4.5.

Financial Assets
IFRS defines a financial instrument as a contract that gives rise to a
financial asset of one company and a financial liability or equity
instrument of another entity.
Financial assets include stocks and bonds, derivatives, loans and
receivables.
Company A Company B

Issue shares
How do we measure financial assets?
There are two ways of measuring financial assets: Fair value and the
other is amortized cost.

- The fair value of an asset is market value of the asset.

- The amortized cost of a financial asset is the historical cost or the
original cost plus or minus any amortization.
When do we use amortized cost? When do
we use fair value?

• If a company plans to hole financial assets till maturity then we uses

amortized cost.
• If a company does not intend to hold the financial assets to maturity
the financial assets should be measured based on fair value.
 Income statement

Fair value

Comprehensive
income
Measurement of
financial assets

Amortized cost
How do we measure financial assets?
Financial assets can be measured either at fair value or amortized cost.
The measurement basis depends on how financial asset is categorized.
The major categories for financial assets are:
Measured at Cost or Amortized Cost: Under IFRS, financial assets are
measured at amortized cost if the asset’s cash flows occur on specified
dates and consist solely of principal and interest, and if the business
model is to hold the asset to maturity. For example, investment in a
long-term bond. Unrealized gains and losses are not recorded
anywhere.
• Measured at Fair value through profit or loss (FVTPL) under IFRS or
Held-for-Trading under US GAAP: This category of asset is acquired
primarily for the purpose of selling in the near term and is likely to be
held for only a short period of time. Unrealized gains and losses are
shown in the income statement.
• Measured at Fair value through other comprehensive income
(FVTOCI) under IFRS or available-for-sale under US GAAP: This
category of asset is expected neither to be held till maturity nor
traded in the near term. Unrealized gains and losses are shown in
other comprehensive income.

• Unlike IFRS, the US GAAP category available-for-sale applies only to

debt securities and is not permitted for investments in equity
securities.
• Realized gains for all categories are shown on the income statement
of the company.

• An important concept related to these assets is mark-to-market. It is

the process whereby the value of a financial instrument is adjusted to
reflect current value based on market prices.
Example

Company owners contribute $100,000, which is invested in a 20-year

bond with a 5% coupon paid semi-annually. After six months, the
company receives the first coupon payment of $2,500. At this stage,
the market price has increased to $102,000.
Show the balance sheet and income statement treatment under each
of the following categorizations: Held-for-Trading (HFT) , Asset for sale
(AFS) and Held for maturity (HTM).
4.6 Deferred Tax Assets

Deferred tax assets (DTA) arise when income tax payable based on
income for tax purposes is temporarily greater than income tax
expense based on reported financial statement income.
In other words, taxable income is higher than accounting profit. Any
deferred tax asset is the result of a temporary difference that is
expected to reverse in the future.
Deferred tax asset reverses when tax benefits are realized in the future
resulting in lower cash outflows.
5. Non-Current Liabilities

• All liabilities that are not classified as current are considered to be

non-current or long-term liabilities.
• Long-term financial liabilities - Include loans, notes and bonds
payable. These are usually reported at amortized cost on the balance
sheet.
• Deferred tax liabilities - Result from temporary timing difference
between a company’s taxable income and reported income. They are
defined as the amounts of income taxes payable in future periods in
respect of taxable temporary differences.
6. Equity

Equity is the owners’ residual claim on a company’s assets after

subtracting its liabilities.
6.1. Components of Equity
• The five components of equity are:
• Contributed capital: Total amount paid in by common and preferred
shareholders.
• Treasury shares: These are shares that have been repurchased by the
company, but not yet retired.
• Retained earnings: Cumulative income of firm since inception that
has not been distributed as dividends.
6.1. Components of Equity
• Accumulated other comprehensive income: These include items
which lead to changes in equity but are not part of the income
statement or from issuing stock, reacquiring stock, and paying
dividends.
• Non-controlling interest (minority interest): It is the portion of a
subsidiary not owned by the parent company. For example, if a firm
owns 80% of a subsidiary, then it will report 20% of net assets of the
subsidiary as minority interest.
6.2. Statement of Changes in Equity

