Question

When inventory costs are declining, explain the impact to the balance sheet and income statement using the FIFO method.

Answer 1

Answer

• Under FIFO method, units sold are assumed to be sold from earliest purchases first. The first arrived units, are sold first.
  This means that ending inventory will be from LATEST purchases.
• When inventory costs are declining and FIFO method is in use, the earlier purchases would have been at HIGHER cost and latest recent purchases would have been on LOWER COST.
• Impact on Income Statement:
  >Since earliest purchases were on HIGHER COST, the Cost of Goods Sold would be HIGHER.
  >Higher Cost of Goods Sold = Higher expense item = Lower Gross Profits.
  >Lower gross profits = Lower net income = Lower income taxes.
• Impact on Balance Sheet:
  >Since latest purchases are at declining lower cost, the ending inventory value would be at LOWER COST.
  >Lower ending inventory value = Lower Assets.
  >Moreover, impact on income statement that has led to lower net income will lead to LOWER Retained earnings and hence lower Stockholder’s Equity.