Inventory is the goods and materials that are available in stock by a company as part of business management. A property not amounting to a capital asset[i], a property held by a taxpayer mainly for sale to customers, a stock or other property in the hand of a tax payer amounts to inventory items[ii].
There are two inventory identification methods. They are:
- First in First out Method (FIFO);
- Last in First out Method (LIFO).
FIFO is a method of inventory accounting in which the oldest remaining items are assumed to be the first sold. The principle behind FIFO is what comes in first will be handled first and what comes in next waits until the first one is finished. The FIFO method of costing issued materials follows the principle that materials used must carry the actual experienced cost of the specific units used.
The FIFO method is recommended whenever the size and the cost of units are large, when the materials are put under a specific purchased lot, and when two or three different receipts of the materials are on a materials card at the same time.
Whereas, in LIFO, assets produced or acquired last are used, sold, or disposed of primarily during an accounting year. In other words, the assets that are acquired most recently are sold first under the LIFO method.
The LIFO method is used when one cannot specifically identify the items of inventory and the quantity of inventory was purchased at different times at various prices. Therefore, the LIFO method is an asset management and valuation method that assumes that assets produced or acquired last are the ones that are used, sold, or disposed of first.
It is to be noted that the FIFO method and the LIFO method produce different results in income, based on the trend of price levels of the goods included in those inventories. It can be seen that, when prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. Whereas, under FIFO, the cost of goods sold will be lower and the closing inventory will be higher. However, when prices fall, then LIFO will produce a smaller cost of goods sold and a higher closing inventory.
[i] 26 USCS § 751.
[ii] 26 USCS § 1221.