FIFO vs LIFO inventory systems

A big part of accounting revolves around the wonderful world of tax compliances and regulatory bodies that work in conjunction with the accounting aspect of tabulating business performance and tracking the flow of money throughout the company.

Stock valuation or stock accounting deals with valuation of company’s inventory, which can vary due to not only not only how many products are held in inventory but how much these products or materials cost.

The distinction in important due to the fact that over time, cost of most raw materials increase because of inflation. This means that value of inventory can change even though the company maintains fixed stock. This fluctuating nature of inventory gave rise to two primary methods of valuation of inventory or stock valuation: FIFO and LIFO

What if FIFO method of valuation?

First in First out (FIFO) is the method of inventory valuation which assumes that the first items you add in your inventory, whether by purchase or by production, are also the first items that you sell when sell is made. A good example to understand is to think of bread packets at a grocery store. Breads expires in 4 to 5 days which means that the shop keeper has to place the oldest breads in front to ensure that it doesn’t go bad. So the first packets of bread they receive are the first packets that are sold.

What this means in terms of material cost increasing over time, as mentioned above, is that items which are purchased     at the lowest rate are sold first. This means that value of the inventory on the date of end of financial year would be latest or close to current cost as on the date of reporting.

FIFO is the standard inventory valuation method used in most countries across the globe.

 What is LIFO method of valuation?

Last in First out (LIFO) is the opposite of First in First out (FIFO) method of inventory valuation. With LIFO method of valuation of inventory, you sell most recent item purchased first when a sale is made. Here you can take the case of a Marble or Granite dealer. When they make sale the marble slab on top will be taken off to sell to the customer and the older slab would remain in inventory.

Following LIFO method of accounting can lead to increased cost of goods sold which may lower the amount paid by way of taxes at the end of the year. LIFO method of inventory valuation can result in more complex inventory layers as the reported inventory pieces stays on your records for years. The LIFO method of inventory valuation is also not permitted under International Financial Reporting Standards (IFRS)

 Which method should I use?

You may pick one depending on which sector of business you are in. If you do your business in sectors like building products, hardware, electrical supply etc LIFO is the recommended method of inventory valuation. On the other hand if you have small business with perishable products like fruits, vegetables, milk etc, FIFO is the best method of inventory valuation.

However in India, as per Accounting Standard 2 (AS 2) FIFO or Weighted Average Cost method of inventory valuation should be used. The use of appropriate method depends on the type of business and nature of products sold.

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