- CFA Exams
- 2024 Level I
- Topic 5. Financial Statement Analysis
- Learning Module 6. Analysis of Inventories
- Subject 2. The Effects of Inflation and Deflation on Inventories, COGS and Gross Margin
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Subject 2. The Effects of Inflation and Deflation on Inventories, COGS and Gross Margin PDF Download
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 affect comparability between companies, when doing financial ratio analysis.
Impact of Inflation
During periods of rising prices and stable or growing inventories:
Impact of Deflation
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.
LIFO vs FIFO
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.
The general guideline is to use LIFO-based numbers for components that are income-related and FIFO-based data for components that are balance-sheet-related. Ideally, firms could have used FIFO to prepare the balance sheet and LIFO to prepare the income statement. In reality this "perfect" combination is not permitted by accounting rules. Analysts should adjust financial statements between FIFO and LIFO to suit their analytic purposes.
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