The statement of changes in equity presents information about the

increases or decreases in a company’s equity over a period of time.
IFRS requires the following information in the statement of changes in
equity:
• total comprehensive income for the period;
• the effects of any accounting changes that have been retrospectively
applied to previous periods;
• capital transactions with owners and distributions to owners; and
• reconciliation of the carrying amounts of each component of equity
at the beginning and end of the year.
• U.S. GAAP requirement is for companies to provide an analysis of
changes in each component of equity as shown in the balance sheet.
• Sample Statement of Changes in Stockholders’ Equity.
7. Analysis of the Balance Sheet

Balance sheet analysis can help us evaluate a company’s liquidity and

solvency. A balance sheet can be used to analyze a company’s capital
structure and ability to pay liabilities.
7.1. Common-Size Analysis of the Balance Sheet

In this method, all balance sheet items are expressed as a percentage

of total assets.
Common-size statements are useful in comparing a company’s balance
sheet composition over time (time-series analysis) and across
companies in the same industry.
An example of a common-size balance sheet is shown in the
figure below for Company XYZ Inc.
7.2. Balance Sheet Ratios

Balance sheet ratios are those involving balance sheet items only.

Liquidity ratios tell us about a company’s ability to meet current

liabilities, while solvency ratios tell us about a company’s ability to
meet long-term and other obligations.

They also help us evaluate a company’s financial risk and leverage.

The following table summarizes some liquidity ratios
Solvency ratios help to evaluate:
• a company’s ability to meet long-term and other liabilities.
• a company’s financial risk and leverage.
It is important for analysts to remember that ratio analysis requires
judgment. For example, current ratio is only a rough measure of
liquidity. In addition, ratios are sensitive to end of period financing and
operating decisions that can potentially impact current asset and
current liability amounts. Analysts should also evaluate ratios in the
context of a company’s industry. This requires an examination of the
entire operations of a company, its competitors, and the external
economic and industry setting.
Chapter 5: Understanding Cash Flow Statements
Content
• Introduction
• Components and Format of the Cash Flow Statement
• The Cash Flow Statement: Linkages and Preparation
• Cash Flow Statement Analysis
1. Introduction

The cash flow statement provides important information about a

company’s cash receipts and payments during an accounting period.
It is a vital information source that assists users to evaluate a
company’s liquidity, solvency, and financial flexibility.
What is the difference between income and
cash flow statement?
2. Components and Format of the Cash Flow Statement

2.1. Classification of Cash Flows and Non-Cash Activities

• Under both IFRS and US GAAP, cash flows are categorized as operating,
investing, or financing activities on the cash flow statement.
• Operating activities: These are activities related to the normal operations
of a company. Examples include:
- Cash inflows such as cash collected from sales, commissions, royalties, etc.
- Cash outflows such as cash payments for inventory, salaries, and operating
expenses.
- Cash payments and receipts related to trading securities (securities that are
not bought as investments).
Investing activities: These are activities associated with acquisition and
disposal of long- term assets. Examples include:
• Cash from sale of property, plant, and equipment.
• Cash spent to purchase property, plant, and equipment.
• Cash payments and receipts related to investment securities (not
trading securities).
Financing activities: These are activities related to obtaining or
repaying capital. Examples include:
• Issuance or repurchase of a company’s own preferred or common stock.
• Issuance or repayment of debt.
• Dividend payments to shareholders.
Example
Non-cash transactions

• A non-cash transaction is any transaction that does not involve an

outflow or inflow of cash.
2.2. A Summary of Differences between IFRS and US GAAP

• The reporting of interest paid/received and dividends paid/received is

different between IFRS and US GAAP. The differences between the
two standards are summarized in the table below.
2.3. Direct and Indirect Methods for Reporting Cash Flow from
Operating Activities

