Financial Statement Effects of Inventory Method

The choice of inventory method can have significant effects on financial statements. The FIFO, LIFO, and average-cost methods of inventory costing are widely used. Each method has its advantages and disadvantages—none is perfect. Among the factors managers should consider in choosing an inventory costing method are the trend of prices and the effects of each method on financial statements, income taxes, and cash flows.

LIFO results in the highest cost of goods sold because (1) it assumes that the more recent costs are the first ones sold, and (2) these most recently acquired costs are the most expensive ones. FIFO results in the lowest cost of goods sold, and the averagecost method yields results between LIFO and FIFO. Because LIFO reports the highest cost of goods sold figure, it results in the lowest reported net income number. LIFO results in the lowest ending inventory value because it assumes that the earliest costs remain on hand at year-end, and these costs are the least expensive. FIFO yields the highest inventory value, and average cost falls between the two.

In other words, inventory costing methods have different effects on the income statement and balance sheet. The LIFO method is best suited for the income statement because it matches revenues and cost of goods sold. But it is not the best method for valuation of inventory on the balance sheet, particularly during a prolonged period of price increases or decreases. FIFO, on the other hand, is well suited to the balance sheet because the ending inventory is closest to current values and thus gives a more realistic view of a company’s current assets. Readers of financial statements must be alert to the inventory methods a company uses and be able to assess their effects.

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