Two retailers buy the same units at the same prices and sell the same quantity. Because they pick different cost flow methods, they report different gross profit, taxes, inventory and ratios from identical purchases.
Inventory sits on the balance sheet at the smaller of two numbers: historical cost or net realisable value (NRV). NRV is the cash the inventory should bring in: the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.
The logic is simple. An asset should not be carried at more than it will recover. When NRV drops below cost, you write inventory down to NRV and recognise the loss now, in cost of goods sold (COGS) or a separate loss line. That measurement choice has implications for the financial statements and ratios. Pretax income falls in the write-down period.
Common mistakes
- Reversing the inflation table. Under rising prices, LIFO produces higher COGS and lower ending inventory, not the opposite. In Example 2, LIFO COGS is $8,000 and FIFO COGS is $6,900. Trap: swapping the two when half-remembering the rule.
- Forgetting that LIFO produces higher operating cash flow. Lower taxes mean more cash retained. The cash flow direction is opposite to the gross margin direction. Trap: assuming the lowest-margin method also gives the lowest cash flow, when Example 2's LIFO firm keeps $275 more cash.
- Filling LIFO from the wrong end. LIFO COGS takes the newest layers first. Taking the oldest layers gives $6,900, the FIFO answer, not the $8,000 LIFO answer in Example 2. Trap: $6,900 sits beside $8,000 in the answer choices.
Bottom line
- IFRS = lower of cost and NRV (write-down reversals allowed up to original cost). US GAAP FIFO and weighted average = lower of cost and NRV; LIFO and retail method = lower of cost or market (replacement cost between NRV...
- Cost of goods available is fixed; the cost flow method only splits it between COGS and ending inventory. Weighted average unit cost = cost of goods available / units available.
- Rising prices + FIFO = highest ending inventory, lowest COGS, highest gross margin, highest taxes, highest current ratio.
- Rising prices + LIFO = lowest ending inventory, highest COGS, lowest gross margin, lowest taxes, highest operating cash flow, highest inventory turnover. Deflation reverses every direction.
Exam shortcut
Before any cost flow question, total the pool (units and dollars). Compute one method, then get ending inventory as pool minus COGS, which halves the work and catches errors. For the direction table, memorise one line, "FIFO highest inventory, LIFO highest COGS in inflation," and derive the rest.
The full lesson (about 3,915 words, 26 min read) adds 10 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- analysis of inventories
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