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Fifo vs lifo

What Are FIFO and LIFO?

FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are distinct inventory costing methods used by businesses to value their inventory and determine the Cost of Goods Sold (COGS) over an accounting period. These methods fall under the umbrella of Inventory Accounting within financial accounting, influencing a company's Financial Statements, particularly the Income Statement and Balance Sheet. The choice between FIFO and LIFO significantly impacts reported profitability and tax liabilities, especially during periods of price changes.

FIFO assumes that the first units of inventory purchased or produced are the first ones sold, meaning the oldest costs are expensed first. Conversely, LIFO assumes that the most recently purchased or produced units are the first ones sold, meaning the newest costs are expensed first. While these are costing assumptions, they do not necessarily reflect the physical flow of goods. For instance, a grocery store might physically sell older produce first (FIFO physical flow) but could theoretically use LIFO for accounting purposes if permitted.

History and Origin

The evolution of inventory costing methods, including FIFO and LIFO, is closely tied to the historical economic conditions and the development of accounting standards. FIFO, being a more intuitive method that often aligns with the physical flow of goods (especially for perishable items), has a longer, more general history in accounting practice.

LIFO, however, gained significant traction and formal recognition in the United States during the mid-20th century, particularly in response to periods of rising prices. Companies facing Inflation found that expensing the latest, higher costs could reduce reported profits and, consequently, their income tax burden. This method became attractive during the inflationary periods of the 1970s and 1980s. Congress first approved the use of LIFO in the 1938 and 1939 Revenue Acts, influenced by industries like petroleum refining and metals that experienced significant price fluctuations10.

A key aspect of LIFO's history in the U.S. is the "LIFO conformity rule." Since LIFO became an accepted method for income tax purposes, the Internal Revenue Code has required that if a taxpayer uses LIFO for tax purposes, they must also use LIFO for financial reporting to shareholders, beneficiaries, or for credit purposes9,8. This rule, enshrined in Internal Revenue Code Section 472(c), prevents companies from manipulating inventory valuation to show higher profits to investors while reporting lower profits for tax purposes7.

Key Takeaways

  • FIFO (First-In, First-Out) assumes the oldest inventory costs are expensed first, while LIFO (Last-In, First-Out) assumes the newest inventory costs are expensed first.
  • The choice between FIFO and LIFO impacts a company's reported Gross Profit, Net Income, and Taxable Income.
  • During periods of rising costs, FIFO typically results in lower COGS, higher net income, and higher taxes. LIFO results in higher COGS, lower net income, and lower taxes.
  • LIFO is permitted under Generally Accepted Accounting Principles (GAAP) in the U.S. but is prohibited under International Financial Reporting Standards (IFRS).
  • The LIFO conformity rule in the U.S. mandates that companies using LIFO for tax purposes must also use it for their primary financial reporting.

Formula and Calculation

While FIFO and LIFO don't have a single, universal formula in the traditional mathematical sense, they are applied through a cost flow assumption to determine the value of Inventory and Cost of Goods Sold. The core principle for calculating COGS and ending inventory under these methods involves tracking the cost layers of inventory.

For any inventory system, the following accounting identity holds:

Beginning Inventory+Purchases=Cost of Goods Sold+Ending Inventory\text{Beginning Inventory} + \text{Purchases} = \text{Cost of Goods Sold} + \text{Ending Inventory}

FIFO Calculation:

To calculate COGS using FIFO, you would assume the units sold are from the earliest purchases. The cost of ending inventory would then be based on the most recent purchases.

For example, if a company has:

  • Beginning Inventory: 100 units @ $10
  • Purchases: 50 units @ $12, then 70 units @ $15

And sells 130 units.

COGS (FIFO) would be:

  1. 100 units from Beginning Inventory @ $10 = $1,000
  2. 30 units from first Purchase @ $12 = $360
    Total COGS = $1,360

Ending Inventory (FIFO) would be:

  1. 20 units remaining from first Purchase @ $12 = $240
  2. 70 units from second Purchase @ $15 = $1,050
    Total Ending Inventory = $1,290

LIFO Calculation:

To calculate COGS using LIFO, you would assume the units sold are from the most recent purchases. The cost of ending inventory would then be based on the earliest purchases.

Using the same example (100 units @ $10, 50 units @ $12, 70 units @ $15, sell 130 units):

COGS (LIFO) would be:

  1. 70 units from second Purchase @ $15 = $1,050
  2. 50 units from first Purchase @ $12 = $600
  3. 10 units from Beginning Inventory @ $10 = $100
    Total COGS = $1,750

Ending Inventory (LIFO) would be:

  1. 90 units remaining from Beginning Inventory @ $10 = $900
    Total Ending Inventory = $900

As seen in the example, the same physical units sold can result in different reported COGS and ending inventory values depending on the method chosen.

Interpreting FIFO and LIFO

The interpretation of a company's financial health and performance is significantly influenced by whether it uses FIFO or LIFO for its inventory valuation. Analysts and investors need to understand these methods to make accurate comparisons and assessments.

When prices are rising due to Inflation, LIFO generally results in a higher Cost of Goods Sold because the most expensive, recently acquired inventory is assumed to be sold first. This leads to a lower reported Net Income and, consequently, lower Taxable Income and tax payments. From a tax perspective, LIFO can be advantageous in an inflationary environment as it defers tax liabilities. However, it also means the inventory reported on the Balance Sheet is valued at older, lower costs, which may not reflect the current market value of the remaining inventory.

