uses and limitations of the balance sheet in financial analysis

c. describe alternative formats of balance sheet presentation

d. contrast current and non-current assets and current and non-current liabilities

e. describe different types of assets and liabilities and the measurement bases of
each

f. describe the components of shareholders’ equity

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Understanding Balance Sheets

Page 1
➞ Components and format/ Assets = Liabilities + Owner’s LOS a
Equity - describe
- the accounting equation
Assets are financed by Debt or Equity
(A) = (L) + (E)
Assets (what a company owns)
➞ resources owned by a company as a result of past events
➞ future economic benefits are expected to flow
Liabilities (what a company owes)
➞ obligations of a company as a result of past events
➞ future outflows of economic benefits expected
Equity ➞ Assets – Liabilities (equity = book value) ➞ equity ≠ market value
≠ intrinsic value
Note: for an item to be recognized as A or L, a future economic benefit
flowing to or from the entity must be probable and the item has a
cost or value that can be measured reliably (Exhibit #1, #2)

Page 2
➞ Uses and Limitations/ LOS b
- describe
BS is at a point in time ➞ changes each day, however info.
is only available periodically
BS mixes costs and values of items ➞ mixed model with
respect to measurement
historical cost
adjusted historical cost
fair value ➞ but only at a point in time
aspects of a company’s ability to generate future cash flows
are not included on the B.S. (IS, CFS far more useful for valuation)
BS useful for assessing the entity’s Liquidity & Solvency
ability to meet Equity > 0
short-term liabilities - ability to
meet LTD

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Page 3
➞ Alternative formats/ LOS c, d
1/ current/non-current classification – both IFRS & GAAP - describe
- distinguish
- referred to as a ‘classified’ balance sheet requirement
Assets: Current ➞ expected to be sold, used up, or converted to cash over
an operating cycle (1 yr. unless longer is justified)
cash-to-cash cycle
Non-current ➞ represent the infrastructure from which the company
- not expected to be sold, used up, or converted operates
to cash in one Yr.
Liabilities: current – expected to be settled in one operating cycle (1 yr.
Non-current - all others unless longer is justified)

➞ Current assets – current liabilities = Working Capital (measures ability to meet

liabilities as they fall due)
2/ Liquidity-based presentation – all A/L are presented in order of liquidity
- can be used under IFRS if it is more relevant
or informative (exhibit #3)

Page 4
Current Assets/ certain specific line items, if material, LOS e
should be shown - describe

1/ Cash/Cash equivalents ➞ highly liquid, short-term investments (< 90 days)

- financial assets ➞ reported at amortized cost or fair value
exit price
2/ Marketable securities – equity/debt securities that trade in public
- financial assets markets

3/ Trade Receivables – amounts owed to a company by its customers for

g/s already delivered
- financial assets ➞ reported at net realizable value (amt. owed less
AR bad debts est.)
- Allowance for D.A. – called a ‘contra’ account
net AR ➞ amount reported on B.S. ➞ additions become Bad Debts Exp.
on IS.
➞ amt. for All. for D.A.
reported in the Notes

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Page 5
Current Assets/ LOS e
3/ Trade Receivables - % uncollectible affected by: - describe
changes in credit terms Quality of customers
changes in risk mgmt. policies Changes in estimates
- age refers to length of time a receivable has been outstanding
- Concentration of credit risk ➞ reported in Notes (example #1)

Current Liabilities/
1/ Trade Payables – owed to vendors for the purchase of g/s
2/ Bank Loans
financial
Notes Payable
liabilities
Current portion of LTD

Page 6
Current Liabilities/ LOS e
3/ Accrued expenses – expenses incurred but not yet paid - describe
4/ Deferred income/Unearned revenue – payment for g/s received before
delivery is made
Non-current assets/
1/ Property, Plant & Equipment (PPE) – tangible assets used in operations
GAAP/IFRS ➞ cost model IFRS ➞ Revaluation model
historical cost ➞ purchase price, delivery, installation
- Accum. Dep. ➞ except land
- Impairment ➞ recoverable amount < carrying value – loss goes on IS
= net PPE - presented as a net amount (IFRS – reversible,
GAAP – no)
terms: Recoverable amount ➞ higher of (FV – costs to sell) & (value in use)

amount obtainable in an PV of future CFs

arm’s length transaction

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Page 7
Non-current assets/ LOS e
2/ Investment Property – non-operating property (IFRS only) - describe
- cost model or fair value (must apply to whole class)
changes from period-to-period = g/L on IS

Page 8
Non-current assets/ LOS e
3/ Deferred Tax Assets ➞ income tax payable for tax purposes - describe
is more than income tax expense for reporting purposes
- temporary differences

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Page 9
➞ Equity/ LOS f
par value - describe
1/ Capital contributed by owners
paid-in-capital
# of shares – authorized – allowed to sell
- issued – sold
- outstanding – issued – repurchased (Treasury Stock)
2/ Preferred Shares – based on characteristics, may be classified as
Equity – perpetual, non-redeemable
Debt – mandatory redemption at a fixed amount at a
future date
3/ Treasury Shares – shares that have been repurchased but not cancelled
non-voting - may be resold (no gain/loss involved)
no dividends - done if a) shares undervalued
b) to fulfill options
c) limit dilution

