During periods of significantly increasing costs, the LIFO cost flow assumption instead of the FIFO cost flow assumption will have the following effect:
LIFO results in lower inventory costs on the balance sheet because the latest, higher costs were removed from inventory ahead of the older lower costs
LIFO means that the gross profit, operating income, taxable income, income taxes paid, and retained earnings will be lower because of the higher cost of goods sold
Examples of Effect on Financial Ratios from LIFO Instead of FIFO
When there is significantly increasing costs, the following profitability ratios will be smaller under LIFO than FIFO:
The inventory turnover ratiowill be greater when LIFO is used during periods of increasing costs. The reason is that the cost of goods sold will be higher and the inventory costs will be lower using LIFO instead of FIFO.
Let's say you use LIFO instead of FIFO to value your inventory. If we assume all other factors stay the same, your cost of goods sold would increase because the most recent, and therefore most expensive, items are included in the calculation. This change would result in a lower inventory turnover ratio.
When prices are falling, FIFO will result in lower current assets and lower gross profit.LIFO will result in higher current assets and higher gross profit. When prices are rising, FIFO will result in higher current assets and higher gross profit. LIFO will result in lower current assets and lower gross profit.
The LIFO method decreases net income on paper. That reduces the taxes you owe assuming that inflation is at work. If you're running a public company, lower earnings may not impress your shareholders. Most companies that use LIFO are those that are forced to maintain a large amount of inventory at all times.
Since inventory costs have risen in recent periods, LIFO causes the retailer's COGS to increase and net income to decrease on its income statement for the current period – whereas COGS would be lower under FIFO, and the reported net income would be higher.
Under FIFO, the oldest merchandise is sold first, and recent items are reflected in the inventory. There are fewer chances that the inventory becomes obsolete; therefore, it will provide a more meaningful value of the current ratio.
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