Properly matching costs with sales is a major role in accounting for inventory. The matching principle is used to decide how much of the cost of the goods available for sale is deducted from sales and how much is carried forward as inventory and matched against future sales.
Four very common methods used to assign costs to inventory and to cost of goods sold are as follows:
(1) Specific identification;
(2) First-In, First-Out (FIFO);
(3) Last-In, First-Out (LIFO);
(4) Weighted average.
In this paper, the most common methods, LIFO and FIFO are discussed. Usage of each method causes the greatest differences in numbers reported on the balance sheet and income statement, and, ultimately, the financial statements. According to Jesswein …show more content…
While in the market where prices are rising rapidly, value of inventory goes up resulting into gain in net profit. Thus, if prices increase, inventory profit is maximized and total earnings increase as well. And if prices decrease, costs are maximized and thus profit is minimized (Merjos, 1974).
According to Merjos (1974), from corporate’s standpoint, advantages of LIFO far outweigh the drawbacks. LIFO method reduces tax liability. As quality of earnings increases, illusory inventory profits decreases and that decrease vulnerability of earnings (Merjos, 1974).
From another viewpoint, some factors of FIFO offset the tax advantages of LIFO and that is the reason of FIFO usage by greater number of firms. Such factors are: lower implementation costs of the FIFO method; agency costs; and signaling motives (Bar-Yosef et al, 1995).
In the studies, Bar-Yosef et al (1995) shows that, firms with higher production costs suffer more tax disadvantages if they are using FIFO method. And for the firms with lower production costs, this tax disadvantage suffering is far less. This implies that the tax advantages from LIFO for the firms with lower production cost are not as large as the tax advantages for the less efficient firms (i.e., firms with higher changes in production …show more content…
Insufficient LIFO data are available for evaluations of the Agriculture, Forestry, and Fishing industry, the Mining industry, the Construction industry, and the Public Administration industry. (Murdoch et al, 2013).
Study conducted by Murdoch et al (2013) shows that in terms of asset cost, LIFO manufacturing firms are an average of about 5 to 6 times larger than that of FIFO Manufacturing firms. Also, both LIFO and FIFO Manufacturing firms hold about 20% of their assets as inventory. LIFO Manufacturing firms earn about 4 % higher after-tax operating return on their assets (ROA).
In contrast, in terms of total assets, LIFO Transportation industry firms are about half the size, or less, of FIFO firms in this industry. Both LIFO and FIFO firms also hold about the same proportion of their assets as inventory (5-6%) and FIFO firms are about 5-6% more profitable in ROA terms (Murdoch et al, 2013).
For Wholesale Trade Firms, the average LIFO is more than twice the size of FIFO firms in this industry, but FIFO firms are about 2% more profitable in terms of ROA. Relative to the size of their assets, LIFO firms hold about 25% more inventory than FIFO firms (Murdoch et al,