Under IFRS and US GAAP, there are two acceptable formats for
reporting cash flow from operating activities: indirect and direct.
• The indirect method shows how cash flow from operations can be
obtained from reported net income through a series of adjustments.
• The direct method shows the specific cash inflows and outflows that
result in reported cash flow from operating activities.
Direct Format Sample
In the direct format, we look at the specific cash inflows and outflows
that resulted in cash flow from operating activities. This method is
encouraged by both IFRS and US GAAP.
Indirect method

With the indirect

method, we start
with net income
and make several
adjustments for
non- cash, non-
operating items to
arrive at the cash
flow from
operations.
3. The Cash Flow Statement: Linkages and Preparation

3.1. Linkages of the Cash Flow Statement with the Income Statement
and Balance Sheet
Link between the Cash Flow Statement and the Balance Sheet
Link between Cash Flow Statement, Balance Sheet, and Income
Statement

• Example:
Suppose the beginning accounts receivable is 200, the revenue during
the year is 5,000 and the cash collected from customers is 4,800.
What is the ending accounts receivables?
Link between Cash Flow Statement, Balance Sheet, and Income
Statement

Ending receivables = Beginning receivables + Revenue – Cash collected from customers

3.2. Steps in Preparing the Cash Flow Statement

• Operating Cash Flow

Direct method:
In the direct method, we take each item from the income statement
and convert it to its cash equivalent by removing the impact of accrual
accounting.
Rules:
With asset:
• Increase in asset will have a negative impact on cash flow.
• Decrease in asset will have a positive impact on cash flow.

With liability:
• Increase in liability will have a positive impact on cash flow
• Decrease in liability will have a negative impact on cash flow
• Cash collected from customers: Adjust sales or revenue for changes in
accounts receivable (assets) and unearned revenue (liabilities).
= Revenue - A/R + U/R

• Cash for inputs: Adjust COGS for changes in inventory (asset) and
accounts payable (liabilities).

• Cash operating expenses: Adjust Selling, General & Administrative

Expense (SG&A) for changes in related accrued liabilities or prepaid
expenses.
• Cash interest paid: Adjust interest expense for changes in interest
payable.

• Cash taxes paid: Adjust tax expense for changes in tax payable and
changes in deferred tax assets and liabilities.
Indirect method:

Indirect method shows how cash flow from operations can be obtained
from reported net income as a result of a series of adjustments.
 Operating Activities: Indirect Method
egin with net income Net Income
dd back all non cash charges to income + Depreciation expense
nd subtract all non cash components of
evenue
ubtract gain or losses that resulted from - Gain on sale of equipment
nancing or investing cash flows
ll or subtract changes to balance sheet
perating accounts
Increases in the operating asset account - Increase in current (operating) assets
(use of cash) are subtracted, while + decrease in current (operating) assets
decrease (source of cash) are added
Increases in the operating liability + Increase in current (operating) liabilities
account (sources of cash) are added, - Decrease in current (operating) liabilities.
while decrease (uses of cash) are
Investing cash flows

CFI is calculated by examining the change in the gross asset account

that results from investing activities. Typically, this change results from
purchases or sale of equipment (long- term assets).
Cash from sale of equipment
= Historical cost of equipment sold
− Accumulated depreciation on equipment sold
+ Gain on sale of equipment
where:
Historical cost of equipment sold = beginning balance
+ equipment purchased − ending balance equipment
Accumulated depreciation on equipment sold = beginning value of
depreciation + depreciation expense – ending value of depreciation
Financing cash flows

Cash flow from financing activities refers to cash flows between the
firm and the suppliers of capital. Suppliers of capital include creditors,
bondholders, and shareholders.
4. Cash Flow Statement Analysis

