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The Sexy Part Of Inventory: FIFO and LIFO

account calculateAccounting gives us the impression of boring, rigid and ooo, did I mention boring? However, accounting is probably one of the greatest inventions of our times. It allows us to keep track of everything in life and in business through the simple concept of double entry.  It is also something that we as investors, need to have a basic understanding of as we go through a company’s annual report.

Today we look at just one small part of the massive accounting guide; inventory.

Not all inventory are created equal

In all the component companies of The Straits Times Index (SGX: ^STI), all of them would need to carry some inventory. Even service providers such as Singtel (SGX: Z74) would still need to have some inventory on its book albeit very small compared to its overall asset base.

However, there are more than one ways to record inventory and two very similar companies can end up recording a very different inventory base if each of them has chosen a different recording method.

There are three ways of recording for inventory; first in first out (FIFO), last in first out (LIFO), and weighted average.  Companies (All Singapore-registered companies) that follow the IFRS accounting standards, LIFO is not permitted in the accounting standards. However, not all of the companies listed in Singapore follow the IFRS accounting standard.  Investors should double check which inventory method the company is using.

What is the difference?

FIFO (First in first out) as the name suggests, records the cost of inventory in the order of their purchase timing. The cost of goods sold will be based on the inventory purchased at the earliest date first. During an inflationary period, FIFO accounting will end up with a lower cost of goods sold than the reality and records a higher operating income for the company.

LIFO will generally have the opposite effect. The inventory that is last bought will be used in the recording of cost of goods sold first.

Weighted average is a method where company will just average out the cost of the inventory regardless of when the inventory is purchase. The end result is a situation in between using FIFO and LIFO.

Foolish Summary

The greatest effect these methods will have on a company’s financial is during a time of hyperinflation. Thus, when looking through company, it is worth noting when the period of high inflation was and how it has skewed the financials of a company during those times.