Question

Which method is better to evaluate inventory? FIFO, LIFO or weighted average?

Answer 1

Your ideal inventory costing method may vary based on what you are valuing the inventory for. Remember, it is generally permissible to use different methods on your tax returns and financial statements prepared for investors or managers.

For Taxes

The IRS provides three options for valuing inventory: identifying specific items, FIFO or LIFO. If you are not using LIFO, you may be required to report the lower of cost or market value.

If you expect your costs to continually rise, the LIFO method typically provides the largest deduction because the newest, and presumably most expensive, inventory is deducted first.

While you are free to select the most advantageous method when you first file taxes, you must use the same method each year. You may not switch between FIFO and LIFO from year to year simply because one offers a larger deduction in the current year.

For Financial Statements

All three inventory cost methods are typically allowed under Generally Accepted Accounting Principles, but you should check for specific provisions related to your operations. If you operate or seek investments internationally and need to follow International Financial Reporting Standards, you may not use the LIFO method.

If your goal is to show larger profits and more assets on your financial statements, you want to reduce your costs of goods sold and increase your inventory value. Assuming that costs generally rise, FIFO will typically be more advantageous.

You are free to change methods from year to year, but you must identify the method you used, and investors will want to see an explanation for changes in inventory methods.

For Management Decisions

When making management decisions, you want to see if your operations are sustainable under both current and historic prices. While you don’t want to overreact to short-term fluctuations, you also don’t want high costs to be masked in an overall average.

Consider having your controller services prepare inventory and costs of good sold reports using all three methods so you can see both the optimistic and pessimistic outlooks.