4.1. Evaluation of the Sources and Uses of Cash

Evaluation of the cash flow statement should involve the following:
• Evaluate where the major sources and uses of cash flow are between
operating, investing, and financing activities. Major sources of cash
for a company can vary with its stage of growth.
• However, for all companies analysts must analyze whether operating
cash flows are positive and cover capital expenditures.
• Evaluate the primary determinants of operating cash flow. Analysts
should compare operating cash flow with net income. If a company
has large net income but poor operating cash flow, it may be a sign of
poor earnings quality. In addition, analysts need to look at
consistency of operating cash flows.
• Evaluate the primary determinants of investing cash flow. This is
useful for letting the analyst know how much is being invested for the
future in property, plant, and equipment and how much is put aside
in liquid investments.
4.2. Common-Size Analysis of the Statement of Cash Flows
In common-size analysis of a company’s cash flow statement, there are
two alternative approaches. In the first approach, we express each line
item of cash inflow ( or outflow) as a percentage of total inflows (or
outflows).
In the second approach, we express each line item as a percentage of
revenue.
• The common-size cash flow statement makes it easier to see trends in
cash flow rather than just looking at the total amount.
• The second approach is useful for the analyst in forecasting future
cash flows.
4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity
Free cash flow to firm (FCFF) is the cash flow available to all the
suppliers of capital to a company after all operating expenses have
been paid and necessary investments in working capital and fixed
capital have been made. The suppliers of capital include both lenders
(debt) and equity shareholders (equity).
Free cash flow to equity (FCFE)

Free cash flow to equity (FCFE) is the cash flow available to the
company’s stockholders after all operating expenses and borrowing
costs (principal and interest) have been paid and necessary
investments in working capital and fixed capital have been made.
• The formula for computing FCFE is as follows:
FCFE = CFO – FCInv + Net borrowing
Where:
FClnv: Fixed capital investment
4.4. Cash Flow Ratios
• There are several ratios useful for the analysis of the cash flow
statement. These ratios generally fall into cash flow performance
(profitability) ratios and cash flow coverage (solvency) ratios.
Chapter 6: Financial Analysis Techniques
The content
• Introduction
• The Financial Analysis Process
• Analytical Tools and Techniques
• Common ratios used in financial analysis
• Equity Analysis
• Credit Analysis
• Business and Geographic Segments
• Model Building and Forecasting
1. Introduction
• Financial analysis is a useful tool in evaluating a company’s
performance and trends.

• The primary source of data is the company’s annual reports, financial

statements, and Management Discussion and Analysis (MD&A) .

• An analyst must be capable of using a company’s financial statements

along with other information such as economy/industry trends to
make projections and reach valid conclusions.
2. The Financial Analysis Process

• An analyst must clarify the purpose and context of why it is needed.

• An analyst can choose the right techniques for the analysis.

• For example, the level of detail required for a substantial long-term

investment in equities will be higher than one needed for a short-
term investment in fixed income.
2.1. The Objectives of the Financial Analysis Process
2.2. Distinguishing between Computation and Analysis

• An effective analysis is not just a compilation of various pieces of

information, tables, and graphs. It includes both calculations and
interpretations.
• For analyzing past performance, an analyst computes several ratios,
compares them against benchmarks, evaluates how the company
performed, and determines the reasons behind its good/bad
performance.
• Similarly, for a forward-looking analysis, an analyst must forecast and
make recommendations after analyzing trends, management quality,
etc.
3. Analytical Tools and Techniques
- Various tools and techniques such as ratios, common size analysis,
graphs and regression analysis help in evaluating a company’s
performance.
- Evaluations require comparisons, but to make a meaningful
comparison of a company’s performance, the data needs to be
adjusted first.
- An analyst can then compare a company’s performance to other
companies at any point in time (cross-section analysis) or its own
performance over time (time-series analysis).
3.1 Ratios
• A ratio is an indicator of some aspect of a company’s performance like
profitability or inventory management that tells us what happened,
but not why it happened.
• Ratios help in analyzing the current financial health of a company,
evaluate its past performance, and provide insights for future
projections.
• Calculating ratios is straightforward, but interpreting them is
subjective.
Uses of ratio analysis

Ratios allow us to evaluate:

