Financial Statement Effects of Inventory Costing Methods - Online Tutor, Practice Problems & Exam Prep

Choosing between FIFO, LIFO, and average cost methods significantly impacts financial statements. In a rising price environment, FIFO results in lower COGS, higher gross profit, and higher ending inventory, while LIFO leads to higher COGS and lower gross profit. Conversely, in a falling price environment, FIFO incurs higher COGS and lower ending inventory, while LIFO shows the opposite. Understanding these effects is crucial for accurate financial reporting and decision-making in accounting.

Financial Statement Effects of Inventory Costing Methods:Rising Prices

Alright. So now we've seen how to use FIFO, LIFO, and average cost; let's see the effect of choosing one over the other. What effect does that have on the financial statements? When we choose one over the other, we're going to see, just like we saw when we were doing our practice problems, that there will be differences in how we calculate COGS, right? We got different answers for the cost of goods sold depending on the method, and since it's going to give us differences in COGS, that means it's going to change our gross profit based on the method we choose, right? Think about it; COGS is an essential part of the gross profit equation. So if COGS is going to be a different number, well, we're going to get a different gross profit, and if we get a different gross profit, we're going to get a different net income too, right? Net income, well, gross profit is a part of our net income equation, so if gross profit is different, net income is going to be different. And finally, ending inventory is also going to be different depending on which case, which cost flow assumption we pick: FIFO, LIFO, or average cost. Okay? So those are all going to be affected based on what we pick. So let's see how they get affected. Here we go, we have excerpts; this came from the periodic inventory example that we did previously, but either way, it doesn't matter where the numbers came from, it's just the idea of I just want to show you that it can be different. Notice that the sales amount, the amount we sold is still the same regardless of which method we chose, but the cost of goods sold is different based on the methods. So let's go ahead and calculate gross profit in each of these situations just to get a little practice, and that's just going to be our sales minus our cost of goods sold, 26,720. So in this first one, we get 12,280, right? That's just that minus that, 39,000 - 26,720 and we'll do that for each of them. 39,000 -29,180 and notice we're getting different answers for all of them. Right? Our gross profit is different in each case. Minus 27,968 and we get 11,032. Right? So, one more thing I want to note is that the FIFO and the LIFO are always going to be extremes. They're always going to be on one end of the spectrum and the average cost is going to be in the middle, that makes sense, right? Because it's the average. So the FIFO and LIFO are extremes here and that's what I want to focus on. What happens? What's the difference with FIFO and LIFO? And remember, the whole reason we have to use these costing methods is that we don't always get the products at the same price, right? We might pay more for one shipment than we did for another shipment and that's going to cause discrepancies here, okay? So the way we think about how FIFO and LIFO are going to be affected is whether prices are generally rising or declining over the period, right? So, did prices go up throughout the period or did prices fall throughout the period? Okay, so let's think about how this is going to affect all of these accounts based on these environments. Let's start with the rising price environment and I want to go down here to this little, simplified little schedule I have down here. So let's start in the left-most red boxes where we're in a rising environment and we're in a FIFO situation, right? We're going to use FIFO so that means we're selling the oldest units, okay? And notice I've got a rising price environment with my metaphor here of these growing dollar signs, right? So you would imagine that that last shipment cost us a lot more because of the rising price, okay? So let's say for this example so that we can be consistent, let's say that we sell 3 of the shipments and we have one of the shipments left in ending inventory. From a FIFO perspective, if we're going to sell 3 shipments, we're going to sell the 3 cheaper shipments, right? Because FIFO sells the oldest ones first and those will be all going to our cost of goods sold, right? And then this down here, this would be left in ending inventory. Right? So what does that mean? In this case, we see that the largest value is still in ending inventory where the small values went to cost of goods sold. Compare that to a LIFO method. If we're doing LIFO, well, we're going to sell the latest units first, right? So you could probably see what's going to happen here, if we sell 3 shipments, now we're going to have the expensive shipments in cost of goods sold and we're going to have the cheap shipment that's left over. That's the one that goes to ending inventory. Alright, so let's make that comparison now. Notice that our cost of goods sold is going to be a lot bigger in a LIFO method than in a FIFO method when we're dealing with rising prices, right? In this situation, the prices were rising, so those expensive shipments made their way into cost of goods sold in LIFO, alright? So let's go ahead and see, let's fill in this little chart based on what we just learned. So in FIFO, if we're in a rising price environment, the cost of goods sold in FIFO is going to be less. Right? We're going to have a lower value in cost of goods sold and this is going to be higher, right? These are going to be higher just like we saw down here, right? We circled the big ones, so the big ones went to cost of goods sold in LIFO, okay? So how is that going to affect our gross profit? So remember gross profit COGS is a negative number, right? We have a negative number for COGS to get us to our gross profit. So if COGS is smaller, that means that the expense part of gross profit is smaller, right? That makes gross profit higher. Does that make sense? Because the expense, the cost of goods sold is less so we're going to have a higher gross profit. Okay? And that's going to extend to a higher net income as well because we have that lower expense, but what happens to ending inventory? So I guess we can make the same assumption here. This is what's happening here. This is going to be lower for our gross profit, right? Because in a LIFO situation, the more expensive shipments made it into cost of goods sold. How about ending inventory? Let's look at what's left over. In our ending inventory in FIFO, we have the expensive stuff, right? So the ending inventory is going to be higher in FIFO and it's going to be lower in LIFO. So notice this all has to do with a situation where we have rising prices, right? So the prices are going up through the period, so you have to think of well, at the end of the period the prices were higher, right? So those in a LIFO method, those higher prices go to cost of goods sold. Alright? So let's go ahead, let's take a quick break and we'll do the same thing with the falling price environment, okay? So we'll see how this affects in falling prices. Cool? Let's pause now.

