Question

how can the choice of inventory methods impact the financial statements? Please explain.

Answer 1

There are five types of inventory methods -- FIFO, LIFO, Dollar Value LIFO, Retail Inventory, and Average Cost.

Thechoice of inventory method should reflect a company's economic circumstances in order to create accurate financial statements.

When prices are falling, FIFO will result in lower current assets and lower gross profit. LIFO will result in higher current assets and higher gross profit.

Whenprices are rising, FIFO will result in higher current assets and higher gross profit. LIFO will result in lower current assets and lower gross profit.

Types of Inventory Methods

Inventories are valued in the "Current Assets" section of the balance sheet using one of the following five methods. It's important to note that these methods will be affected by the system used to update inventory – "perpetual" or "periodic". A perpetual system updates inventory every time a change in inventory occurs, and a periodic system updates inventory at the end of the accounting period.

First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or acquired. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold. The ending inventory balance reflects recent inventory costs.

Last-In First-Out (LIFO) is the reverse of FIFO; the latest cost (i.e., the last in) is assigned to cost of goods sold and matched against revenue. Some systems permit determining the costs of goods at the time acquired or made but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. The LIFO reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes in the United States.

Dollar Value LIFO is a variation of LIFO. Any increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.

The Retail Inventory method is typically used by resellers of goods to simplify record keeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

The Average Cost method relies on average unit cost to calculate cost of goods sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.

Impact on Financial Statements

The choice of inventory method should reflect a company's economic circumstances in order to create accurate financial statements. In addition to the inventory method chosen, use of a perpetual or periodic inventory system will affect the amount of current assets in the balance sheet and gross profit in the income statement, especially when prices are changing.

Period of Rising Prices

Under FIFO: Ending Inventory is higher, and Total Current Assets are higher; cost of goods sold is lower, and gross profit is higher.

Under LIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.

Period of Falling Prices

Under FIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.

Under LIFO: Ending Inventory is higher, and total current assets are higher; cost of goods sold is lower, and gross profit is higher.

Conclusion:

All methods of inventory costing are acceptable; no single method is the only correct method. Different methods are attractive under different conditions.

If a company wants to match sales revenue with current cost of goods sold, it would use LIFO. If a company seeks to reduce its income taxes in a period of rising prices, it would also use LIFO. On the other hand, LIFO often charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net income by changing the timing of additional purchases.

The FIFO and specific identification methods result in a more precise matching of historical cost with revenue. However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. The weighted-average method also allows manipulation of income. Only under FIFO is the manipulation of net income not possible.

Generally, companies use the inventory method that best fits their individual circumstances. However, this freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report higher income. Continuous switching of methods violates the accounting principle of consistency, which requires using the same accounting methods from period to period in preparing financial statements. Consistency of methods in preparing financial statements enables financial statement users to compare statements of a company from period to period and determine trends. If we switch inventory methods, we must restate all years presented on financial statements using the same inventory method.