Inventory accounting methods help report cost information to management and investors. They don't directly affect the physical management of the inventory operations. Yet, these methods can provide insights to general consumers of the financial world and investors.
Before describing the practical uses, here is a brief primer on three main inventory accounting methods.
1) Specific identification,
2) First-in first-out (FIFO), and
3) Last-in first-out (LIFO).
The specific identification method provides the most precise reporting by matching the cost of each sold product with its specific inventory item. For instance, car dealerships often use this method to match a specific car’s model and year with the sale. However, this approach can be cumbersome for companies dealing with large quantities of similar products, like nuts and bolts.
In the FIFO method, a company assumes the oldest inventory is sold first. This method is particularly suitable for businesses managing perishable goods, such as food products, where older items (like milk or bread) are typically placed at the front to be sold first.
The LIFO method, in contrast, assumes the most recent inventory is sold first.
Now, let's explore some practical uses of these inventory accounting methods:
1. LIFO as an inflation gauge: Most publicly traded grocery retailers in the U.S. use the LIFO method, which can serve as a useful indicator of inflation. As LIFO method assumes that the recent inventory purchases are sold first, the inventory on the balance sheet is understated compared to its current cost (FIFO method). The difference between the two methods is usually tracked by companies on a regular basis. Comparing this difference year over year provides realistic information about inflation.
2. LIFO and investment opportunities: Understanding the LIFO method can reveal potential investment opportunities. Since LIFO understates the tangible book value of a business by masking the true replacement cost of inventory, this can be especially significant in inflationary environments.
3. Management quality: The choice of accounting method provides insights into management's behavior. LIFO is a conservative accounting choice for inventory valuation. This method is also more accurate as it matches current costs to company's sale. Conversely, FIFO can show a higher profit margin, which may appeal to management looking to boost earnings and stock price, particularly in low-margin industries like grocery retail. Investors should prefer to partner with conservative management teams that use LIFO, as it indicates a more cautious and realistic approach to financial reporting while enhancing the odds of a successful investment.
Abhay Srivastava is the Founder and Managing Member of AS Investment Partners LLC, a value investing firm (www.asinvpartners.com).
