How Inflation and Deflation of Inventory Costs Affect Financial Statements

Rising inventory costs (inflation) or declining inventory costs (deflation) can have a significant impact on a company’s financial statements, depending on the inventory valuation method that is used.

Differences in the valuation method selected can, therefore, affect comparability between companies, when doing financial ratio analysis.

The Effect of Inflation and Deflation of Inventory Costs on Financial Statements

• Whenever inventory unit costs decline and inventory quantities either 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. A company’s gross profit, operating profit, and income before taxes will, therefore, be lower.
• Whenever inventory unit costs rise and inventory quantities either 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 company’s gross profit, operating profit, and income before taxes will, therefore, be higher.
• The ending inventory amount under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items.
• The cost of sales under LIFO will more closely reflect current replacement values.
• The LIFO ending inventory amounts are typically not reflective of the current replacement value because the ending inventory is assumed to be the oldest inventory and costs are allocated accordingly.

Example: Effect of Inflation on Inventory Costs

Assume two companies, company A and company B, are identical in all respects except for the fact that company A uses the LIFO inventory valuation method, while company B uses the FIFO method. Each company has been in operation for 3 years and maintains a base inventory of 1,200 units each year. Except for the first year, each year the number of units purchased is equal to the number of units sold. Over the three-year period, 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:

• Company A (LIFO): Ending inventory = 1200 × $8 = $9,600.

  This is unchanged each year since 1,200 units are said to remain in inventory.

• Company B (FIFO): Ending inventory = 1200 × $8 = $9,600 in year 1;

  1200 × [($8 × (1.03)] = $9,888 in year 2; and

  1200 × [($8 × (1.03)²]= $10,185 in year 3.

Sales:

• Company A (LIFO): Sales = (10,000 × $12) = $120,000 in year 1;

  (10,000 × $12)(1.08)(1.03) = $133,488 in year 2; and

  (10,000 × $12)(1.08)²(1.03)² = $148,492 in year 3.

• Company B (FIFO): Sales = (10,000 × $12) = $120,000 in year 1;

  (10,000 × $12)(1.08)(1.03) = $133,488 in year 2; and

  (10,000 × $12)(1.08)²(1.03)² = $148,492 in year 3.

Cost of Sales:

• Company A (LIFO): Cost of sales = (10,000 × $8) = $80,000 in year 1;

  (10,000 × $8)(1.08)(1.03) = $88,992 in year 1;

  (10,000 × $8)(1.08)²(1.03)² = $98,995 in year 2.

• Company B (FIFO): Cost of sales = (10,000 × $8) = $80,000 in year 1 when there was no beginning inventory;

  For years 2 and 3, cost of sales = beginning inventory + purchases – ending inventory = (10,000 × $8) + [(10,000 × $8)(1.08)(1.03)]-[10,000($8)(1.03) = $86,592 in year 2; and

  (10,000 × $8)(1.03) + [(10,000 × $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:

$$\begin{array}[t]{c} \text{} & \textbf{Company} & \textbf{Year 1} & \textbf{Year 2} & \textbf{Year 3} \\ \hline \begin{array}[t]{c} \text{Ending inventory} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{\$9,600} \\ \text{} \\ \text{\$9,600} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$9,600} \\ \text{} \\ \text{\$9,888} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$9,600} \\ \text{} \\ \text{\$10,185} \\ \text{} \end{array} \\ \hline \begin{array}[t]{c} \text{Sales} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{\$120,000} \\ \text{} \\ \text{\$120,000} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$133,488} \\ \text{} \\ \text{\$133,488} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$148,492} \\ \text{} \\ \text{\$148,492} \\ \text{} \end{array} \\ \hline \begin{array}[t]{c} \text{Cost of Sales} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{\$80,000} \\ \text{} \\ \text{\$80,000} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$88,992} \\ \text{} \\ \text{\$88,752} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$98,995} \\ \text{} \\ \text{\$98,748} \\ \text{} \end{array} \\ \hline \begin{array}[t]{c} \text{Gross Profit} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{\$40,000} \\ \text{} \\ \text{\$40,000} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$44,496} \\ \text{} \\ \text{\$44,736} \\ \text{} \end{array} & \begin{array}[t]{c} \text{\$49,497} \\ \text{} \\ \text{\$49,744} \\ \text{} \end{array} \\ \hline \end{array} $$

$$\textbf{Financial Ratio Analysis} \\ \begin{array}[t]{ccccc} \text{} & \textbf{Company} & \textbf{Year 1} & \textbf{Year 2} & \textbf{Year 3} \\ \hline \begin{array}[t]{c} \text{Inventory Turnover Ratio} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{8.33} \\ \text{} \\ \text{8.33} \\ \text{} \end{array} & \begin{array}[t]{c} \text{9.27} \\ \text{} \\ \text{8.98} \\ \text{} \end{array} & \begin{array}[t]{c} \text{10.31} \\ \text{} \\ \text{9.70} \\ \text{} \end{array} \\ \hline \begin{array}[t]{c} \text{Gross Profit Margin} \\ \text{} \\ \text{} \\ \text{} \end{array} & \begin{array}[t]{c} \text{Company A} \\ \text{(LIFO)} \\ \text{Company B} \\ \text{(FIFO)} \end{array} & \begin{array}[t]{c} \text{0.33} \\ \text{} \\ \text{0.33} \\ \text{} \end{array} & \begin{array}[t]{c} \text{0.33} \\ \text{} \\ \text{0.34} \\ \text{} \end{array} & \begin{array}[t]{c} \text{0.33} \\ \text{} \\ \text{0.33} \\ \text{} \end{array} \\ \hline \end{array} $$

From the table, it can be observed that:

• the inventory turnover ratio (cost of sales/ending inventory) for both companies increased each year. This results from the fact that the units sold increased, whereas the units in ending inventory remained unchanged. The increase in the inventory turnover ratio is higher for company A because its cost of sales is increasing for inflation while the inventory carrying amount is unaffected by inflation, and
• the gross profit margin (gross profit/sales) is stable for company A which uses the LIFO method because both sales and cost of sales are increasing at the same rate of inflation. The gross profit margin is not so stable after the first year for company B which uses the FIFO method because a proportion of the cost of sales reflects an older purchase price.

Question 1

Which of the following statements is accurate?

1. When unit costs increase, and quantities either remain constant or increase, LIFO allocates a lower amount of the total cost of goods available for sale to 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 either remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to 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 either remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to 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 either remain constant or increase, FIFO allocates a lower amount of the total cost of goods available for sale to 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 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.