FIFO and LIFO Methods are Inventory Accounting Methods used to calculate the amount of money an entity has tied up in its Inventory. While under FIFO method, stock purchased first is sold first, while under LIFO Method stock purchased recently is sold first. Following are some advantges and disadvantages of these two inventory calculation method:
Advantages of LIFO Method:
- Since, under LIFO method, cost of material sold is taken to be cost of most recent inventory purchased, it reflects the current market price. Thus, this methods relates the book of accounts to the recent trend of market price of materials and ensures matching of cost of production and current sales revenue.
- Since, the cost of materials shows the recent trend in price of materials, the use of LIFO Inventory Method does not show undue high profits in the Income Statement of the company as against FIFO Method, provided market is going through inflation and not falling prices.
- Even during times of Falling Prices, Profits tends to increase but the finished product are accounted to be more competitive.
- Since, most of the countries are in Inflationary Times, LIFO accounting will tend to show correct profits(lower) of the company because of high current prices of material and thus company avoids undue taxes to a fair extent.
Disadvantages of LIFO Method:
- Calculating Inventory values under LIFO becomes complicated when frequent purchases are made at highly fluctuation.
- LIFO is not much popular because use of this method of inventory accounting is prohibited in IFRS.
- This method of inventory accounting is not acceptable by Income Tax Authorities of many countries.
- Also, at times of falling, companies following LIFO Method will require to write off the stock value for the purpose of adhering to the prinicipal of Stock Valuation i.e Cost or Market Price whichever is lower.
Advantages of FIFO Method:
- This method of Inventory Accounting is a coherent method involving the consideration of normal procedure of accounting for earlier purchased materials being used for consumption/sales purpose.
- It is easy to understand and is simple.
- Closing Stock is valued at market price as initial purchases are assumed to be consumed or sold. Thus, it helps in providing a true picture of company’s accounts.
- Most of the companies follow this method when cost of materials is steady.
Disadvantages of FIFO Method:
- At times of increasing prices, this method does not reflect market prices as sales or consumption transactions are issued from first purchases.
- This method increases the risk of clerical errors.
Which method is Suitable?
Generally, FIFO Method of Inventory Accounting is suitable for the organization as since companies prefer to sell out initial stock to avoid deterioration. Also, the oldest unsold or unutilized inventory items are classified as either partly or fully.
FIFO. (n.d.). Retrieved November 1, 2013, from Ready Ratios: http://www.readyratios.com/reference/accounting/fifo.html
Gupta, R. (n.d.). Advantages and disadvantages of LIFO method in cost accounting. Retrieved November 1, 2013, from PreserveArticles: http://www.preservearticles.com/201103234655/advantages-and-disadvantages-of-lifo-method-in-cost-accounting.html
Robinson, T. (2011). Inventory Accounting. In CFA Institute, Financial Reporting and Analysis (pp. 129-141). Boston: Custom.