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: Understanding FIFO and LIFO
1. What is the Historical Cost Principle in accounting?
The Historical Cost Principle is a fundamental accounting concept which states that an asset should be recorded on the balance sheet at its original purchase price. This cost, also known as the original cost, is not changed even if the market value of the asset increases over time. It provides a reliable and verifiable basis for accounting records.
2. What is the main difference between the FIFO and LIFO methods of inventory valuation?
The primary difference lies in the assumption of which inventory items are sold first.
- FIFO (First-In, First-Out) assumes that the first units purchased are the first ones sold. The closing inventory is valued at the cost of the most recently purchased items.
- LIFO (Last-In, First-Out) assumes that the last units purchased are the first ones sold. The closing inventory is therefore valued at the cost of the oldest purchased items.
3. How do FIFO and LIFO affect the Cost of Goods Sold (COGS) and net income during a period of rising prices?
During inflationary periods (rising prices), the choice of method has a significant impact on financial statements.
- Under FIFO, the older, lower-cost inventory is expensed first, resulting in a lower Cost of Goods Sold (COGS), higher reported net income, and a higher tax liability.
- Under LIFO, the newer, higher-cost inventory is expensed first. This leads to a higher COGS, lower reported net income, and consequently, a lower tax liability.
4. Can you provide a simple example of the FIFO method in action?
Imagine a business makes the following purchases:
- Jan 1: Buys 10 units @ ₹10 each
- Jan 15: Buys 10 units @ ₹12 each
5. Why is the LIFO method not permitted under International Financial Reporting Standards (IFRS)?
The LIFO method is forbidden under IFRS primarily because it can distort earnings and is not considered to be a true representation of the actual flow of inventory in most businesses. By matching the most recent costs against revenues, LIFO can sometimes show an outdated and unrealistically low inventory value on the balance sheet, especially during periods of rising prices. In contrast, U.S. GAAP still permits its use.
6. Does the choice between FIFO and LIFO have to match the actual physical flow of goods?
No, this is a common misconception. FIFO and LIFO are cost flow assumptions, not a mandate on how physical inventory must be managed. A company using the LIFO method for accounting can still physically sell its oldest stock first (like a grocery store selling milk). The choice of method is for accounting and valuation purposes to determine the Cost of Goods Sold and the value of ending inventory.
7. What is the Weighted Average Cost method for inventory?
The Weighted Average Cost (WAC) method values both the Cost of Goods Sold and the ending inventory based on the average cost of all similar goods available for sale during the period. It is calculated by dividing the total cost of goods available for sale by the total number of units available. This method smooths out price fluctuations and is seen as a compromise between FIFO and LIFO.
