Managing a business is quite difficult and to remain competitive, companies started giving more emphasis on inventory valuation. Inventory is one of the major components of the current assets of any business. Inventories typically include the value of raw material, work in progress, etc. Most of the time all types of inventory will be aggregated on the balance sheet into one-line items. There are several methods to calculate the value of inventory. Ideally, there are mainly two ways to value inventory, i.e. LIFO and FIFO.
LIFO stands for Last In First Out and FIFO stands for First In First Out. It is quite important to measure inventory to record expenses with the respective revenue. Selection of the right method at the right time is very crucial for the firm and it also helps the company in making good business decisions and showing the desirable financial position.
LIFO vs FIFO
LIFO and FIFO explain the order in which inventory, purchased or sold, is recorded in the accounting statements. For companies that are operating on the principle of FIFO, the oldest inventory purchased is recorded in the books first and in LIFO, the newest inventory purchased is recorded in the books first. Both are very important methods in accounting. Both IFRS and GAAP do not put any restrictions on the FIFO method. But IFRS does not allow the LIFO method for accounting. In the case of LIFO, the balance sheet gives the value of the newest unsold inventory and on the other hand, FIFO shows the value of the oldest unsold inventory.
Inventory Valuation
Inventory valuation means calculating the monetary value of all the items that make up the inventory.
At the end of each period, a month or a year, one should do a physical inventory count to determine the inventory in hand, so that economic order quantity and the time of order could be matched.
Inventory can be valued using either of the above two methods, LIFO and FIFO, and would give a different answer under both. Under FIFO, we consider that the inventory that is purchased first, is sold out first, therefore when a sale is made, the value of inventory that is accounted for is the value at which the inventory was purchased initially i.e. the oldest price of the inventory we purchased. On the contrary, LIFO considers that the inventory that is most recently purchased should be considered while accounting for the profit of the company.
Now imagine an inflationary environment. The oldest inventory would be the cheapest and as time passes by, the value of inventory would rise. Under FIFO, the cost of sales would be of the inventory purchased initially and therefore would be the least. On the contrary, under LIFO, the cost of inventory would be the most recent one, therefore would be the highest.
This leads to FIFO showing a higher profit in the income statement as compared to a company following LIFO. But note that, the business done by both the companies is exactly the same. It is just the accounting rules followed that are showing the difference in the profits. Then a valid question that arises in our mind is, why are these companies even following LIFO if it shrinks our profits? Because under LIFO, the profit gets hidden in the inventory account and is called LIFO Reserve.
LIFO Reserve is the difference between the FIFO cost and the LIFO cost. In other words, it is the amount of profit hidden in the inventory account. Think! You are accounting for the inventory recently purchased at high prices and the inventory at lower prices is not being used. When in future, this inventory will be used, then the profits will get inflated and will come out to be more than a company following FIFO.
Let us understand this with a LIFO method example and a FIFO method example.
Suppose we are operating a shirt-selling store in an inflationary environment. We have purchased 3 t-shirts at the following prices.
Price of 1st t-shirt = $2
Price of 2nd t-shirt = $4
Price of 3rd t-shirt = $6
Let us suppose we are able to sell a t-shirt for $10 and following LIFO. The t-shirt was purchased last at $6 will going to be recorded first. So, Revenue equals $10 and Cost equals $6. Therefore, Gross profit is equal to $4.
Revenue: $10
Cost: $6
Gross Profit: $10 less $6 = $4
Under FIFO the t-shirt we purchased first at $2 will be sold first. So, Revenue equals $10 and Cost equals $2. Gross profit = $8.
Revenue: $10
Cost: $ 2
Gross Profit: $10 less $2 = $8
As we see from the above LIFO FIFO example gross profit will decrease with LIFO and increase in the FIFO method of accounting thus resulting in higher tax in case of FIFO and lower tax in case of LIFO.
Importance of Inventory Valuation?
Inventory valuation is important to correctly estimate the gross profit, financial position, helps in decision making, and estimation of next year’s purchase.
How do businesses use both LIFO and FIFO in strategy?
If a firm sees inventory cost is going to remain stable or increase then LIFO is the preferable method to be used because LIFO results in a lower level of profit which will result in lower taxes and higher cash flow. Therefore, it gives a deferred tax advantage. Similarly, FIFO provides a higher profit, which results in higher taxes and lower cash flows.
Conclusion
If a manufacturer or retailer sells products and the cost of products and supplies tends to increase over time. In this case, LIFO is the most appropriate method to be used resulting in lower taxable income as compared to FIFO and benefit the business owner.
Always keep in mind if you want to maintain a strong balance sheet, to satisfy investors and qualify for loans, FIFO is the best appropriate method used. So, the choice of the appropriate method is very important in inventory valuation in a company.
