As the owner of a business, do you know the importance of inventory for your business? In this case, inventories are all types of goods owned by the company. Inventory can be sold or consumed for the operation of a business.
There are at least two systems for inventory accounting, namely LIFO (last in first out) and FIFO (first in first out). These two recording systems definitely have an important role in your business, regardless of whether your capital to buy the inventories comes from bank loans or other online loans.
LIFO vs FIFO for Inventory Accounting
LIFO and FIFO are the two most common inventory methods that are used by a company. The goal is to properly account for cost of purchased inventory on the balance sheet. Generally, a business can calculate its inventory either directly or through profits shown in the income statement and the cash flow statement.
It is also important for you to pay more attention to the method of determining the cost of inventory when doing inventory counting. In practice, there are a lot of companies that make assumptions about the inventory costing method for inventories that go into and out of the company.
Not only companies have to track the number of items to be sold, but they also have to track the cost of each item. Applying different inventory costing methods affects the company’s profits as well as the amount of taxes to be paid annually.
Know the importance of inventory and cost methods
Inventory usually takes the most investment of funds. One way to calculate the profits generated by a company is to track sales revenues and all the costs involved in producing the goods.
So the profits can be obtained by the remaining money from sales after the company covers all the costs, including the cost of purchasing inventory.
When considering LIFO, FIFO, average cost, or other inventory pricing method such as the lower of cost or market, a company chooses the costs to be recorded for the inventory it sells. This affects how much profit to be reported for each month or year.
Therefore, the business owner must choose one of the right methods and keep using it for 1 year. Business owner needs to get permission from the IRS to switch to another method the following year.
Both LIFO and FIFO have a different effect on the company’s financial statements. To understand this, it is very important for you to consider how the inventory is determined.
Determining ending inventory
This is an important thing that must be considered carefully by all business owners. It determines the inventory value displayed on a company’s monthly, quarterly or annual financial statements. This number can change with each unit the company sells and affects the ampunt of profit, asset balance, and tax liability.
The equation to calculate ending inventory is as follows:
Beginning inventory + Net purchases – Cost of goods sold = Ending inventory
Depending on which you’re referring to, be it LIFO or FIFO, it can certainly give very different results.
Last-In, First-Out (LIFO)
LIFO or “last-in, first-out” is a method of accounting for inventory that assumes an inventory unit which is bought first will come out last. It also means that the first unit to be sold is the last inventory that comes into the warehouse.
Under LIFO, if there is the last units of inventory purchased were bought at the highest price, then the units are sold first. Lower-priced older units remain in the inventory.
In addition, it is also important to note that the LIFO method is based on the assumption that the outflow of inventory costs is the opposite of how the costs occur chronologically.
LIFO is well used in inventory accounting to increase the cost of goods sold by a company. It is also used to reduce net profits, which can then reduce corporate tax liability. So, it is not surprising that LIFO is much more desirable when the corporate tax rate is higher.
However, this inventory accounting method rarely provides good representation for the replacement costs of the inventory units. This is certainly one of its weaknesses. Not only that, it may not correspond with the actual physical flow of goods.
There are several advantages of LIFO for inventory accounting method: 1) Easy to compare current costs with current income, 2) If prices increase then the price of goods becomes conservative, 3) Operating profit is not affected by profit or loss from price fluctuations, 4) More tax savings.
LIFO also has some disadvantages: 1) It contradicts the actual physical flow of inventory, 2) Cost of accounting is higher because this method is far more complicated and difficult, 3) The resulting profit or loss is lower.
FIFO (First-In, First-Out)
As the name suggests, FIFO means the first entry comes out first. This method assumes that the first units to enter warehouse are sold first. So, the oldest items are sold first.
This system is usually used by companies with perishable inventory. FIFO can even be considered as the most preferred accounting method in an environment with increasing prices.
If the market price of inventory naturally increases, FIFO will provide lower cost of goods sold. The point here is to look better in front of bankers and investors, but your company’s tax liability will be higher. The reason is because the costs are lower so your company is recorded to have higher profits.
In running a business, it is very important for you to know how to calculate net income and profits right. The goal is to minimize potential losses of your company from miscalculation.
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This is all the information we can share about LIFO and FIFO for inventory accounting. We hope this information is both useful and insightful for a business owner like yourself.