LIFO OR FIFO

WHICH ONE IS BETTER?

PRINCIPLES OF FINANCIAL ACCONTING

Muhammad Athar Jamil
16-Sep-09

Specific method:
By the specific method, the actual costs of the specific units sold are transferred from inventory to cost of good sold. This method achieves the proper matching of sales revenue and cost of goods sold when an individual units in the inventory are unique. However, the method becomes awkward and may produce misleading results if the inventory consists of homogeneous items.

Flow assumptions:
These are the three methods of flow assumptions, which should be applied only to an inventory of homogeneous items.

Average cost method:

By the average cost method, the average cost of all units in the inventory is computed and used in recording the cost of good sold. This is the only method in which all units are assigned the same per unit cost.

FIFO:
FIFO is the assumption that first unit purchased is the first unit sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older and often lower cost to the cost of goods sold.

LIFO:
LIFO is the assumption that the recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In the period of inflation, LIFO usually results in lower reported profits and lower income taxes then the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

Affects of Inventory Methods:

Inventory methods does not have any affect on performance except for their effect on income taxes, the answer to this question is no. During a period of rising price, a company might report higher profits by using FIFO instead of LIFO. But the company would not really be more

profitable. An inventory valuation methods affects only the allocation of cost between the inventory account and the cost of goods sold account. It has no effect on the total costs actually incurred in purchasing of manufacturing inventory. Except for income taxes, differences in the profitability reported under different inventory methods exist only on paper. The inventory method in use does affect the amount of income taxes owed. To the extent that an inventory method reduces these taxes, it does increase profitability.

Conclusion:
From the above explanations, it is clear that FIFO can increase the income in days of increasing prices but it also will results in higher income taxes where as in LIFO method, whether the prices are rising or declining the income tax will always be lower. So we can conclude that FIFO can benefit in days of only rising prices but LIFO can benefit in long term usage. Thus LIFO is better.