• operational efficiency.
• financial flexibility.
• changes in company/industry over time.
• company performance relative to industry.
Limitations of ratio analysis

Ratio analysis also has certain limitations. Some of the factors to

consider include:
• Need to use judgment: An analyst must exercise judgment when
interpreting ratios.
For example, a current ratio of 1.1 may not necessarily be good/bad
unless viewed in perspective of other companies/industry.
• Nature of a company’s business: Companies may have divisions
operating in different industries. This can make it difficult to find
comparable ratios.
• Use of alternate accounting methods: Using alternate methods may
require adjustments before the ratios are comparable.
For example, Company A might use the LIFO method to measure
inventory, while a comparable company might use the FIFO method.
Similarly, one company may use the straight line method of
depreciation, while another may use an accelerate method.

• Consistency of results of ratio analysis: One set of ratios may indicate

a problem, while the other may indicate the problem is short term
making the results inconsistent.
3.2. Common-Size Analysis

• Common-size financial statements are used to compare the

performance of different companies with an industry or a company’s
performance over time.
• Common size statements are prepared by expressing every item in a
financial statement as a percentage of a base item.
Common-Size Analysis of the Balance Sheet

There are two types of common-size balance sheets: vertical and

horizontal.
Vertical common-size balance sheet
• A vertical common-size balance sheet is prepared by dividing each
item on the balance sheet by the total assets for a period and
expressed as a percentage. This highlights the composition of the
balance sheet.
end analysis or time-series analysis provides information on historical performance and growth.
ndicates how a particular item is changing – whether it is improving or deteriorating
Cross-Sectional Analysis
The vertical common-size balance sheet can be used in cross-sectional
analysis (also called relative analysis) to compare a specific metric of
one company with the same metric for another company or companies
for a single time period.
Horizontal Common-Size Balance Sheet
4. Common Ratios Used in Financial Analysis
A large number of ratios are used to measure various aspects of
performance. Commonly used financial ratios can be categorized as
follows:
4.1. Interpretation and Context
• As standalone numbers, the financial ratios of a company are not
meaningful. The ratios are usually industry specific. For instance, one
cannot compare the ratios of HSBC with that of Facebook.
• The financial ratios should be used to periodically evaluate a
company’s past performance (trend analysis) and its goals and
strategy; how it fares against its peers in the industry (cross-sectional
analysis); and the effect of economic conditions on its business.
4.2. Activity Ratios

• Activity ratios measure how efficiently a company manages its assets.

4.3 Liquidity ratios
Liquidity ratios measures a company’s ability to meet short-term obligations. It also
indicates how quickly it turns assets into cash.
4.4 Solvency Ratios
Solvency ratios measure a company’s ability to meet long-term
obligations. In simple terms, it provides information on how much debt
the company has taken and if it is profitable enough to pay the interest
on debt in the long term. It has to be analyzed within an industry’s
perspective. Certain industries such as real estate use a higher level of
leverage.
4.5. Profitability Ratios
Profitability ratio is used to evaluate the company’s ability to generate
income as compared to its expenses and other cost associated with the
generation of income during a particular period.
5. Equity Analysis

One of the most common applications of financial analysis is that of

selecting stocks. An equity analyst uses various tools (such as valuation
ratios) before recommending a security to be included in an equity
portfolio. The valuation process consists of the following steps:
• Understanding the company’s business and existing financial profile.
• Forecasting the company’s performance, such as revenue projections.
• Selecting the appropriate valuation model.
• Converting forecasts to a valuation.
• Making the investment decision to buy or not to buy.
5.1. Valuation Ratios

Valuation ratios aid in making investment decisions. They help us

determine if a stock is undervalued or overvalued.
5.2 Industry-Specific Ratios
Ratios serve as indicators of some aspect of a company’s performance
and value. Aspects of performance that are important in one industry
may be irrelevant in another. These differences are reflected through
industry-specific ratios.

