FIFO and LIFO accounting

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FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. In other words, the cost associated with the inventory that was purchased first is the cost expensed first. With FIFO, the cost of inventory reported on the balance sheet represents the cost of the inventory most recently purchased.

Consider this example: WikiWorld Co. had the following inventory at hand, in order of acquisition in November:

Number of Units Cost
100 units $50
125 units $55
75 units $59

Suppose WikiWorld Co. sells 210 units during November. The company would expense the cost associated with the first 100 units at $50 and the remaining 110 units at $55. Under FIFO, the total cost of sales for October would be $11,050. The ending inventory would be calculated the following way:

Number of Units Price per unit Total
Remaining 15 units $55 $825 ($55 x 15 units)
75 units $59 $4425 ($59 x 75 units)
Total $5250

Therefore, the balance sheet would now show inventory valued at $5250.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in the U.S.[1]

In the example above, the company (using LIFO accounting) would expense the cost associated with the first 75 units at $59, 125 more units at $55, and the remaining 10 units at $50. Under LIFO, the total cost of sales for October would be $11,800. The ending inventory would be calculated the following way:

Number of Units Price per unit Total
Remaining 90 units $50 $4500 ($50 x 90 units)
Total $4500

So the balance sheet would show $4500 in inventory under LIFO.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve (which, in the example above, is $750). This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.[2]

In most sets of accounting standards, e.g. IFRS, FIFO (or LIFO) valuation principles are "in-fine" subordinated to the higher principle of lower of cost or market valuation.

References[edit]

  1. ^ Gibson SC. (2002). LIFO vs. FIFO: a return to the basics. The RMA Journal. RINA Free full text[dead link].
  2. ^ "LIFO Reserve Definition". AccountingTools. Retrieved 2011-11-09. 

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