Historical Cost Methods: Understanding FIFO and LIFO

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.