Compare and contrast the effect on net income, cost of goods sold, and inventory of the FIFO, LIFO, and weighted-average cost flow assumptions

Answer 1

COMPARISON OF AND CHOICE AMONG COST-FLOW ASSUMPTIONS

When purchase prices change, no cost-flow assumption places up-to-date costs on both the income statement and the balance sheet. For example, consider a period of rising prices. If cost of goods sold for the income statement includes recent, higher acquisition prices, as occurs under LIFO, then older, lower acquisition prices must appear in the cost of ending inventory on the balance sheet. As long as accounting standards require firms to use acquisition costs for valuing inventory, either the income statement or the balance sheet will reflect current cost figures, but not both.

Of the three cost-flow assumptions, FIFO results in balance sheet figures that are closest to current cost because the latest purchases dominate the ending inventory amounts. However, the FIFO cost of goods sold will be out of date because FIFO assumes that the earlier acquisition costs of the beginning inventory and the earliest inventory acquisitions during the period become expenses. When prices rise, FIFO usually leads to the highest reported net income of the three methods, and when purchase prices fall, it leads to the smallest.

LIFO ending inventory can contain costs of items acquired many years previously. When inventory costs have been rising and inventory amounts increasing, LIFO produces balance sheet figures that are usually much lower than current costs. However, LIFO's cost of goods sold figure approximates current costs. Of the three cost-flow assumptions, LIFO usually results in the smallest net income when inventory costs are rising (highest cost of goods sold) and the largest net income when inventory costs are falling (lowest cost of goods sold). Also, LIFO results in the least fluctuation in gross margins in businesses in which selling prices tend to change as acquisition costs of inventories change.

The weighted-average cost-flow assumption falls between the other two in its effects, but it resembles FIFO more than LIFO in its effects on the financial statements. When inventory turns over rapidly, the weighted-average inventory cost-flow assumption provides amounts virtually identical to FIFO's amounts.

Differences in cost of goods sold and inventories under different cost-flow assumptions relate in part to the rate of change in the acquisition costs of inventory items. Using older purchase prices for inventories under LIFO or using older purchase prices for cost of goods sold under FIFO has little impact if prices are stable. As the rate of price change increases, the effect of using older versus more recent prices increases, resulting in larger differences in cost of goods sold and inventories between FIFO and LIFO.

Differences in cost of goods sold also relate in part to the rate of inventory turnover—that is, the speed with which the firm sells its products. As inventory turnover increases, current-period inventory acquisitions make up an increasing proportion of the cost of goods available for sale. Because purchases are the same regardless of the cost-flow assumption, cost of goods sold amounts will not vary as much with the choice of cost-flow assumption. Even with rapid inventory turnover, inventory amounts on the balance sheet can still differ significantly depending on the cost-flow assumption. The longer a firm uses LIFO, the greater will be the difference between inventories based on LIFO and FIFO cost-flow assumptions.