Lesson 2 of 6 · 14 min
Rising and falling costs: effects on statements and ratios
When unit costs rise, FIFO reports lower cost of sales, higher profit and higher inventory than LIFO or weighted average; when costs fall, every one of those effects reverses.
In short
- Rising costs, stable or growing quantities: FIFO → lowest cost of sales, highest gross profit, highest inventory. LIFO → the opposite. Weighted average sits between.
- Falling costs: FIFO → highest cost of sales and lowest profit and inventory; LIFO → highest profit.
- FIFO inventory ≈ current replacement cost; LIFO cost of sales ≈ current replacement cost.
- Rising costs: LIFO looks less profitable and less liquid but more efficient (higher inventory turnover) than FIFO. The extra efficiency is an accounting illusion.
- The effects spread to taxes, net income, retained earnings, total assets and ratios such as the current ratio, ROA and debt-to-equity.
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