Inventory plays a critical role in a business firm's financial management. Of all the current assets on a firm's balance sheet, it is likely that inventory is the largest asset category in terms of value. Inventory is only on the balance sheet of companies that sell products. Some service businesses also have to use inventory accounting if they have to use the products they purchase in servicing their customers.
Because inventory is the major current asset on the balance sheet of firms that sell products, inventory accounting is a very important part of a business firm's financial management. The manner in which a firm accounts for its inventory can impact its cost of goods sold, cash flow, and profit. The Generally Accepted Accounting Principles (GAAP) include the standards applicable to inventory accounting. The Financial Accounting Standards Board (FASB) is the source for the GAAP standards.
Inventory accounting is not difficult, but it can be tedious. 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.
Managers must have a way to account for the different prices assigned to inventory at the end of each accounting period.
LIFO (last-in-first-out) and FIFO (first-in-first-out) are the two most common inventory cost methods that companies use to account for the costs of purchased inventory on the balance sheet.
What Is First-In, First-Out (FIFO)?
FIFO is the standard, or default, inventory accounting method for business firms.
The FIFO method assumes that the first items put on the shelf are the first items sold. In other words, the first items of inventory you purchased are sold first.
This system is preferred by most companies, but it is especially used in companies where the inventory is perishable or subject to quick obsolescence.
FIFO is the preferred accounting method in an environment of rising prices. If the inventory market prices go up, FIFO will give you a lower cost of goods sold because you are recording the cost of your older, cheaper goods first. From a tax perspective, the Internal Revenue Service (IRS) requires that you use the accrual method of accounting if you have inventory.
How Does FIFO Work?
For example, a tanker delivers 2,000 gallons of gasoline to Henry's Service Station on Monday. The price at that time is $2.35 per gallon. On Tuesday, the price of gasoline has gone up, and the tanker delivers 2,000 more gallons at a price of $2.50 per gallon.
Under FIFO, the gasoline station would assign the $2.35-per-gallon gasoline to cost of goods sold, since the assumption is that the first gallon of gasoline purchased is sold first. The remaining $2.50-per-gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period.
What Is the Impact of FIFO on Financial Statements?
The method a business chooses to account for its inventory can directly impact its financial statements. Net income will be higher, using the FIFO method of accounting inventory, and the cost of goods sold will be lower since the lower price will be used to calculate that figure. The company's tax liability will be higher due to higher net income and lower cost of goods sold. 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.
Your bottom line will look better to your banker and investors, but your tax liability will be higher due to higher profit from lower costs.
Because FIFO represents the cost of recent purchases, it usually more accurately reflects inventory replacement costs than other inventory accounting methods.
What Is Last-In, First-Out (LIFO)?
LIFO is the inventory accounting method that operates under the assumption that a business firm uses its inventory last in, first out. The assumption is that the firm sells the last unit of inventory purchased first. Using FIFO, you would sell the inventory in the order it comes in.
Switching between inventory costing methods affects the company's profits and the amount of taxes it must pay each year, which is why the practice is discouraged by the IRS. Once a business chooses either LIFO or FIFO as its inventory accounting method, it must get permission from the IRS to change methods using Form 970.
One reason firms must get approval to change to LIFO is to prevent companies from changing inventory accounting methods in the middle of a time period for more favorable tax treatment.
How Does LIFO Work?
We will change the previous example, involving gasoline and a tanker truck, to illustrate LIFO inventory accounting. A tanker delivers 2,000 gallons of gasoline to Henry's Service Station on Monday. The price at that time is $2.35 per gallon. On Tuesday, the price of gasoline has gone up, and the tanker delivers 2,000 more gallons at a price of $2.50 per gallon.
Under LIFO, the gasoline station would assign the $2.50-per-gallon gasoline to cost of goods sold, since the assumption is that the last gallon of gasoline purchased is sold first. The remaining $2.35-per-gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period.
Using LIFO, if the last units of inventory bought were purchased at higher prices, the higher-priced units are sold first, with the lower-priced, older units remaining in inventory. This increases a company's cost of goods sold and lowers its net income, both of which reduce the company's tax liability. This makes LIFO more desirable when corporate tax rates are higher.
LIFO seldom gives a good representation of the replacement cost for the inventory units, which is one of its drawbacks. In addition, it may not correspond to the actual physical flow of the goods.
What Is the Impact of LIFO on Financial Statements?
The method a business chooses to account for its inventory can directly impact its financial statements. Net income will be lower, using the LIFO method of accounting inventory, and the cost of goods sold will be higher since the higher price will be used to calculate that figure. The company's tax liability will be lower due to lower net income and higher cost of goods sold. The value of inventory shown on the balance sheet will be lower since $2.35 rather than $2.50 is used to calculate the value of ending inventory.
LIFO usually does not reflect inventory replacement costs as well as other inventory accounting methods. The LIFO method of inventory accounting is a more complex method of costing inventory. Here is an example of LIFO inventory accounting.
Determining Ending Inventory
Calculating ending inventory is important because it determines the inventory value that's shown on a company's financial reports and statements. This number changes with each unit the company sells and affects the company's reported profit, asset balance, and tax liability.
The equation to calculate ending inventory is as follows:
The two common ways of valuing this inventory, LIFO and FIFO, can give significantly different results for ending inventory.
Importance of Inventory and Cost Methods
Understanding the important role that inventory plays in finances is critical. Of all the assets on a firm's balance sheet, it is likely that inventory is the largest asset category in terms of value.
The way a business firm values its inventory can affect its balance sheet and income statement greatly due to the large amounts of money tied up in inventory for product-producing firms.
Inventory is where many companies have the majority of their funds invested. Inventory typically consists of raw materials, work-in-process, and finished goods.
To calculate the profit a company produces, it must track sales revenue as well as the costs involved in producing its products.
When considering LIFO or FIFO, the cost a company chooses to record for the inventory it sells affects how much profit it can report for a period, based on its ending inventory.
LIFO vs. FIFO: Which Works Best for You?
In most cases, as recognized by the IRS, the FIFO inventory accounting method works best. Not only is the LIFO inventory accounting method more complicated, it does not fit as well in every situation.
LIFO is not as effective with regard to the replacement cost of a business's inventory. It is also not appropriate if the business has inventory that easily becomes obsolete or inventory that is perishable. LIFO will always show a lower net income on the firm's financial statements.
Issues and Challenges With LIFO
Inventory accounting is only one part of a company's management of its inventory investment, but an important one. When you're using LIFO accounting methods in the context of a decline in inventory purchase prices, your balance sheet will soon bear little relation to your actual financial position because your lower costs reflect on your cost of goods sold.
But as you sell through your inventory, you begin selling goods that were actually acquired for a higher price at some earlier time.
The earlier costs are still in the inventory account. The result is that the reported inventory asset balance has no relation to the cost of goods at current prices. For this reason, many companies choose to use a weighted-average cost method or use the current market price, also known as replacement cost, to prevent these types of issues.