Inventory AccountingInventory Accounting

The effect a somewhat arbitrary The effect a somewhat arbitrary choice of inventory accounting choice of inventory accounting

has on financial statementshas on financial statements

Presented March 23, 2001 by Paul Kadota for the Maxidigm Investment Club

Inventory AccountingInventory Accounting

4th Unit $

1st Unit $

3rd Unit $

2nd Unit $

Size of trapezoidrepresents cost of good produced

First In, First Out (FIFO)First In, First Out (FIFO)

Out: oldestunit costs

In: newest unitcost of production

Newest Unit $

Oldest Unit $

Inventory

Cost of Goods Sold

Last In, First Out (LIFO)Last In, First Out (LIFO)

Out: newestunit costs

In: newest unit costof production

Newest Unit $

Oldest Unit $Inventory

Cost of Goods Sold

Comparisons using LIFO ReserveComparisons using LIFO Reserve

LIFO Reserve

FIFO Inventory

LIFO Inventory =-

LIFO to FIFO Balance SheetLIFO to FIFO Balance Sheet

Add LIFO Reserve to LIFO InventoryAdd LIFO Reserve to LIFO Inventory Inc. R.E. by (LIFO Reserve) * (1 - t)Inc. R.E. by (LIFO Reserve) * (1 - t) Inc. defer’d tax by (LIFO Reserve) * tInc. defer’d tax by (LIFO Reserve) * t

Financial RatiosFinancial Ratios

Use LIFO for income-relatedUse LIFO for income-related Use FIFO for balance sheet-relatedUse FIFO for balance sheet-related Profit Margin: LIFOProfit Margin: LIFO Liquidity Ratios: FIFOLiquidity Ratios: FIFO Turnover Ratios: ideally, LIFO COGS; Turnover Ratios: ideally, LIFO COGS;

FIFO InventoryFIFO Inventory

FIFO LIFO ComparisonFIFO LIFO Comparison

Truer value of Truer value of inventoryinventory

Unskewed Balance Unskewed Balance Sheet ratiosSheet ratios

Can understate Can understate COGS and COGS and overstate incomeoverstate income

Can result in higher Can result in higher taxestaxes

Truer value of Truer value of COGSCOGS

Unskewed Income Unskewed Income Statement ratiosStatement ratios

Can understate Can understate inventory and inventory and understate assetsunderstate assets

Can result in lower Can result in lower taxestaxes

FIFOFIFO LIFOLIFO