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Accounting for Inventory using LIFO and FIFO

Explanation. Keeping proper track of inventory for a retail business (or, similar, non-manufacturing organizations)
is important for understanding profitability. Recall that when a business sells some of its merchandise the
inventory (asset) is credited (decreased) and a cost of goods sold expense is recognized (debited). The cost of
goods sold expense is subtracted from the amount of the sale (revenue, credited) in order to determine the net
income (profit) from the sell. Further, the net income will add to the equity (or, net worth) portion of the balance
sheet. Thus, it is vital that we use the proper value of the inventory when recording the transaction.
So what is the difficulty? One would think that keeping a record of the value of inventory is a fairly easy thing to
do. When a business purchases inventory, we record it by debiting the inventory account in the amount it cost and
crediting either the cash account (decreasing an asset) or the accounts payable account (increasing a liability). That
is true. The difficulty, however, comes when identifying the value of the inventory that is actually sold. In the
examples that follow we see that the business purchases the same type of goods to sell, and initially add to
inventory, but the price that we pay for those goods change over time. If this happens, then which price should we
actually use to record the value of the goods sold as our expense? For many types of businesses, it is
straightforward to match the sale of merchandise to the cost of it in inventory. However, for some businesses, the
type of merchandise makes this matching of inventory to sale is difficult.

There are several methods of keeping track of inventory and therefore matching sales to their property inventory
cost. We will concentrate two methods.
(1) FIFO. This stands for First-In, First-Out. In this approach, the goods purchased and added to inventory
first are assumed to be the ones sold first.
(2) LIFO. This stands for (you guessed it) Last-In, First-Out. In this approach, the goods purchased and added
to inventory last are assumed to be the ones sold first.
The two approaches can lead to very different amounts of net income. For example, suppose that the things the
business is buying to add to inventory (and hopefully resell) are rising dramatically in price. Using the LIFO
approach in this type of situation will lead to lower net income than would the FIFO approach. We would be using
the most expensive items out of our inventories first, thus showing higher cost of goods sold expense for the same
revenue. A possible alternative to the above two approaches would be to use some average cost method, which is
done by some businesses. The difficulty is that business can use whatever method they like, and may switch or use
different methods for different purposes. The only requirement a public corporation has is that they must state
clearly the method being used. Some corporations are more user-friendly (when analyzing them) by showing what
their net income would have been under another approach. Lets try a couple examples.

Jitters Coffee House buys coffee beans from a wholesaler, places the beans in large barrels in its store, then allows
customers to bag their own coffee beans from the barrels. Lets suppose the following transactions occur (assume
all transactions involved cash).
On 7/1 Jitters purchases 5 pounds worth of beans from its wholesaler for $20 (or, $4 per pound)
On 7/5 Jitters purchases an additional 5 pounds of beans from it wholesaler. This time, the cost of the 5
pounds of beans went up to $30 (or, $6 per pound)
On 7/8 Jitters sells 5 pounds worth of beans to a customer for $40 (or, $8 per pound).
What would be the net income for the sale on 7/8? Consider, first, how the 7/8 transaction would be recorded?
Account
Cash

Debit

Credit
40

Inventory
Cost of Goods Sold Expense
Sales Revenue

???
???
40

We need to know if we sold the beans purchased on 7/1 or the beans purchased on 7/5. Complete the recording of
the transaction assuming we use the FIFO (First-In, First-Out).

Using the FIFO Method


Account
Cash

Debit

Credit
40

Inventory
Cost of Goods Sold Expense
Sales Revenue

20
20
40

The net income on this transaction would be $20 (= Sales Revenue Cost of Goods Sold Expense = 40 20).
What if Jitters uses the LIFO (Last-In, First-Out) Method?

Using the LIFO Method


Account
Cash

Debit

Credit
40

Inventory
Cost of Goods Sold Expense
Sales Revenue

30
30
40

The net income on this transaction would be $10 (= Sales Revenue Cost of Goods Sold Expense = 40 30). As
with accounting for depreciation, the accountants decision as to how to record inventory (FIFO or LIFO, or some
other method) will certainly impact the financial statements.

For a little more practice, lets change the transactions slightly.


On 7/1 Jitters purchases 5 pounds worth of beans from its wholesaler for $20 (or, $4 per pound)
On 7/5 Jitters purchases an additional 5 pounds of beans from it wholesaler. This time, the cost of the 5
pounds of beans went up to $30 (or, $6 per pound)
On 7/8 Jitters sells 7 pounds worth of beans to a customer for $56 (or, $8 per pound).
Use the FIFO method to record the last transaction on 7/8.

Using the FIFO Method


Account
Cash

Debit

Credit
56

Inventory
Cost of Goods Sold Expense
Sales Revenue

32
32
56

The net income on this transaction would be $24 (= Sales Revenue Cost of Goods Sold Expense = 56 32).
How did we arrive at the $32 Inventory reduction and Cost of Goods Sold Expense?
The customer purchased 7 pounds of beans. Under FIFO, we assume that the first 5 pounds of beans were
those purchased on 7/1 (the First purchase) for $20. The additional 2 pounds to the customer came from the
beans purchased on 7/5 for $6 per pounds or $12 total. Thus, we reduce inventory by $32 and recognize the
cost of goods sold expense.
What if Jitters uses the LIFO (Last-In, First-Out) Method?

Using the LIFO Method


Account
Cash

Debit

Credit
56

Inventory
Cost of Goods Sold Expense
Sales Revenue

38
38
56

The net income on this transaction would be $18 (= Sales Revenue Cost of Goods Sold Expense = 56 38).
How did we arrive at the $38 Inventory reduction and Cost of Goods Sold Expense?
The customer purchased 7 pounds of beans. Under LIFO, we assume that the first 5 pounds of beans were
those purchased on 7/5 (the Last purchased) for $30. The additional 2 pounds to the customer came from
the beans purchased on 7/1 for $4 per pounds or $8 total. Thus, we reduce inventory by $38 and recognize
the cost of goods sold expense.