The two most common techniques used in valuing COGS and ending inventory
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Amid the ongoing LIFO vs. FIFO debate in accounting, deciding which method to use is not always easy. LIFO and FIFO are the two most common techniques used in valuing the cost of goods sold and inventory. More specifically, LIFO is the abbreviation for last-in, first-out, while FIFO means first-in, first-out.
The International Financial Reporting Standards – IFRS – only allows FIFO accounting, while the Generally Accepted Accounting Principles – GAAP – in the U.S. allows companies to choose between LIFO or FIFO accounting.
There are other methods used to value stock such as specific identification and average or weighted cost. The method that a business uses to compute its inventory can have a significant impact on its financial statements.
Last In, First Out (LIFO)
The LIFO system is founded on the assumption that the latest items to be stored are the first items to be sold. It is a recommended technique for businesses dealing in products that are not perishable or ones that don’t face the risk of obsolescence.
Whenever there are price increases, such as in an inflationary period, the LIFO method has the impact of recording the sale of higher-priced items first while the cheaper, older products are maintained as stock. Doing so causes a firm’s cost of goods sold to increase and the net income to decrease. Both aspects help to minimize the company’s tax liability
The best way to explain the concept is through an illustration. Consider a dealership that pays $20,000 for a 2015 model car during spring and $23,000 for the same during fall. In December, the dealership sells one of these automobiles for $26,000.
From the perspective of income tax, the dealership can consider either one of the cars as a sold asset. If it accounts for the car purchased in the fall using LIFO technique, the taxable profit on this sale would be $3,000. However, if it considers the car bought in spring, the taxable profit for the same would be $6,000.
Apart from reducing the tax liability, using the LIFO technique offers other benefits, such as:
It complies better with the matching principle, as it charges costs with the revenues of a similar period
Reduces the likelihood of write-downs of inventory if their fair market value has decreased
In some industries, it conforms with the actual physical flow of inventory, such as in extraction industries (i.e., coal, oil and gas)
However, last-In, first-out does come with a few disadvantages. One of its drawbacks is that it does not correspond to the normal physical flow of most inventories. Also, the LIFO approach tends to understate the value of the closing stock and overstate COGS, which is not accepted by most taxation authorities. If a company uses the LIFO method, it will need to prepare separate calculations, which calls for additional resources.
First In, First Out (FIFO)
With FIFO, the assumption is that the first items to be produced are also the first items to be sold. For example, let’s say a grocery receives 30 units of milk on Mondays, Thursdays, and Saturdays. The store owner will put the older milk at the front of the shelf, with the hopes that the Monday shipment will sell first.
Under the first-in, first-out technique, the store owner will assume that all the milk sold first is from the Monday shipment until all 30 units are sold out, even if a customer picks from a more recent batch.
FIFO is mostly recommended for businesses that deal in perishable products. The approach provides such ventures with a more accurate value of their profits and inventory. FIFO is not only suited for companies that deal with perishable items but also those that don’t fall under the category.
With the FIFO method, the stock that remains on the shelves at the end of the accounting cycle will be valued at a price closer to the current market price for the items. It means that the inventory will be of higher value.
Why Use FIFO?
The biggest advantage of FIFO lies in its simplicity. It is easy to use, generally accepted and trusted, and it follows the natural physical flow of inventory.
Another advantage is that there’s less wastage when it comes to the deterioration of materials. Since the first items acquired are also the first ones to be sold, there is effective utilization and management of inventory.
The LIFO vs. FIFO methods are different accounting treatments for inventory that produce different results. Although LIFO is an attractive choice for those looking to keep their taxable incomes low, the FIFO method provides a more accurate financial picture of a company’s finances and is easier to implement.
Thank you for reading our guide on LIFO vs. FIFO accounting methods. CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To learn more, the following resources will be helpful:
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