In: Accounting
International Financial Reporting Standards (IFRS) do not permit companies to use the LIFO method for inventory accounting. In its form 20-F, CNH discloses that it uses the first-in-first-out (FIFO) method to accounting for its inventory. Assume that prices that Caterpillar and CNH pay for inventory typically increase over time. In general terms, how does each company’s inventory accounting method affect its balance sheet and income statement? How would the choice between LIFO and FIFO affect the statement of cash flows, if at all? What if prices typically decrease over time?
In general there are two inventory accounting methods. They are FIFO ( First in First Out) and LIFO ( Last in First Out).
Effect of LIFO on balance sheet and income statement:
When prices increase the recent purchases are of higher cost compared to earlier ones.
By using LIFO method the initially purchased prices will remain in closing inventory leading to lower value of inventory which consequently reduce the net income as closing inventory is credited to income statement. The value of inventory in balance sheet will be low when compared to actual cost.
The above analysis is exactly opposite when company chooses FIFO Method.
Effect on cash flow:
By using FIFO inventory will be valued at higher value when prices increase. So there is an increase in value of inventory compared to previous year. In cash flow from operating activities the increase in inventory value will be deducted thereby decreasing cash flow from operating activities.
It is exactly opposite when prices decrease.
Effect of LIFO method will be opposite to FIFO method.