Financial Statement Effects of Inventory Costing Methods:Falling Prices

Alright. Let's continue with the falling price environment. So if we're talking about FIFO in a falling price environment, well, let's say again that we sell 3 shipments. Right? If we're going to sell 3 shipments in FIFO, well, we're going to sell the first shipments. So we're going to sell these 3 shipments in FIFO, and those would go to cost of goods sold, and then this last shipment would end up in our ending inventory. Right? Same thing with LIFO. Let's think about LIFO now. If LIFO was going to sell 3 shipments, well, they sell the last shipments, right? So, they're going to sell these 3 shipments. So, the smaller values are going to cost of goods sold, and the big value is left in ending inventory. Okay? So let's go ahead and summarize this information into our falling price environment box up here.

Okay, so let's first think about COGS. Cost of goods sold, which one's going to be higher? Is FIFO or LIFO going to have a higher cost of goods sold in this falling price environment? It makes sense that FIFO does too, right? Because prices are falling, but we're selling the old expensive units. So FIFO is going to have higher cost of goods sold in this situation and LIFO lower. So based on that same logic that we talked about gross profit, if COGS is an expense and it's a higher expense, well that's going to bring our profit down, right? When the expense goes up, we have a lower profit. So this will have a lower profit and this by the same logic has a higher profit, and gross profit and net income go hand in hand. If we're going to have a lower gross profit, well, that's going to end up as a lower net income and vice versa here for LIFO.

Last but not least is our ending inventory. So think about the ending inventory. Well in FIFO, we see that they're left with just the small balance whereas LIFO has the big balance left, right? So this one's going to be lower and this one will be higher. Alright. Notice, it's pretty much just the opposite of what we had up here, right? In the rising price environment. Cool?

One last little note here behind me is that companies reporting in LIFO, so if you're going to use LIFO, it's a requirement that you also show what would have happened under FIFO, okay? So you use what's called a LIFO reserve to help you transfer from LIFO to FIFO. Again, this is going to be beyond the scope of this class, you're probably not going to have to do anything with the LIFO reserve, but it's just a good thing to note that there's a requirement to show what your inventory would have been like in FIFO, okay? And that just helps comparability across companies. Alright. Cool. So let's go ahead and pause here, and we'll move on to the next video.

Here’s what students ask on this topic:

What are the financial statement effects of using FIFO versus LIFO in a rising price environment?

In a rising price environment, FIFO (First-In, First-Out) results in lower Cost of Goods Sold (COGS) because the older, cheaper inventory is sold first. This leads to a higher gross profit and higher net income. Additionally, the ending inventory will be higher as it consists of the more expensive, newer inventory. Conversely, LIFO (Last-In, First-Out) results in higher COGS because the newer, more expensive inventory is sold first. This leads to a lower gross profit and lower net income. The ending inventory will be lower as it consists of the older, cheaper inventory.

How does the choice between FIFO and LIFO affect net income in a falling price environment?

In a falling price environment, FIFO (First-In, First-Out) results in higher Cost of Goods Sold (COGS) because the older, more expensive inventory is sold first. This leads to a lower gross profit and lower net income. Conversely, LIFO (Last-In, First-Out) results in lower COGS because the newer, cheaper inventory is sold first. This leads to a higher gross profit and higher net income. Therefore, the choice between FIFO and LIFO significantly impacts net income based on the price trend of inventory.

Why is it important to understand the effects of inventory costing methods on financial statements?

Understanding the effects of inventory costing methods like FIFO, LIFO, and average cost on financial statements is crucial for accurate financial reporting and decision-making. These methods impact key financial metrics such as Cost of Goods Sold (COGS), gross profit, net income, and ending inventory. For instance, in a rising price environment, FIFO results in lower COGS and higher net income, while LIFO results in higher COGS and lower net income. These differences can affect a company's tax liabilities, profitability analysis, and inventory valuation, making it essential for accountants and financial analysts to choose the appropriate method.

What is the LIFO reserve and why is it required?

The LIFO reserve is an accounting measure that companies using the LIFO (Last-In, First-Out) inventory method must report. It represents the difference between the inventory reported under LIFO and what it would have been under FIFO (First-In, First-Out). The LIFO reserve is required to enhance comparability across companies that use different inventory costing methods. By disclosing the LIFO reserve, companies provide a clearer picture of their inventory valuation and financial position, allowing stakeholders to make more informed comparisons and decisions.

How does the average cost method impact financial statements compared to FIFO and LIFO?

The average cost method smooths out price fluctuations by averaging the cost of all inventory items available for sale during the period. This results in a Cost of Goods Sold (COGS) and ending inventory value that falls between those calculated using FIFO (First-In, First-Out) and LIFO (Last-In, First-Out). In a rising price environment, the average cost method will show COGS higher than FIFO but lower than LIFO, and ending inventory lower than FIFO but higher than LIFO. This method provides a middle-ground approach, reducing the extremes seen with FIFO and LIFO, and can be useful for companies with stable inventory costs.