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Inventory Accounting – LIFO and FIFO

Inventory is considered current assets because it is merchandise that are usually sold within a year or within an operating cycle. It is the most valuable current asset for retailers and should be closely monitored. Too much inventory can cause cash flow problems and unnecessary expenses like storage expenses and obsolete items. On the balance sheet, the value of inventory should be reported as the costs incurred to obtain the merchandise instead of the selling price. The cost of goods sold, the cost of the merchandise that was sold to customers, is reported on the income statement when the revenue is recognized. The costs include actual merchandise cost when it is purchased, transportation cost, etc. The basic equation of inventory is :

Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory

 Inventory accounting is the process of keeping track and determining the costs and there are generally three common methods:

  • Last-in, First-out (LIFO) method assumes that the newest inventory is always sold first. Therefore the remains is the oldest inventory.
  • (First-in, First-out) FIFO method assumes the oldest inventory is always sold first. Therefore the remains is the recently purchase. This method is generally used by companies with perishable inventory.
  • Weighted average method, the cost of single item is the weighted average cost of the entire inventory. This method is commonly used by the companies with undifferentiated inventory such as fuels and grains.

Different method will result in different figure on financial statements. Over the long term, prices tend to rise. Net income calculated under FIFO method is higher because the cost of goods sold recognized may be the cost a few years ago. Similarly, net income calculated under LIFO method is lower because the cost of inventory obtained recently is higher. Hence, LIFO has tax advantage most of the time because of the lower reported net income. This method is used by many companies although it does not properly represent the true flow of goods for most of the firms. The difference between the cost of an inventory under the FIFO and LIFO methods is called the LIFO reserve which is the amount of taxable income deferred as a result of using the LIFO method.