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What is the difference between FIFO & LIFO accounting?

As an aspiring investor, it is crucial for you to learn the different types of accounting standards used globally and how they will impact your company valuation. Here are some of the differences in accounting for inventory between Australia and the United States.

Two of the most popular methods of conducting inventory accounting are the First in First Out method (FIFO) and the Last in First Out method (LIFO). The FIFO method is generally associated with International Financial Reporting Standards, while LIFO is exclusively permitted in the United States under GAAP accounting standards (http://www.ifrs.com/updates/aicpa/ifrs_faq.html question 11).

The following table demonstrates a number of the key differences between these two inventory accounting systems.

First in First Out Method Last in First Out Method
The first item purchased is the first item sold The last item purchased is the first to be sold
The cost of goods consists of the first item sold The cost of goods consists of the last item sold
Ending inventory consists of most recent purchases The ending inventory consists of earliest purchases

Advantages of each system

Under the FIFO method, the ending inventory is based on most recent purchases which is a better approximation of the current cost. Should the inventory purchased be subject to high levels of inflation, FIFO accounting will understate the cost of goods compared to the current base. Earnings may, therefore, be overstated and overestimate a company’s ‘real’ income.

Under the LIFO method, as the item purchased most recently is assumed to be the first item sold, in an inflationary environment the cost of goods sold will be higher than under the FIFO method and earnings will be lower. Lower earnings enable the company to pay fewer taxes and increases the company’s net cash flow. Since ending inventory is valued using the earliest costs, in an inflationary environment LIFO ending inventory is less than the actual current cost.

Why are there different inventory accounting methods?

When firms purchase and sell inventory, the cost of their products sold must be reported in the income statement under ‘Cost of goods sold’. If the cost of a firm’s inventory were to remain constant over time, determining the firm’s cost of goods sold would be easy! However, since the cost of inventory changes over time a firm must select a cost flow formula to allocate inventory costs. Firms do have the flexibility to select more than one inventory method; however, they must select an inventory method for items of similar nature and usage.

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