Different Depreciation Methods for Pro ...
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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.
Example: Effect of Inflation on Inventory Costs
Assume two companies, Company A and Company B, are identical, except that Company A uses the LIFO inventory valuation method. In contrast, company B uses the FIFO method. Each company has operated for three years and maintains a base inventory of 1,200 units yearly. Except for the first year, the number of units purchased is equal to the number of units sold each year. Over the three years, unit sales increased by 8 percent each year, and the unit purchase and selling prices increased at the beginning of each year to reflect inflation of 3 percent per year. In the first year, 10,000 units were sold for $12.00 per unit, and the unit purchase price was $8.00.
Ending Inventory:
Sales:
Cost of Sales:
For years 2 and 3, cost of sales = beginning inventory + purchases – ending inventory = \((10,000 \times \$8) + [(10,000 \times \$8)(1.08)(1.03)]-[10,000(\$8)(1.03) = \$86,592 \) in year 2; and
\((10,000 \times \$8)(1.03) + [(10,000 \times \$8)(1.08)]^2(1.03)^2] – [10,000(\$8)(1.03)]^2 = \$96,523\) in year 3.
The results are summarized in the following table:
$$ \textbf{Financial Ratio Analysis} \\
\begin{array}{c|c|c|c|c}
& \text{Company} & \text{Year 1} & \text{Year 2} & \text{Year 3} \\ \hline
{\text{Inventory} \\ \text{Turnover Ratio} } & {\text{Company A(LIFO)}} & 8.33 & 9.27 & 10.31 \\ \hline
& {\text{Company B } \text{(FIFO)}} & 8.33 & 8.98 & 9.70 \\ \hline
{ \text{Gross Profit} \\ \text{Margin}} & \text{Company A(LIFO)} & 0.33 & 0.33 & 0.33 \\ \hline
& \text{Company B(FIFO)} & 0.33 & 0.34 & 0.33
\end{array} $$
From the table, it can be observed that:
Question 1
Which of the following statements is accurate?
- 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.
- 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.
- 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:
- FIFO method.
- LIFO method.
- 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.