Lifo and Fifo

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Date Submitted: 03/12/2011 01:02 AM

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LIFO (last in first out) and FIFO (first in first out) are both inventory valuation methods.

LIFO is a cost flow assumption that states the newest merchandise purchased is the first to be sold. Under this method of inventory valuation, companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.

FIFO is a cost flow assumption that states that the oldest merchandise purchased is the first to be sold.  FIFO matches the actual physical flow of merchandise.  Under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. Food products are examples that would be suited to use FIFO method.

Advantages of LIFO

LIFO matches current costs and current revenues better compared to FIFO. LIFO is best used when prices are rising because it leads to income tax savings and therefore allows the company to keep more cash within its business.

Companies that use LIFO report high cash flow since income taxes are reduced as a result of lower net income.

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Disadvantages of LIFO include: (i) Using LIFO can result in distortions of earnings when normal inventory levels are depleted, (ii) Since the stock in hand does not reflect current market price, ending inventory will either be overstated or under-stated in the balance sheet

Advantages of FIFO

FIFO method satisfies the historical cost and matching principles because it assumes inventory sold is the one that was received first.

Ending inventory under FIFO is valued at the market price since it will consist of recent purchase of purchases.

Using FIFO, valuation of inventory reflects the replacement cost of the inventory on hand

Disadvantages of FIFO: (i) It does not take into account the effect of inflation and may therefore report inflated net profit thereby...

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