Chapter 1 Introduction
1.3 Research Structure
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1.3 Research Structure
The research process and structure is presented as follow:
Figure 1-1 Research Process and Structure
Introduction
Literature Review
Research Method
Empirical Results and Analysis
Conclusion
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2.1 The Development and Fundamental Principles of IAS2
International Accounting Standards 2 (IAS 2), ―Valuation and Presentation of Inventories in the Context of the Historical Cost System,‖ was first issued in October 1975 by International Accounting Standards Committee (IASC). In December 1993, IASC issued a revised IAS 2 Inventories. In December 1997, the Standing Interpretations Committee developed SIC-1 ―Consistency-Different Cost Formulas for Inventories.‖ To improve the International Accounting Standards, the International Accounting Standards Board (IASB) revised IAS 2 again in December 2003, which replaced both IAS Inventories in 1993 and SIC-1. The revised IAS 2 was effective and applied annually from January 1, 2005.
The objective of IAS 2 is to prescribe the accounting treatment for inventories.
It provides guidance for determining the cost of inventories and for subsequently recognizing an expense, including any write-down to net realizable value. It also provides guidance on the cost formulas that are used to assign costs to inventories.
The scope of IAS 2 includes assets held for sale in the ordinary course of business (finished goods), assets in the production process for sale in the ordinary course of business (work in process), and materials and supplies that are consumed in production (raw materials). However, IAS 2 excludes certain inventories from its scope, such as work in process arising under construction contracts, financial
instruments, biological assets related to agricultural activity, and agricultural produce at the point of harvest.
One of the most fundamental principles of IAS 2 is that inventories are required to be stated at the lower of cost and net realizable value (NRV). The inventory cost
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should include costs of purchase (including taxes, transport, and handling) net of trade discounts received, costs of conversion (including fixed and variable manufacturing overheads) and other costs incurred in bringing the inventories to their present location and condition. Inventory cost should not include abnormal waste, storage costs, administrative overheads unrelated to production, selling costs, foreign
exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency, and interest cost when inventories are purchased with deferred settlement terms.
NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.
Estimates of net realizable value are based on the most reliable evidence available at the time the estimates are made, of the amount the inventories are expected to realize.
The amount of any write-down of inventories to net realizable value and all losses of inventories shall be recognized as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.
Inventories should be written down to net realizable value item by item. A company can only group similar or related items when the inventory relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line. It is not appropriate to write inventories down on the basis of a classification of inventory,
In terms of techniques for the measurement of cost, standard cost method, retail method, specific costs method, FIFO and weighted average cost method are allowed.
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Standard costs take into account normal levels of materials and supplies, labor,
efficiency and capacity utilization and should be regularly reviewed and revised in the light of current conditions. Specific costs are attributed to the specific individual items of inventory that are not interchangeable. The retail method is often used in the retail industry and the cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin. For items that are
interchangeable, IAS 2 allows the FIFO or weighted average cost formulas. The same cost formula should be used for all inventories with similar characteristics as to their nature and use to the entity.
The LIFO formula, which had been allowed prior to the 2003 revision of IAS 2, is no longer allowed for several reasons. First, the LIFO method treats the newest items of inventory as being sold first, and consequently the items remaining in
inventory are recognized as if they were the oldest. Therefore, the use of LIFO results in inventories being recognized in the balance sheet at amounts that bear little
relationship to recent cost levels of inventories. This is generally not a reliable representation of actual inventory flows. Second, the use of LIFO in financial reporting is often tax-driven, because it results in cost of goods sold expense calculated using the most recent prices being deducted from revenue in the
determination of the gross margin. However, IASB indicates that tax considerations do not provide an adequate conceptual basis for selecting an appropriate accounting treatment and that it is not acceptable to allow an inferior accounting treatment purely because of tax regulations and advantages in particular jurisdictions. In addition, it is not appropriate to allow an approach that results in a measurement of profit or loss for the period that is inconsistent with the measurement of inventories for balance sheet purposes. As a result, IASB decided to eliminate the LIFO method because of its lack
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of representational faithfulness of inventory flows.
IAS 2 covers the cost of inventories of a service provider. To the extent that service providers have inventories, they measure them at the costs of their production.
These costs consist primarily of the labor and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. Labor and other costs relating to sales and general administrative
personnel are not included but are recognized as expenses in the period in which they are incurred. The cost of inventories of a service provider does not include profit margins or non-attributable overheads that are often factored into prices charged by service providers.
IAS 2 also has certain disclosure requirement for inventory. A company must disclose the accounting policy for inventories, the carrying amount, for merchandise, supplies, materials, work in progress, and finished goods. The carrying amount of any inventories carried at fair value less costs to sell, the amount of any write-down of inventories recognized as an expense in the period, the amount of any reversal of a writedown to NRV and the circumstances that led to such reversal, the carrying amount of inventories pledged as security for liabilities, and cost of inventories recognized as expense.