- reduces Sh. Eq. by $ amount of repurchase

Page 10
➞ Equity/ LOS f
4/ Retained Earnings – cumulative amount of earnings not - describe
paid to owners
5/ AOCI – Accumulated Other Comprehensive Income – gains/losses not
recognized in IS
𝐀𝐎𝐂𝐈𝐭 = 𝐀𝐎𝐂𝐈𝐭"𝟏 + 𝐎𝐂𝐈𝐭
6/ Non-Controlling Interest (minority interest) – the equity interests of
minority shareholders in the subsidiaries that have been
consolidated but are not wholly owned (Exhibit 14/15)
➞ Statement of Changes in Equity/ itemizes changes in each equity
account over a period of time
IFRS requires TCI capital transactions or
retrospective effect distributions with owners
of policy changes component carrying amounts
GAAP ➞ reconciliation of each equity reconciliation
account on the B.S. (Exhibit #16)

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Cash Flow Statements

a. compare cash flows from operating, investing, and financing activities and
classify cash flow items as relating to one of those three categories given a
description of the items

b. describe how non-cash investing and financing activities are reported

c. compare and contrast the direct and indirect methods of presenting cash
from operating activities and describe arguments in favor of each method

d. contrast cash flow statements prepared under International Financial

Reporting Standards (IFRS) and US generally accepted accounting
principles (US GAAP)

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Understanding Cash Flow Statements

Page 1
CFS ➞ converts the accrual-based income statement LOS a
to a cash-based statement - compare
- provides a reconciliation between beginning and - classify
ending cash balances
- Components and format of the CFS/
1/ Cash flow from operations (CFO) - day-to-day activities
inflows ➞ increases in liabilities, decreases in assets, cash
sales (sales of dealing/trading securities)
outflows ➞ decreases in liabilities, increases in assets, cash
payments for expenses (purchase of dealing/trading securities)

2/ Cash flow from investing (CFI) - purchase/sale of long-term assets

and other investments
PPE, intangible
LT/ST investments in equity/debt assets
- excludes Cash equivalents
and dealing/trading securities

Page 2
3/ Cash flow from financing (CFF) - obtaining and LOS a
- compare
repaying capital shareholders
- classify
creditors
inflows ➞ selling stock, borrowing
example #1
outflows ➞ share repurchases, loan repayments

LOS b
➞ Non-cash investing/financing activities - describe
- simple rule ➞ no cash, no CFS reporting
(e.g. barter, stock dividends, conversion of convertible securities)
- if significant, any non-cash transaction example #2
is required to be disclosed in the Notes
to the CFS

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Page 3
2 acceptable formats for reporting CFO (IFRS/GAAP) LOS c
- compare
1/ Direct method will result in same CFO, - describe
2/ Indirect method only presentation differs
- presentation of CFI/CFF sections are the same under IFRS/GAAP
regardless of how CFO is presented
➞ Direct Method: IS items that are reported on an accrual basis are
converted to a cash basis
+/ provides information on the specific sources of operating
cash receipts and payments
➞ Indirect Method: Net Income is adjusted for non-cash items,
non-operating items, and changes in working capital
accounts from accrual accounting
+/ Shows the reasons for differences between net income & CFO
Exhibit #2, #3

Page 4
LOS d
- contrast

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Inventories

a. contrast costs included in inventories and costs recognised as expenses in the

period in which they are incurred

b. describe different inventory valuation methods (cost formulas)

c. calculate and compare cost of sales, gross profit, and ending inventory using
different inventory valuation methods and using perpetual and periodic
inventory systems

d. calculate and explain how inflation and deflation of inventory costs affect the
financial statements and ratios of companies that use different inventory
valuation methods

e. explain LIFO reserve and LIFO liquidation and their effects on financial
statements and ratios

f. demonstrate the conversion of a company’s reported financial statements from

LIFO to FIFO for purposes of comparison

g. describe the measurement of inventory at the lower of cost and net realisable
value

h. describe implications of valuing inventory at net realisable value for financial

statements and ratios

i. describe the financial statement presentation of and disclosures relating to

inventories

j. explain issues that analysts should consider when examining a company’s

inventory disclosures and other sources of information

k. calculate and compare ratios of companies, including companies that use

different inventory methods

l. analyze and compare the financial statements of companies, including

companies that use different inventory methods

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Inventories
Page 1
⇒ Cost of Inventories/ LOS a
IFRS/GAAP: inventoriable costs - distinguish
• costs of purchase (price, duties, taxes, insurance, delivery)
rodu c t
p less (discounts, rebates)
costs
• conversion cost (RM, Direct/Indirect Labor, Direct/Indirect MOH)

