Question

Explain how LIFO, FIFO, and Weighted average inventory systems will have different affects on a firm's income statement and balance sheet. If a firm was concerned about reducing their tax burden, which inventory system would best benefit them? Assume costs have been steadily rising over time. Response should be around 150 words.

Answer 1

Impact on the Financial Statements

Without inflation, all three inventory valuation methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.

During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income (due to the age of the inventory being used in cost of goods sold) and Increased net income can increase taxes owed.

Using LIFO during periods of inflation tend to show and ending inventory amount on the balance sheet that is much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

With Weighted average cost, the results fall in between FIFO and LIFO. Keep in mind deflation (falling prices) have an opposite effect on each method.

Without inflation all three inventory valuation methods would produce the same results. However, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.

The FIFO method assumes that the first unit in inventory is the first until sold. FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income and increased net income can increase taxes owed.

The LIFO method assumes the last item entering inventory is the first sold. During periods of inflation LIFO shows ending inventory on the balance sheet much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

The average cost method takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

Advantages and Disadvantages of Weighted-Average

When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

Advantages and disadvantages of LIFO

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management ‘s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

Advantages and Disadvantages of FIFO

The FIFO method has four major advantages:

It is easy to apply.

The assumed flow of costs corresponds with the normal physical flow of goods.

No manipulation of income is possible.

The balance sheet amount for inventory is likely to approximate the current market value.

All the advantages of FIFO occur because when a company sells goods, the first cost it removes from inventory are the oldest unit costs. The cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income .The disadvantages of FIFO include the recognition of paper profits and a heavier tax burden if used for tax purposes in periods of inflation.

FIFO and Income Tax

Using FIFO to value your inventory provides income tax benefits in some cases. If the price of goods rises over the year, your unsold inventory costs will be higher at the year's end and the cost of the goods you sold will be lower, which means you will have a higher income for tax purposes. If the cost of your inventory drops over the year, the cost of goods sold increases, meaning you will have a lower taxable income. When deflation occurs, your company may wish to have more cash on hand to help it get through any rough patches.

TAX BENEFITS OF LIFO

The primary reason and benefit for a business to change to LIFO is the current tax savings it produces. LIFO allows businesses to deduct the most recent costs of purchased inventory against their current sales. LIFO matches current sales with current costs of those sales. If inflation is producing rising product costs, the cost of goods sold is increased under LIFO, which creates a higher cost of goods sold deduction and, thus a lower taxable income. This tax benefit is, in effect, the “interest-free loan” noted above. As with most tax savings opportunities, it is important to realize the tax savings created by adopting LIFO during an inflationary period represent a deferral of income and the corresponding tax on this income. If inflation goes away and product prices decline or if all the inventory is liquidated, the deferred income will be recognized and the related tax paid. Thus, these tax savings generated over a number of years would be repaid, but at no interest charge. For businesses in industries or markets which generally see inflation (even if it is as little as one to two percent), however, the tax savings from LIFO will continue to grow year after year.

                Implications of using the weighted average cost method for inventory are that when prices rise, COGS are less than that acquired under the Last in First Out (LIFO) method, but more than that acquired under First in Last Out (FIFO). When comparing the two alternatives, inventory stock is not as badly understated as under LIFO, but it is not as current under FIFO. Weighted-average costing, on the other hand, takes a middle-of-the-road approach.

Businesses can bias reported income under the average cost method by buying or not buying inventory stock near the end of the financial year. Conversely, the averaging process reduces the effects of whether a company buys or does not buy stock.

The various inventory costing methods involve assumptions about how costs flow through a business. In some cases, assumed cost flows may agree with the actual physical flow of stock. Although physical flows can be declared in support for a specific inventory method, it is recognised that an inventory method’s assumed cost flows don’t necessarily correspond with the actual physical flow of the goods.

What is agreed, is that the inventory valuation approach you use will impact directly on the profit, tax and closing inventory of your company!