Paper: 02, Accounting & Financial Analysis

Module: 38, FIFO and LIFO Methods of Valuation of

Inventory

Prof. S P Bansal
Principal Vice Chancellor
Investigator Maharaja Agrasen University, Baddi

Prof YoginderVerma
Pro–Vice Chancellor
Co-Principal Investigator Central University of Himachal Pradesh. Kangra.
H.P.

Dr. O.P Verma

Paper Coordinator Department of Commerce
Himachal Pradesh University shimla

Dr Sanjeet Sharma
Assistant Professor
Content Writer Department of Commerce
Govt College Nadaun (HP)
 Items Description of Module
Subject Name Management
Paper Name Accounting & Financial Analysis
Module Title FIFO and LIFO Methods of Valuation of
Inventory
Module Id Module No-38
Pre- Requisites Basis of Valuation of Inventories
Objectives Methods of Valuation of Inventories
Keywords Valuation, Periodic, Periodic,

QUADRANT-I
Module 38 FIFO and LIFO Methods of Valuation of Inventories
1. Learning objectives
2. Introduction
3. Basis of valuation of inventories
4. Methods of valuation of inventories
5. Specific Identification Method
6. First In First Out (FIFO) Method
7. Last In First Out (LIFO) Method
8. Weighted Average Price Method
9. Selection of Best Method
10. Summary

LEARNING OBJECTIVES:
This module will help the students to:
 Understand the basis of Inventory Valuation
 Classification of methods of valuation of inventory
 Understand the Specific Identification Costs Method
 Understand the Meaning and Features of First-In-First-Out (FIFO) Method
 Explain the Meaning and Features of LIFO Method
 Discuss Weighted Average Price Method
 Compare different methods of valuation of inventory

INTRODUCTION
Inventory is one of the most important assets possessed by a business. Preparation of
accurate income statement and balance sheet of a concern depends on correct valuation of
its inventory. There are different methods for assigning historical costs to inventory and
goods sold. Choosing the correct inventory valuation method depends largely on the
characteristics and need of the business.

BASIS OF VALUATION OF INVENTORIES

According to Accounting Standard 2 (Revised), the inventories should be valued at the
lowest of “cost” and “net realisable value”.
Inventories should be valued at
the lowest of

Cost Net realizable value

Cost of purchase Cost of conversion Other costs

Cost of Inventories
Cost of inventories includes not only the price paid for acquisition of inventories but also
all costs incurred for bringing and making them fit for use in production or for sale, e.g.,
 transportation costs,
 duties paid,
 insurance-in-transit,
 manufacturing expenses,
 wages paid or
 Manufacturing expenses incurred for converting raw materials into finished
products, etc.
Simply it can be concluded that Cost of inventories is the aggregate of
 cost of purchase,
 cost of conversion, and
 Other costs incurred in bringing the inventories to their present location and
condition.
Net realisable value
Net realisable value is the estimated selling price in the ordinary course of business less
the estimated costs of completion and the estimated costs necessary to make the sale.
METHODS OF VALUATION OF INVENTORIES
The main objective of valuation of inventories is the proper determination of income
through the process of matching appropriate costs against revenues. It requires assigning
of proper costs to inventory as well as goods sold. Some of methods for assigning
historical costs to inventory and goods sold are being given as below.
 METHODS OF
VALUATION OF
INVENTORIES

