Explain the methods of inventory valuation, such as First-In-First-Out (FIFO) and Last-In-First-Out (LIFO), and their effects on cost of goods sold and ending inventory.

Methods of Inventory Valuation: FIFO and LIFO

First-In-First-Out (FIFO):
FIFO is an inventory valuation method that assumes the first items purchased (first-in) are the first ones to be sold (first-out). Under FIFO, the cost of goods sold (COGS) is calculated using the cost of the oldest or earliest inventory in stock, and the ending inventory is based on the cost of the most recent purchases.

Effects on Cost of Goods Sold (COGS) and Ending Inventory:

* FIFO results in a higher cost of goods sold when prices are rising because the oldest and lowest-cost inventory is used first. As a result, COGS reflects the lower costs, leading to higher profits in periods of inflation.
* The ending inventory is valued at the most recent costs, which typically reflects the current market prices. This means the balance sheet shows a more accurate representation of the company's current assets.

Last-In-First-Out (LIFO):
LIFO is an inventory valuation method that assumes the last items purchased (last-in) are the first ones to be sold (first-out). Under LIFO, the cost of goods sold (COGS) is calculated using the cost of the most recent inventory purchases, and the ending inventory is based on the cost of the oldest inventory in stock.

Effects on Cost of Goods Sold (COGS) and Ending Inventory:

* LIFO results in a lower cost of goods sold when prices are rising because the most recent and higher-cost inventory is used first. This reduces reported profits during periods of inflation.
* The ending inventory is valued at the older costs, which may not reflect the current market prices. As a result, the balance sheet may understate the company's current assets.

Comparison of FIFO and LIFO:

1. Income Statement Impact:

* FIFO tends to report higher net income during periods of inflation due to lower COGS, resulting in higher profits.
* LIFO, on the other hand, reports lower net income during inflationary periods due to higher COGS, leading to lower profits.
2. Balance Sheet Impact:

* FIFO generally results in a higher ending inventory value compared to LIFO during inflationary periods because the most recent costs are used for valuing inventory.
* LIFO often leads to a lower ending inventory value compared to FIFO during inflation because the older costs are used for inventory valuation.
3. Tax Considerations:

* In countries where income taxes are based on reported profits, FIFO may result in higher tax liabilities during inflationary periods due to higher net income.
* In contrast, LIFO may lead to lower tax liabilities during inflationary periods as net income is lower.
4. Inventory Holding:

* FIFO generally encourages companies to sell older inventory first, which may lead to lower inventory holding costs and minimize obsolescence risks.
* LIFO may lead to holding newer inventory for a longer period, potentially increasing the risk of inventory obsolescence.

Selection of Method:
The choice between FIFO and LIFO depends on various factors, including accounting regulations, tax laws, industry practices, and the specific financial objectives of the company. In countries where LIFO is allowed, companies may use it to reduce tax liabilities during periods of inflation. On the other hand, FIFO is more commonly used in international accounting standards and may provide a more accurate reflection of a company's current financial position in certain circumstances.

Overall, the method of inventory valuation (FIFO or LIFO) has significant implications for a company's financial reporting, profitability, and tax liabilities, making it essential for businesses to carefully consider the method that aligns with their financial goals and regulatory requirements.