Accountants use specific terms when discussing inventory methods. This video explains the different terms and why different terms are needed.
- Let's talk inventory. - Okay, tell me what it is. - Inventory is the name given to goods that are either manufactured or purchased for resale in the normal course of business. A car dealer's inventory is automobiles. A grocery store's inventory is vegetables, meats, dairy products, canned goods, bakery items. Sears' inventory is comprised of shirts, Kenmore appliances, DieHard batteries and more. - And like other items of value, such as cash or equipment, inventory's classified as an asset and is reported on a company's Balance Sheet.
- When products are sold, they are no longer assets. The cost to purchase or manufacture the products must be removed from the asset classification, removed from inventory on the Balance Sheet, and reported on the Income Statement as an expense, Cost of Goods Sold. - Now, if you hang around accountants or Financial Statements very much, and the discussion turns to inventory, you'll start to hear terms like LIFO and FIFO. These are inventory methods that are commonly used by companies. Our objective today is to familiarize you with these terms.
- As Jim said, LIFO and FIFO are terms used to designate specific inventory methods. LIFO means Last In First Out. In other words, the last inventory we purchased is the first inventory we assume that we're going to sell. - And likewise with FIFO, which means First In First Out, the first inventory purchased is the first inventory that is assumed to be sold. - So using LIFO, the last ones in are the first ones out. The ones we keep, the ending inventory, those are the first inventory we purchased.
With FIFO, the first ones in are the first ones out. So the inventory, the ones we keep, are the last inventory items that were purchased. - Now it is important to point out here that the inventory methods we have been discussing are assumptions. The accounting rules do not require that the assumed flow of goods for costing purposes matches the actual physical movement of goods purchased and sold, though in some cases the assumed cost flow may be similar to the physical flow. - A grocery store, for example, usually tries to sell the oldest units first to minimize spoilage.
Thus, the physical flow of goods would reflect a FIFO pattern: first in, first out. But the grocery store could also use FIFO, LIFO, or some sort of average of the two, in determining its ending inventory and its cost of good sold, the numbers that are assumed to be used and reported in the Financial Statements. - On the other hand, a company that stockpiles coal must first sell the coal purchased last since it's on the top of the pile. That company might use the LIFO cost assumption which reflects physical flow, or it might use one of the other alternatives.
- This is hard for many people to get their arms around. Many people think that the physical flow and the accounting flow should be the same. Now perhaps they should be, but that's not required by the accounting rule makers. - And in some cases it would be hard to determine. In the coal example, suppose the coal is taken from the side of the pile instead of the top? Or is dropped through a chute and loaded into trucks? All three of these physical methods for loading coal are used. Which method would be right? - When there is no one right answer, accounting rule makers will often allow companies to choose an inventory method, or a depreciation method, and then require the company to disclose the selected method in the Notes to the Financial Statements.
- For example, Walmart discloses in their Notes to the Financial Statements that they use LIFO. Microsoft uses an average costing method. - John Deere, makers of big agricultural and construction equipment, states that the inventory in the United States they value using LIFO, and their inventory outside the United States they value using FIFO. - So when the discussion turns to inventory and people start throwing around these LIFO and FIFO terms, at least you will know what they are talking about. They are talking about the assumptions when accounting for the movement of inventory from the Balance Sheet to the Income Statement.
- And remember, the physical flow does not have to be the same as the assumed accounting flow of inventory cost. The two can be different. To know if they are, just consult the Notes to the Financial Statements. - So that's the basic introduction to the differing inventory methods. It can and does get much more complicated. - Okay, so I've got another inventory method for you. How about LAFO? - What does LAFO stand for? - LAFO, let the auditor figure it out. - Ah yeah, you're killing me. - But wait, I got another one. How about FISH? - What does that stand for? - First in, still here.
- I believe we've heard enough from you.
Skill Level Beginner
Q: Why can't I earn a Certificate of Completion for this course?
A: We publish a new tutorial or tutorials for this course on a regular basis. We are unable to offer a Certificate of Completion because it is an ever-evolving course that is not designed to be completed. Check back often for new movies.