Inventory Valuation Methods (FIFO &

LIFO)

Table of Contents

● Introduction
● What is Inventory, and how is it valued?
● Is Inventory Tracking a must?
● Inventory Valuation Method
● Different Methods of Inventory Valuation
● Example of FIFO
● Example of LIFO
● Difference between FIFO and LIFO
● Which method is better?
● GAAP/IFRS Regulations for FIFO/LIFO
● Closing Thoughts
Introduction

In the retail business, your goal is not only to generate revenue and profit
but also to keep track and manage your inventory. We all know how to
import inventory management and what’s its contribution towards healthy
and optimum business operations. In this blog, we will learn all about
inventory valuation and accounting principles. Why it is so important to
value our inventory, different methods for inventory valuation, and how
you should choose your inventory valuation method based on your
business.

What is Inventory, and how is it valued?

Generally speaking, Inventory is the company’s goods that can be classified

under three stages of production:

● Products that are raw materials

● Items that are in production
● Goods are ready for sale

Inventory accounting assigns values to the company’s inventory and

classifies them as the company’s assets. Assets are inventory that can be
turned into cash in the near future. In order to accurately value your
company, all your company’s assets need to be assessed.

Is Inventory Tracking a Must?

There are two methods of determining income and expenses for accounting
purposes: Cash accounting and Accrual accounting.
For medium to large scale retail businesses out there own some inventory
or the other. If you own inventory, then according to the IRS(Internal
Revenue Service) requires you to use the accrual method of accounting.

In accrual accounting, the transaction is recorded when it is earned by

sending out an invoice or receiving a bill. That’s why it is essential to track
your inventory on every phase of the business cycle.

The new Tax Cuts and Jobs Act states that “if your business has gross
receipts of less than $25 million, you can treat your inventory as
“non-incidental material and supplies.” In layman terms, what it means is
that the items in your inventory need not be valued and considered as
assets of the company as they are bought for resale. In this case, you can
use the cash method of accounting.

Inventory Valuation Method

At the beginning and end of the fiscal year, inventory valuation is a must.
For valuation purposes, you must use:

● Generally Accepted Accounting Standards guidelines

● Must clearly reflect your income
● Must maintain consistency from year to year

Since inventory is in constant to and fro motion within the company, it's
challenging to track all the costs of individual items. So, GAAP or Generally
Accepted Accounting Standards allow businesses to use some guidelines in
properly evaluating their inventory.
Different Methods of Inventory Valuation
A company can choose from various methods to determine its inventory
costs suggested by GAAP. In this U.S. Generally Accepted Accounting
Principles, also known as GAAP, refer to a standard set of accounting
principles that have been issued by the Financial Accounting Standards
Board(FASB). GAAP allows businesses to use one of the different inventory
accounting methods such as, first in first out (FIFO) and last in first out
(LIFO).

FIFO
FIFO, the acronym stands for First-In-First-Out. It is an inventory
accounting method where the oldest stock or the inventory that entered the
warehouse first is recorded as sold first. So, if you sell a product, the cost of
goods sold by using the FIFO method is the value of the oldest inventory.
FIFO is one of the most popularly used in inventory valuation methods.
Using the Fifo method has some significant advantages as follows:
● It is more realistic because most businesses ship older stock first to
avoid depreciation of value or spoilage.
● FIFO increases the value of your purchasing inventory as well as net
worth in times of inflation. As a result, you get a higher asset value.
● Your operational reports are always accurate. As you are selling the
first bought item first, your balance sheet will always show the actual
cost price of the inventory.

LIFO
LIFO, the acronym stands for Last-In-First-Out. It is an inventory
accounting method where goods produced or purchased most recently are
recorded as sold first. The cost of the newest products is the first to be
accounted for as the cost of goods sold (COGS), whereas the lower prices of
older goods are counted in inventory. A lot of accountants in the US often
advise using the LIFO method for your inventory accounting when you have
stock with frequently changing costs. Using LIFO as a preferred method for
such scenarios helps with the matching of the latest costs of inventory with
the sales revenue of the current period. This can be a more straightforward
approach for initial inventory valuation as well as for tax filing purposes.
Unlike FIFO, LIFO has some disadvantages while using it as follows:
● LIFO brings taxable income down when your cost price rises, but your
profit will turn out significantly lower.
● If, in the near future, you plan to expand your business, not all
countries allow a LIFO valuation.

