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.
    Look Out!

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

Related Articles
  1. Investing

    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.
  2. Investing

    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.
  3. Small Business

    Understanding First In, First Out (FIFO)

    A company that uses the first in, first out inventory valuation method will sell, use, or dispose of assets that it produced or acquired first.
  4. Insights

    What You Should Know About Inflation

    Find out how this figure relates to your investment portfolio.
  5. Taxes

    Using Tax Lots: A Way To Minimize Taxes

    The method of identifying cost basis can help you to get the most out of reduced tax rates.
  6. Investing

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  7. Investing

    What is Involved in Inventory Management?

    Inventory management refers to the theories, functions and management skills involved in controlling an inventory.
  8. Investing

    Measuring Company Efficiency

    Three useful indicators for measuring a retail company's efficiency are its inventory turnaround times, its receivables and its collection period.
  9. Managing Wealth

    Cost Basis Basics

    The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ...
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center