Accounting: The Language of Business - Vol. 2 (Intermediate: Part 165)

• Proverbs 21:5

  "The plans of the diligent lead to profit as surely as haste leads to poverty". This verse advises that planning for the future is important for avoiding financial stress.

Short-Term Operating Assets: Inventory (Part K) 

by

Charles Lamson 

Comparison of the Moving-Average, First-In, First-Out (FIFO), and Last-In, First-Out (LIFO) Methods

Companies typically use either the moving-average cost, FIFO, or LIFO methods for costing inventory. Although the specific identification method is allowed, virtually no firms use it. Exhibit 10.5 presents the percentage of U.S. companies that use the different cost flow assumptions for at least part of their inventory. As shown, FIFO is the most popular method. 

Source: Accounting Trends and Technologies---2011 (AICPA, New York, NY)

Examples 10.7 (from Part 162), 10.8 (from Part 163), and 10.9 (from Part 164) demonstrate that the three primary cost flow assumptions produce different results for the cost of goods sold reported on the income statement and the valuation of inventory on the balance sheet. The different results can have a significant impact on reported income and several key financial ratios. 

The cost-flow assumptions affect only the allocation of the ending inventory and cost of goods sold: The choice of inventory valuation method does not affect cash flows directly. However, the IRS LIFO conformity rule mandates that a company using LIFO for tax purposes must also use it for financial reporting. The effect of inventory valuation methods on cost of goods sold, and thus net income, and the required book-tax conformity for LIFO lead to possible tax and cash-flow consequences. LIFO generally results in a lower income figure in a period of rising inventory cost. Thus, it is advantageous to use LIFO for tax purposes because its use will increase cash flow by decreasing cash paid for income taxes. Investors and other financial statement users understand that even though using LIFO results in lower net income, using LIFO increases the amount of cash that the company repays and can use in operations. Therefore, investors and other financial statement users do not penalize a company for using LIFO and reporting lower net income. 

Exhibit 10.6 summarizes the moving-average, FIFO, and LIFO inventory valuation methods illustrated in Examples 10.7, 10.8, and 10.9, providing important insight: 

1. In terms of measuring cost of goods sold and ending inventory, the moving- average method falls between the two extreme approaches, LIFO and FIFO. 

2. FIFO will result in the lowest measurement of cost of goods sold (and the highest reported net income) and the highest valuation of inventory on the balance sheet as long as the unit cost of inventory is increasing. 

3. LIFO will result in the highest cost of goods sold (and thus the lowest reported net income) and the lowest valuation of inventory on the balance sheet as long as the unit cost of inventory is increasing. 

The relationships and ranking between the LIFO and FIFO methods noted in Exhibit 10.6 hold only if costs are rising for inventory acquisition and if units in inventory are constant or increasing. If costs are declining, then the comparison is exactly the opposite with LIFO resulting in higher net income and a higher inventory valuation. 

Inventory Allocation Methods: International Financial Reporting Standards (IFRS). IFRS does not allow the LIFO approach. International Accounting Standards settings view LIFO as imposing an unrealistic cost-flow assumption that lacks representational faithfulness of inventory flows (IASC, International Accounting Standard 2, “Inventories,” BC 11, 19).

The fact that IFRS does not permit the LIFO cost-flow assumption would be a major obstacle for U.S. companies if the United States allowed IFRS. There could be significant cash flow effects for companies currently saving taxes as a result of using LIFO. A company ceasing the use of LIFO is obligated to pay the IRS all the tax savings it received from using LIFO over a four-year period. Consider Chevron Corporation, a petroleum company that uses the LIFO cost-flow assumption. By the end of 2016, it had saved more than $1 billion in taxes by using LIFO. 

*GORDON, RAEDY,SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 524-526*

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