Which inventory cost flow method will produce the highest income and asset values in an inflationary environment multiple choice question?

How to Value Inventory

Inventory valuation is the cost associated with an entity's inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity's balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. Do not add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are direct labor, direct materials, factory overhead, freight in, handling fees, and import duties.

Why Inventory Valuation is Important

Inventory valuation is important for the reasons noted below.

Impact on the Cost of Goods Sold

When a higher valuation is recorded for ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.

Impact on Multiple Periods

An incorrect inventory valuation will cause the reported profits in two consecutive periods to be incorrect, because the incorrect ending balance in the first period will be wrong, and it then carries over into the beginning inventory balance in the next reporting period.

Impact on Loan Ratios

If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.

Impact on Income Taxes

The choice of cost-flow method used can alter the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.

The Lower of Cost or Market Rule

Under the lower of cost or market rule, you may be required to reduce the inventory valuation to the market value of the inventory, if it is lower than the recorded cost of the inventory. There are also some very limited circumstances where you are allowed under international financial reporting standards to record the cost of inventory at its market value, irrespective of the cost to produce it (generally limited to agricultural produce).

Inventory Valuation Methods

When assigning costs to inventory, one should adopt and consistently use a cost-flow assumption regarding how inventory flows through the entity. Examples of cost-flow are noted below. Whichever method chosen will affect the inventory valuation recorded at the end of the reporting period.

Specific Identification Method

The specific identification method is used when you want to track the specific cost of individual items of inventory. It is most commonly used when each inventory item is unique, such as in an art gallery.

First In, First Out Method

The first in, first out method is used when the first items to enter the inventory are the first ones to be used. This means that the costs of the oldest items in the inventory records are charged to the cost of goods sold first. In a period of price inflation, this means that the cost of goods sold tends to be somewhat low, resulting in higher reporting profits and more income taxes.

Last In, First Out Method

The last in, first out method is used when the last items to enter the inventory are the first ones to be used. This implies that the oldest items are kept in stock, which is not likely. However, it is frequently used because it charges the most recent costs to the cost of goods sold; in a period of price inflation, this tends to reduce profits and therefore the amount of income taxes to be paid.

Weighted Average Method

The weighted average method applies an average of the costs in inventory to the cost of goods sold. This means that the cost of goods sold will be neither excessively high nor low in a period of price inflation, making this method representative of the actual cost of the items stored in inventory.

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.

• 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.

Which inventory valuation method is best during inflation?

Which cost flow method results in the highest net income?

Which of the three inventory cost flow assumptions leads to higher net income in an inflationary environment?

Which inventory method gives highest profit?