Assessing Inventory Management
Read this section, which focuses on efficiency metrics and the impact of inventory method on financial statement analysis.
Impact of Inventory Method on Financial Statement Analysis
LEARNING OBJECTIVES
Explain how a company's choice of inventory method affects their financial statements
KEY TAKEAWAYS
Key Points
- There are five types of inventory methods - FIFO, LIFO, Dollar Value LIFO, Retail Inventory, and Average Cost.
- The choice of inventory method should reflect a company's economic circumstances in order to create accurate financial statements.
- When prices are falling, FIFO will result in lower current assets and lower gross profit. LIFO will result in higher current assets and higher gross profit.
- When prices are rising, FIFO will result in higher current assets and higher gross profit. LIFO will result in lower current assets and lower gross profit.
Key Terms
- balance sheet: A balance sheet is often described as a "snapshot of a company's financial condition. " A standard company balance sheet has three parts: assets, liabilities, and ownership equity.
- income statement: Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.
Types of Inventory Methods
Inventories are valued in the "Current Assets" section of the balance sheet using one of the following five methods. It's important to note that these methods will be affected by the system used to update inventory – " perpetual " or "periodic". A perpetual system updates inventory every time a change in inventory occurs, and a periodic system updates inventory at the end of the accounting period.
Businesses need to manage their inventories.: Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.
First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or acquired. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold. The ending inventory balance reflects recent inventory costs.
Last-In First-Out (LIFO) is the reverse of FIFO; the latest cost (i.e., the last in) is assigned to cost of goods sold and matched against revenue. Some systems permit determining the costs of goods at the time acquired or made but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. The LIFO reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes in the United States.
Dollar Value LIFO is a variation of LIFO. Any increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.
The Retail Inventory method is typically used by resellers of goods to simplify record keeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.
The Average Cost method relies on average unit cost to calculate cost of goods sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.
Impact on Financial Statements
The choice of inventory method should reflect a company's economic circumstances in order to create accurate financial statements. In addition to the inventory method chosen, use of a perpetual or periodic inventory system will affect the amount of current assets in the balance sheet and gross profit in the income statement, especially when prices are changing.
Period of Rising Prices
Under FIFO: Ending Inventory is higher, and Total Current Assets are higher; cost of goods sold is lower, and gross profit is higher.
Under LIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.
Period of Falling Prices
Under FIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.
Under LIFO: Ending Inventory is higher, and total current assets are higher; cost of goods sold is lower, and gross profit is higher.