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May 16, 2022 May 16, 2022/ The inventory cost flow assumption states that the cost of an inventory item changes from when it is acquired or built and when it is sold. Because of this cost differential, management needs a formal system for assigning costs to inventory as they transition to sellable goods. Example of the Inventory Cost Flow AssumptionFor example, ABC International buys a widget on January 1 for $50. On July 1, it buys an identical widget for $70, and on November 1 it buys yet another identical widget for $90. The products are completely interchangeable. On December 1, the company sells one of the widgets. It bought the widgets at three different prices, so what cost should it report for its cost of goods sold? There are several possible ways to interpret the cost flow assumption. For example:
The cost flow assumption does not necessarily match the actual flow of goods (if that were the case, most companies would use the FIFO method). Instead, it is allowable to use a cost flow assumption that varies from actual usage. For this reason, companies tend to select a cost flow assumption that either minimizes profits (in order to minimize income taxes) or maximize profits (in order to increase share value). In periods of rising materials prices, the LIFO method results in a higher cost of goods sold, lower profits, and therefore lower income taxes. In periods of declining materials prices, the FIFO method yields the same results. The cost flow assumption is a minor item when inventory costs are relatively stable over the long term, since there will be no particular difference in the cost of goods sold, no matter which cost flow assumption is used. Conversely, dramatic changes in inventory costs over time will yield a considerable difference in reported profit levels, depending on the cost flow assumption used. Thus, the accountant should be especially aware of the financial impact of the inventory cost flow assumption in periods of fluctuating costs. All of the preceding issues are of less importance if the weighted average method is used. This approach tends to yield average profit levels and average levels of taxable income over time. Note that the LIFO method is not allowed under IFRS. If this stance is adopted by other accounting frameworks in the future, it is possible that the LIFO method may not be available as a cost flow assumption. May 16, 2022/
Assets produced or acquired last are the first to be expensed Last-in First-out (LIFO) is an inventory valuation method based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the last-in, first-out method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the balance sheet while the newest inventory costs are expensed first. Download the Free TemplateEnter your name and email in the form below and download the free template now!
Example of Last-In, First-Out (LIFO)Company A reported beginning inventories of 200 units at $2/unit. Also, the company made purchases of:
If the company sold 350 units, the order of cost expenses would be as follows:
The total cost of goods sold for the sale of 350 units would be $1,700. The remaining unsold 450 would remain on the balance sheet as inventory for $1,275.
LIFO vs. FIFOTo reiterate, LIFO expenses the newest inventories first. In the following example, we will compare it to FIFO (first in first out). FIFO expenses the oldest costs first. Consider the same example above. Recall that under LIFO, the cost flows for the sale of 350 units are as follows:
Under FIFO, the sale of 350 units:
The company would report the cost of goods sold of $875 and inventory of $2,100. Under LIFO:
Under FIFO:
Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used. Using Last-In First-Out, there are more costs expensed. As discussed below, it creates several implications on a company’s financial statements. Impact of LIFO Inventory Valuation Method on Financial StatementsRecall the comparison example of Last-In First-Out and another inventory valuation method, FIFO. The two methods yield different inventory and COGS. Now it is important to consider – what impact does the use of LIFO make on a company’s financial statements? 1. Low quality of balance sheet valuationBy using LIFO, the balance sheet shows lower quality information about inventory. It expenses the newest purchases first, leaving older, outdated costs on the balance sheet as inventory. For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the newer snowmobile – $75,000. Therefore, it will provide lower-quality information on the balance sheet compared to other inventory valuation methods as the cost of the older snowmobile is an outdated cost compared to current snowmobile costs. 2. High quality of income statement matchingSince LIFO expenses the newest costs, there is better matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost. For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5. The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators. If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement. LIFO in Accounting StandardsUnder IFRS and ASPE, the use of the last-in, first-out method is prohibited. However, under GAAP, the use of Last-In First-Out is permitted. The inventory valuation method is prohibited under IFRS and ASPE due to potential distortions on a company’s profitability and financial statements. The revision of IAS Inventories in 2003 prohibited LIFO from being used to prepare and present financial statements. One of the reasons is that it can reduce the tax burden in the case of inflating prices. Recall the example we did above and assume that the sales price of a unit of inventory is $15: Under LIFO:
Gross profits under LIFO = $5,520 – $1,700 = $3,820 Under FIFO:
Gross profits under FIFO = $5,520 – $875 = $4,645 Under LIFO, the company reported a lower gross profit even though the sales price was the same. Now, it may seem counterintuitive for a company to underreport profits. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax. Therefore, it can be used as a tool to save on tax expenses. However, the main reason for discontinuing the use of LIFO under IFRS and ASPE is the use of outdated information on the balance sheet. Recall that with the LIFO method, there is a low quality of balance sheet valuation. Therefore, the balance sheet may contain outdated costs that are not relevant to users of financial statements. Key Takeaways from Last-in First-Out (LIFO)
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