Overstating (O) or understating (U) inventory has an effect not only on the balance sheet but also on reported income and cash flow. O and U occur when the purchase price and value of inventory change over time. Let's take, for example, a company that trades scrap steel.

The best way to illustrate O and U is to do it through an example.

Basic concept:

Formula 8.1

COGS = beginning inventory + purchases - ending inventory

If the price of a company's inputs (such as steel, lumber, etc.) is rising:

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.

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 would be higher.
  • Assets would be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.

Average-cost method

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

Specific identification method

  • If this method is used, it is extremely hard to tell, since each product has been accounted for individually. Questions of the effect of prices are common in CFA exams as well as most basic accounting exams but often overlooked. This example of rising prices (inflationary environment) can be viewed in various ways: Under FIFO, while the company will pay more in taxes, investors may overlook this due to the increase in income and working capital. Under LIFO, the lower income scenario may be only temporary and reverse in the next reporting period when they sell the inventory that was acquired before the rising price scenario.

    COGS = beginning inventory + purchases - ending inventory

    In the past, exam questions typically focus on differences between LIFO and FIFO, but don't rely on the past.

Inventory Valuation

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