Explain inventory costing, depreciation, impairment, goodwill and lease accounting, and how each choice changes reported profit.
When purchase prices change, the method decides which costs reach COGS.
Example: a firm buys one unit at $10, then one at $14, and sells one for $20. FIFO gross profit is 10; LIFO gross profit is 6; average cost gross profit is 8.
Inventory is carried at the lower of cost and net realizable value. Write-downs reduce profit; under IFRS they can be reversed if value recovers.
Days inventory outstanding (DIO) = inventory / COGS x 365. Maple: 150 / 600 x 365 = 91.3 days. Rising DIO can signal weak demand and future write-downs.
Cost is spread over useful life.
Management chooses useful lives and salvage values. Longer lives mean lower expense and higher profit today. Compare depreciation as a percentage of gross PP&E across peers.
A cost that creates a benefit beyond one year is capitalized as an asset and depreciated; otherwise it is expensed immediately. Capitalizing raises profit now and moves the cash outflow from operations to investing, which flatters both earnings and CFO. WorldCom's fraud was the capitalization of billions in ordinary network line costs.
Purchased intangibles with finite lives are amortized. Goodwill arises only in an acquisition: purchase price minus the fair value of identifiable net assets acquired. If a buyer pays 500 for a company whose identifiable net assets are worth 350, goodwill is 150. Goodwill is not amortized; it is tested for impairment at least annually. A goodwill impairment is an admission that the company overpaid.
When an asset's carrying amount exceeds its recoverable amount, it is written down through the income statement. The charge is non-cash but reflects real lost value.
Under IFRS 16, a lessee records a right-of-use asset and a lease liability for almost every lease, then recognizes depreciation and interest. Under US GAAP (ASC 842) leases also go on the balance sheet, but operating leases show a single straight-line lease expense within operating costs. Result: an IFRS retailer reports higher EBITDA than an identical US GAAP retailer, and its lease liabilities are more often counted as debt. Adjust before comparing.
A US company reports LIFO inventory of 400 and discloses a LIFO reserve of 60, up from 50 a year earlier.
When a LIFO company sells down old, cheap layers of inventory (a LIFO liquidation), COGS drops and profit jumps for a reason that will not repeat.
A $1,000 asset depreciated at 40% a year on the remaining balance:
| Year | Opening book value | Depreciation at 40% | Closing book value |
|---|---|---|---|
| 1 | 1,000 | 400 | 600 |
| 2 | 600 | 240 | 360 |
| 3 | 360 | 144 | 216 |
Straight-line over five years would charge 200 a year. The declining method front-loads the expense, which is closer to how many assets lose value, and is the basis of Canadian capital cost allowance for tax.
Average age of PP&E is roughly accumulated depreciation / annual depreciation. With accumulated depreciation of 300 and annual depreciation of 50, the assets are about six years into their lives. Rising average age with flat capital spending suggests underinvestment, which flatters free cash flow today and costs more later.
Fixed asset turnover = revenue / net PP&E. Maple: 1,000 / 500 = 2.0. It measures how much revenue each dollar of plant produces; compare it with peers and over time.
Under IFRS (IAS 36), an asset or cash-generating unit is impaired when its carrying amount exceeds its recoverable amount, the higher of fair value less costs of disposal and value in use (the present value of its expected cash flows). Under US GAAP, long-lived assets first face a recoverability test using undiscounted cash flows and are then written down to fair value; goodwill is tested by comparing a reporting unit's fair value with its carrying amount.
A cash-generating unit is carried at 900. Its value in use is 800 and its fair value less costs of disposal is 750. The recoverable amount is the higher, 800, so the impairment is 900 minus 800 = 100. The charge reduces operating profit and the unit's carrying amount; it uses no cash.
Under certain conditions, companies capitalize interest on assets under construction, software developed for internal use and, under IFRS, development costs. All of these move costs from the income statement to the balance sheet and onto future depreciation or amortization. Compare the capitalized amounts with total spending each year.
For a retailer, find the inventory method, the depreciation policy and useful lives, goodwill as a share of equity, and total lease liabilities. Compute DIO for three years.
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