This leads to understatement and an often unrealistic valuation of stock in hand. Inventory management and accounting is an important focus area, especially for large manufacturing and trading entities. LIFO method on the other hand is a relatively irrational method as it rarely mimics actual physical movement of inventory.
There are also other methods of inventory valuation which can be adopted by entities, subject to the jurisdictional GAAP regulations such as specific identification method and weighted average method. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment.
A numerical example of how FIFO method works for a trading company is detailed below: As is demonstrated above, under the FIFO method, the goods purchased last on 22 nd January remain in stock on 31 st January. Application of FIFO method has several benefits : Entities prefer to sell their older stock first to reduce risk of obsolescence loss, as FIFO is in tandem with this it is considered as a more realistic method of inventory accounting Values stock in hand at the latest purchase prices — making the values more current and realistic.
FIFO does however suffer from some drawbacks: FIFO may not be as accurate in times of high inflation, as current prices may be excessively high whereas cost of goods sold are being valued at older historical prices As cost of goods sold at historical prices, FIFO method results in lower charge to profit especially in times of increasing prices.
This increases tax cost for the entity as profits are inflated. Forgot Password? This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy.
By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy. Popular Course in this category. Course Price View Course. Free Investment Banking Course. Login details for this Free course will be emailed to you. Email ID. Effect of Deflation Converse to the inflation scenario, accounting profit and therefore tax is lower using FIFO in a deflationary period.
Value of unsold inventory, is lower. Using LIFO for a deflationary period results in both accounting profit and value of unsold inventory being higher. Record keeping Since oldest items are sold first, the number of records to be maintained decreases. Since newest items are sold first, the oldest items may remain in the inventory for many years.
This increases the number of records to be maintained. Fluctuations Only the newest items remain in the inventory and the cost is more recent. Hence, there is no unusual increase or decrease in cost of goods sold. Goods from number of years ago may remain in the inventory. Selling them may result in reporting unusual increase or decrease in cost of goods.
Follow Share Cite Authors. Related Comparisons. In order to account for the value of the inventory, there are several methods to do it.
One of the most prominent ones is LIFO, in which the first products placed in the inventory are first sold in the accounting year. One of the major drawbacks of this method is the decrease in the profits for a business, but it also helps in providing the benefit of less corporate tax.
In case of cost increase by the company, these savings significantly prove to be a boon for the company in the future. LIFO is very profitable for American companies as it helps them to reduce the tax burden; hence is widely used in the United States.
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