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2.2 Inventory, Sales and Earnings Related Literature
Broadly speaking, past LIFO research has focused on two key questions. The first question is about the sophistication of managers’ inventory accounting method decision. For example, Bar-Yosef (1992) and Cushing (1992) discuss whether
managers would choose LIFO to minimize the company’s tax payment, or they would choose FIFO to avoid lower reported earnings. Hughes, P.J (1994) analyzes the manager's choice of both an inventory accounting method and capital structure in order to communicate private information about the firm's future cash flows.
The second question is about investors' reactions to LIFO adoptions. For example, Biddle (1988) focuses on analysts’ forecast errors and stock price behavior near the earnings announcement dates of LIFO adopters. Jennings (1992) examines investor and stock price reaction to LIFO adoption decisions. Kang (1993) discusses the stock price effects of LIFO tax benefits. Guenther (1994) analyzes the effect that the ―LIFO reserve‖ has on firm value, and the results indicate a significant negative relation between the LIFO reserve and the value of equity because larger LIFO reserves may be associated with greater accounting costs and may be a proxy for the average expected effect of future inflation on the firm’s input prices.
However, few literatures consider the effect of inventory accounting methods on financial statements analysis. This study examines how inventory accounting methods affect inventory and how the inventory affects future sales and earnings.
According to the IASB, LIFO is generally not a reliable representation of actual inventory flows. International Accounting Standard (IAS) 2 sets out the accounting treatment for inventories and provides guidance on determining their cost. IAS 2 points out that the LIFO method treats the newest items of inventory as being sold
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first, and consequently the items remaining in inventory are recognized as if they were the oldest; therefore, the use of LIFO results in inventories being recognized in the balance sheet at amounts that bear little relationship to recent cost levels of
inventories. Some respondents argued that the use of LIFO has merit in certain
circumstances because it partially adjusts profit or loss for the effects of price changes.
However, the Board concluded that it is not appropriate to allow an approach that results in a measurement of profit or loss for the period that is inconsistent with the measurement of inventories for balance sheet purposes. As a result, the Board decided to eliminate the allowed alternative of using the LIFO method.
Several studies have addressed that Inventory is one of the fundamental signals for Future Earnings. Chi-Wen Jevons Lee (1988) finds significant association between the Earnings and Profit ratio (E/P ratio) and the inventory accounting methods.
According to common economic intuition, each dollar of pretax cash flow in a FIFO firm should lead to higher accounting earnings, higher tax payments and a higher stock price than in a FIFO firm, so the E/P ratios of the FIFO firms should be higher than those of the LIFO firms. However, Lee finds the E/P ratios of the LIFO firms are higher than those of the FIFO firms. Although he hasn’t established a complete causal link, he shows that inventory accounting can affect a company’s stock valuation.
Bernard (1991) examines the relation between inventory disclosures, future sales and future earnings. He uses a ―lead time‖ or ―production smoothing‖ model and a
―stockout model‖ of inventory to evaluate the predictive ability of inventory. He finds that an unexpected change in total inventory is a negative leading indicator of future earnings and profit margins, because an inventory buildup generally reflects decline in future sales, but the increase in inventory is positively related to future sales, because inventory reflects management's private information about demand. This paper
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reveals a strong relation between inventory and future sales and earnings, and
provides valuable insight that inventory disclosures can improve predictions of future sales and earnings.
Thiagarajan. (1993) Abarbanell (1997) analyzes the underlying relations between accounting-based fundamental signals and security prices. He finds that inventory is one of the fundamental signals for future earnings for several reasons. One of the reasons is that increase in finished goods inventory that outstrips sales demand is predicted to indicate bad news for earnings. The other reason is that inventory changes in excess of sales changes are negatively associated with future earnings performance. The study shows that inventory is one of the crucial elements for earnings information analysis.
Thomas and Zhang (2003) indicate that the negative relation between accruals and future abnormal returns is due mainly to inventory changes, and inventory changes represent the one component that exhibits a consistent and substantial relation with future returns. They document several key empirical regularities for extreme inventory change companies and explore the relation between sales and inventory changes. They think firms with inventory increases experience higher profitability, growth, and stock returns over the prior five years, but those trends reverse after the extreme inventory change. They also think quarterly cost of goods sold (COGS) and sales ratio and selling, general and administrative (SG&A) expenses and sales ratio exhibit similar patterns. In addition, LIFO companies with inventory increases represent one subgroup of extreme inventory change companies that exhibits
abnormal return and profitability patterns unlike those observed for other companies.
Jennings and Thompson (1996) investigate the relative usefulness of LIFO and non-LIFO financial statements as a basis for valuation. It is often argued that LIFO
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income statements are more useful as a basis for valuation than those prepared under alternative cost-flow assumptions because LIFO cost of goods sold is based on relatively current inventory costs. In contrast, non-LIFO balance sheets are alleged to be more useful for valuation because their inventory values better represent the net assets available to generate future resource inflows. Jennings and Thompson use LIFO reserve disclosures to construct ―as if‖ non-LIFO income statements and
balance sheets for 991 LIFO users and compare the extent to which elements of actual LIFO financial statements and their ―as if‖ non-LIFO counterparts explain the
observed distribution of equity values for these firms. The comparisons indicate that LIFO cost of goods sold is a more useful indicator of future resource outflows, LIFO reserve disclosures are useful supplements to the LIFO balance sheet, and LIFO-based income statements explain slightly more of the cross-sectional variation in equity values than their ―as if‖ non-LIFO counterparts.