Inventory ordinarily Inventory ordinarily

interchangeable not interchangeable

Specific First In First Out Last In First Out Weighted Average

Identification (FIFO) Method (LIFO) Method Price Method
Method

1. SPECIFIC IDENTIFICATION METHOD

Specific Identification Method is the simplest method used for valuation of inventories.
Specific identification method is suitable in situations where it is possible to physically
separate different purchases and each item sold and each item remaining in the inventory
can be identified. The cost of specific items that are sold during a period is included for
calculating the cost of goods sold for that period. Further, the cost of specific items
remaining at the end of a period is included for calculating inventory at the end of that
period. This method can be practiced in businesses such as car dealerships, jewelers, and
art galleries
This method can applied only
 when a company knows the cost of every individual item that is sold,
 the quantity of inventory is limited and
 Each inventory item is unique.
Example of Specific Identification Method
The working of the system can be understood with the help of the following illustration.
Illustration1. The following is the record of receipts of certain materials during Jan, 2015:
 Jan. 02 Received 800 units for Job No. 2 @ 10 per unit.
 Jan. 03 Received 600 units for Job No. 3 @ 11 per unit.
 Jan. 18 Received 400 units for Job No. 4 @ l2 per unit.
During Jan. 2015, the following issues of materials are made:
 Jan.. 10 Issued 400 units to Job No. 2.
 Jan.. 14 Issued 200 units to Job No. 3.
 Jan.. 19 Issued 400 units to Job No. 2.
 Jan.. 20 Issued 400 units to Job No. 4.
Show how these transactions will appear in the Stores Ledger and state the amount of
inventory of Jan. 31, 2015.
Solution Stores Ledger
Date Receipt Issues Balance
Job Qty. Rate Amt Date Job Qty. due rate Amt Qty Amt
No. No.
Jan.2 2 800 10 8000 800 8000
Jan.3 3 600 11 6600 1400 14600
Jan.10 2 400 400 10 4000 1000 10200
Jan.14 3 200 400 11 2200 800 8400
Jan.18 4 400 12 4800 1200 13200
Jan.19 2 400 …. 10 4000 800 9200
Jan.20 4 400 ….. 12 4800 400 4400
Suitability
 When the materials or goods have been purchased for a specific job or customer.
 When a company is handling a small number of items.

ADVANTAGES OF SPECIFIC IDENTIFICATION METHOD:

In this method actual costs are matched against revenues. An important advantage of
specific identification method that, in this method flow of cost is corresponding to the
physical flow of inventory.

DISADVANTAGES OF SPECIFIC IDENTIFICATION METHOD

This method is inappropriate in most cases due to practical considerations. Some of the
limitations of this method are as below
(i) Manipulation of Income: The biggest limitation of using this method is that
it opens doors to income manipulation and the net income can be easily
manipulated under this method.
(ii) Incase of number of inventory items: In case of a manufacturing concern
have number of inventory items. Then, then this method will fail as it is
almost impossible to identify the cost of each individual item of inventory.
STOP Quick Revision
SPECIFIC IDENTIFICATION METHOD
 Specific identification method is suitable in situations where it is possible to
physically separate different purchases a each item sold and each item remaining
in the inventory can be identified.

2. FIRST IN FIRST OUT (FIFO) METHOD

According to this method inventory is used/ sold in the order they have been purchased
and older inventory is issued first. It is based on the principle that cost should he charged
to revenue in the order in which these have been incurred.
Simply:
 Goods or materials received first are issued first.
 „First come- first serve‟ is the basis of issuing goods or materials.
Example of FIFO Method
The working of this method can be understood with the following illustration. The
following are purchases of material during the month Jan. 2015:
  Jan. 1, 2011 Opening Balance 1,000 units @ Rs 2
 Jan. 6 Received from vendor 400 units @ Rs 3
 Jan. 11 Received from vendor 300 units @ Rs 2
 Jan. 20 Received from vendor 600 units @ „Rs 3
 Jan. 26 Received from vendor 800 units @ „Rs 2
Issues of materials were as follows:
 Jan. 5- 400 units,
 Jan 10 – 800 units
 Jan.18- 200 units
Prepare store ledger accounts showing how the value of the issues would be recorded
under FIFO method
Store ledger accounts
Date Receipts Issue Balance
Qty Rate Amt Qty Rate Amt Qty Rate Amt
Jan. 1 1000 2 2000
Jan. 5 400 2 800 600 2 1200
Jan. 6 600 2 1200
400 3 1200
400 3 1200
Jan. 10 600 2 1200
200 3 600
200 3 600
Jan. 11 200 3 600
300 2 600
300 2 600
Jan. 18 200 3 600 300 2 600
Jan. 20 300 2 600
600 3 1800
600 3 1800
Jan. 26 300 2 600
800 2 1600 600 3 1800
800 2 1600

