In a perfect world, all goods that a company has purchased would be labeled with their specific price values, and when specific goods were sold, their actual value would be accounted for as expense. However, for most industries, goods are not marked with their cash value, so instead, accountants must use arbitrary rules to allocate the cost of the goods to expense.

For example, Payless Shoe Source might buy two pairs of shoes from Nike. Payless knows that it paid $25 for the first shipment, but with the later shipment, inflation raised the price to $30, so it has $55 of inventory that must eventually be allocated to expense. Unlike items that depreciate though, inventory is allocated to expense when it is used to realize revenues-in this case, when a pair of shoes is sold. However, since the shoes aren't marked with their specific price, it's not so easy to pinpoint when a sale occurs which pair was sold and which should stay in inventory.

If the value of the shoes were labeled, then if a customer bought a pair, then Payless could easily check to see if the customer bought the $25 pair or the $30 dollar pair. Then, Payless's accountants could debit cash or accounts receivables and credit revenue for this sold good. They would then also debit allocate the expense to Cost of Goods Sold and credit their inventory asset, using the value of the specific shoe sold as the cost of the good sold.

However, most companies don't do this and couldn't afford, furthermore, to label every specific item with both the marked up price and the historical cost to purchase. With some items, like liquids collectively contained or small items, it would not be worth the trouble or maybe even impossible.

Generally accepted accounting principles, however, do give accountants a few ways to allocate assets to expense in this case. Over time, the two major systems to arise have been FIFO and LIFO.

FIFO stands for First In, First Out. The "In" part refers to when a good goes to inventory, while the "Out" part refers to when a good is expensed. So, in this case, the first good to be purchased (in this case, the $25 pair) is the first to be allocated out to expense, REGARDLESS OF WHICH SHOE ACTUALLY IS SOLD. Therefore, it doesn't matter what the value of the shoe is: FIFO arbitrarily and consistently allocates the earliest items placed in inventory to expense.

LIFO, on the other hand, stands for Last In, First Out. In that case, the last good to be purchased is the first good to be allocated to expense.

What are the differences?

For financial reporting purposes and tax purposes, LIFO and FIFO have different advantages and disadvantages. For example, with FIFO, as long as a company's good generally appreciate in value (due to inflation,) income statements will show higher revenues, because ALWAYS, the company is taking the least expensive quantities to cost of goods sold. In the shoe case, one is only counting $25 in expenses, not $30.

In LIFO, on the other hand, with increasing costs, one is always allocating the GREATEST costs to expense, so income statements will look lower for investors.

HOWEVER, LIFO still has a purpose-it was invented for tax, after all. If a company allocates more expense, then it has less income to be taxed, so a company's tax burden is lessened. Furthermore, the company is allocating a more recent, and therefore more 'current' price.

As stated before, GAAPs and all boards that influence financial accounting currently accept both FIFO and LIFO; they each have their purposes, but companies simply must be consistent over time with which method they will use.

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