The Choice of Inventory Method

FIFO, LIFO, specific identification, and average cost are all acceptable inventory methods. Firms are free to choose one of these methods and consistently apply it across periods. Interestingly, GAAP does not require that the assumed flow of costs corresponds to the actual flow of goods.Supermarkets, for example, put their older products on the front of shelves so that they will be sold before items acquired more recently; this helps preserve the general freshness of the merchandise available to customers. In this case, goods actually flow on a FIFO basis. However, supermarkets are not required to use FIFO in the preparation of their financial statements.

This raises a question about the factors that are considered by managers in selecting an inventory method. Because LIFO and FIFO yield the most dissimilar results, the following discussion focuses on them.

Taxes – The example we used to illustrate the various inventory methods was characterized by a period of rising prices. Many industries have experienced decades of inflation in inventory costs. In such periods, LIFO assigns the higher, recently acquired inventory costs to cost of goods sold. Of course, a higher cost of goods sold results in lower reported income. Thus, the selection of LIFO in inflationary periods reduces both reported pre-tax income and income taxes. Because a smaller check will be written to the IRS, the use of LIFO actually increases a firm’s cash flow, even though reported net income is lower than under FIFO.

In general, firms are not required to select the same accounting principle for financial reporting and for taxes. Because financial statements and tax returns serve different purposes, this makes sense. LIFO, however, is an exception to this general rule. If LIFO is used for tax purposes, it must be used for financial reporting. Many firms prepare their tax return using LIFO to obtain the associated tax savings and are thus required to use it for their financial statements.

Implementation Costs – Although we need not be concerned about the details, simply note that LIFO is more costly to implement than FIFO or average cost, especially for small firms. This may help explain why large firms tend to adopt LIFO more often than small firms. Managers must balance the tax savings from LIFO with the costs of implementation.

Quality of Financial Statement Information – LIFO and FIFO result in different financial statement numbers for inventory, cost of goods sold, and net income.Which method results in the most useful information? The answer is not clear-cut.

FIFO’s ending inventory calculation is based on a firm’s most recent acquisition costs. Thus, the inventory amount on the balance sheet is likely to be very close to current value. In contrast, LIFO’s ending inventory is based on the costs of beginning inventory and the earliest acquisitions. Keep in mind that this occurs each year and that the beginning inventory may contain components carried forward from many years ago. Thus, in a period of rising prices, LIFO ending inventory values may be dramatically understated.

On the other hand, LIFO provides more informative income statement numbers because it matches current inventory costs with revenues. Cost of goods sold under LIFO consists of the costs of the most recent acquisitions. These costs approximate amounts necessary to replace inventory as it is depleted. Because of this, LIFO is more consistent with the matching principle. Furthermore, gross profit under LIFO is a useful measure of the resources generated from inventory sales that are available to cover other expenses and provide for net income. Managers can then view the gross profit measure as an indicator of “spendable” resources.

LIFO and Loan Agreements – As mentioned in previous chapters, many firms have loan agreements that require them to maintain certain levels of financial ratios. The current ratio is one example. Given that during a period of rising prices, LIFO results in a lower inventory figure, current assets will also be lower. This results in a lower current ratio and a greater likelihood of loan agreement violations. A number of other ratios will be similarly affected. When adopting LIFO, managers must be confident that the use of LIFO will not result in levels of financial ratios that violate existing loan agreements.

LIFO and Management Compensation – Because LIFO reduces reported net income in a period of rising prices, LIFO may also reduce the compensation of managers who have bonuses based on reported income. This could limit management’s motivation to adopt LIFO.

LIFO and Stock Prices – LIFO results in lower reported net income during a period of rising prices. Some managers may fear that the stock market will react negatively to a lower income stream. A more sophisticated view, however, recognizes that LIFO results in lower taxes, thereby increasing a firm’s cash flow. The increased cash flow benefits the firm and its shareholders, and should result in higher stock prices. Research evidence is ambiguous regarding the stock market reaction to LIFO adoptions.

Actual Usage of Inventory Methods – Accounting Trends and Techniques conducts an annual survey of 600 major U.S. corporations to ascertain their financial reporting practices.

FIFO is the most frequently used method, followed by LIFO, with the average-cost method a distant third. The total number of firms exceeds the 600 that were surveyed because many firms use multiple inventory methods. Keep in mind that the results are for major corporations; as mentioned, because LIFO is relatively expensive to implement, smaller businesses utilize LIFO less frequently. Also, LIFO is not widely used outside the United States.

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