Note: For making clear issue on dated Jan.10 is shown below in the figure:

600 units @ 2 Firstly use this

Issue on Jan 600 units @ 2
10 = 800 units +
200 units @ 2

400 units @ 3

FEATURES OF FIRST IN FIRST OUT (FIFO) METHOD

Some of features of First In First out (FIFO) Method are explained as below
1. Assumption of method: Under this method, it is assumed that
 the materials/goods that are sold or used first are those are bought first. Or
 the first inventory item that arrives is the first inventory item to go out. Or
 the goods that arrive first are the first to be used. Or
2. Value of Inventory: According to FIFO method, inventory in hand will always be the
most recently purchased items and valued at most recent or current prices.
3. Cost of goods sold
The cost of goods purchased first (first-in) is the cost of goods sold first (first-out). This
means the cost of goods sold is taken on older prices.
4. Suitability
The FIFO method suitable in the following circumstances:
 When nature of materials/goods are perishable.
 Purchases are not made frequently.
 When the prices in market show declining trend.
 Incase inventory items are bulky, slow moving and costly.
5. Impact of Fluctuations in Prices: These can be divided in to two parts
 In periods of rising prices
 In periods of falling prices
In periods of rising prices: In periods of rising prices in FIFO method
 inventory will be valued at a higher prices
 Cost of goods sold will also be relatively deflated.
 profits will be inflated
 Increase in liability for payment of taxes.
In periods of falling prices: In periods of falling prices in FIFO method
 inventory will be valued at a lower prices
 resulting in deflating the profits,
 Reducing the income tax liability.
6. Effect on Balance sheet and Income statement: These can be divided in to two parts
 In normal circumstances
 Incase Fluctuation in Prices
In normal circumstances: In normal circumstances in FIFO method balance sheet
shows a more correct and fair picture since the inventories at end is valued at the recent
or current marked price.
Incase Fluctuation in Prices:
These can further be divided in to two parts:
 In periods of rising price FIFO method gives
 In periods of falling price FIFO method gives
In periods of falling price FIFO method gives
 a more correct, fair and meaningful balance sheet
 a less realistic income statement.
In periods of rising price FIFO method gives
 a less correct, fair and meaningful balance sheet
 a more realistic income statement.
ADVANTAGES OF FIFO METHOD:
The FIFO method has the following advantages
(i) Simple and Easy: FIFO method is easy to operate and it is easy to
calculate value of inventory. Further, this method is also simple to understand.
 (ii) Realistic: FIFO method is realistic method as it is based on assumption that
inventory is issued in the normal order they were received. Because it is
logical that materials purchased earlier are used in earlier jobs.
(iii) Inventory at current prices: Under FIFO method value of inventory reflects
actual price paid. Further, I under this method inventory valued at most recent
prices.
(iv) Reduces the risk: Under FIFO method inventory is issued in the normal order
they were received. Thus, this method reduces the risk of inventory to become
outdated or to perish.
(v) Acceptable by tax authorities and IAS: This method of valuation of
inventories also recommended and acceptable by tax authorities and IAS 2.
(vi) No unrealized profit: FIFO method is based on cost. Therefore, no
unrealized profit enters into the financial accounts of the company.
DISADVANTAGES OF FIFO METHOD:
The method suffers from the following disadvantages:
(i) Cost of goods of sold not on recent prices: In this method older items are
issued, cost of production not reveal recent prices. Due to this price of
products manufactured may not reflect current market prices.
(ii) Create problems incase of price fluctuation: Incase of prices fluctuate a lot
this method becomes time consuming and calculation becomes complicated.
(iii) Possibility of clerical errors: In this method calculations are complicated and
due to this the possibility of clerical errors increases.
(iv) Difficult to make Comparison between jobs: In this method a job started a
few minutes after another job may have totally different charge for materials.
Thus, comparison between different jobs even using the same type of material
becomes sometimes difficult.
(v) Higher tax liability In case of inflation, the value of cost of goods sold will
be lowest and it will maximize net income and tax liability. Thus, this
method results in a higher tax liability.
STOP Quick Revision
FIRST IN FIRST OUT (FIFO) METHOD
According to this method inventory is used/ sold in the order they have been purchased
and older inventory is issued first.
ADVANTAGES OF FIFO METHOD
 Simple and Easy
 Realistic
 Inventory current price
 Reduces the risk
 Acceptable by tax authorities and IAS
 No unrealized profit
DISADVANTAGES OF FIFO METHOD
 Cost of goods of sold not on recent prices
 Create problems incase of price fluctuation
 Possibility of clerical errors
 Difficult to make Comparison between jobs
 Higher tax liability .

