FIFO and LIFO accounting

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

Inventory goods held for resale

Inventory or stock is the goods and materials that a business holds for the ultimate goal of resale.

Contents

FIFO

"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 purchase.

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

Number of unitsCost
100 units$50
125 units$55
75 units$59

If Foo 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 November would be $11,050. The ending inventory would be calculated the following way:

Number of unitsPrice per unitTotal
Remaining 15 units$55$825 ($55 x 15 units)
75 units$59$4425 ($59 x 75 units)
Total$5250

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

LIFO

"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 since International Financial Reporting Standards (IFRS) banned LIFO, more companies returned to FIFO.[ citation needed ]

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time.

International Financial Reporting Standards Technical standard

International Financial Reporting Standards, usually called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB) to provide a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade and are particularly relevant for companies with shares or securities listed on a public stock exchange. They are progressively replacing the many different national accounting standards.

LIFO is used only in the United States, which is governed by the generally accepted accounting principles (GAAP). Section 472 of the Internal Revenue Code directs how LIFO may be used. [1]

The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code (USC). It is organized topically, into subtitles and sections, covering income tax in the United States, payroll taxes, estate taxes, gift taxes, and excise taxes; as well as procedure and administration. Its implementing agency is the Internal Revenue Service.

In the example above, the company (Foo Co.) (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 November would be $11,800. The ending inventory would be calculated the following way:

Number of unitsPrice per unitTotal
Remaining 90 units$50$4500 ($50 x 90 units)
Total$4500

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 (in the example above, it 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, such as the International Financial Reporting Standards, FIFO (or LIFO) valuation principles are "in-fine" subordinated to the higher principle of lower of cost or market valuation.

Lower of cost or market is a conservative approach to valuing and reporting inventory. Normally, ending inventory is stated at historical cost. However, there are times when the original cost of the ending inventory is greater than the net realizable value, and thus the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to "Cost of goods sold" (COGS) if non-material, or "Loss on the reduction of inventory to LCM" if material.

In the United States, publicly traded entities which use LIFO for taxation purposes must also use LIFO for financial reporting purposes [3] but such companies are also likely to report a LIFO reserve to their shareholders. A number of tax reform proposals have argued for the repeal of LIFO tax provision. The "Save LIFO Coalition" argues in favor of the retention of LIFO. [4]

FEFO

Stands for first-expired, first-out - a way of dealing with perishable products, or with a specified expiry date.

Related Research Articles

Balance sheet summary of the financial balances of a sole proprietorship, a business partnership, a corporation or other business organization

In financial accounting, a balance sheet or statement of financial position or statement of financial condition is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business partnership, a corporation, private limited company or other organization such as Government or not-for-profit entity. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year.

Historical cost

In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting assets and liabilities at their historical costs, which are not updated for changes in the items' values. Consequently, the amounts reported for these balance sheet items often differ from their current economic or market values.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Cost of goods sold carrying value of goods sold during a particular period

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

Depreciation Decrease in asset values, or the allocation of cost thereof

In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease in value of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used.

Income statement Financial statement of a company: shows the company’s revenues and expenses during a particular period

An income statement or profit and loss account is one of the financial statements of a company and shows the company’s revenues and expenses during a particular period.

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.

Financial accounting field of accounting

Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement say that the loss from the exercise is accounted for by noting the difference between the market price of the shares and the cash received, the exercise price, for issuing those shares through the option.

Goodwill (accounting) accounting

Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so. Goodwill also does not include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations. Goodwill is also only acquired through an acquisition; it cannot be self-created. Examples of identifiable assets that are not goodwill include a company’s brand name, customer relationships, artistic intangible assets, and any patents or proprietary technology. The goodwill amounts to the excess of the "purchase consideration" over the net value of the assets minus liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched. Under US GAAP and IFRS, goodwill is never amortized, because it is considered to have an indefinite useful life. Instead, management is responsible for valuing goodwill every year and to determine if an impairment is required. If the fair market value goes below historical cost, an impairment must be recorded to bring it down to its fair market value. However, an increase in the fair market value would not be accounted for in the financial statements. Private companies in the United States, however, may elect to amortize goodwill over a period of ten years or less under an accounting alternative from the Private Company Council of the FASB.

Stock management is the function of understanding the stock mix of a company and the different demands on that stock. The demands are influenced by both external and internal factors and are balanced by the creation of purchase order requests to keep supplies at a reasonable or prescribed level. Stock management is important for every other business enterprise.

Specific identification (inventories)

Specific identification is a method of finding out ending inventory cost.

The following outline is provided as an overview of and topical guide to accounting:

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

International Financial Reporting Standards requirements

This article lists some of the important requirements of International Financial Reporting Standards (IFRS).

Average cost method

Under the 'Average Cost Method', it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.

IAS 2 is an international financial reporting standard produced and disseminated by the International Accounting Standards Board (IASB) to provide guidance on the valuation and classification of inventories.

FIFO may refer to:

References

  1. Internal Revenue Code, § 472: Last-in, first-out inventories, accessed 23 December 2016
  2. "LIFO Reserve Definition". AccountingTools. Retrieved 2011-11-09.
  3. "LIFO Conformity Rules". Mondaq. Retrieved 2015-07-09.
  4. About Save LIFO Coalition, accessed 23 December 2016