For example, companies in the retail industry may report same-store

sales changes because in the retail industry it is important to
distinguish between growth that results from opening new stores and
growth that results from generating more sales at existing stores.
6. Credit Analysis
Credit risk is the risk that the borrower will default on a payment when
it is due.

For example, if you are a bondholder, credit risk is the risk that the
bond issuer will not pay you the interest on time.

Credit analysis is the evaluation of this credit risk. Just as ratio analysis
is useful in valuing equity, it can also be applied to analyze the
creditworthiness of a borrower.
6. Credit Analysis
• Credit ratings are based on a combination of qualitative and
quantitative factors.
• Qualitative factors include an industry’s growth prospects, volatility,
technological change, competitive environment, operational
effectiveness, strategy, governance, financial policies, risk
management practices, and risk tolerance.
• Quantitative factors include profitability, leverage, cash flow
adequacy, and liquidity.
7. Business and Geographic Segments
A business or geographic segment is a portion of a company that has
risk and return characteristics distinct from the rest of the company
and accounts for more than 10% of the company’s sales or assets.
Companies are required to report some items for significant segments
separately.
8. Model Building and Forecasting
• Analysts use several methods to forecast future performance. One
commonly used method is to project sales and to combine the
forecasted sales numbers with expected values for key ratios.

• For example, by using sales numbers and gross profit margin, one can
determine cost of goods sold and gross profit. This method is
particularly useful for mature companies with stable margins.
• Besides ratio analysis, techniques such as sensitivity analysis, scenario
analysis, and simulations are often used as part of the forecasting
process.
• Scenario analysis shows a range of possible outcomes as specific
assumptions or input variables are changed.
• With scenario analysis, a number of different scenarios are defined
and outcomes are estimated for each outcome.
• Simulations involve the use of computer models and input variables
which are based on a pre-defined probability distribution.
Chapter 6: Inventories
The content
1. Introduction
2. Cost of inventories
3. Inventory Valuation Methods
4. The LIFO Method
5. Inventory Method Changes
6. Inventory Adjustments
7. Evaluation of Inventory Management
1. Introduction
• Inventories are assets held by a company to produce finished goods
for sale.

• They are shown as a current asset on the balance sheet; and can
represent a significant part of the total assets for many companies.

• Manufacturing and merchandising companies (Ex: Nike) generate

sales and profit through the sale of inventory. An important measure
in calculating profits is cost of goods sold, i.e.,
• There is no universal inventory valuation method. IFRS and US GAAP
allow different identification methods to measure the cost of
inventory such as specific identification, weighted average cost, first
in, first out, and last in, first out.
2. Cost of Inventories
When a company spends money on inventory, most of the costs are
capitalized. Capitalizing means creating an asset on the balance sheet.
Inventory costs that are capitalized include:
• costs of purchase (this includes the purchase price, import and tax
duties, transport and handling costs).
• costs of conversion (costs such as labor, material, and overheads
which are directly related to converting raw materials to finished
goods).
• costs necessary to bring inventories to their present location and
condition (this will include the cost of transporting goods to a
showroom).
Costs that are expensed in the period incurred include:
• Abnormal costs arising due to wastage of material, labor, or other
production inputs.
• Storage costs of final/finished goods.
• Administrative overheads.
• Selling costs.
• Unused portion of fixed production overhead.
• Transportation of finished goods to the customer.
3. Inventory Valuation Methods

The four inventory valuation methods for accounting inventory are:

• Specific Identification
• FIFO (First In, First Out)
• Weighted Average Cost
• LIFO (Last In, First Out)
3.1. Specific Identification

• Specific identification is used when:

• Items are unique in nature and not interchangeable.
• Cost of inventory is high.
• Every item in the inventory can be tracked individually.

