How LIFO FIFO Average methods Effects Financial Statements

 

How LIFO FIFO Average methods Effects Financial Statements?

First, FIFO stands for First-In, First-Out. That means the oldest inventory items are sold first. In times of rising prices, the older, cheaper items are recorded as COGS, which would leave the newer, more expensive items in inventory. So COGS would be lower, leading to higher profits, and closing inventory would be higher. But if prices are falling, it's the opposite.

 

Then there's LIFO, Last-In, First-Out. Here, the newest inventory is sold first. If prices are rising, the COGS would be higher because the newer, more expensive items are sold first. That leads to lower profits and lower closing inventory. However, in the US, LIFO is allowed for tax purposes, but under IFRS it's not permitted. So the user might need to consider the accounting standards applicable here.

 

Average Cost method smooths things out by taking the weighted average of all units. This method tends to moderate the effects of price fluctuations. COGS and closing inventory values are somewhere between FIFO and LIFO in inflationary environments.

 

Now, question is about the effects on COGS, closing inventory, and profits. It is need to structure to clearly show the impact under each method.

 

Practical examples would be useful. Let me think of a simple example with numbers. Suppose a company buys 100 units at $5, then 100 units at $7. If they sell 150 units, how does each method affect the numbers?

 

For FIFO, they'd sell the first 100 at $5 and 50 at $7. COGS = (100*5)+(50*7)= $850. Closing inventory is 50*7= $350.

 

For LIFO, they sell 100 at $7 and 50 at $5. COGS= (100*7)+(50*5)= $950. Closing inventory is 50*5= $250.

 

Average cost would be total cost divided by total units: (100*5 + 100*7)/200 = $6 per unit. COGS=150*6= $900. Closing inventory=50*6= $300.

 

In this case, during rising prices (from $5 to $7), FIFO has lower COGS, higher profit, higher inventory. LIFO the opposite. Average is in the middle.

 

We should also consider the tax implications. Higher profits under FIFO mean higher taxes, which might not be desirable. LIFO can reduce taxable income. But again, depends on the accounting standards.

 

Another point is the impact on financial ratios. For example, inventory turnover, gross margin, etc., which could affect how the company is perceived by investors.

 

Why a company would choose one method over another.  Companies in industries with rising costs might prefer LIFO to match current costs with revenues, even if it lowers profits.

 

The choice of method affects the balance sheet and income statement differently. FIFO gives a more accurate inventory value on the balance sheet, while LIFO gives a better matching of costs and revenues on the income statement.

 

But under IFRS, LIFO isn't allowed, so if the user is in a country that uses IFRS, they can't use LIFO. That's an important point to mention.

 

Also, in times of deflation, the effects reverse. FIFO would result in higher COGS because the older, more expensive inventory is sold first, leading to lower profits. LIFO would have lower COGS, higher profits.