Question

The Reflection below, like others that follow it in the course, requires you to use your judgement and draw upon personal experience and the knowledge you have acquired so far in the course. Do not turn to outside resources to find one single correct answer or definition.

In a period of steadily rising prices (meaning the cost to purchase inventory is increasing over time), what would be the implications of choosing FIFO vs. LIFO? Which method would show a higher net income, and which would show a lower net income? Which method does a better job of matching expenses and revenues? Which method reflects the most recent costs of inventory on the balance sheet? What implications might this have that would be relevant for users of the financial statements to know?

Answer 1

FIFO and LIFO are two methods of inventory valuation or inventory management. As per FIFO system, material received first are sold first, or we can say, are removed first from inventory. FIFO stands for, "First In First Out ".

As per LIFO method, material received last are sold first, or are first removed from inventory. LIFO stands for , "Last In First Out ".

In a period of steadily rising prices, ( Meaning the cost to purchase inventory is increasing over time), that is, in Inflatory conditions, If FIFO is chosen, then the cost of goods sold is lowerbecause they were purchased earlier. Of inflated selling price is considered, then the amount of gross profit, net profit, Income tax and taxable income will be higher. Where as, on the other hand , if LIFO is chosen, then the cost of goods sold (Purchase price) is high because latest inflated stock is considered. If goods are sold at the latest (inflated) price, the amount of gross profit, net profit, Income tax and taxable income is less as compared to FIFO method.

• So, during Inflation, FIFO method shows higher Net income and LIFO method shows lower net income. And during deflation , LIFO method shows higher Net income and FIFO method shows lower net income .
• LIFO method of valuing inventory does a better job of matching expenses and revenues, since it considers the recent inflated cost of inventory against the inflated selling price and thus, does not result in excessively higher Net profits.
• FIFO method reflects the most recent cost of inventory on the balance sheet. Since, the older inventory, which was purchased at lower cost is removed for sale. The remaining latest inventory, which was purchased at inflated price is in closing stock and thus, reflect most recent cost of inventory on the balance sheet. Implications of closing inventory valuation method that would be relevant for users of the financial statements to know are-
• Whether the inventory is valued accurately and the profits shown are correct.
• If the inventory is valued at lower cost, then profit may not be actual. It results in paying more tax.
• On the basis of Inventory, which is often considered as security for obtaining loan, should be valued correctly .
• Whether the organization is having proper working capital / cash.
• Inventory should be valued keeping in mind the nature of goods. For example, FMCG goods should be valued using FIFO method.