Download The inventory method chosen will affect the amount of

The inventory method chosen will affect the amount of current assets
and gross profit income statement, especially when prices are
changing.
LEARNING OBJECTIVE [ edit ]
Explain how a company's choice of inventory method affects their financial statements
KEY POINTS [ edit ]
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 assetsand lower gross profit. LIFO will
result in higher current assetsand higher gross profit.
When prices are rising, FIFO will result in higher current assetsand higher gross profit. LIFO will
result in lower current assets and lower gross profit.
TERMS [ edit ]
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.
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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.
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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 offsetin 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 theincome 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.