Inventory Accounting (FIFO vs. LIFO)

Welcome back. Take your seats, please. Today we tackle a topic that seems mundane on the surface but is, in reality, one of the most powerful levers a CFO has to "manage" both taxes and reported earnings: Inventory Valuation.

In a world of fluctuating prices-what we call inflationary or deflationary environments-the method you choose to account for the "stuff" sitting in your warehouse determines the profit you report to shareholders and the check you write to the tax authorities.

1. The Core Dilemma: Which Item Did We Sell?

Imagine a retailer like Titan Company Ltd. (Watches and Jewelry). They buy gold at different prices throughout the year. When a customer buys a ring in December, which "batch" of gold did it come from? The cheaper gold bought in January, or the expensive gold bought in November?

Accounting gives us two primary philosophies to answer this: FIFO and LIFO.

I. FIFO (First-In, First-Out)

This assumes that the oldest inventory items are sold first.

• Logic: The items remaining on the Balance Sheet are the ones most recently purchased (current market prices).
• The Result: In an inflationary environment (prices rising), FIFO results in a lower Cost of Goods Sold (COGS) and therefore higher reported profit.

II. LIFO (Last-In, First-Out)

This assumes the most recently purchased items are sold first.

• Logic: The oldest, "cheaper" costs stay on the Balance Sheet.
• The Result: In an inflationary environment, LIFO results in a higher COGS and lower reported profit.

The Global Rule (IFRS/Ind AS): Under Indian Accounting Standards (Ind AS) and IFRS, LIFO is prohibited. It is seen as a way to unfairly manipulate profits to avoid taxes. Only US GAAP allows LIFO. In India, we primarily use FIFO or the Weighted Average Cost method.

2. Classroom Calculation: The Inflation Impact

Let’s look at a stylized 2026 scenario for Asian Paints. They buy chemical resins for their paint production.

• Beginning Inventory: 1,000 Liters @ ₹100/L
• Purchase 1 (June): 1,000 Liters @ ₹120/L
• Purchase 2 (Sept): 1,000 Liters @ ₹150/L (Prices are rising!)
• Sales: The company sells 1,500 Liters at ₹300/L.

The Professor's Analysis:

Under FIFO, Asian Paints looks more profitable (₹2.9L vs ₹2.4L). However, under LIFO, the company would pay less in taxes because their "paper profit" is lower. This is why US companies love LIFO during inflation-it keeps cash in the business by reducing the tax bill.

3. Inventory Turnover: The Efficiency Metric

We don't just care about the value; we care about the velocity. How fast is the inventory moving?

Inventory Turnover COGS \ Average Inventory

• High Turnover: Excellent. It means capital isn't "trapped" in the warehouse. For a company like Avenue Supermarts (DMart), high turnover is the secret to their massive success.
• Low Turnover: Dangerous. It suggests "obsolete" stock or a lack of demand.

4. The "Lower of Cost or Market" (LCM) Rule

Accounting is conservative. If Asian Paints has inventory on the books at ₹150/L, but the market price of resin crashes to ₹80/L, they cannot keep it at ₹150. They must "write it down" to ₹80.

This leads to an Inventory Impairment Charge on the Income Statement, which is often a signal to analysts that management over-purchased or that demand is cooling.

5. Summary: Why This Matters for 2026

As we analyze competitors in 2026, keep these three points in mind:

1. Price Volatility: In a year of high inflation, a company using FIFO will show "phantom profits" that aren't necessarily due to better sales, but just the timing of their inventory.
2. Cash Flow: FIFO makes the Balance Sheet look stronger (higher asset value) but results in higher tax outflows.
3. The "Write-Down" Risk: Always check the footnotes for "Inventory Valuation" policies to see if the company is sitting on "dead stock."