3. LAST IN FIRST OUT (LIFO) METHOD

Under LIFO method the newest inventory is recorded as sold or used first. According to
this method the last items of materials/goods purchased are the first to be issued/sold.
Example of Last In First Out (LIFO) Method
The working of this method can be understood with the following illustration. The
following are purchases of material during the month Jan. 2015:
 Jan. 1, 2011 Opening Balance 1,000 units @ Rs 2
 Jan. 6 Received from vendor 400 units @ Rs 3
 Jan. 11 Received from vendor 300 units @ Rs 4
 Jan. 20 Received from vendor 600 units @ „Rs 3
 Jan. 26 Received from vendor 800 units @ „Rs 2
Issues of materials were as follows:
 Jan. 5- 400 units,
 Jan 10 – 800 units
 Jan.18- 200 units
Prepare store ledger accounts showing how the value of the issues would be recorded
under LIFO method
Store ledger accounts
Date Receipts Issue Balance
Qty Rate Amt Qty Rate Amt Qty Rate Amt
Jan. 1 1000 2 2000
Jan. 5 400 2 800 600 2 1200
Jan. 6 400 3 1200 600 2 1200
400 3 1200
Jan. 10 400 3 1200 200 2 400
400 2 800
Jan. 11 300 4 1200 200 2 400
300 4 1200
Jan. 18 200 4 800 200 2 400
100 4 400
Jan. 20 600 3 1800 200 2 400
100 4 400
600 3 1800
Jan. 26 800 2 1600 200 2 400
100 4 400
600 3 1800
800 2 1600
Note: For making clear issue on dated Jan.10 is shown below in the figure:

600 units @ 2 Firstly use this

Issue on Jan 400 units @ 3
10 = 800 units +
400 units @ 2

400 units @ 3

FEATURES OF LIFO METHOD

Some of Features of LIFO Method are explained as below
1. Assumption of method: LIFO is based on the principle that
 the last inventory goods received will be the first inventory goods sold or used.
 arrive last are the first to be used.
2. Value of Inventory
When the LIFO method is used, the inventory at the end of a year consists of the goods
placed in inventory at the beginning of the year. Thus, under this method, inventory
valued at the earliest cost.
3. In circumstances of Fluctuations in Prices: These can be divided in to two parts
 In periods of rising prices
 In periods of falling prices
In periods of rising prices: In periods of rising prices, LIFO will
 result in the lowest ending inventory,
 highest cost of goods sold,
 Lowest net income.
 Reduction in liability for payment of taxes.
In periods of falling prices: In periods of falling prices, LIFO method will result in
 inventory will be valued at a higher prices
 resulting in increase the profits,
 Increasing the income tax liability.
4. Effect on Balance sheet and Income statement
These can be divided in to two parts
 In normal circumstances
 Incase Fluctuation in Prices
In normal circumstances: In normal circumstances when this method is used balance
sheet shows a distorted picture since the inventory at end is shown at old costs
Incase Fluctuation in Prices: These can further be divided in to two parts:
In periods of rising price LIFO method gives
 a more meaningful, true and fair view of balance sheet
 a less realistic income statement.
In periods of falling price LIFO method gives
 a less meaningful balance sheet
 a more realistic income statement.
ADVANTAGES OF LIFO METHOD:
The method has the following advantages:
(i) Valuation of issues at current prices: Under LIFO method current market
prices are used for valuing materials issued to different jobs or calculating the
cost of goods sold.
(ii) No unrealized profit or loss: LIFO method is based on cost and no
unrealized profit or loss recorded under this method.
(iii) Suitability LIFO method is suitable for materials non-perishable type.
(iv) Lower a business's tax liability: When LIFO method used in the times of
growing inflation it can reduce a company‟s tax responsibility.
DISADVANTAGES OF LIFO METHOD:
The method suffers from the following disadvantages:
(i) Not appropriate for some businesses: This method is not appropriate for
businesses with perishable inventory items because those businesses have to
sell the oldest inventory items first.
(ii) Create obsolete inventory: LIFO can incur obsolete inventory. This is
because older inventory will remain on the shelves and may become obsolete
over time.
(iii) IFRS prohibit the use of LIFO: Finally, International Financial Reporting
Standards not recommend the use of LIFO and it has been heavily regulated
under the International Financial Reporting Standards

