Basics of LIFO and FIFO Inventory Accounting Methods

The two common ways of valuing this inventory, LIFO and FIFO, can give significantly different results for ending inventory. This system is preferred by most companies, but it is especially used in companies where the inventory is perishable or subject to quick obsolescence. LIFO might be better for taxes if your product’s inventory value changes frequently. 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. You’re allowed to go back to LIFO only if the IRS gives specific permission.

Importance of Inventory and Cost Methods

Further, since the company has been reporting a cost of sales lower than the actual replacement cost, due to price decreases, the company’s cost of sales has been underestimated. To make a proper estimation of Xtractor’s cost of sales, the amount of decrease of the LIFO reserve needs to be added to the cost of sales. Inflation is the overall increase in prices over time, and this discussion assumes that inventory items purchased first are less expensive than more recent purchases. Since the economy has some level of inflation in most years, prices increase from one year to the next. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method as once early inventory is booked, it may remain on the books untouched for long periods of time. FIFO and LIFO are two methods of accounting and reporting inventory value.

First In, First Out (FIFO) Cost

Instructions Compute the cost of ending inventory and the cost of goods sold under (1) FIFO and (2) LIFO. Elsa’s Boards sells a snowboard, Xpert, that is popular with snowboard enthusiasts, Information relating to Elsa’s purchases of Xpert snowboards during September is shown below. On December 1, Kiyak Electronics Ltd. has three DVD players left in stock. Kari Downs, an auditor with Wheeler CPAs, is performing a review of Depue Company’s inventory account. Depue did not have a good year, and top management is under pressure to… You are provided with the following information for Koetteritz Inc. for the month ended June 30, 2019.

• LIFO usually doesn’t match the physical movement of inventory, as companies may be more likely to try to move older inventory first.
• At the beginning of October, Glee had in beginning inventory 2,000 of Unique’s CDs with a unit cost of $7.
• Companies with perishable goods or items heavily subject to obsolescence are more likely to use LIFO.
• Because FIFO represents the cost of recent purchases, it usually more accurately reflects inventory replacement costs than other inventory accounting methods.

Is FIFO a Better Inventory Method Than LIFO?

Given that the cost of inventory is premised on the most recent purchases, these costs are highly likely to reflect the higher inflationary prices. Also, through matching lower cost inventory with revenue, the FIFO method can minimize a business’ tax liability when prices are declining. Businesses would use the FIFO method because it better reflects current market prices. This is achieved by valuing the outstanding inventory at the cost of the most recent purchases. The FIFO method can help ensure that the inventory is not overstated or understated.

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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. When a business manager buys inventory to sell to customers, it is bought at different points in time. Because of that, the same inventory may have a different cost every time it is purchased. Not only does a manager buy inventory at different prices, but they may also use and sell inventory at different prices as well.

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. 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. In either case, the average cost will provide figures between those of FIFO and LIFO. LIFO usually provides a realistic income statement at the expense of the balance sheet.

The value of inventory shown on the balance sheet will be higher since $2.50 rather than $2.35 is used to calculate the value of ending inventory. Companies that undergo long periods of inactivity or accumulation automatic extension of inventory will find themselves needing to pull historical records to determine the cost of goods sold. So, which inventory figure a company starts with when valuing its inventory really does matter.