Inflation and Deflation of Inventory Costs

Rising inventory costs (inflation) or declining inventory costs (deflation) can significantly impact a company’s financial statements, depending on the inventory valuation method used. Differences in the selected valuation method can affect companies’ comparability when doing financial ratio analysis.

FIFO Method

• Inflation: When inventory unit costs rise and inventory quantities remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet. Therefore, a company’s gross profit, operating profit, and income before taxes will be higher.
• Deflation: When inventory unit costs decline and inventory quantities remain constant or increase, FIFO allocates a higher amount of the total cost of goods available for sale to the cost of sales on the income statement and a lower amount to ending inventory on the balance sheet. Therefore, a company’s gross profit, operating profit, and income before taxes will be lower.

Generally, ending inventory amount under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items.

LIFO Method

• Inflation: When inventory unit costs rise, LIFO allocates a higher amount of the total cost of goods available for sale to the cost of sales on the income statement and a lower amount to ending inventory on the balance sheet. Therefore, a company’s gross profit, operating profit, and income before taxes will be lower.
• Deflation: When inventory unit costs decline, LIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet. Therefore, a company’s gross profit, operating profit, and income before taxes will be higher.

The cost of sales under LIFO will more closely reflect current replacement values. However, the LIFO ending inventory amounts normally do not reflect the current replacement value because the ending inventory is assumed to be the oldest inventory, and costs are allocated accordingly.

Question 1

Which of the following statements is most likely accurate?

1. When unit costs increase and quantities remain constant or increase, LIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet.
2. When unit costs increase and quantities remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet.
3. When unit costs decrease and quantities remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet.

Solution

The correct answer is B.

Whenever inventory unit costs rise and inventory quantities remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to the cost of sales on the income statement and a higher amount to ending inventory on the balance sheet.

A is incorrect because it describes FIFO and not LIFO.

C is incorrect because under those circumstances (declining prices), FIFO allocates a higher amount of the total cost of goods available for sale to the cost of sales on the income statement and a lower amount to ending inventory on the balance sheet and not the reverse as indicated.

Question 2

For a company to increase its assets during a deflationary period, it needs to follow the:

1. FIFO method.
2. LIFO method.
3. Average cost of inventory method.

Solution

The correct answer is B.

Using LIFO during a deflationary period would make a company add the most recently purchased inventory (the least expensive), which would leave the oldest inventory (the most expensive) to be added to the ending inventory. Hence, the increased value of inventory would lead to increased assets.