In Section 3, "Equities", you were introduced to LIFO and FIFO as part of a discussion dealing with valuing shares of stock you sold. You will recall that you had acquired these shares over a span of time, and the price of the shares you bought changed over that time. If you reckoned that you sold the first shares you bought, then you employed FIFO. If you consider the last shares you bought to be the ones you sold, then you employed LIFO.

The same applies to inventory. Whether we are discussing finished goods that are up for sale or the raw materials used to make those goods, GAAP allows a company to use either LIFO or FIFO to determine how much they are worth for balance sheet purposes. Most prices trend up over time, so FIFO suggests that the inventory the company holds is the last - and typically most expensive - to be acquired. LIFO suggests that the inventory held is the first to be acquired and thus cost less to acquire.

In the example in Section 3, the answer to the question, "How much money did I make on this deal?" changed by one-third depending on whether you used LIFO or FIFO.

This will also happen when valuing inventories, especially in industries where prices are very dynamic: oil, agriculture and computer components, for example.

A company's computation of the value of its inventory could be significantly different under FIFO than under LIFO; for most products, it would be higher under FIFO. However, many technology-oriented products - those computer components, for example - tend to drop in price, so in those cases inventory value would be higher under LIFO. In either case, a fundamental analyst needs to know if a company is using FIFO or LIFO to account for inventory so that she can accurately compare that company's fiscal soundness with that of its peers.

We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line in the article Inventory Valuation for Investors: FIFO and LIFO.

Introduction

Related Articles
  1. Investing

    When & Why Should a Company Use LIFO

    By using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
  2. Small Business

    Understanding First In, First Out (FIFO)

    A company that uses the first in, first out inventory valuation method will sell, use, or dispose of assets that it produced or acquired first.
  3. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  4. Taxes

    Using Tax Lots: A Way To Minimize Taxes

    The method of identifying cost basis can help you to get the most out of reduced tax rates.
  5. Investing

    International Financial Reporting Standards

    Learn about the purpose of the IFRS, as well as its benefits, goals and fundamental difference from the U.S. GAAP.
  6. Insights

    What You Should Know About Inflation

    Find out how this figure relates to your investment portfolio.
  7. Managing Wealth

    Cost Basis Basics

    The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ...
  8. Investing

    Days Sales of Inventory

    Days Sales of Inventory, also called Days Inventory Outstanding, is a key financial measurement of a company's performance pertaining to inventory management. In simple terms, it tells how many ...
Frequently Asked Questions
  1. Where do most fund managers get their market information?

    Many fund managers, whether they manage a mutual fund, trust fund, pension or hedge fund, have access to resources that the ...
  2. What's the difference between short-term investments and marketable securities?

    Understand the difference between short-term investments and marketable equity securities, and learn the importance of short-term ...
  3. Are fringe benefits direct or indirect costs?

    Learn how to allocate costs associated with fringe benefits provided to employees and how to determine when a cost is either ...
  4. How is a bank guarantee different from a traditional loan?

    Read about the differences between a traditional bank loan and a bank guarantee, and why a third party might require a guarantee ...
Trading Center