Inventories are the current assets of the company, including raw material, work-in-progress, and finished goods, that are held for sale in the normal course of business of the company.
Under IFRS, the cost of goods sold (COGS) or the cost of sales (COS) depends upon the beginning balance of inventory, purchases, and ending balance of inventory. In form of an equation, it can be written as:
This equation can be rearranged to solve for any of the variables, as follows:
,
,
or,
The valuation of inventories is done based on the estimates and assumptions, thus giving a lot of scope for the management to manipulate its value. This may, in turn, result in the manipulation of the income statement and balance sheet of the company. It is, therefore, important for an analyst to understand the mechanics behind the valuation of inventories, so that it becomes easy to analyze the financial statements appropriately, understanding how the figures of profits might have been affected due to estimates and assumptions made by the management.
In this chapter, we will read about the treatment and valuation of inventory as prescribed by the IFRS and U.S. GAAP, inventory cost flow methods, calculation of COGS, and the effect of such methods on firm’s liquidity, profitability, activity, and solvency.