LIFO versus FIFO
LIFO versus FIFO
LIFO method
The last in first out (LIFO) method first matches against revenue the cost of the last goods purchased. It a periodic inventory system is used, then it would be assumed that the cost of the total quantity sold or issued during the month have come from the most recent purchases. The ending inventory would be priced by using the total units as a basis of computation and disregarding the exact dates involved.
Example:
Assume that a company had the following transactions in the first month of operations.
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Periodic Inventory System:
Assume that the cost of the 4,000 units withdrawn on absorbed the 2,000 units purchased on March 30 and 2,000 units of the 6,000 units purchased on March 15. The inventory and related cost of goods sold would then be computed as shown below:
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Perpetual Inventory System:
If a perpetual inventory record is kept in quantities and dollars, application of the last in first out method will result in different inventory and cost of goods sold amounts as shown below:
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The month-end periodic inventory computation presented above (inventory $25,600 and cost of goods sold $18,300) shows a different amount from the perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600). This is because the periodic system matches the total withdrawals for the month with the total purchases for the month in applying the last in first out method. In contrast, the perpetual system matches each withdrawal with the immediately preceding purchases. In effect, the periodic computation assumed that the cost of the goods that were purchased on March 30 were included in the sale or issue on March 19.
Advantages of Last in First Out LIFO) Method:
One obvious advantage of LIFO approach is that in certain satiations the LIFO cost flow actually approximates the physical flow of the goods in and out of inventory. For example, in the case of a coal pile, the last coal in is the first coal out because it is on the top of the pile. The coal remover is not going to take the coal from the bottom of the top of the pile. The coal that is going to be taken first is the coal that was placed on the pile last. How ever the coal pile situation is one of the only a few situations where the actual physical flow corresponds to LIFO. Therefore most adherents of LIFO use other arguments for its widespread employment, as follows:
Matching:
In LIFO, the more recent costs are matched against current revenues to provide a better measure of current revenues. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that by failing to match current costs against current revenues, transitory or "paper" profits ("inventory profits") are created. Inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost. The cost of goods sold therefore is understated and profit is overstated. Using LIFO (rather than a method such as FIFO), current costs are matched against revenues and inventory profits are thereby reduced.
Tax Benefits/Improved Cash Flow:
Tax benefits are the major reason why LIFO has become popular. As long as the price level increases and inventory inventory quantities do not decrease, a deferral of income tax occurs, because the items most recently purchased at the higher price level are matched against revenues.
Future Earnings Hedge:
With LIFO, a company's future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases. Since the most recent inventory is sold first, there is not much ending inventory sitting around at high prices vulnerable to a price decline. In contrast, inventory costed under FIFO is more vulnerable to price decline, which can reduce net income substantially.
Disadvantages of Last In First Out Approach:
Despite its advantages, LIFO has the following drawbacks:
Many corporate managers view the lower profits reported under the LIFO method in inflationary times as a distinct disadvantage. They would rather have higher reported profits than lower taxes. Some fear that an accounting change to LIFO may be misunderstood by investors and that, as a result of the lower profits, the price of the company's stock will fall. In fact, though, there is some evidence to reduce this contention.
FIFO method
The first in first out (FIFO) method assumes that goods are used in the order in which they are purchased. In other words, it assumes that the first goods purchased are the first used (in manufacturing concerns) or the first goods sold (in the merchandising concerns). The inventory remaining must therefore represent the most recent purchases.
Example:
Assume that a company had the following transactions in the first month of operations.
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Periodic Inventory System:
Assume that the company uses the periodic inventory system (amount of inventory computed only at the end of the month). The cost of the ending inventory is computed by taking the cost of the most recent purchase and working back until all units in the inventory are accounted for. The ending inventory and cost of goods sold are determined as shown below:
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Perpetual Inventory System:
If a perpetual inventory system in quantities and dollars is used, a cost figure is attached to each withdrawal. Then the cost of the 4,000 units removed on march 19 would be made up of the items purchased on March 2 and March 15. The inventory on a FIFO basis perpetual system for the company is shown below:
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The ending inventory in this situation is $27,100, and the cost of goods sold is $16,800 [(2,000 @ $4.00) + (2,000 @ $4.40)].
Notice that in these two FIFO examples, the cost of goods sold and ending inventory are the same. In all cases where first in first out method (FIFO Method) is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. This is true because the same costs will always be first in and, therefore, first out - whether cost of goods sold is computed as goods are sold throughout the period (the periodic system).
Objectives and Advantages of FIFO Method:
One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it does not permit manipulation of income because the enterprise is not free to pick a certain cost item to be charged to expense.
Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the fist goods in are the first goods out, the ending inventory amount will be composed of the most recent purchases. This is particularly true where the inventory turnover is rapid. This approach generally provides a reasonable approximation of replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.
Disadvantages of FIFO Method:
The basic disadvantages of first in first out method (FIFO Method) are that costs are not matched against current revenues on the income statement. The oldest costs are charged against the more revenue, which can lead to distortion in gross profit and net income.
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