FIFO and LIFO compared As shown in the preceding paragraphs, when the unit costs of a company's merchandise purchases change over time, the FIFO and LIFO inventory methods can result in different cost of goods sold dollar amounts and different ending merchandise inventory dollar amounts. These differences are important because they affect the company's financial statements. Remember, the cost of goods sold is usually the largest expense on merchandising companies' income statements and the ending merchandise inventory is usually one of the large assets on their balance sheets. Furthermore, the differences between FIFO and LIFO can affect the amount of cash companies have available to use.

To see the income statement effects and the cash effects of FIFO and LIFO, assume the 70 units sold by the merchandise company discussed above had a sales price of $38 per unit. Also assume the company's operating expenses were $800, and its income tax rate was 35%. The following table shows the effects of the FIFO and LIFO inventory methods.
 

 

FIFO

LIFO

FIFO – LIFO

Sales (70 units @ $38)

$2,660.00

$2,660.00

$0.00

Cost of Goods Sold (calculated earlier)

$1,140.00

$1,075.00

+ $65.00

Gross Profit

$1,520.00

$1,585.00

- $65.00

Operating Expenses

$800.00

$800.00

$0.00

Income Before Taxes

$720.00

$785.00

- $65.00

Income Taxes Expense (35%)

$252.00

$274.75

- $22.75

Net Income

$468.00

$510.25

- $42.25

As the above calculations show, the LIFO and FIFO inventory methods resulted in several differences on the company's income statement. The company's changing unit costs in December, decreasing from $18 to $15, resulted in the cost of goods sold being higher under the FIFO method than under the LIFO perpetual method. FIFO's higher cost of goods sold resulted in lower gross profit, lower income before taxes, lower income taxes expense, and lower net income than under the LIFO perpetual method. Management must be aware of these differences, especially if management's performance is evaluated on the basis of net income. If management believes the company's merchandise unit costs will continue to decrease over time, and if management wants to report higher income than lower income, the LIFO perpetual inventory method may be preferred. On the other hand, if management believes the company's merchandise unit costs will change and start to steadily increase over time, and if management wants to report higher income than lower income, the FIFO inventory method may be preferred. Managers must possess knowledge of how inventory methods affect companies' income, especially if their performance is evaluated on a net income basis. Because the income effects of inventory costing methods can be quite large, companies are not allowed to simply change from FIFO to LIFO or LIFO to FIFO haphazardly. Management must choose the inventory method to use and apply it consistently from year to year. Occasionally, when conditions change, companies may be allowed to change inventory methods, but such changes occur very rarely.

A second important difference between FIFO and LIFO is the income taxes expense. In the above illustration, the company's income taxes expense was $22.75 lower under FIFO than under LIFO. Since income taxes must be paid to governments, the company would have to pay out $22.75 less cash if it used the FIFO inventory method. Since the $22.75 cash would not have to be paid out to governments, the company could use it for other purposes. For example, if the company could invest the $22.75 in a project that will generate a 10% return before taxes, the following will result.
 

FIFO vs LIFO cash difference (income taxes expense)

$22.75

 

Expected return on investment (10%)

$2.28

($22.75 x .10)

Expected income taxes expense (35%)

$.80

($2.28 x .35)

Expected return after taxes

$1.48

($2.28 - $.80)

Based on the above analysis, the company will have $1.48 more resources (assets) if it uses the FIFO inventory method instead of the LIFO perpetual method. This $1.48 of resources is a direct result of postponing income tax payments of $22.75 and investing the $22.75 at a 10% return before taxes. Although $1.48 in resources is not enough for any business manager to consider, the differences between inventory methods can be quite large for real companies. For example, Wal-Mart postponed $600 million as of January 31, 2007 by using an inventory method for tax purposes that differed from the inventory methods it used in the preparation of its financial statements.. The cash savings from income taxes on such large inventory differences can be significant. Managers must possess knowledge of how inventory methods affect companies' income taxes because the cash savings can result in more resources for managers to use.
 

** You now have the background to do text exercise 8.13 and problems 8.1 and 8.2.

 

 

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