Accounting for Inventories
2.5. Financial statements under different cost flow methods
The net income before taxes, inventory, and cost of goods sold amounts differ under three cost flow methods as shown below:
Illustration 8: Financial statements under different cost flow methods for general example
| Income Statement |
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|
FIFO |
LIFO |
Weighted- Average |
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| Sales |
$10,800 |
$10,800 |
$10,800 |
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| Cost of Goods Sold |
(4,660) |
(4,810) |
(4,733) |
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| Gross Margin |
6,140 |
5,990 |
6,067 |
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| Operating Expenses |
0 |
0 |
0 |
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| Income before Taxes |
6,140 |
5,990 |
6,067 |
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| Income Tax Expense |
(1,842) |
(1,797) |
(1,820) |
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| Net Income |
$4,298 |
$4,193 |
$4,247 |
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| Balance Sheet |
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| Assets |
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| Cash |
$9,698 |
$9,743 |
$9,720 |
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| Inventory |
600 |
450 |
527 |
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| Total Assets |
$10,298 |
$10,193 |
$10,247 |
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| Liabilities |
0 |
0 |
0 |
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| Equity |
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| Contributed Capital |
$4,500 |
$4,500 |
$4,500 |
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| Retained Earnings |
5,798 |
5,693 |
5,474 |
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| Total Equity |
$10,298 |
$10,193 |
$10,247 |
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| Statement of Cash Flows |
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| Operating Activities |
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| Cash Inflow from Sales |
$10,800 |
$10,800 |
$10,800 |
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| Cash Outflow for Inventory |
(3,760)* |
(3,760) |
(3,760) |
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| Cash Outflow for Tax |
(1,842) |
(1,797) |
(1,820) |
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| Net Cash Flow from Operating Activities |
$5,198 |
$5,243 |
$5,220 |
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| Investing Activities |
$ 0 |
$ 0 |
$ 0 |
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| Financing Activities |
$ 0 |
$ 0 |
$ 0 |
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| Net Increase in Cash |
$5,198 |
$5,243 |
$5,220 |
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| Beginning Cash Balance |
$4,500 |
$4,500 |
$4,500 |
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| Ending Cash Balance |
$9,698 |
$9,743 |
$9,720 |
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(*) $3,760 = $2,160 + $1,600
You have probably noticed that income before taxes is the highest for FIFO ($6,140) and the lowest for LIFO ($5,990). Why so? Note that the ending inventory balances are just vise versa for FIFO and LIFO (respectively, $600 and $450). Because the cost of goods sold is the difference between the cost of goods available for sale and the ending inventory, the net income before taxes is the highest under the cost flow method that provides for the highest ending inventory balance. Thus, the cost of goods sold under FIFO ($4,660) is lower than the cost of goods sold under LIFO ($4,810).
In conclusion, the net income under the FIFO cost flow method is greater than under the other two methods. Thus, companies that employ FIFO pay higher income taxes. In contrast, companies using LIFO pay lower income taxes.
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