Inventory valuation methods
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| FIFO & LIFO Methods |
Manufacturers often need to keep
products
Or raw materials in stock. This stock of Items is called inventory. Inventories make
Up the most valuable current asset for such
Companies so it is important to determine And keep track of their costs. Inventory
accounting is the process to do that
There Are various methods for inventory Accounting. Generally accepted accounting Principles (GAAP) has defined such Accounting methods
The Four most common GAAP accounting methods are - Specific Identification Method, Weighted Average Method, FIFO Method, and LIFO Method. Choosing an appropriate method Is very important because it can impact Earnings and current assets of a company. A particular method can be well suited for Some business types than others. Companies can choose any of these methods Irrespective of how their inventories are Sold. They must adhere to guidelines from The IRS in this matter
Or raw materials in stock. This stock of Items is called inventory. Inventories make
Up the most valuable current asset for such
Companies so it is important to determine And keep track of their costs. Inventory
accounting is the process to do that
There Are various methods for inventory Accounting. Generally accepted accounting Principles (GAAP) has defined such Accounting methods
The Four most common GAAP accounting methods are - Specific Identification Method, Weighted Average Method, FIFO Method, and LIFO Method. Choosing an appropriate method Is very important because it can impact Earnings and current assets of a company. A particular method can be well suited for Some business types than others. Companies can choose any of these methods Irrespective of how their inventories are Sold. They must adhere to guidelines from The IRS in this matter
Specific Identification Method
In this method, companies record cost to Acquire goods as well as
cost of goods sold For each inventory item individually. This Method is most
suitable for companies that Have limited inventory, cost per unit of Inventory
items are high and items are relatively unique. Jewelers, car dealers, art
Galleries, etc. are the examples of Businesses where this method is suitable
It is the most Precise way of determining Inventory prices But is too
cumbersome for Companies with large or medium-sized Inventories
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| Inventory accounting methods |
Weighted Average Method
In the Weighted Average Method, Companies determine the weighted
average Cost of the inventory. This method is Suitable for companies that
maintain a large inventory of uniform items such as Fuels or grai
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FIFO Method
FIFO stands for First In First Out. In FIFO Method it is assumed
that the oldest Inventory or the inventory which was Purchased first is sold
first. Inventory from Recent purchases are sold later. This Method is suitable
for companies selling Perishable goods such as food or drugs
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LIFO Method
LIFO stands for Last In First Out. In LIFO It is assumed that the
most recent Purchased inventory is sold first
Prior or old inventory is sold
later
A company in the coal business is a good Example where LIFO method is
obvious. Coal on top of the coal pile is always going To be sold first
Comparison of above methods
Let's understand the difference between
The above four methods
through example
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Assume that a company purchases four Identical items at
different times during an Accounting period (For Specific Identification methods
assume items
(Are unique
1st item is purchased for $15
2nd item is purchased at a cost of
$18
3rd item is purchased at a cost of $20
4th item is purchased at a cost of
$22
Assume that a company now sells one item Of this inventory at $25
The cost of goods sold, profit and ending Inventory balance will differ
depending on The choice of an accounting method
If the 2nd item is sold using Specific Identification method then
the cost of goods Sold would be $18, profit would be $7, and Ending inventory
balance would be $57 $15+$20+$22
Using FIFO method, the cost of goods sold Would be $15, profit
would be $10, and Ending inventory balance would be $60 $18+$20+$22
Using LIFO method, the cost of goods sold Would be $22, profit
would be $3, and Ending inventory balance would be $53 $15+$18+$20
Using Weighted Average method
The cost of goods sold would be
$18.75 ($15+$18+$20+$22) / 4
Profit would be $6.25
Ending inventory
balance would be $56.25 $18.75 x 3 remaining items
The specific Identification method's Numbers are not comparable
against Numbers from other methods because of The uniqueness of its items in
inventory
It is evident from the numbers of remaining Three methods that FIFO
has the lowest Cost of goods sold, the highest profit, and The highest ending
inventory balance. Companies’ following FIFO method pays Higher taxes because
of higher profits. LIFO is just opposite and offers substantial Tax savings due
to lower profits and lower Inventories. It is important to note that in The
example cost of item was inflated at Each purchase. If the cost of purchase is
Reversed in order i. e. deflated then the Effects of FIFO and LIFO will be just
Opposite
The Weighted Average method falls in Between FIFO and LIFO methods
Since the choice of inventory accounting Methods has a significant
effect on a Company's Income statement and balance Sheet
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