CFA Level II ExamFinancial Statement AnalysisMedium
An analyst is comparing two companies, Company X and Company Y, operating in the same industry. Company X uses the LIFO inventory method, while Company Y uses FIFO. In a period of rising inventory costs, which of the following is most likely true regarding their reported financial statements?
- ACompany Y will report a lower cost of goods sold (COGS) and higher net income than Company X.
- BBoth companies will report the same COGS and net income, assuming identical physical inventory flows.
- CCompany X will report a higher inventory value on its balance sheet than Company Y.
- DCompany X will report a lower cost of goods sold (COGS) and higher net income than Company Y.
Show answer & explanationAnswer & explanation
Correct answer: A. Company Y will report a lower cost of goods sold (COGS) and higher net income than Company X.
In a period of rising costs, FIFO assumes the first (cheapest) inventory is sold, leading to a lower COGS and thus higher net income. LIFO assumes the last (most expensive) inventory is sold, leading to a higher COGS and lower net income.
Why the other options are wrong
- B. Inventory costing methods directly impact COGS and net income, so they will not be the same in a period of rising costs.
- C. Under LIFO with rising costs, the inventory remaining on the balance sheet is the oldest (cheapest) inventory, leading to a lower inventory value than FIFO, which leaves the newest (most expensive) inventory.
- D. This statement is incorrect. Under LIFO with rising costs, COGS is higher, and net income is lower.
LIFO vs. FIFO (Rising Costs)
The choice between LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) inventory costing methods significantly impacts reported COGS, inventory value, and net income, especially during periods of changing costs.
- Rising Costs: FIFO results in lower COGS, higher net income, higher inventory value.
- Rising Costs: LIFO results in higher COGS, lower net income, lower inventory value.
- LIFO is permitted under U.S. GAAP but prohibited under IFRS.
- Impacts profitability ratios and working capital measures.
Memory trick: Rising Costs: FIFO's First, Leaves Profit Burst; LIFO's Last, Makes Income Past.