- all cost absorption ends when the inventory hits the FGI warehouse floor
→ Balance Sheet → Income Statement
⇒
- when acquired or - when sold
converted

IFRS/GAAP: non-inventoriable costs

- abnormal costs from material wastage, labor or wastage of other
period production inputs
costs
- storage costs not part of ‘normal’ production process
(go to IS) - administrative overhead and selling expenses (Example #1)

Page 2
⇒ Inventory Valuation Methods/ LOS b
IFRS → cost formulas - describe
GAAP → cost flow assumptions
- same inventory valuation method must be used for all items that
have a similar nature and use (items with a different nature can use
a different method)
- Beginning Inventory + Purchases - Ending Inventory = COGS

how inventory is valued affects

⇒ COGS
IFRS/GAAP methods/
1/ Specific Identification
- typically used for non-interchangeable items
- COGS and Ending Inventory (EI) reflect actual costs
- matches physical flow with actual costs
2/ FIFO - first-in, first-out
- oldest units sold first → COGS
- newest units in Inventory → EI

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Page 3
⇒ Inventory Valuation Methods/ LOS b
IFRS/GAAP methods/ - describe
3/ Weighted-average cost → costs allocated evenly across all
units for sale
• COGS + EI → units valued at average prices
GAAP only/
4/ LIFO - last-in, first-out → newest units sold first → COGS
⇒ units in Inventory → EI
→ oldest
LOS c
→ periods of rising prices: LIFO → higher COGS vs FIFO
- calculate
→ lower EI vs FIFO - interpret
- periodic inventory system - inventory on hand calculated periodically
- perpetual inventory system - inventory account updated continuously
- under both, COGS & EI will be the same for FIFO example #2, #3
and specific id (not for LIFO or w.a.)

Page 4
- constant or increasing inventory levels: LOS d
A) if unit costs are increasing - calculate
COGS: LIFO > AVCO > FIFO → LIFO → lower gross income (EBIT, NI) - explain
EI: FIFO > AVCO > LIFO → FIFO → higher asset value

LIFO → COGS more closely reflects current replacement value

FIFO → EI

B) if unit costs are decreasing

COGS: FIFO > AVCO > LIFO → FIFO → lower profitability
⇒
EI: LIFO > AVCO > FIFO → LIFO → higher asset values
example #4
P LIFO P P
LIFO
COGS COGS
EI COGS FIFO
EI EI
EI EI
COGS EI
FIFO LIFO
COGS FIFO COGS
t t t

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Page 5
⇒ LIFO Method/ LOS e, f
- recall, when prices are increasing, LIFO will have - explain
(IS) higher COGS vs FIFO, lower EBT vs FIFO and - convert

∴ lower tax expense, and lower NI

(BS) → EI will be lower vs FIFO, lower - WC

- total assets
- retained earnings, lower Sh. Eq.
⇒
(CFS) → CFO higher due to lower taxes

- if a company is in an industry characterized by decreasing prices, doubtful

they would elect to use LIFO for tax purposes (and thus reporting purposes)

- many companies will use LIFO for tax purposes and external reporting
(required: if LIFOtax, then LIFOreporting) and FIFO or AVCO for internal
reporting → better pricing decisions

Page 6
⇒ LIFO Reserve/ LOS e, f
- for companies that use LIFO, GAAP requires the - explain
“LIFO Reserve’ be reported in the notes - convert

LIFO Reserve → difference between reported LIFO inventory carrying

amount and the carrying amount if FIFO was used
i.e. FIFOEI - LIFOEI → earliest cost

most recent cost ⇒

- typically LR Reserve > 0 → LR is a cumulative balance

• FIFOEI = LIFOEI + LR adjust LIFO Inventory and COGS

• COGSFIFO = COGSLIFO - (LRend - LRbeg) to be comparable with FIFO

• LIFO Liquidation → LR may increase over time if:

• prices are rising
• quantities added to inventory > quantities sold

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Page 7
⇒ LIFO Reserve/ LOS e, f
• LIFO Liquidation - explain
→ quantity of units sold > quantity of units added to inventory - convert

- then company experiences a LIFO liquidation

some of the older units in

inventory are sold (called LIFO layers)

→ So: if costs have been increasing over

⇒ time, and a LIFO liquidation occurs,
those units will have very low COGS relative to other items
sold → larger gross margins

one-time event → not sustainable

- a decline in LR may be evidence of a LIFO liquidation

decreasing prices can cause LR to decrease

without any LR Liquidation (example #5)

Page 8
⇒ Inventory Adjustments/ LOS g, h
- cost of inventory may not be recoverable due to spoilage, - describe
obsolescence, or declines in selling prices

IFRS/ inventories shall be measured at the lower of cost or

net realizable value

- estimated selling price (in the ordinary course of business)

- estimated costs to make the⇒ sale
- estimated costs to get inventory into condition for sale

- if value of inventory drops below carrying value

1/ inventory written down to NRV
- typically through a ‘Inventory Valuation Allowance’ acct.

2/ Write-down charged to COGS or reported separately

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