LIFO, last-in-first-out and FIFO, first-in-first-out the two most common inventory accounting methods. The choice of the method of inventory accounting by a small business can directly impact its balance sheet , income statement and statement of cash flows. Not only do companies have to track the number of items sold, but they have to track the cost of items each item. These two methods are ways in which they can do that. Each will have a different effect on their financial statements.
How is Inventory Determined?
Inventory can be broken down into three categories: raw materials, work-in-process, and finished goods. Raw materials are inventory used to produce assets for sale. Work-in-process is assets in production for sale. Finished goods are assets intended for sale. The inventory equation is the following:
- Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory
There are two common methods for accounting for this inventory.
LIFO - Last-In, First-Out
LIFO assumes that the last items put on the shelf are the first items sold. LIFO is a good system to use when your products are not perishable or become obsolete. Under LIFO, when prices rise, the higher priced items are sold first and the lower priced products are left in inventory. This increases a company's cost of goods sold and lowers their tax liability and, as a result, their net income.
This inventory accounting method seldom approximates replacement costs for inventory, which is one of its drawbacks. In addition, it usually does not correspond to the actual physical flow of goods.
Let's use the gasoline industry as an example. Let's say that a tanker truck delivers 2,000 gallons of gasoline to Henry's Service Station on Monday and the price at that time is $2.35/gallon. On Tuesday, the price of gasoline has gone up and the tanker truck delivers 2,000 more gallons at a price of $2.50/gallon. Under LIFO, the gasoline station would assign the $2.50 gallon gasoline to Cost of Goods Sold and the remaining $2.35 gallons of gasoline would be used to calculate the value of ending inventory at the end of the accounting period.
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