Portfolio Management - LIFO and FIFO Valuation of Inventory

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


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