What is contability? If you asked me this question a year ago, I would answer that it is about numbers, calculations… but now, after having learned ACC201 and continuing to learn ACC202, I have another vision about accounting, it provides information for decision making in the business world Whether you’re investing in Walmart stock, buying new equipment, forecasting future sales or expenses, you almost always use accounting information. In my opinion, one of the most important accounting insights is 3 basic inventory techniques or cost flow assumptions: FIFO (stands for first-in, first-out), LIFO (stands for last-in, first-out), and WAVG. (means weighted average). In this article, I only want to focus on FIFO and LIFO. Let’s review these concepts:
FIFO means that the oldest inventory items are recorded as sold first, but it does not necessarily mean that the exact newest physical item has been tracked and sold.
LIFO, on the other hand, means the exact opposite, the most recently purchased items are recorded as sold first.
For example, a bakery produces 100 cakes on Monday at a cost of $1 each and 100 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 100 pies on Wednesday, the COGS is $1 per pie (recorded on the income statement) because that was the cost of each of the first few pies in inventory. The $1.25 cakes would be allocated to ending inventory (appears on the balance sheet). Instead, LIFO states that the same bakery would allocate $1.25 per cake to COGS, while the remaining $1 cakes would be used to calculate the value of inventory at the end of the period.
Any company can use FIFO or LIFO to sell their products. If inflation did not exist, the FIFO and LIFO methods would produce exactly the same results. As in the example above, when prices are stable, our bakery could produce all of its loaves for $1, and FIFO, LIFO would give us a cost of $1 per cake. But our economy seems more complicated, prices tend to rise, which means that the choice of accounting method can drastically affect the company’s profits. We can easily see that if the selling price increases day by day, choosing the FIFO method of accounting will have the opposite effect. FIFO will help the company to make more profit. It means that the inventory you sell costs less than the inventory you have left. Therefore, choosing FIFO accounting results in a lower COGS on the income statement vs. LIFO and a higher inventory valuation on your balance sheet vs. LIFO.
LIFO is not a good option in inflation because leftover inventory can be extremely old and perhaps obsolete. This results in a valuation that is much lower than current prices. But we can’t always use FIFO method because in some special situations LIFO is the best option. For example, in the deflation economy, we should choose LIFO because the price will go down gradually. The more new products we sell first, the better profit we will make. One more reason for businesses to consider LIFO is taxes. Because FIFO results in a lower COGS on the income statement, it will generate higher profits. But when profits are higher, taxes are also higher. And when taxes are higher, after-tax earnings are lower. On the other hand, LIFO results in lower pre-tax earnings (since COGS are higher) and therefore lower taxes and higher after-tax earnings. The process to choose FIFO or LIFO is not easy, it requires accountants to carefully analyze to give the best option for any company.