Inventory Costing Methods and Their Impact on Financial Statements

Overview

• Four Main Inventory Costing Methods
  • Specific Identification
  • First-In, First-Out (FIFO)
  • Last-In, First-Out (LIFO)
  • Weighted-Average Method
• Purpose: Understand how different methods affect financial statements and the decision-making behind choosing a method.

Impact on Financial Statements

Income Statement

• Specific Identification

  • Cost of Goods Sold (COGS): $5,200
  • COGS depends on specific items sold and their costs.

• First-In, First-Out (FIFO)

  • COGS: $5,180
  • In periods of rising prices:
    • Results in lowest COGS
    • Highest gross profit and net income

• Last-In, First-Out (LIFO)

  • COGS: $5,240
  • In periods of rising prices:
    • Results in highest COGS
    • Lowest gross profit and net income

• Weighted-Average Method

  • COGS: $5,193
  • Falls between FIFO and LIFO for COGS, gross profit, and net income.

Decision Making for Businesses

• Choosing FIFO

  • Higher net income to attract investors and secure favorable loan terms.

• Choosing LIFO

  • Lower net income to pay less in income taxes, keeping more cash in hand.

• Choosing Weighted-Average

  • A balanced approach between the benefits of FIFO and LIFO.

Balance Sheet

• General Principle

  • COGS available for sale ($6,700) is consistent across methods.

• Impact of FIFO

  • Lower COGS implies higher merchandise inventory on the balance sheet.

• Impact of LIFO

  • Higher COGS implies lower merchandise inventory on the balance sheet.

• Impact of Weighted-Average

  • Merchandise inventory values fall between FIFO and LIFO.

Specific Identification Method

• Results vary based on which items are sold.
• Rarely used in practice, thus less focus.

Periods of Declining Prices

• Income Statement Impacts

  • FIFO results in highest COGS, lowest net income.
  • LIFO results in lowest COGS, highest net income.
  • Weighted-average maintains middle ground.

• Balance Sheet Impacts

  • FIFO leads to lowest merchandise inventory.
  • LIFO leads to highest merchandise inventory.

Lower-of-Cost-or-Market-Rule (LCM)

• Principles

  • Merchandise inventory should be reported at the lower of its historical cost or market value.
  • Follows the conservatism principle: report the least favorable figures when options exist.

• Example Application

  • Smart Touch Learning adjusts inventory value from $3,000 to $2,200 due to obsolescence.
  • Requires an adjusting entry to decrease inventory and increase cost of goods sold.

• Disclosure Principle

  • Companies must disclose inventory valuation policies in financial statements footnotes.

Conclusion

• Understanding of the impact of different inventory costing methods on financial statements.
• Insight into the application of the lower-of-cost-or-market-rule.