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Comparing LIFO and FIFO Firms in Financial Accounting

Comparing the financial statements of firms that use different inventory methods is troublesome. In these situations, differences in ratios might be due to the different accounting methods or to the different underlying economic conditions of the firms. Whenever possible in making interfirm comparisons, financial statement numbers should be recast to reflect the use of a uniform accounting method.

Although firms do not usually make disclosures enabling such analyses, companies using LIFO often reveal their FIFO-based inventory values. In all likelihood, these firms are motivated to do this because FIFO usually results in a lower CGS number than LIFO. Regardless of the motivation, the disclosures provide the basis to generate ratios on a FIFO basis for firms that actually use LIFO.

OB, which uses LIFO, elected to disclose the replacement cost of its inventories. Replacement cost approximates the FIFO cost of inventories and allows the analyst to adjust OB’s financial ratios for purposes of comparisons to FIFO firms. Recall the calculation for cost of goods sold:

CGS = Beginning inventory + Purchases - Ending inventory

Under LIFO, the calculation for 1997 was:

CGS = Beginning inventory + Purchases - Ending inventory
$250,815,000 = $66,799,000 + $252,242,000 - $68,226,000

The inventory disclosures indicate that under FIFO (or replacement cost), the beginning inventory would have been higher by $15,100,000 and the ending inventory would have been higher by $14,138,000. The only differences in the cost of goods sold calculations relate to the valuation of beginning and ending inventory. Therefore, FIFO-based cost of goods sold can be computed by adjusting LIFO-based cost of goods sold by these inventory valuation differences.

CGS under LIFO = $250,815,000
Plus the increase in the beginning inventory valuation under FIFO = 15,100,000
Less the increase in the ending inventory valuation under FIFO = (14,138,000)

CGS under FIFO = $251,777,000

Notice that in this particular situation CGS under FIFO is higher than under LIFO.This is rather unusual.Firms typically employ LIFO to capture the tax benefit of higher CGS and lower taxable income. OB’s lower LIFO-based CGS could be due to two factors. First, the unit cost of its inventory items might be declining. Under LIFO, these recently acquired, lower-priced goods are the ones assumed sold. Alternatively, recall that OB scaled back some operations. In the process, OB might have liquidated certain lines of apparel. If these lines had been held for a number of years, their recorded LIFO cost was likely based on rather old (and low) prices. In fact, OB’s inventory note appearing in Figure 5.9 in the section Inventories of Manufacturers references such a situation by using the phrase “liquidation of certain LIFO layers.”

Figure 5.9 in the section Inventories of Manufacturers provides sufficient information to recalculate OB’s ratios on a FIFO basis. OB’s FIFO-based and LIFO-based ratios are summarized in figure 5.11. As often happens, little difference exists in the gross profit percentages generated by the two methods. This occurs because the beginning and ending inventories are higher under FIFO by roughly the same amount; the previous calculation of FIFO cost of goods sold showed that these two inventory increases tend to cancel each other.

Figure 5.11 - Inventory Ratio

Inventory method has a more dramatic effect on NDS. The FIFO ratio indicates that OB has more inventory on hand than suggested by the LIFO ratio. Given that many analysts believe FIFO yields more relevant balance sheet numbers, OB’s inventory levels may be more problematic than they first appeared.

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