Concepts Behind LIFO And FIFO
LIFO and FIFO are two inventory valuation methods. It is important to note here that LIFO and FIFO are inventory valuation methods only. The actual outflow of inventory may or may not be as per LIFO or FIFO.
FIFO stands for First In First Out. It means that the goods which are purchased or produced the first need to go out first. In other words, the oldest inventory is disposed of first. FIFO is used widely by companies who purchase or produce perishable goods. In order to ensure that the inventory is not worn out, the oldest inventory goes out first. So during valuation, the remaining stock is valued at the prices of the latest stock. This also allows for profit to be calculated as per the cost of the inventory.
LIFO stands for Last In First Out. It means that the goods which are purchased or produced the extreme need to go out first. In other words, the latest and newest inventory is disposed of first. Companies widely use this method in order to decrease their tax liability as it is a general trend that the cost of the inventory increases with time. Thus, if the cost of the latest inventory is used up, the Cost of goods sold increases which lead to fewer profits and ultimately reduces the tax liability of a company. This may at times result in showing a false picture of the company's profits. Thus, LIFO method is used rarely and is not allowed in the International Standards for Accounting. Only FIFO and weighted average methods are considered right. It is, however, allowed in the United States.
The LIFO and FIFO methods are used depending on the type of organization and their inventory management systems. FIFO is the more widespread method as it works on the simple principle that what comes in first should go out first which is accepted by the masses. LIFO and FIFO methods change the cost of the goods sold. Also, it is important to keep the fact in mind that, in case the inventory is priced uniformly throughout the accounting period, there will be no difference in LIFO and FIFO.
Let us take an example to understand LIFO and FIFO better. Suppose there are four orders for inventory in a period priced at $10, $15, $20 and $25 respectively. In the year two orders were sold at $25 each.
Here, as per FIFO, the cost of the good sold will be $10 and $15, i.e. $25. The valuation of the stock will include the remaining units of $20 and $25, i.e., $45. Profit here would be $50-$25, i.e. $25.
If LIFO is used here, the cost of the good sold will be $20 and $25, i.e. $45. The valuation of the stock will include the remaining units of $10 and $15, i.e., $25. Profit here would be $50-$45, i.e. $5.
Difficulties Encountered In LIFO And FIFO
LIFO and FIFO methods of inventory valuation can be very challenging. The problems given for LIFO and FIFO are tough and usually, involve a lot of transactions. There are different production and order cost that needs to be kept in mind while doing inventory valuation. Every transaction needs to be recorded. Usually, there are formats which a student needs to follow which are very similar to the inventory journal maintained at real warehouses. These journals have various columns and involve calculation for each transaction. Sometimes, in assignments, the transactions are so many, and in case you miss even one or record one incorrectly, your whole sum gets messed up. We had heard a complaint from students seeking help that when they tried to solve problems, they had to do the same problem more than three times because of silly errors in one transaction. The problems are complex and challenging.
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