Every business needs to know the value of the products it has to sell. Without this information, a business cannot decide on a competitive selling price, schedule raw materials purchases and schedule production to replace items that are sold--just to name a few of the vital business decisions that rely on accurate inventory information.
Perpetual vs. Periodic
The first choice a firm must make is whether to use a perpetual inventory control system or a periodic system. One deciding factor is the level of technology available. If the company has the ability to record transactions in real time, as with point-of-sale scanning equipment, the perpetual system may be chosen. With this system, sales are recorded immediately--the inventory account is perpetually changing. The second system, periodic, uses additional accounts to track sales, purchases of inventory and customer returns. These accounts hold aggregated sales data, which is not posted to the inventory account until the period ends. The period can be monthly, yearly or any time frame the firm chooses.
After choosing one of the above systems, there is another choice to make. How will the costs of items sold be recorded? This is an important decision. A method that lowers costs will increase net income and taxes. The company must consider factors like expected sales volume and whether future inventory purchases will rise or fall in price. Let’s look at two methods of inventory valuation.
FIFO stands for first in – first out. With this valuation method, the cost of the oldest inventory on the shelf (the first purchased) is used to record a sales transaction. The physical inventory sold does not have to be the oldest; this is a cost valuation method. With FIFO, the value of the inventory account will be the same with perpetual or periodic accounting because the earliest costs are used whether the account is updated immediately or at the end of the period.
LIFO stands for last in – first out. When using LIFO, the cost for the most recently purchased inventory is used when posting a sales transaction. As with FIFO, the accounting of costs does not have to coincide with the movement of units out the door. In fact, with LIFO, the unit need not even be on hand when a sale is made. If it is purchased before the end of the period, it is the last unit, and its cost will be used when a sale is made.
In the United States, a company may only use LIFO for tax reporting purposes but may use FIFO to prepare publicly released financial statements. The decision must be made whether it is to the company's advantage to maintain two separate sets of calculations for this purpose. While the tax implications mentioned above are important, it is also important to appear attractive to potential investors. If management does not weigh all the factors, it could be detrimental to the company’s future growth and prosperity.