Investments, tenth edition

   Inventory Valuation 

 There are two commonly used ways to value inventories:    LIFO    (last-in first-out) and 

   FIFO    (first-in first-out). We can explain the difference using a numerical example. 

 Suppose Generic Products, Inc. (GPI), has a constant inventory of 1 million units of 

generic goods. The inventory turns over once per year, meaning the ratio of cost of goods 

sold to inventory is 1. 

 The LIFO system calls for valuing the million units used up during the year at the cur-

rent cost of production, so that the last goods produced are considered the first ones to be 

sold. They are valued at today’s cost. 

 The FIFO system assumes that the units used up or sold are the ones that were added to 

inventory first, and goods sold should be valued at original cost. 

 If the price of generic goods has been constant, at the level of $1, say, the book value 

of inventory and the cost of goods sold would be the same, $1 million under both systems. 

But suppose the price of generic goods rises by 10 cents per unit during the year as a result 

of general inflation. 

 LIFO accounting would result in a cost of goods sold of $1.1 million, whereas the end-

of-year balance sheet value of the 1 million units in inventory remains $1 million. The 

balance sheet value of inventories is given as the cost of the goods still in inventory. Under 

LIFO the last goods produced are assumed to be sold at the current cost of $1.10; the 

goods remaining are the previously produced goods, at a cost of only $1. You can see that 

although LIFO accounting accurately measures the cost of goods sold today, it understates 

the current value of the remaining inventory in an inflationary environment. 

 In contrast, under FIFO accounting, the cost of goods sold would be $1 million, and the 

end-of-year balance sheet value of the inventory would be $1.1 million. The result is that 

the LIFO firm has both a lower reported profit and a lower balance sheet value of invento-

ries than the FIFO firm. 

 LIFO is preferred over FIFO in computing economic earnings (i.e., real sustainable 

cash flow) because it uses up-to-date prices to evaluate the cost of goods sold. However, 

    19.6 

Comparability Problems  

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bod61671_ch19_635-677.indd   658

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  C H A P T E R  

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 Financial 

Statement 

Analysis 

659

LIFO accounting induces balance sheet distortions when it values investment in invento-

ries at original cost. This practice results in an upward bias in ROE because the investment 

base on which return is earned is undervalued.