Next-In First-Out (NIFO) is a method of inventory valuation used for internal purposes. NIFO involves charging the cost of goods sold by the replacement cost of the item sold from inventory. The value of NIFO inventory valuation method is derived from its ability to integrate the effect of inflation into the costing process. It is not an accepted inventory valuation method under GAAP because it violates the historical cost principle.
Next-In, First-Out (NIFO) is a method of inventory valuation that involves costing inventory by its replacement cost rather than its historical cost.
The historical cost principle states that assets are recognized at their historical cost.
The NIFO approach is not accepted under the generally accepted accounting principles (GAAP). It is strictly used for internal purposes because of its practical application in price-setting for business managers.
What is the Historical Cost Principle?
The historical cost principle states that an asset is journalized at its historical purchase cost. Every asset comes with two values – its historical cost and its market value. Historical cost is the price paid, or the liability agreed, when the transaction occurred. Market value is constantly fluctuating and is subjective to what buyers are willing to pay. Therefore, historical cost is used under generally accepted accounting principles (GAAP) because it is objective, reliable, and verifiable.
Criticism of the Historical Cost Principle
The application of the historical cost principle can potentially lead to inefficient outcomes for society. Firstly, the balance sheet will fail to consider the impact of inflation on purchasing decisions.
Secondly, in the income statement, costs are matched to revenue without consideration that the goods were purchased previously. It implies that sales are matched with outdated costs. The major inefficient outcome it leads to is decreased taxable income because of reduced accounting profit.
Commonly Used Inventory Valuation Methods
1. First-In, First-Out Method (FIFO)
The FIFO approach dictates that the goods that arrive first are sold first. The balance sheet presentation positively benefits from FIFO because of higher quality information on inventory valuation. It is because the cost of newer goods will better resemble the good’s current value.
The income statement presentation is negatively impacted because the revenue is matched with an outdated cost. FIFO is accepted under GAAP, IFRS, and ASPE.
2. Last-In, First-Out Method (LIFO)
The LIFO approach assumes that the goods that arrive last are issued first. The balance sheet presentation is negatively affected by LIFO because inventory will be recorded at an outdated cost.
However, the income statement will contain more accurate information, as the sale of inventory will be matched with a recent inventory cost. LIFO is an acceptable accounting practice under GAAP; however, it is not accepted under IFRS and ASPE.
3. Weighted Average Cost Method (WAC)
The weighted average cost method assumes that all goods are issued at the average price of the inventories held. It divides the cost of goods available for sale by the number of units available for sale.
The WAC method produces a different allocation depending on whether the company uses a periodic inventory system or a perpetual inventory system. WAC is accepted under GAAP, IFRS, and ASPE.
Why Would You Use Next-In First-Out?
Although NIFO is not a generally accepted accounting principle, it is commonly used by business managers today. The NIFO method is particularly useful during inflationary periods because it allows companies to price goods on a replacement-cost basis. It is important because management can assess whether the product should continue to be sold or if its price should change.
Therefore, the cost NIFO represents is the inventory’s market value. Overall, NIFO is very practically applicable to most businesses and presents a more accurate inventory value given times of inflation.
Why Isn’t NIFO Acceptable Under GAAP Principles?
Next-In, First-Out is not an acceptable GAAP method of valuing inventory because it can cause a potentially material impact on the reliability and objectivity of financial statements. If a company operates in a sector where producers set extremely volatile prices, it can lead to the company selectively choosing an understated replacement cost to appear more profitable.
Companies must always aim to produce representationally faithful financial statements, and the NIFO method’s lack of objectivity can be detrimental in the financial reporting process.
As an example, consider a microchip manufacturer that decides to sell its microchips for $50 each. The original cost of production to the company was $25, resulting in a reported profit of $25.
If the NIFO method is applied, consider the market value of the microchip at the time of sale. In such a case, the market value of a microchip is $30. Therefore, the company will recognize $30 in cost of goods sold, and $20 as reported profit.
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