Question

Write a one-page paper describing, discussing, and analyzing LIFO and FIFO. Research and include other sources. Include a title page, reference page, in-text citations.

Answer 1

FIFO (First In, First Out) and LIFO (Last In, First Out) are two methods of accounting for the value of inventory held by the company. By accounting for the value of the inventory it becomes practicable to report the cost of goods sold or any inventory related expenses on the Profit and Loss Statement and to report the value of Inventory of any kind on the balance sheet.

When the historical costs (or COGS) of each specific stock unit is known, the above instructions for reaching the total current inventory value are sufficient. However, the firm must refer to additional valuing rules when both of two conditions apply:

• Firstly, units in stock are interchangeable.
  One barrel of crude oil as raw materials is probably interchangeable with any other barrel of the same kind. One sealed can of peas in finished goods may be interchangeable with thousands of others in stock.
• Secondly, the costs of acquiring units in stock are changing over time.
  A firm may purchase oil as raw materials in January at $85 / barrel. In June, the same barrel may cost $90, and another barrel may cost $98 in December. Similarly, a can of peas may have a COGS of $1.00 in January, $1.10 in February, and $1.50 in March.

Referring to the example above, suppose the firm adds cans of peas to inventory as follows:

Inventory additions:
      January, 75 cans added, @ $1.00.
      February, 125 cans added, @$1.10.
      March, 100 cans added, @$1.50.

Suppose that a total of 60 cans sell from inventory during these three months. The accounting question in such cases then is this: What was COGS for the 60 units that left stock? Would that be January's COGS or another month's COGS?

With interchangeable units and changing price conditions, companies can choose any one of three approaches to value inventory. After selecting a method for the first reporting period, however, tax authorities do not make it easy to change the plan in subsequent periods.

In any case, three acceptable approaches to valuing under these conditions include:

   1. First in, First Out (FIFO)

   2. Last in, First Out (LIFO)

   3. Average Cost

1. First In First Out (FIFO)

Under FIFO, as items leave inventory, the accountant proceeds as though the single unit in stock for the longest time goes first. And, the next to move has the value of the item on hand second-longest, and so on.

Under FIFO, when 60 cans leave inventory, the firm reports them as 60 of the 75 "January" cans. As a result, COGS becomes the following:

     COGS = 60 x $1.00
                  = $60.00.

2 Last in First Out (LIFO)

Under LIFO, the accountant precedes as though the first to leave is the item that has been there the shortest time. And, the next to move has the value of the item on hand for the next longest time, and so on&mdashin this case, the value of the100 "March" cans. As a result, for a COGS becomes the following::

     COGS = 60 x $1.50
                  = $90.00

Choosing a Costing Approach

Which costing approach should a company choose? Remember that once a firm chooses a costing method, tax authorities do not make it easy to change.

• When costs are rising, LIFO maximizes COGS and therefore minimizes the total value of the remaining items. A higher COGS under LIFO leads to lower reported income and lower taxes.
• When costs are rising, FIFO minimizes COGS and thus maximizes the total value of remaining items. A lower COGS under FIFO leads to higher reported income and higher taxes.

Note that International Financial Reporting Standards (IFRS) do not allow the use of LIFO in many countries.

Regardless of which accounting convention is in use, FIFO, in fact, describes the actual flow of inventory in most companies. Few companies sell newer items before selling older stock they are holding. Many companies choose the Average cost method instead of either LIFO or FIFO, believing the average provides a more accurate measure of true stock costs during the period.