Example of FIFO
Let’s understand how FIFO is used to calculate Cost of Goods Sold (COGS)
using a rudimentary example

EVENT FIFO
Buys an Item $100

Buys the same item after inflation $150

Sells an item for $175 -$100

Reported profit $75

In the FIFO method, when calculating profit, its initial/oldest purchasing

cost is subtracted from its selling price to calculate the reported profit.

Example of LIFO
The same example used earlier can be used to show the LIFO method for
calculating the cost of goods sold (COGS)

EVENT LIFO
Buys an Item $100

Buys the same item after inflation $150

Sells an item for $175 -$150

Reported profit $25

In the LIFO method, when calculating profit, it’s most recent purchasing
cost is subtracted from its selling price to calculate the reported profit. As
you can see, using the LIFO method for inventory valuation and accounting
lowers your return profit.

Difference Between FIFO and LIFO

FIFO or LIFO are the methods that companies use to assess their inventory
and calculate profit. The amount of profit a company generates affects their
income taxes.

The difference between FIFO and LIFO are showcased as below.

Comparison Parameter FIFO LIFO

Meaning The first in first out or The last in first out or
the FIFO method the LIFO method
assumes that the oldest assumes that the last
products in a company's item of inventory
inventory have been purchased is the first
 sold first. one sold.

Restrictions No restrictions by GAAP IFRS restricts LIFO

or IFRS method

Recording Keeping In the FIFO method, the In the LIFO method, the
number of record number of record
keeping decreases keeping increases

Impact of Inflation Decreases the COGS Increases the COGS and

and increases the net decreases the net profit
profit

Preference Higher Lower

Which method is better?

From what we have understood so far, we can say that the higher the cost
inventory lower is the tax while lower the cost of inventory turns out to be
the higher tax.

To know which method is best suited for your business, you need to look at
the way your inventory costs are changing.
● If your inventory cost is increasing or is likely to increase in the near
future, LIFO can be better. Because the cost of goods is higher, you
will benefit from the lower taxes.
● If you feel that inventory cost could be decreasing in the near future,
FIFO is the best option.
● If your preference is to accurately assess your inventory cost, FIFO is
the better option. It is so because FIFO operates on the assumption
that the older and less costly items are usually sold first.
GAAP/IFRS regulations for FIFO and LIFO
Generally Accepted Accounting Principles, also known as GAAP, is
responsible for setting up standards for accounting procedures in the
United States. Under GAAP, both FIFO and LIFO are legal.

However, the point to be noted is that the International Accounting

Standards Body (IFRS) has not permitted the LIFO method.

Outside of the US, most other countries follow the rules laid down by the
IFRS(International Financial Reporting Standards) Foundation. This is the
reason why most US based companies use the LIFO method for financial
statements and switch to the FIFO method for their overseas operations.

If you ever decide that it would be ideal for your business to switch from the
LIFO method to the FIFO method, you need to file FORM 970 with the
IRS(Internal Revenue Service). You are allowed to go back to FIFO only if
the IRS gives specific permission.

Closing Thoughts
This blog was written in an attempt to answer all the demanding questions
regarding FIFO and LIFO methods of Inventory Valuation and Accounting.

In a nutshell, we have learned about Inventory Valuation and its

importance for business. The reason being, it is the way by which you can
accurately determine the total value of all your assets and liabilities. While
we have seen both FIFO and LIFO methods of inventory valuation, one
thing is clear. No method is a foolproof solution for your business. Both
methods have their pros and cons. As such, one should choose the method
according to their own business. If you are a firm that wants to deal with
international operations, FIFO is the best method as outside the USA; not
many countries support the LIFO method.

If you feel any queries whatsoever regarding the topic, feel free to ask me in
the comments section below.

https://www.freshbooks.com/hub/accounting/fifo-vs-lifo

https://blog.brightpearl.com/fifo-vs-lifo-which-is-best

https://www.investopedia.com/articles/02/060502.asp

https://www.thebalancesmb.com/fifo-and-lifo-inventory-methods-397456

https://www.educba.com/fifo-vs-lifo/​(Infographics)