Under specific identification, items are shown on the balance sheet at

their actual costs. Examples: Jewelry, expensive watches, highly valued
art pieces, used cars, etc.
3.2. First In, First Out (FIFO)
Under First In, First Out:
• Oldest goods purchased or manufactured are assumed to be sold
first.
• Newest goods purchased or manufactured remain in ending
inventory.
• When prices are increasing or stable, cost assigned to items in
inventory is higher than the cost of items sold.
• The following example illustrates how cost of goods sold and
inventory are accounted for in each period:

Assume you bought four pencils. The first two pencils were worth $1
each and the next two pencils were worth $2 each. Before you start
selling, your inventory consists of four pencils.
3.3. Weighted Average Cost

Under weighted average cost method, each item in inventory is valued

using an average cost of all in the inventory.

• Let’s use the pencils example again to illustrate how inventory is

calculated using the WAC method.
• Total cost of pencils available for sales = $6
• Total number of pencils available for sale = 4 Weighted average cost
per pencil = $6/4 = $1.5
3.4. Last In, First Out (LIFO)
Under Last In, First Out method:
• The newest items purchased or manufactured are assumed to be sold
first.
• Oldest goods purchased or manufactured remain in ending inventory.
• The cost of goods sold reflects the cost of goods purchased or
manufactured recently; the value of inventory reflects the cost of
older goods purchased.
3.5. Calculation of Cost of Sales, Gross Profit, and Ending
Inventory
Based on the inventory valuation method used by a company, the
allocation of inventory costs between cost of goods sold on the income
statement and inventory on the balance sheet varies in periods of
changing prices.

Continuing with the pencils example, assume each of the pencils was
sold for $5. The table below summarizes the cost of goods sold,
inventory ending value, and gross profit under each of the methods:
3.6. Periodic versus Perpetual Inventory Systems

The two types of inventory systems used to keep track of changes in

the inventory are:
• Periodic system
• Perpetual system
Periodic system
The company measures the quantity of inventory on hand periodically.
It is not a continuous process unlike the perpetual system. Purchases
are recorded in a purchases account. Ending inventory is determined
through a physical count of the units in inventory.
Cost of goods sold (COGS) = Beginning Inventory + Purchases –
Ending Inventory.
The formula above can be rearranged to determine the value of any of
the items. For example:
Ending inventory = Beginning Inventory + Purchases - COGS
Perpetual system

As the name implies, inventory and COGS are continuously updated in

this system. Purchases and sale of units are directly recorded in the
inventory as and when they occur.
3.7. Comparison of Inventory Valuation
Methods
The allocation of total cost of goods available for sale to COGS and
ending inventory varies under different inventory valuation methods.
4. The LIFO Method

LIFO is permitted under US GAAP, but not under IFRS. Under the LIFO
conformity rule,
When prices are increasing, LIFO method will result in higher COGS,
lower profit, income tax expense, and net income. Due to lower taxes,
the LIFO method will also result in higher after- tax cash flow.

LIFO conformity rule which is extremely important and this rule say
that the same method must be used for tax and financial report. In
other words, if you are using LIFO for your financial reporting then that
same method is used for tax reporting.
• This is different from depreciation, with depreciation you are allowed to used
straight-line method or whatever method is appropriate for financial reporting
and a different method for tax reporting.

• In this particular case, if a company wants to reduce its taxes it can use the LIFO
method in the US because that is where it was allowed.

• LIFO method reduces earnings before tax and then reduces taxes I mentioned this
before also. However Companies which use the LIFO method must also disclose
LIFO reserve.

• LIFO reserve is the difference between inventory reported at FIFO and inventory
reported at LIFO.
4.1. LIFO Reserve
The LIFO reserve is the difference between the reported LIFO inventory
carrying amount and the inventory amount that would have been
reported if the FIFO method has been used instead. The equation for
LIFO reserve is given by:
LIFO reserve = FIFO inventory value – LIFO inventory value.
US GAAP requires companies using the LIFO method to disclose the
amount of the LIFO reserve either in the notes to financial statements
or in the balance sheet. An analyst can use the disclosure to adjust a
company’s COGS and ending inventory from LIFO to FIFO. This makes it
easier to compare the company’s performance with other companies
that use FIFO.
• The following formulas show how to make adjustments for inventory,
COGS, and net income from LIFO to FIFO: