To summarize, the financial results of using each of the three alternative methods are as follows:
As the examples presented here highlight, gross profit can be affected by the company’s choice of its inventory costing method. In periods of rising prices, FIFO produces higher gross profits than LIFO because lower cost inventories are matched against sales revenues at current market prices. This is sometimes referred to as FIFO’s phantom profits as the gross profit is actually a sum of two components: an economic profit and a holding gain. The economic profit is equal to the number of units sold multiplied by the difference between the sales price and the replacement cost of the inventories (approximated by the cost of the most recently purchased inventories):
Economic profit = 30 units X ($800 - $600) = $6,000
Economic profit = 30 units X ($800 - $600) = $6,000
The holding gain is the increase in replacement cost since the inventories were acquired and is equal to the number of units sold multiplied by the difference between the current replacement cost and the original acquisition cost:
Holding gain = 30 units X ($600 - $500) = $3,000
Of the $9,000 in reported gross profit, $3,000 relates to the inflationary gains realized by the company on inventories it purchased some time ago at prices lower than current prices. Holding gains are a function of the inventory turnover (e.g., how long the goods remain on the shelves) and the rate of inflation. Once a serious problem, these gains have been mitigated during the past decade due to lower inflation and management scrutiny of inventory quantities through improved manufacturing processes and better inventory controls. In countries with higher inflation rates than the United States, however, FIFO holding gains can still be an issue.
Inventory Costing Effects on the Balance Sheet
In periods of rising prices, and assuming that the company has not previously liquidated older layers of inventories, LIFO reports ending inventories at prices that can be significantly lower than replacement cost. As a result, balance sheets for LIFO companies do not accurately represent the current investment that the company has in its inventories. John Deere, for example, recently reported inventories under LIFO costing nearly $2 billion. Had these inventories been valued under FIFO, the reported amount would have been $3 billion, a 50% increase. More than $1 billion of invested capital was omitted from its balance sheet.
Inventory Costing Effects on Cash Flows
The increase in gross profit under FIFO also results in higher pretax income and, consequently, higher tax liability. In periods of rising prices, companies can get caught in a cash flow squeeze as they pay higher taxes and must replace the inventories sold at replacement costs higher than the original purchase costs. This can lead to liquidity problems, an issue that was particularly acute in the high inflationary period of the 1970s.
One of the reasons frequently cited for the adoption of LIFO is the reduction of tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO inventory costing for tax purposes also use it for financial reporting. This is the LIFO conformity rule.
Holding gain = 30 units X ($600 - $500) = $3,000
Of the $9,000 in reported gross profit, $3,000 relates to the inflationary gains realized by the company on inventories it purchased some time ago at prices lower than current prices. Holding gains are a function of the inventory turnover (e.g., how long the goods remain on the shelves) and the rate of inflation. Once a serious problem, these gains have been mitigated during the past decade due to lower inflation and management scrutiny of inventory quantities through improved manufacturing processes and better inventory controls. In countries with higher inflation rates than the United States, however, FIFO holding gains can still be an issue.
Inventory Costing Effects on the Balance Sheet
In periods of rising prices, and assuming that the company has not previously liquidated older layers of inventories, LIFO reports ending inventories at prices that can be significantly lower than replacement cost. As a result, balance sheets for LIFO companies do not accurately represent the current investment that the company has in its inventories. John Deere, for example, recently reported inventories under LIFO costing nearly $2 billion. Had these inventories been valued under FIFO, the reported amount would have been $3 billion, a 50% increase. More than $1 billion of invested capital was omitted from its balance sheet.
Inventory Costing Effects on Cash Flows
The increase in gross profit under FIFO also results in higher pretax income and, consequently, higher tax liability. In periods of rising prices, companies can get caught in a cash flow squeeze as they pay higher taxes and must replace the inventories sold at replacement costs higher than the original purchase costs. This can lead to liquidity problems, an issue that was particularly acute in the high inflationary period of the 1970s.
One of the reasons frequently cited for the adoption of LIFO is the reduction of tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO inventory costing for tax purposes also use it for financial reporting. This is the LIFO conformity rule.
Companies using LIFO inventory costing are required to disclose the amount at which inventories would have been reported had the company used FIFO inventory costing. The difference between these two amounts is called the LIFO reserve. Analysts can use this reserve to compute the amount by which cash flow has been affected both cumulatively and for the current period by the use of LIFO. For example, John Deere reports the following in a recent annual report:
LIFO inventories are reported on the balance sheet at $1,999 million. Had the company used FIFO inventory costing, inventories would have been reported at $3,001 million. The difference of $1,002 million is the LIFO reserve. This is the amount by which inventories and pretax income have been reduced because the company adopted LIFO. Assuming a 35% tax rate, Deere has saved more than $350 million ($1,002 million X 35%) through the use of LIFO inventory costing. During 2004, the LIFO reserve increased by $52 million ($950 million to $1,002 million). For 2004, then, LIFO inventory costing decreased pretax income by $52 X million and decreased taxes by $18 million ($52 million 35% tax rate). The net decrease in income is, therefore, $34 million in that year.
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