5.5 Inventories, Long-Lived Assets, and Taxes

Inventories, Long-Lived Assets, And Taxes

Inventories and long-lived assets are both operating assets, but their accounting hits income, cash flow classification, and ratios differently. Inventory cost flows to cost of goods sold (COGS) when items are sold; long-lived asset cost is capitalized and then depreciated or amortized over its useful life, unless impairment or disposal intervenes. Taxes add a third layer because tax rules often differ from financial-reporting rules.

Inventory cost-flow assumptions

Product costs include purchase price, conversion, and other costs to bring inventory to its present location and condition; period costs are expensed as incurred. The cost-flow assumption need not match the physical flow of goods.

In rising prices, FIFO reports higher income and a higher (closer-to-current) inventory balance than LIFO. LIFO produces higher COGS, lowering taxable income and cash taxes where it is permitted, but IFRS prohibits LIFO entirely; US GAAP allows it (and requires LIFO firms to disclose a LIFO reserve so analysts can convert to FIFO for comparability).

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 turnover = COGS / average inventory
Days of inventory  = 365 / inventory turnover

Rising days of inventory on hand may flag slowing sales, overstocking, or obsolescence; falling days may mean efficiency or stockout risk. Under both frameworks inventory is generally written down to the lower of cost and net realizable value (US GAAP uses lower of cost or market for LIFO/retail), and IFRS permits reversal of a prior write-down while US GAAP does not.

Capitalize versus expense

A cost is capitalized when it is expected to provide future economic benefit and meets recognition criteria; otherwise it is expensed. Capitalizing moves the cash outflow into investing (CFI) and spreads the cost through depreciation/amortization, while expensing hits the income statement now and usually lowers CFO.

This is a classic earnings-quality lever: aggressive capitalization inflates near-term profit and CFO.

Depreciation and impairment

Straight-line depreciation spreads cost evenly; accelerated methods (e.g., double-declining balance) front-load expense, lowering early income and asset carrying value; units-of-production ties expense to use. Comparing useful lives, residual values, and methods across peers is essential, since longer assumed lives understate depreciation and overstate income. Impairment writes an asset down when its carrying amount is no longer recoverable; the loss is noncash in the period taken and reduces future depreciation. IFRS allows impairment reversals for most assets (not goodwill); US GAAP generally prohibits reversals.

Income taxes

Separate tax expense (accrual) from taxes paid (cash). The effective tax rate = income tax expense / pretax income. Temporary differences between an item's book carrying amount and its tax base create deferred taxes.

• A deferred tax liability (DTL) arises when taxable income is lower than book income now (the firm will owe more later). The classic source is tax depreciation exceeding book depreciation.
• A deferred tax asset (DTA) arises when taxable income is higher now or deductions come later, such as warranty accruals, bad-debt allowances, or loss carryforwards.

A DTA is only valuable if future taxable income is expected; otherwise a valuation allowance reduces it. A low effective rate can reflect genuine tax planning, geographic mix, or credits, or it can reflect one-time benefits or a valuation-allowance release that will not recur, so always read the tax-rate reconciliation footnote.

A worked deferred-tax example

Consider an asset costing 1,000 with a five-year life. For books the firm uses straight-line depreciation (200 per year); for tax it uses an accelerated schedule that allows 400 in year one. With a 25% tax rate, the year-one book depreciation expense is 200 while the tax deduction is 400, so taxable income is 200 lower than book income on this item. The firm pays less cash tax now but will pay more later as the schedules cross, creating a deferred tax liability of (400 − 200) x 25% = 50. Over the asset's life the total depreciation is identical under both methods, so the DTL builds early and unwinds to zero by year five.

This is the canonical source of a DTL and a frequent exam scenario; the mirror image, where a book expense (such as a warranty accrual) is deducted for tax only when paid, builds a deferred tax asset.

Intangibles, goodwill, and amortization

Long-lived assets are not only tangible. Intangible assets with finite lives (patents, licenses, customer lists) are amortized over their useful lives, just as PP&E is depreciated. Intangibles with indefinite lives, and goodwill arising from an acquisition, are not amortized; instead they are tested for impairment at least annually.

A critical comparability point: research costs are expensed under both frameworks, but development costs may be capitalized under IFRS once technical and commercial feasibility is demonstrated, whereas US GAAP generally expenses both research and development as incurred (with narrow software exceptions). Two otherwise identical firms can therefore report different income and asset bases purely because of this divergence, so an analyst comparing an IFRS reporter with a US GAAP reporter should consider restating development costs onto a common basis before drawing conclusions about profitability or asset efficiency.