STOP Quick Revision

LAST IN FIRST OUT (LIFO) METHOD
 Under LIFO method the newest inventory is recorded as sold or used first.
ADVANTAGES OF LIFO METHOD
 Lower a business's tax liability
 Valuation of issues at current prices
 No unrealized profit or loss
DISADVANTAGES OF LIFO METHOD
 Not appropriate for some businesses
 Create obsolete inventory
 IFRS prohibit the use of LIFO

DIFFERENCE BETWEEN FIFO AND LIFO

The difference between LIFO and FIFO method are given as below:
Point of difference FIFO LIFO
1. Assumption goods or material goods or material
 received first  received last
 issued first  issued first
2.Valuation of Cost of cost of goods sold does not cost of goods sold reflect
goods sold reflect current market price current market price

3. Value of inventory Closing inventory reflect Closing inventory does not

current market price. reflect current market price.
4. Effect on profit and tax During the periods of During the periods of
liability falling prices, falling prices,
 lower income is  higher income is
reported reported
 Reducing the tax  Increasing the tax
liability. liability.
During the periods of rising During the periods of rising
prices, prices,
 higher income is  Lower income is
reported reported
 Increasing the tax  Reducing the tax
liability. liability.
5. Effect on balance sheet Balance sheet shows a more balance sheet shows a
correct picture since the distorted picture since the
closing inventories is closing inventory is shown
valued nearer to the current at old costs
marked price.

4. WEIGHTED AVERAGE PRICE METHOD

Weighted Average Price Method is based on the assumption that materials or goods
which are purchased are combined into a common bin, after that they lose their separate
identity. The inventory does not consist of specific batch of goods. The inventory is thus
priced on the basis of Weighted Average prices. These are weighted according to the
quantity purchased at each price. Weighted Average cost is calculated given as below:
value of inventory at beginning of year  purchases during the year
Average cost 
Number of units at the beginnning of year  number of units purchased during year

Example of Weighted Average Price Method:

The working of this method can be understood with the following illustration. The
working of this method can be understood with the following illustration. The following
are purchases of material during the month Jan. 2015:
 Jan. 1, 2011 Opening Balance 1,000 units @ Rs 2
 Jan. 6 Received from vendor 400 units @ Rs 3
 Jan. 11 Received from vendor 300 units @ Rs 2
Issues of materials were as follows:
 Jan. 5- 400 units,
 Jan 10 – 800 units
 Jan.18- 200 units
Prepare store ledger accounts showing how the value of the issues would be recorded
under LIFO method
Store ledger Account
Date Receipts Issue Balance
Qty Rate Amt Qty Rate Amt Qty Amt
Jan. 1 1000 200
Jan. 5 400 2 800 600 1200
Jan. 6 400 3 1200 1000 2400
Jan. 10 800 2.40 1920 200 480
Jan. 11 300 2 600 500 1080
Jan. 18 200 2.16 432 300 648

ADVANTAGES OF WEIGHTED AVERAGE PRICE METHOD:

