Historical Cost Methods - LIFO and FIFO
Read about historical cost methods of inventory management and know what LIFO and FIFO are.
Izhar Ahmad19 Dec, 2023
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Historical Cost Methods: Historical cost is used as a measure in accounting, especially within the Historical Cost methods. In this way of doing accounting, the value of an asset is shown on the balance sheet at its original cost, which is the price at which the business bought the asset in the first place. In the United States, under GAAP rules, historical cost methods are applied to fixed assets.
Within inventory management and accounting, two common historical cost methods are applied to determine the cost of goods sold and the leftover inventory value: LIFO (Last-In, First-Out) and FIFO (First-In, First-Out). These methods offer different views on inventory management and carry effects for financial reporting.Also Read- Difference Between Microeconomics And Macroeconomics
Different Types of Historical Cost Methods
There are many historical cost methods, but FIFO and LIFO are commonly used, we have mentioned a few types of these methods:First-In, First-Out Method (FIFO):
Under FIFO, materials are issued in the order of their receipt by the company. This means that the oldest stocks are utilized first before newer items. The closing stock at the end of the year reflects the latest market prices. FIFO is advantageous for its simplicity in maintenance and recording, and it logically follows the flow of goods. However, it may pose challenges in calculations when there are significant fluctuations in the prices of goods.Last-In, First-Out Method (LIFO):
LIFO is the inverse of FIFO, where the goods received last are the first to be issued. This method prioritizes the use of the latest purchases, leaving previous acquisitions in stock. Although LIFO better aligns costs with revenue, it is generally considered illogical. Some companies may choose LIFO to manipulate stock valuation during rising prices. A major drawback is that the year-end stock does not reflect the market value, leading tax authorities to disapprove of LIFO as an acceptable inventory recording method.Average Method:
The average method comes in two types: simple and weighted. In the simple average method, the prices of various purchases are added together and divided by the number of prices, resulting in a single average price. Closing stock is then valued at this average price. This method is suitable for firms that do not need to specifically identify costs related to revenue.Specific Identification Method:
This approach involves meticulously tracking and recording the cost of each item in the inventory. The total value of the closing inventory is determined by summing up the costs of all individual items. While this method may be labor-intensive, it is essential for valuing inventory, particularly when goods are designated for specific jobs or processes. The special identification method aligns with the flow of goods and associated costs directly with revenue.FIFO Vs LIFO-Key Differences
The key differences between FIFO and LIFO are given in the table below:| Particulars | LIFO (Last-In, First-Out) | FIFO (First-In, First-Out) |
| Inventory Flow Assumption | Assumes the most recently acquired inventory is sold first. | It assumes that the oldest inventory gets sold first. |
| Cost Calculation | Reflects current market conditions, using recent prices for the cost of goods sold. | Reflects historical costs, using older prices for the cost of goods sold. |
| Impact on Cost of Goods Sold | May result in a higher cost of goods sold, especially in inflationary environments. | May result in a lower cost of goods sold due to the use of older, lower-cost inventory. |
| Environmental Factors | Preferred in inflationary environments with rising inventory costs. | Typically utilized in deflationary conditions when inventory costs may fall. |
| Matching Principle | Better matches current revenues with recent costs. | Better matches historical revenues with historical costs. |
| Tax Advantages | Can provide tax advantages, especially during inflationary periods, by potentially lowering taxable income. | May not offer the same tax advantages, but is suitable in deflationary periods. |
| Inventory Tracking | Requires careful inventory tracking and record-keeping for accurate application. | Demands meticulous inventory tracking and documentation for proper implementation. |
| Inventory Obsolescence | May result in higher instances of inventory obsolescence due to older stock being less likely to be sold. | Reduces the risk of inventory obsolescence as older inventory is sold first. |
| Reduced Inventory Obsolescence | May not reduce the risk of inventory obsolescence. | Reduces the risk of inventory obsolescence by selling older inventory first |
Also Read- Difference Between Human Resources and Human Capital
Similarities between LIFO and FIFO
- Both LIFO and FIFO are methods utilized for inventory valuation, determining the cost of goods sold and the remaining inventory value.
- They are commonly employed in financial reporting and inventory management practices.
- Accurate inventory tracking and record-keeping are imperative for the proper application of both LIFO and FIFO.
- Both methods have a significant impact on financial statements, influencing the profitability and overall financial performance of a business.
- Market conditions, including factors like inflation and deflation, influence both LIFO and FIFO.
- LIFO and FIFO offer insights into inventory turnover and contribute to effective inventory management practices.
- Careful consideration of tax implications is necessary for both methods, and they may provide tax advantages in specific jurisdictions.
- Businesses must weigh the advantages and disadvantages of both methods when selecting an inventory valuation approach.
- Both LIFO and FIFO play a crucial role in influencing the balance sheet by determining the value of ending inventory.
- They are essential components in managing inventory costs and ensuring the accurate reporting of financial information.
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Advantages of FIFO
- Offers a more accurate representation of historical costs when calculating the cost of goods sold. - Minimizes the risk of inventory obsolescence by prioritizing the sale of older inventory. - Facilitates accurate financial reporting in periods of deflation or declining prices. - Enables precise year-over-year comparisons of financial performance. - Results in a higher reported value for ending inventory on the balance sheet due to recent inventory costs.Disadvantages of FIFO
- May lead to a lower reported cost of goods sold compared to LIFO. - The cost of products sold may not always represent current market realities. - Could result in higher taxable income during periods of inflation or rising prices. - Demands accurate inventory tracking and record-keeping for correct method application. - May not fully capture the impact of recent inventory costs on financial performance.Advantages of LIFO
- Offers a more accurate representation of current market conditions when calculating the cost of goods sold. - Potentially lowers taxable income, providing opportunities for tax advantages. - Aids in managing tax liability, particularly in inflationary periods. - Aligns recent costs with current revenues, enhancing the accuracy of financial reporting.Disadvantages of LIFO
- May result in a higher reported cost of goods sold compared to FIFO. - Reduces the value of ending inventory on the balance sheet due to the use of older inventory costs. - Can distort financial performance indicators during inflationary periods or when prices are rising. - Demands precise inventory tracking and record-keeping for correct method application. - Poses a risk of inventory obsolescence if older inventory remains unsold or becomes outdated.Historical Cost Methods FAQs
What is the purpose of using historical cost?
The historical cost concept is useful because it enables organizations to track the value of their assets over time, even if that value varies.
What is the main advantage of the historical cost concept?
The advantages of employing this cost method are the objectivity and dependability of accounting data.
What exactly are FIFO, LIFO, and WAC?
The three most common and widely used inventory valuation methods are: FIFO (First-In-First-Out); LIFO (Last-In-Last-Out); and WAC (Weighted Average Cost).
What are the four costing methods?
Process costing, job costing, direct costing, and throughput costing are the most popular costing approaches.
What are the four kinds of costs?
Costs can be categorized into four categories: fixed costs, variable costs, direct costs, and indirect costs.
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