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LIFO vs FIFO

See Also:
Inventory Turnover Ratio Analysis
Inventory to Working Capital
Perpetual Inventory System
Just in Time Inventory System
Work in Progress

LIFO vs FIFO – Last In, First Out vs First In, First Out

In the field of accounting, LIFO vs FIFO are two methods of valuing inventory. LIFO assumes the last items acquired are the first sold, and the first items acquired remain in inventory. FIFO assumes the first items acquired are the first sold, and the items acquired most recently remain in inventory. Both methods are approved by GAAP.

The idea is that a company accumulates inventory over time. And the items in inventory were purchased at differing prices. As products are sold, inventory costs move from the balance sheet to the income statement. Accountants have the option of valuing the items sold and the items remaining in inventory according to the oldest or the most recent costs of the inventory.

FIFO and LIFO are merely methods for recording and reporting the cost of inventory and have nothing to do with the actual flow of physical inventory. For example, a company can sell its oldest inventory first, and still use the LIFO method for financial reports.

FIFO Inventory Method

The FIFO inventory method assumes the first items acquired are the first sold, and the items acquired most recently remain in inventory.

A new firm may want to use FIFO to increase the value of the assets on its balance sheet. Assuming prices rise over time, the oldest inventory will be the cheapest. Expensing the oldest inventory first comparatively decreases the cost of goods sold, increases net income, and increases the value of inventory on the balance sheet because the items remaining in inventory are the most recent and costly items.

LIFO Inventory Method

The LIFO inventory method assumes the last items acquired are the first sold. And the first items acquired remain in inventory.

Using LIFO can have tax advantages. Since prices typically rise over time, the most recent inventory acquired is the most expensive. Expensing the most costly inventory will increase the cost of goods sold and decrease the taxable income. Refer to this as the LIFO reserve.

Average Cost Inventory Method

The average cost inventory method is another way to value inventory. This method simply uses the average cost of the items in inventory. In addition, they use this cost to value the items sold as well as the items that remain in inventory. To calculate the average cost of the inventory, divide total cost of goods available for sale by number of units available for sale.

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Disclosure of Accounting Changes

See Also:
Accounting Principles
Probable Losses
Subsequent Events
Business Segments
How to Make Dramatic Changes in Business
Planning Your Exit Strategy
Percentage Completion Method
What Your Banker Wants You To Know

Accounting Changes

Accounting changes and error corrections are the switch from one principle of accounting to another – like with inventory and recognition of revenue. Error corrections come from an accounting change in estimates, such as accounting changes in depreciation method for assets or how it might record the company uncollectible accounts. For example, a company might decide that it needs to switch to straight line depreciation from an accelerated method. This makes it easier and in line for tax purposes. Companies might also decide that a better way of accounting for its inventory is to adopt the Last in First out (LIFO) method; instead of a First in First out (FIFO) method.

Disclosure of Accounting Changes

Regardless of the accounting change, when a company adopts a new method of accounting, GAAP requires companies to disclose these changes in the financial statements. Whenever the company is writing its notes to inform the (potential) investor, it must announce the specific change first. Then it is required to announce the impact that this change will have upon the company’s income and the balance sheet.

Accounting Changes Example

Jimbo Slice works for a toy manufacturer by the name of Awesome Toy Co. The economy has recently gone through a downturn and the company expects that it will not receive a larger amount of its accounts receivable because many of its customers are on the verge of declaring bankruptcy. Jimbo has decided that a change in accounting estimate is needed in regards to the estimation of bad debt expense. At the year end, Jimbo must list this change in estimate on the financial statement and its effect on income which is most likely a reduction.

Accounting changes can either be an obstacle or an advantage for your company. Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

accounting changes, Disclosure of Accounting Changes

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