The main advantages of this method are as below:
(i) Logical: Weighted Average Price Method logically recognizes that identical
items of inventory, even purchased at different intervals, have equal value.
(ii) Minimizes fluctuations and ease the pricing process: Weighted Average
Price Method minimizes fluctuations in costs of materials issued. Further, it
eases the pricing process.
(iii) Smoothes out fluctuations in profits: Weighted Average Price Method
smoothes out fluctuations in profits that have occurred due to price
fluctuations.
(iv) Computerized system can be applied: Weighted Average Price Method is
easier to be computerized than other methods of valuation of inventories.
(v) Acceptable by tax authorities and IAS: This method of valuation of
inventories also recommended and acceptable by tax authorities and IAS 2.
(vi) Popular method: Weighted Average Price Method is very popular on account
of its being based on the total quantity and value of materials purchased.

DISADVANTAGES OF WEIGHTED AVERAGE PRICE METHOD:

Some of the limitations of this method are given as below:
(i) Does not reflect actual price: Weighted Average Price Method does not
reflect actual price paid for as it based on average price. Therefore, it values
inventory at average prices not on actual prices.
(ii) Rounding off create problems: Calculations in Weighted Average Price
Method results in figures with several decimal places. Rounding off results in
slightly inaccurate figures.
(iii) Not suitable: In period of rising prices, Weighted Average Price Method does
not reflect current prices.
STOP Quick Revision
WEIGHTED AVERAGE PRICE METHOD
 Weighted Average Price Method is based on the assumption that materials or
goods which are purchased are combined into a common bin, after that they lose
their separate identity.
 Inventory is thus priced on the basis of Weighted Average prices.
ADVANTAGES OF WEIGHTED AVERAGE PRICE METHOD:
 Logical
 Minimizes fluctuations and ease the pricing process
 Smoothes out fluctuations in profits
 Computerized system can be applied
 Acceptable by tax authorities and IAS
 Popular method
DISADVANTAGES OF WEIGHTED AVERAGE PRICE METHOD
 Does not reflect actual price
 Rounding off create problems
 Not suitable

COMPARISON OF FIFO AND WEIGHTED AVERAGE PRICE METHOD

FIFO and Weighted Average Price Method provide different results in different
circumstances and some of these are explained below in table:
Situation FIFO Weighted Average Price
Method
If prices are showing rising trend
Value of inventory at the end Higher Lower
Net Income Higher Lower
Valuation of Assets Higher Lower
If prices are showing rising trend
Value of inventory at the end Lower Higher
Net Income Lower Higher
Valuation of Assets Lower Higher
SELECTION OF BEST METHODS
There are several methods to value and cost inventory. Inventories represent important
current assets of a concern. Selection of the right inventory valuation method depends on
the specific characteristics and objectives of the valuation. Below are the
recommendations of Indian accounting standard and International Financial Reporting
Standard about selection of valuation method of inventory.
Recommendation from Accounting Standard 2 (Revised)
Accounting Standard 2 (Revised) provides
 First in First out (FIFO) or Weighted Average method for computing the cost of
inventories.
 It has recommended the use of specific Identification Method only in case of
goods or services which are meant for specific projects.
Recommendation from IFRS
Under IFRS, entities are permitted to employ one of three cost formulas when reporting
inventory expense. These methods are:
 Specific Identification
 First-in, First-out ("FIFO")
 Weighted-Average Cost
So, it can be concluded that generally FIFO and Weighted Average method are popular
and recommended methods.
STOP Quick Revision
 Generally FIFO and Weighted Average method are popular and recommended
methods.

SUMMARY
Preparation of accurate income statement and balance sheet of a concern depends on
correct valuation of its inventory. According to Accounting Standard 2 (Revised), the
inventories should be valued at the lowest of “cost” and “net realisable value”. There are
different methods for assigning historical costs to inventory and goods sold. These
mainly include Specific Identification Method, FIFO,LIFO and Weighted Average Price
Method. Generally FIFO and Weighted Average method are popular and recommended
methods.