O Inventory, inventory! Wherefore art thou inventory? I couldn't have said it better than that pining lover of by gone days. There are few areas in accounting that allow such divergent views, each of which sustain an ardent troupe of followers.
Pick your side!
"Deny thy LIFO; and refuse your tax advantages"
The GAAP treatment of inventory is really that silly. Here is why.
GAAP allows several different valuation methods for inventory, each providing their advantages and disadvantages. FIFO, LIFO, Moving and Weighted Average, and even specific identification.
Adding to the difficulty is that inventory does not just include items purchased, but will include other costs associated with getting those goods ready for sale.
Using anything but specific identification for inventory is silly. I will get into what each method looks like, but let me rant for a moment. We now have these neat things called computers. Use of barcodes and even lower end automatic barcode reading equipment make tracking individual boxes possible. Many retailers use this tracking to stock their stores. For costing purposes you don't even need to specifically identify each individual box, just attach a barcode that represents the cost. I call my method IST-ICT, I Sold This-It Cost This.
I had an interesting experience recently. While in an accounting research class we where discussing the use of samples in auditing. The "consensus" was that it was too much work to audit every transaction. I asked "Why?" The reaction was interesting. Here I was in a graduate level class, literally questioning everything I had been taught for the last several years. I made my case well. "Why in a time that advanced computer technology is being used by clients and auditors can we not put every transaction through a computerized auditing program?" and "I don't think that it is unrealistic, given the timeframe of large scale engagements, that an audit of all transactions take place."
So why can't we do that with inventory? In some cases it is that actual cost of developing and maintaining such a system, in most cases though it is simply the advantage of using one method over the other. You will see as I describe each method
FIFO - First In First Out: This method assumes that the first goods purchased are the first goods sold. It should be intuitive that this method closely matches the "actual" flow of goods as older items would be brought out and sold first as stock is rotated. The critics of this method say that because older costs are used it results in understated cost of goods sold. Newer, replacement products cost more and as such forecasting of future expenses is less reliable. This is true in a period of inflationary prices. This translates to a Balance sheet that is more "fair" and an Income Statement that is less "fair"
LIFO - Last In First Out: The reverse of FIFO. It assumes that the most recently purchased items are the goods that are sold first. In some cases this can closely match flow of goods (think about technology where obsolescence horizons are extremely short) but generally that is not the case. Proponents say that because the newer, higher costs are being used this provides a more accurate representation of the actual costs of sales going forward and in turn results in a more reliable net income figure. Inventory on the B/S would be less "fair" while net income on the I/S would be more "fair".
So which would you choose? Higher costs and lower net income (LIFO) or lower costs and higher net income (FIFO)? Beware - if you choose LIFO for your taxes you have to use it for financial reporting as well. Wait, did I mention that? Oh yeah, adding to the complexity you can use different methods for financial reporting (GAAP) and taxes (IRS). The exception if the LIFO conformity rule above.
Study up: this is a heavily tested area of accounting both in academia and on the CPA exams.
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