5.5 Inventories, Long-Lived Assets, and Taxes

Inventories, Long-Lived Assets, And Taxes

Inventories and long-lived assets are operating assets, but their accounting affects income, cash flow classification, and ratios in different ways. Inventory costs flow to cost of goods sold when items are sold. Long-lived asset costs are capitalized and then depreciated or amortized over useful lives, unless impairment or disposal changes the pattern. Taxes add another layer because tax rules often differ from financial reporting rules.

Inventory accounting begins with which costs are included and which cost flow assumption is used. Product costs usually include purchase price, conversion costs, and other costs needed to bring inventory to its present location and condition. Period costs are expensed as incurred. The cost flow assumption does not need to match the physical flow of goods.

FIFO usually reports higher income and inventory than LIFO when prices rise. LIFO can create lower taxes if tax rules allow it because higher COGS reduces taxable income. Under IFRS, LIFO is not permitted. Under US GAAP, LIFO may be used. Analysts comparing FIFO and LIFO firms should use the LIFO reserve when disclosed to improve comparability.

LIFO conversion snippets:

FIFO inventory = LIFO inventory + LIFO reserve
FIFO COGS = LIFO COGS - increase in LIFO reserve
FIFO pretax income = LIFO pretax income + increase in LIFO reserve

Inventory analysis also uses turnover and days measures. Inventory turnover equals COGS divided by average inventory. Days of inventory on hand equals 365 divided by inventory turnover. Rising days may indicate slower sales, overstocking, obsolete goods, or intentional buildup before expected demand. Falling days may indicate efficiency or understocking risk.

Long-lived assets raise the capitalization question. A cost should be capitalized when it is expected to provide future economic benefits and meets recognition criteria. Capitalizing moves the cash outflow to investing cash flow and expenses the cost over time through depreciation or amortization. Expensing records the cost immediately in the income statement and usually in operating cash flow.

Depreciation allocates the cost of tangible long-lived assets over useful life. Straight-line depreciation records equal expense each period. Accelerated methods record more expense early and less later. The units-of-production method links expense to use. Analysts should compare useful lives, residual values, and depreciation methods across peers.

Impairment occurs when an asset's carrying amount is no longer recoverable under the applicable standard. An impairment loss reduces assets and current income but is a noncash charge in the period recognized. Future depreciation may decline because the carrying amount is lower. IFRS and US GAAP differ in some impairment details, including reversals for certain assets.

Income tax analysis separates tax expense from taxes paid. Effective tax rate equals income tax expense divided by pretax income. Cash tax rate compares cash taxes paid with pretax income or taxable income proxies. Differences arise because financial reporting rules and tax rules recognize revenues and expenses at different times or measure them differently.

Deferred tax liabilities arise when taxable income is lower than accounting income now because the company will owe more tax in the future, all else equal. Accelerated tax depreciation compared with straight-line book depreciation is a common source. Deferred tax assets arise when taxable income is higher now or deductions can be used later, such as some warranty accruals, loss carryforwards, or bad debt allowances.

Tax quality questions matter. A low effective tax rate can reflect real tax planning, geographic mix, tax credits, valuation allowance changes, or one-time benefits. A deferred tax asset is valuable only if the company expects sufficient future taxable income. Analysts should review the tax footnote for rate reconciliation, carryforwards, uncertain tax positions, and valuation allowances.