What is accounting? If you asked me this question a year ago, I would answer that everything is about numbers, calculations … but now, after having learned ACC201 and continuing to learn ACC202, I have another look at accounting, it provides information for decision-making in the business world. Whether you are investing in Wallmart stocks, buying new equipment, forecasting future sales or expenses, you almost always use accounting information. In my opinion, one of the most important knowledge about accounting are 3 basic inventory techniques or cost flow assumptions: FIFO (means first in, first out), LIFO (means last in, first out) and WAVG (represents the weighted average). In this article, I just want to focus on FIFO and LIFO. Let’s review these concepts:

FIFO means that the oldest inventory items are recorded as sold first, but it does not necessarily mean that exactly the newest physical item has been tracked and sold.

LIFO, on the other hand, means the exact opposite, the most recently purchased items are recorded as sold first.

For example, a bakery produces 100 cakes on Mondays at a cost of $ 1 each, and 100 more on Tuesdays at $ 1.25 each. FIFO states that if the bakery sold 100 cakes on Wednesday, the COGS is $ 1 for a cake (recorded on the income statement) because that was the cost of each of the first cakes in inventory. The $ 1.25 cakes would be allocated to ending inventory (it appears on the balance sheet). In contrast, LIFO states that the same bakery would allocate $ 1.25 per cake to COGS, while the remaining $ 1 cakes would be used to calculate the inventory value at the end of the period.

Any company can use FIFO or LIFO to sell its products. If inflation did not exist, the FIFO and LIFO methods would produce exactly the same results. As in the previous example, when prices are stable, our bakery could produce all of its loaves of bread for $ 1, and FIFO, LIFO would give us a cost of $ 1 for a cake. But our economy seems more complicated, prices tend to rise, which means that the choice of accounting method can drastically affect the profits of the company. We can easily see that if the selling price increases day by day, the choice of the FIFO accounting method will have the opposite effect. FIFO will help the company make more profit. It means that the inventory you sell costs you less than the inventory you have left. Therefore, the choice of FIFO accounting results in a lower COGS on the income statement vs. LIFO and higher inventory valuation on your balance sheet vs. LIFO.

LIFO is not a good choice in inflation because excess inventory can be extremely old and perhaps obsolete. This results in a much lower valuation than current prices. But we can’t always use the FIFO method because in some special situations, LIFO is the best option. For example, in the economics of deflation, we should choose LIFO because the price will gradually go down. The more new products we sell first, the better profit we will make. One more reason for companies to consider LIFO is taxes. Because FIFO results in lower COGS in the income statement, it will generate higher profits. But when the profits are higher, the taxes are too. And when taxes are higher, after-tax earnings go down. On the other hand, LIFO results in lower pre-tax earnings (since COGS are higher) and therefore you get lower taxes and higher after-tax earnings. The process to choose FIFO or LIFO is not simple at all, it requires accountants to carefully analyze it to give the best option for any company.