What are inventories?

Inventories include items used as part of the company’s operating cycle. More specifically, they are:

• used up in the production process (inventories of raw materials and goods for resale);
• sold as they are (inventories of finished goods) or sold at the end of a transformation process that is either underway or will take place in the future (work in progress).

How are they accounted for?

Costs that should be included in inventories

The way inventories are valued varies according to their nature: supplies of raw materials and goods for resale or finished products and work in progress. Supplies are valued at acquisition cost, including the purchase price before taxes, customs duties and related purchase costs. Finished products and work in progress are valued at production cost, which includes the acquisition cost of raw materials used, plus direct and indirect production costs insofar as the latter may reasonably be allocated to the production of an item.

Costs must be calculated based on normal levels of activity, since allocating the costs of below-par business levels would be equivalent to deferring losses to future periods and artificially inflating profit for the current year. In practice, this calculation is not always properly performed, so we would advise readers to closely follow the cost allocation.

Financial charges, research and development costs and general and administrative costs are not usually included in the valuation of inventories unless specific operating conditions justify such a decision.

In all sectors of activity where inventories account for a significant proportion of the assets, we would strongly urge readers to study closely the impact of inventory valuation methods on the company’s net income.

Valuation methods

Under IAS, there are three main methods for valuing inventories:

• the weighted average cost method;
• the FIFO (First In, First Out) method;
• the identified purchase cost method.

Weighted average cost consists in valuing items withdrawn from the inventory at their weighted average cost, which is equal to the total purchase cost divided by quantities purchased.

The FIFO method values inventory withdrawals at the cost of the item that has been held in inventory for the longest. The identified purchase cost is used for noninterchangeable items and goods or services produced and assigned to specific projects.

For items that are interchangeable, the IASB allows the weighted average cost and FIFO methods but no longer accepts the LIFO method (Last In, First Out) that values inventory withdrawals at the cost of the most recent addition to the inventory. US GAAPs permit all methods (including LIFO) but the identified cost method.

During periods of inflation, the FIFO method enables a company to post a higher profit than under the LIFO method. The FIFO method values items withdrawn from the inventory at the purchase cost of the items that were held for longest and thus at the lowest cost, hence a high net income. The LIFO method produces a smaller net income as it values items withdrawn from the inventory at the most recent and, thus, the highest purchase cost. The net income figure generated by the weighted average cost method lies midway between these two figures. Analysts need to be particularly careful when a company changes its inventory valuation method. These changes, which must be disclosed and justified in the notes to the accounts, make it harder to carry out comparisons between periods and may artificially inflate net profit or help to curb a loss.

Finally, where the market value of an inventory item is less than its calculated carrying amount, the company is obliged to recognise an impairment loss for the difference (i.e., an impairment loss on current assets).

How should financial analysts treat them?

First, let us reiterate the importance of inventories from a financial standpoint. Inventories are assets booked by recognising deferred costs. Assuming quantities remain unchanged, the higher the carrying amount of inventories, the lower future profits will be. Put more precisely, assuming inventory volumes remain constant in real terms, valuation methods do not affect net profit for a given period. But, depending on the method used, inventory receives a higher or lower valuation, making shareholders’ equity higher or lower accordingly.

When inventories are being built up, the higher the carrying amount of inventories, the faster profits will appear. The reverse is true when inventories are decreasing. Overvalued inventories that are being run down generate a fall in net income. Hence the reticence of certain managers to scale down their production even when demand contracts. Finally, we note that, tax-related effects apart, inventory valuation methods have no impact on a company’s cash position.

From a financial standpoint, it is true to say that the higher the level of inventories, the greater the vulnerability and uncertainty affecting net income for the given period. We recommend adopting a cash-oriented approach if, in addition, there is no market serving as a point of reference for valuing inventories, such as in the building and public infrastructure sectors. In such circumstances, cash generated by operating activities is a much more reliable indicator than net income, which is much too heavily influenced by the application of inventory valuation methods.

Inventories are merely accruals (deferred costs), which are always slightly speculative and arbitrary in nature, even when accounting rules are applied bona fide.

Consequently, during inflationary periods, inventories carry unrealised capital gains that are larger when inventories are moving slower. In the accounts, these gains will appear only as these inventories are being sold, even though these gains are there already. When prices are falling, inventories carry real losses that will appear only gradually in the accounts, unless the company writes down inventories. The only financial approach that makes sense would be to work on a replacement cost basis and, thus, to recognise gains and losses incurred on inventories each year. In some sectors of activity where inventories move very slowly, this approach seems particularly important.

In 1993, champagne houses carried inventories at prices that were well above their replacement cost. We firmly believe that had inventories been written down to their replacement cost, the ensuing crisis in the sector would have been less severe. The companies would have recognised losses in one year and then posted decent profits the next instead of resorting to all kinds of creative solutions to defer losses. The same can be argued regarding the loan portfolios carried by the Japanese banks in the early 2000s.