Inflation/Deflation and Inventory Accounting Analysis

Deflation and inventory accounting analysis

• LIFO income statement in a falling price environment – LIFO method will raise reported margins.  Most recent goods are the least expensive and LIFO will calculate lower COGS and thus a higher gross margin.
• LIFO balance sheet in a falling pricing environment – LIFO method raises the value of inventory because the cheapest items have been taken off the balance sheet first.
• Example: If an analyst knows that a company employs LIFO and the prices of its goods have fallen due to weakening market demand, then the analyst may look to revise the balance sheet based on FIFO, as the real value of the company’s short-term assets is likely over-stated.
• FIFO income statement in a falling price environment – FIFO method will lower reported margins.  Oldest goods are the most expensive because prices have fallen over time and FIFO will calculate higher COGS and thus a lower gross margin.
• FIFO balance sheet in a falling pricing environment – FIFO method lowers the value of inventory, as the oldest and most expensive items are taken off the balance sheet first.

LIFO, FIFO, and Economic Reality

• FIFO and the Balance Sheet – Regardless of an inflationary or deflationary environment, FIFO should best approximate the fair market value of balance sheet inventory as the value is based on more recent prices; the oldest goods have been sold out of inventory under FIFO.

• LIFO and the Income Statement – Regardless of an inflationary or deflationary environment, LIFO should best approximate a company’s current gross profit performance.  The most recent goods purchased have been applied to cost of goods sold and this best approximates the company’s near term inventory replacement cost.