which cost flow assumption generally results in the highest reported amount of net income in periods of rising inventory costs?

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Comparison Between Different Cost Flow Assumptions

Written by True Tamplin, BSc, CEPF®

Updated on September 17, 2021

This article compares the effect of different cost flow assumptions—FIFO, average cost, and LIFO—on ending inventory, cost of goods sold, and gross margin for the Cerf Company.

As shown in the table below, the highest gross margin and ending inventory, as well as the lowest cost of goods sold, resulted when FIFO was used. The lowest gross margin and ending inventory and highest cost of goods sold resulted when LIFO was used.

The average cost fell between these two extremes for all three accounts. This is because the acquisition price of the inventory consistently rises during the year, from $4.10 to $4.70.

We deliberately constructed this example to reflect rising prices. This is because, in today’s economy, rising prices are more common than falling prices. However, in some sectors of the economy, such as electronics, prices have been falling.

In this case, the income statement and balance sheet effects of LIFO and FIFO would be the opposite of the rising-price situation. That is, LIFO would produce the highest gross margin and the highest ending inventory cost.

Note: The figures in this table are taken from the example shown in the article entitled “Application of different cost flow assumptions.”

Rising Prices and FIFO

In a period of rising prices, FIFO produces the highest gross margin and the highest ending inventory. The high gross margin is produced because the earliest (and, therefore, the lowest) costs are allocated to the cost of goods sold.

Thus, cost of goods sold is the lowest of the three inventory costing methods, and gross margin is correspondingly the highest of the three methods.

Ending inventory reflects the highest cost under FIFO because the latest and highest costs are allocated to ending inventory. These results are logical, given the relationship between ending inventories and gross margin.

On the one hand, many accountants approve of using FIFO because ending inventories are recorded at costs that approximate their current acquisition or replacement cost. Thus, inventories are realistically valued on the firm’s balance sheet.

On the other hand, other accountants criticize FIFO because it matches the earliest cost against sales and results in the highest gross margin.

Some accountants argue that these profits are overstated because, in order to stay in business, a going concern must replace its inventory at current acquisition prices or replacement costs. These overstated profits are often referred to as inventory profits.

Example

To illustrate the concept of inventory profits, suppose that a firm enters into the following transactions:

2 January: Purchases one unit of inventory at $60

15 December: Purchases another unit of inventory at $85

31 December: Sells one unit at $100—current replacement cost of inventory at $85

On a FIFO basis, the firm reports a gross margin of $40 ($100 — $60). However, if it is to stay in business, the firm will not have $40 available to cover operating

expenses. This is because it must replace the inventory at a cost of at least $85.

Therefore, in reality, the firm has only $15 ($100 — $85) available to cover its operating expenses. The $25 difference between the $85 replacement cost and the $60 historical cost is the inventory profit.

The inventory profit is considered a holding gain caused by the increase in the acquisition price of the inventory between the time that the firm purchased and then sold the item.

This holding gain is not available to cover operating costs because it must be used to repurchase inventory at new, higher prices.

Rising Prices and LIFO

In an economy where prices are rising, LIFO results in the lowest gross margin and the lowest ending inventory.

The low gross margin results when the latest and highest costs are allocated to cost of goods sold. Thus, cost of goods sold is the highest of the three inventory costing methods, and gross margin is the lowest of the three methods.

Also, under LIFO, the ending inventory is recorded at the lowest cost of the three methods because the earliest and lowest prices are allocated to it.

In fact, if a company switched to LIFO 20 years ago, the original LIFO layers, if unsold, would be costed at 20-year-old prices.

In terms of its effects on the balance sheet and income statement, LIFO has the opposite effect of FIFO. Consequently, LIFO is criticized because the inventory cost on the balance sheet is often unrealistically low.

Therefore, working capital, the current ratio, and current assets tend to be understated. The potential consequences may be drastic, as illustrated by the following excerpt from the 2019 Safeway annual report:

Consolidated working capital increased to $303 million in 2019 from $231 million and $218 million in 2018 and 2017, respectively. The current ratio increased to 1.19 from 1.15 and 1.16 in those years.

Had the company valued its inventories using FIFO, its current ratio would have been 1.40, 1.35, and 1.36, and working capital would have been $621 million, $520 million, and $508 million at the year-ends of 2019, 2018, and 2017, respectively.

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Source : learn.financestrategists.com

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