Assets - Inventory Analysis

Computing Inventory Balances
In computing ending inventory balances under the various methods we will use the following example.

Example:
Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1. Average-cost method - Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry large amount of units.

Total cost: $130
Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

2. First in first out - Under this inventory method, the units that were first purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 101 and 102)
Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65 = $235

3. Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)
Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

Usefulness of Inventory Data When Prices Are Stable or Changing
If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO, LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort the reported income, cash flow and inventory.

I. Rising Price (Inflationary) Environment

FIFO method

  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).

LIFO method

  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax and cash flow will be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).

Average-cost method

  • Since it's an average, it would be in between LIFO and FIFO.

II. Decreasing Price (Deflation) Environment

FIFO method

  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax, and cash flow would be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).

LIFO method

  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).
Look Out!

Make sure you understand this concept very well. It can make or break an entire sample set if you reverse the effects conceptually

Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation".

Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their general-purpose statements.

Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods
When comparing two companies, one must ensure that they are comparing apples with apples. If the first company uses the FIFO method and the other the LIFO method, then there is a problem. To make the comparison relevant, one must convert LIFO to FIFO or FIFO to LIFO.

Converting LIFO to FIFO


Related Articles
  1. Professionals

    Converting LIFO to FIFO

    CFA Level 1 - Converting LIFO to FIFO. This topic covers various methods of converting LIFO to FIFO. Includes sample calculations for simple and complex conversions.
  2. Fundamental Analysis

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  3. Professionals

    Converting FIFO to LIFO

    CFA Level 1 - Converting FIFO to LIFO. Learn how to both FIFO and the average-cost method to LIFO. Provides formulas showing how both conversions affects COGS.
  4. Professionals

    Causes of Decline in LIFO Reserve

    CFA Level 1 - Causes of Decline in LIFO Reserve. Learn why a company's LIFO reserves might decline. Describes "LIFO liquidation" and its effects on profitability and COGS.
  5. Professionals

    Effects of Misstated Inventory

    CFA Level 1 - Effects of Misstated Inventory. Learn the effects of overstating or understating inventory for each of the four inventory costing methods.
  6. Professionals

    Basics of Inventories

    CFA Level 1 - Basics of Inventories. Introduces the basics of inventory processing systems. Highlights and expains the four methods of calculating inventory costs.
  7. Fundamental Analysis

    Why Last In First Out Is Banned Under IFRS (XOM)

    We explain why Last-In-First-Out is banned under IFRS
  8. Professionals

    LIFO and FIFO Valuation of Inventory

    LIFO and FIFO Valuation of Inventory
  9. Fundamental Analysis

    When & Why Should a Company Use LIFO

    By using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
  10. Professionals

    Effects of Inventory Accounting

    CFA Level 1 - Effects of Inventory Accounting. Learn how a company's accounting choice affects their income, cash flow, balance sheet and various financial ratios.
RELATED TERMS
  1. LIFO Reserve

    The difference between the FIFO and LIFO cost of inventory for ...
  2. LIFO Liquidation

    When a company using the LIFO (Last In, First Out) method of ...
  3. Dollar-Value LIFO

    An accounting method used for inventory that follows the last ...
  4. Highest In, First Out - HIFO

    In accounting, an inventory distribution method in which the ...
  5. Flow Of Costs

    Refers to the manner in which costs move through a firm. Typically, ...
  6. Average Inventory

    A calculation comparing the value or number of a particular good ...
RELATED FAQS
  1. What are the business consequences of using FIFO vs. LIFO accounting methods?

    Learn about the real business consequences from using a first-in, first out inventory accounting method versus a last-in, ... Read Answer >>
  2. Does US GAAP prefer FIFO or LIFO accounting?

    Investigate the use of LIFO and FIFO inventory accounting methods under U.S. GAAP, and learn why there is pressure from some ... Read Answer >>
  3. How can the first-in, first-out (FIFO) method be used to minimize taxes?

    Understand what the FIFO inventory method is and how it can be used to minimize taxes. Learn why it would also decrease overall ... Read Answer >>
  4. What are the disadvantages of the FIFO accounting method?

    Learn how the FIFO accounting method differs from the LIFO method and the primary disadvantages for a company using the FIFO ... Read Answer >>
  5. How do you analyze inventory on the balance sheet?

    Learn how to analyze inventory using financial statements and footnotes by doing ratio analysis and performing qualitative ... Read Answer >>
  6. If during a period of rising prices, a LIFO liquidation occurs ...

    The correct answer is: b) Remember that LIFO transmits the latest prices of inventory over to cost. Therefore, what's left ... Read Answer >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center