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Historical Cost Methods - FIFO and LIFO

Last updated date: 21st Apr 2024
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What is Historical Cost?

A historical cost is a measure of the value which is used in accounting. In the Historical Cost method, the value of an asset on the balance sheet is recorded at its original cost. Original cost is the cost at which the asset is being acquired by the company. The historical cost method is used for fixed assets in the United States under the principles of GAAP. The historical cost has a great significance in the accounting system used by the accountant which helps the proper estimation of depreciation value of the assets. 

To further know about the concept, we have vividly explained about the term in our next section.

Understanding Historical Cost

The historical cost principle is the basic accounting principle under the U.S. GAAP. According to the historical cost principle, generally, the assets are recorded on the balance sheet. The recording is done at a historical cost even though the cost has increased over the time period. The assets are held at historical cost, for example, the marketable securities, the impaired intangible assets, etc.

First In First Out Method

First In, First Out, abbreviated and commonly known as FIFO, is an asset-management and a valuation method in which the assets that are produced or acquired first are to be sold, used, or disposed of first. This is the fundamental of the FIFO method. For tax purposes, FIFO assumes that the assets with the oldest costs are included in the income statement, under the heading cost of goods sold (COGS). The remaining inventory assets are then matched to the assets that are most recently purchased or produced.

Working of First In, First Out (FIFO)

The FIFO method is used for the cost flow assumption purposes. In the manufacturing unit, as items progress to the development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense. Under the FIFO, it is assumed that the cost of inventory purchased first will be recognized very first. The money value of total inventory decreases in this process as inventory has been removed from the company’s ownership. The costs associated with the inventory may be calculated in several other ways, a popular way is this FIFO method.

Last In First Out 

Last In, First Out abbreviated and popularly known as LIFO is another method that is used to account for the inventory. This records the most recently produced items that are to be sold first. Under the LIFO system, the cost of the most recent products is purchased or produced and the first to be expensed as the cost of goods sold (COGS), which means that lower cost of older products will be reported as an inventory.

The two alternative methods of inventory-costing are the First In, First Out (FIFO) and LIFO (Last In First Out). In FIFO, the oldest inventory items are recorded and sold first. In another type of cost method, that is the average cost method,  takes the weighted average of all the units available for sale during the particular accounting period and then uses that average cost to determine the COGS and then the ending inventory.

Understanding Last In, First Out (LIFO)

The fact is Last In, First Out (LIFO) is only one used in the United States where all three inventory-costing methods can be used under the GAAP although, the (IFRS) forbids the use of the LIFO method.

Companies that use the LIFO inventory valuations are typically those with relatively large inventories, like the retailers or who are engaged in dealerships, who can take advantage of the lower taxes (when prices are rising) and higher are the cash flows.

Many U.S. companies prefer to use FIFO. Although, a firm using a LIFO valuation when it files taxes must also use LIFO when it reports the financial results to the shareholders. This lower the net income and eventually, the earnings per share.

FAQs on Historical Cost Methods - FIFO and LIFO

1. What is Original Cost?

Ans. Original cost is the total price associated with the purchase of an asset. The original cost of an asset takes into consideration all of the items which can be attributed to its purchase and to putting the asset to further use. Original cost is also known as an asset's cost basis for tax purposes.

Straight Line Depreciation method or the Original Cost method is the simplest and most commonly used depreciation method. In this method, the difference between the original cost of an asset and its estimated scrap value is calculated and then it is divided by the number of years in its estimated calculated life.

2. What is the Full Form of GAAP?

Ans. The full form of GAAP is  Accepted Accounting Principles. They are the collection of commonly-followed accounting rules and the standards for financial reporting.

Generally, Accepted Accounting Principles (GAAP) are the basic accounting principles and guidelines which facilitates the framework for more detailed and more comprehensive accounting rules, standards and other industry-specific accounting practices. Accounting Standards usually are issued by the main accounting body of the country.

3. What is COGS?

Ans. The full form of COGS is Cost of Goods Sold. This refers to the direct cost of producing the goods that are sold by a company. This amount includes the cost of the materials and the labour directly that are used to create the good. It excludes the indirect expenses, such as the distribution costs and the sales force costs.