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In this chapter, Section One will develop the hypotheses for this study, which are based on two economic models. Section Two will present the data selection process.
Section Three will discuss the research methodology and design, and Section Four will examine the empirical models and variables.
3.1 Research Hypotheses
3.1.1 The Production Smoothing Model
The production smoothing model is one of the most widely studied models of inventory in economic literature (Blinder 1986). A necessary motive for a company to smooth production is that demand varies through time. If there is a random element to demand, a company may decide to smooth production and treat inventories as a buffer stock. Therefore, a firm is said to smooth production if the variance of production is less than the variance of sales.
The information structure of the production smoothing model presumes that both cost shock and demand shock would affect production decisions. According to Guido Lorenzoni (2006), demand shock is a sudden event that causes a shift in consumer expectations, which increases or decreases demand for goods or services temporarily, while cost shock is an event that causes a sudden increase of decrease of production costs. The production smoothing model assumes that managers can observe cost shock and part of demand shock before choosing its level of production, price, and expected sales. After these decisions are made, the rest of the demand shock is observed and actual sales are determined. The inventory levels for next period then follow and modify the prior production decision.
Consequently, we can see that when the production is smoothed, the resulting
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inventory levels represent management’s expectations about future demand and cost structures, which may also include management’s private information. As a result, inventory levels can be positive leading indicators of future sales when interpreting financial statements. In addition, unless competitive forces totally eliminate any impact of sales changes upon earnings, inventory levels should also be positive leading indicators of future earnings.
Under LIFO, the changes in inventory mostly represent the changes in inventory volume, while under IFRS, the changes in inventory represent the changes in both inventory volumes and current costs. It is because under LIFO, the items remaining in inventory are recognized as if they were the oldest, so the inventory costs remain the same throughout the year. Thus, any change in inventory levels reflects the inventory volume change. Under IFRS, because the items in inventory are measured by
inventory’s current cost, the changes in inventory levels may result from the changes in costs or volume.
This study further assumes that when inventory volume is the only factor that affects inventory levels, inventory levels will be stronger indicators of future sales and earnings. Therefore, this study assumes that inventory levels reported under LIFO method should be stronger positive indicators of future sales and earnings than inventory levels reported under IFRS method.
Hypothesis 1:
Under LIFO method, inventory levels are stronger positive indicators of future sales than under IFRS method.
Under LIFO method, inventory levels are stronger positive indicators of future earnings than under IFRS method.
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3.1.2 The Stockout Model
The stockout model is one of the inventory models that are more consistent with existing data (e.g., Kahn [1987]). In the stockout model, if actual sales are less than the available stock, the company may carry the remainder into the next period as inventory. If, on the other hand, actual sales are more than the available stock and the company ―stocks out,‖ it generates losses, and if a buyer is willing to let the company sell the product in next period at this period’s price, the company will occur a backlog in next period. As a result, when making production decision, a company must weigh against the possibility of stockout and the possibility of holding excessive inventory.
According to Kahn, under a stockout situation, a company’s sales consist of backlogged sales from previous periods and current demand from this period, so current demand is only partially reflected in current sales; the remainder of current demand is reflected in the frequency of stockouts. A low inventory level indicates a potentially high frequency of stockouts, which further indicates higher level of
demand and sales. On the other hand, a high inventory level indicated a lower level of sales. Consequently, inventory levels are inversely related to future sales. In addition, inventory levels are also leading negative indicators of future earnings, because the lower sales may lead to lower margins, and higher inventory levels lead to higher inventory holding costs.
The stockout model can rationalize the violations of the production smoothing model because it suggests that production can be more variable than sales. Two situations may lead to production counter-smoothing. First, because backlogs may shift sales away from large unexpected demand, while production still responds to previous period’s excess demand, the variance of production is larger than the variance of sales. Second, when demand shock occurs, it changes the ending
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inventory and the expectations about future demand, which increases or decrease optimal production, so the variance of production is larger than the variance of sales.
Under LIFO, the changes in inventory represent the changes in inventory volume, while under IFRS, the changes in inventory represent the changes in both inventory volumes and current costs. This study further assumes that when inventory volume is the only factor that affects inventory levels, inventory levels will be stronger
indicators of future sales and earnings. Therefore, this study assumes that inventory levels reported under LIFO method should be stronger positive indicators of future sales and earnings than inventory levels reported under IFRS method.
Hypothesis 2
Under LIFO method, inventory levels are stronger negative indicators of future
Under LIFO method, inventory levels are stronger negative indicators of future