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Difference between FIFO and LIFO Methods of Inventory Valuation
Raw materials, work-in-progress, and finished goods all makeup inventory, which is one of the most crucial aspects of a firm due to its status as a key asset for retailers and manufacturers. Completed items are another category of stock on hand. Inefficient and ineffective management can spell doom for a business. This is because the cost of goods sold is subtracted from the firm's net income to arrive at its profit.
Many other approaches exist for determining the value of an organization's stock, such as the Last-In-First-Out (LIFO) technique, the First-In-First-Out (FIFO) method, and the Weighted-Average-Cost (WAC) method. Serious consequences may result from employing the wrong valuation approach.
FIFO Method of Inventory Valuation
In the FIFO (first in, first out) system, products is distributed or sold to customers in the order in which the store initially received them. The "first in" approach is another name for this procedure. Since the oldest stock is dealt with first, the risk of spoilage is minimized, making this the optimal technique to adopt when dealing with perishable commodities. There is a time benefit as well when using this technique.
The FIFO method has a number of benefits, including the following −
Keeping track of stock is simplified since fewer of the oldest items are needed to be recorded as they are gradually depleted.
In terms of financial reporting, this approach is not constrained by either IFRS or GAAP.
Current market activity is reflected in the pricing of stock on hand, which serves to keep commodity costs stable.
However, there are a few issues that need to be addressed.
As the price of items sold rises, so does the amount of money collected in taxes.
It's more difficult to keep track of costs when goods need to be returned or exchanged.
LIFO Method of Inventory Valuation
LIFO stands for "last in, first out" and refers to a method of inventory valuation that is predicated on the idea that the very last item in stock will be the one to be purchased first. However, it has been demonstrated that this method is nonsensical and antithetical to the movement of inventory. In a scenario in which there is inflation in an economy, the value of the unsold commodities will decline while the value of the cost of goods sold will grow, resulting in poor profits and increased income tax.
However, if an economy experiences deflation, the value of unsold things will rise while the value of the cost of goods sold will fall, leading to increased profits. This is because the value of unsold items will be higher than the value of the cost of goods sold.
Additional drawbacks of utilizing the LIFO approach for inventory valuation include the following −
IFRS places some limitations on it.
As a result, there is a wider gap between the cost basis of the initial inventory and the most current market price.
It makes it more difficult to evaluate current inventory operations as well as the operational activities of a corporation due to this factor.
Differences − FIFO and LIFO Methods of Inventory Valuation
In the context of inventory management, both methods might be considered valuation techniques. The following table highlights the differences between FIFO and LIFO methods of inventory valuation −
| Characteristics | FIFO Methods of Inventory Valuation | LIFO Methods of Inventory Valuation |
|---|---|---|
Definition |
In the FIFO (first in, first out) system, products are distributed or sold to customers in the order in which the store initially received them. The "first in" approach is another name for this procedure. |
In all situations, the use of LIFO is forbidden by IFRS. |
Restrictions |
The FIFO approach can be used freely without restriction under both IFRS and GAAP. |
IFRS does not permit the usage of LIFO in any circumstance. |
Effect on record keeping |
Using FIFO, you may cut down on the amount of records you have to keep. |
The requirement for meticulous record-keeping increases when LIFO is used. |
Advantages |
Some of the benefits of using FIFO as an inventory valuation method include the simplification of inventory tracking by reducing record keeping as the oldest items are continually used up, the absence of restrictions from either IFRS or GAAP, and the stabilization of cost of goods sold as the items in stock represent recent pricing. |
When an economy experiences deflation, LIFO becomes a more beneficial technique of inventory valuation. In this case, the cost of products sold goes down, but the value of unsold inventory rises, resulting in higher profits. |
Disadvantages |
There are a few problems with using the FIFO approach to value stock, the most significant of which are an increase in taxable income due to rising inventory costs and the challenge of appropriately recording expenses when stock is traded or returned. |
The International Financial Reporting Standards (IFRS) forbid LIFO's use, and the method makes it more challenging for a company to interpret both its current inventory activities and its operating activities because of the difference between the cost basis of initial inventory and the most recent market price. |
Conclusion
It can be difficult to determine which approach to business valuation is appropriate for a certain company. However, a person who is involved in business should choose the technique of valuation by taking into consideration the location of the business, the amount by which the inventory of the business fluctuates, and whether or not the running costs of the business are rising or reducing. Although the FIFO technique of valuation is appropriate for the vast majority of firms on account of the clear picture it paints of both the expenditures that were expended and the profitability of the business, it is not appropriate for all enterprises. Because of this, it is essential to do research before settling on a strategy for determining the value of a company's inventory and putting that method into practice.
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