Impacts of Costing Methods on Financial Statements

The method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements.

Learning Objective

Differentiate between the FIFO, LIFO and Average Cost inventory valuation methods

Key Points

Without inflation all three inventory valuation methods would produce the same results. However, prices do tend to rise over the years, and the company's method costing method affects the valuation ratios.
The FIFO method assumes that the first unit in inventory is the first until sold. FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income and increased net income can increase taxes owed.
The LIFO method assumes the last item entering inventory is the first sold. During periods of inflation LIFO shows ending inventory on the balance sheet much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.
The average cost method takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

Terms

ending inventory
Ending inventory is the amount of inventory a company have in stock at the end of this fiscal year.
net income
Gross profit minus operating expenses and taxes.

Full Text

Inventory Valuation

The method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements. The three main methods for inventory costing are First-in, First-Out (FIFO), Last-in, Last-Out (LIFO) and Average cost.

Inventory valuation method.

The inventory valuation method a company chooses directly effects its financial statements.

First-in, First-Out

The FIFO method assumes that the first unit in inventory is the first until sold. For example, during the week a factory produces items. On Monday the items cost is $5 per unit to make, on Tuesday it is a $5.50 per unit. When the item is sold on Wednesday FIFO records the cost of goods sold for those items as $5. So, the balance sheet has the cost of goods sold at $1 and the balance sheet retains the remaining inventory at $5.50.

Last-in, First-out

The LIFO method assumes the opposite, that the last item entering inventory is the first sold. That means the factory would record the Wednesday cost of goods sold as $5.50 and the remaining inventory at $5.

Average Cost

This method is the most easy to calculate; it takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Assuming the factory made a total of 100 units the price per unit would be $\frac{$5.00 \cdot 50 + $5.50 \cdot 50}{100}=$5.25$.

Impact on the Financial Statements

Without inflation, all three inventory valuation methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company's method costing method affects the valuation ratios.

During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income (due to the age of the inventory being used in cost of goods sold) and Increased net income can increase taxes owed.

Using LIFO during periods of inflation tend to show and ending inventory amount on the balance sheet that is much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

With average cost, the results fall in between FIFO and LIFO. Keep in mind deflation (falling prices) have an opposite effect on each method.

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