Inventory accounting is a crucial aspect of managing a business’s financials. One key decision that businesses need to make is which method they will use to account for their inventory – LIFO or FIFO. The method chosen has an impact on a company’s financial statements so let’s explore the difference between LIFO and FIFO methods.
- LIFO Method: LIFO stands for “Last-In, First-Out” and it assumes that the last items added to inventory are the first ones sold. Therefore, the cost of goods sold (COGS) is calculated based on the cost of the most recent inventory purchases, while the cost of older inventory items is used to value the ending inventory.
The LIFO method is commonly used by businesses with high inflation rates or when the cost of inventory is rising. This is because the method leads to a higher COGS, which results in lower taxable income. However, it can also result in an understated value of inventory on the balance sheet.
For more about the LIFO method, watch this video:
- FIFO Method: FIFO stands for “First-In, First-Out” and it assumes that the first items added to inventory are the first ones sold. Therefore, the cost of goods sold (COGS) is calculated based on the cost of the oldest inventory items, while the cost of newer inventory items is used to value the ending inventory.
The FIFO method is commonly used by businesses with low inflation rates or when the cost of inventory is stable or decreasing. This is because the method leads to a lower COGS, which results in higher taxable income. However, it can also result in an overstated value of inventory on the balance sheet.
For more about FIFO, watch this video:
- Impact on Financial Statements: The choice of LIFO or FIFO method can impact a company’s financial statements in the following ways:
- Income statement: The COGS and gross profit will differ depending on which method is used.
- Balance sheet: The value of inventory on the balance sheet will differ depending on which method is used.
- Tax liability: The taxable income will differ depending on which method is used, which can impact the tax liability.
Conclusion
Understanding inventory accounting is essential for managing a business’s financials. Choosing between the LIFO and FIFO methods can impact a company’s financial statements in different ways. The LIFO method leads to a higher COGS, resulting in lower taxable income but an understated value of inventory on the balance sheet. The FIFO method leads to a lower COGS, resulting in higher taxable income but an overstated value of inventory on the balance sheet. It’s important for businesses to carefully consider which method to use based on their specific circumstances and the impact on their financial statements.