Inventory Valuation (FIFO vs. LIFO) Explained
Do you often look at your businesses but not at how they keep track of their inventory? It is a big part of the assets of many businesses, if not the biggest part. Because of this, it is an important part of the balance sheet, too. So, serious investors need to know how to compare companies in different industries or in their own portfolios based on inventory accounting—let’s see FIFO and LIFO, the two that matter the most in this regard.
- The Last-In, First-Out (LIFO) method is based on the idea that the most recent or most recently added inventory is sold first.
- The First-In, First-Out (FIFO) method is based on the idea that the oldest item in inventory is sold first.
- LIFO isn't practical for many businesses because they wouldn't leave their older inventory sitting around doing nothing.
- FIFO is the best option because companies usually use their oldest inventory first when selling goods.
- Choosing between these two inventory methods affects a company's financial statements because it changes the value of inventory, the cost of goods sold, and the net profit.
What is Inventory Valuation In Accounting?
Inventory is a term for a business's goods at three different stages of production:
- Raw materials are the basic things that are used to make finished goods.
- Work-in-progress refers to things that are being made but are not yet finished.
- Finished inventory is made up of items that are ready to be sold and can be bought and sent to customers.
You can figure out a company's ending inventory by taking the goods it has at the start of a given period, adding the materials it bought to make more goods, subtracting the goods it sold, and calling the difference the cost of goods sold (COGS).
Inventory accounting gives the goods an inventory at each stage of production and counts them as company assets because they can be sold and turned into cash soon. So that a company as a whole can be accurately valued, its assets need to be accurately valued.
Net Purchases + Beginning Inventory - Cost Of Goods Sold = Ending Inventory
All you need to know about Cost Of Goods Sold (COGS).
Understanding Inventory Valuations LIFO And FIFO
Businesses can use the first-in, first-out (FIFO), last-in, first-out (LIFO), or average cost inventory accounting methods, even though LIFO is not IFRS-compliant. These methods are used to follow how inventory moves and to keep track of the right costs.
LIFO and FIFO exist because a company has to figure out how to monitor its inventory movement. The prices a business pays for raw materials, labor, and other costs are always changing. Because of this, the price of making or buying a good today might be different than it was a week ago—hence the difference between FIFO and LIFO.
- First-In, First-Out (FIFO) Explained
The First-In, First-Out (FIFO) method assumes that the first item that goes into inventory or the item that has been in inventory the longest is sold first. For example, let's say a bakery makes 400 loaves of bread on Monday for SAR 2 each and 400 more on Tuesday for SAR 2.50 each.
FIFO says that if the bakery sold 400 loaves on Wednesday, the COGS (on the income statement) is SAR 2 per loaf because that's how much each of the first loaves in inventory cost. The SAR 2.5 loaves would be added to the inventory that was being sold off (on the balance sheet).
- Last-In, First-Out (LIFO) Explained
The Last-In, First-Out (LIFO) method is based on the idea that the last unit or units to come into inventory are the first ones to be sold. So, at the end of the accounting period, the older inventory is left over. The same bakery would put SAR 2.5 on each of the 400 loaves that were sold on Wednesday. The remaining SAR 2 loaves would be used to figure out the value of inventory at the end of the period.
Inventory Valuation: LIFO vs. FIFO
Different industries use different ways to figure out how much a company is worth. Here are some of the ways that LIFO and FIFO are different when it comes to valuing inventory and figuring out how it affects COGS and profits.
Since LIFO uses the most recently bought inventory to figure out COGS, the inventory that is left over could be very old or even out of date. So, LIFO doesn't give an accurate or up-to-date value of inventory because the value is much lower than the prices of items in inventory at the present time.
Also, LIFO isn't practical nor realistic for many companies because they wouldn't leave their older inventory sitting in stock while they used their most recently bought inventory.
FIFO can be a better way to figure out the value of the inventory at the end of the period because the older items have been used up and the prices of the items that were just bought reflect the current market prices. Most companies should use FIFO because they usually use their oldest inventory first when making their goods. This means that the COGS value should reflect how their goods are made.
Companies can choose from a few different ways to keep track of their inventory, but IFRS has some limitations regarding LIFO. LIFO and FIFO are two of these ways. When a company uses the LIFO method, they sell the most recent inventory, which usually costs more to get or make. When a company uses the FIFO method, the cost of goods sold is lower, but there is more inventory.
Depending on which inventory method is used, a company's taxable income, net income, and balance sheet figures will all be different.
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