Conversely, under the same inflationary conditions, FIFO leads to a lower COGS because the older, less expensive inventory is assumed to be sold first. This results in a higher reported net income and higher taxes. The ending inventory value on the balance sheet under FIFO more closely reflects current market prices, as it comprises the most recently acquired, higher-cost goods.

The choice of method can also affect financial ratios. For example, a higher net income under FIFO during inflation would lead to higher Earnings Per Share (EPS), potentially making a company look more profitable to investors. Conversely, the lower reported income under LIFO might make a company appear less profitable but results in better Cash Flow due to lower tax payments.

Hypothetical Example

Consider "TechGadget Inc.," a company that sells specialized computer components. Let's look at their inventory transactions for the month of March:

  • March 1: Beginning inventory of 50 units @ $100 each.
  • March 10: Purchased 70 units @ $110 each.
  • March 20: Purchased 80 units @ $120 each.
  • March 25: Sold 150 units.

Now, let's calculate the Cost of Goods Sold (COGS) and ending inventory using both FIFO and LIFO:

FIFO Method (First-In, First-Out):

Under FIFO, we assume the 150 units sold are from the oldest stock.

  1. From March 1 (Beginning Inventory): 50 units @ $100 = $5,000
  2. From March 10 (First Purchase): 70 units @ $110 = $7,700
  3. From March 20 (Second Purchase): We still need 150 - 50 - 70 = 30 units. So, 30 units @ $120 = $3,600
  • Total COGS (FIFO): $5,000 + $7,700 + $3,600 = $16,300

To find the Ending Inventory (FIFO), we look at what's left from the newest purchases:

  • Remaining from March 20 purchase: 80 - 30 = 50 units @ $120 = $6,000

LIFO Method (Last-In, First-Out):

Under LIFO, we assume the 150 units sold are from the newest stock.

  1. From March 20 (Second Purchase): 80 units @ $120 = $9,600
  2. From March 10 (First Purchase): We still need 150 - 80 = 70 units. So, 70 units @ $110 = $7,700
  • Total COGS (LIFO): $9,600 + $7,700 = $17,300

To find the Ending Inventory (LIFO), we look at what's left from the oldest purchases:

  • Remaining from March 1 (Beginning Inventory): 50 units @ $100 = $5,000

As illustrated, under rising costs, LIFO ($17,300) results in a higher COGS than FIFO ($16,300), leading to a lower Gross Profit and net income for tax purposes.

Practical Applications

The choice between FIFO and LIFO has significant implications across various aspects of business operations, from financial reporting to strategic Inventory Management.

In financial reporting, the selection of an inventory costing method directly affects key financial metrics presented on a company's Financial Statements. During periods of rising prices, companies using LIFO will report a higher Cost of Goods Sold, which translates to lower reported profits and, consequently, lower Taxable Income. This tax benefit is a primary reason for LIFO's adoption in the United States. For instance, companies often aim to reduce their tax liability, and LIFO can achieve this during inflationary periods6. Conversely, FIFO generally results in higher reported profits in an inflationary environment, which can make a company appear more attractive to investors, though it comes with a higher tax bill.

Regulatory bodies also play a role in the practical application of these methods. In the United States, the Internal Revenue Service (IRS) enforces the LIFO conformity rule under Internal Revenue Code Section 472(c), requiring companies to use LIFO for financial reporting if they use it for tax purposes5. This rule ensures consistency between a company's tax returns and the financial statements presented to shareholders and creditors, preventing the manipulation of income for differing purposes4. The Securities and Exchange Commission (SEC) also oversees the disclosure of inventory valuation methods and their impact on financial reporting, expecting transparent reporting of accounting policies. For example, SEC correspondence shows that companies explicitly explain how their chosen inventory method impacts their cost of sales and balance sheet disclosures3.

Internationally, the landscape differs significantly. While FIFO is accepted globally under International Financial Reporting Standards (IFRS), LIFO is explicitly prohibited by IFRS2. This creates complexities for multinational corporations that operate in the U.S. and other countries, often requiring them to maintain separate records or provide reconciliation between GAAP (U.S.) and IFRS.

Limitations and Criticisms

Despite their widespread use, both FIFO and LIFO have inherent limitations and have faced criticism, particularly concerning their impact on financial transparency and comparability.

A primary criticism of LIFO stems from its potential to distort a company's Balance Sheet during inflationary periods. Because LIFO assumes the oldest costs remain in Inventory, the reported inventory value can be significantly understated compared to current market prices. This can make the balance sheet less representative of the true economic value of a company's assets. Furthermore, if inventory levels decrease (a "LIFO liquidation"), older, lower costs are recognized as Cost of Goods Sold, leading to an artificially inflated Net Income and higher tax burden in that period, which can be misleading. An academic paper highlights how LIFO can create undesired results for Inventory Management strategies, especially when firms aim to reduce inventory levels1.

The main criticism of LIFO on a global scale is its non-acceptance under International Financial Reporting Standards (IFRS). This prohibition leads to a lack of comparability between U.S. companies using LIFO under Generally Accepted Accounting Principles (GAAP) and companies in most other countries that must use FIFO or the Weighted Average Cost method. This divergence in Accounting Policies complicates financial analysis for global investors and necessitates adjustments for consistent comparison.

FIFO, while generally aligning with the physical flow of goods for many businesses and being globally accepted, also has its drawbacks, particularly during periods of [Inflation]. In such environments, FIFO results in a lower Cost of Goods Sold and a higher reported gross profit and net income. While this might appear beneficial, it also leads to higher Taxable Income and increased tax payments, thus reducing [Cash Flow]. Critics argue that FIFO can overstate a company's profitability during inflationary periods because it matches older, lower costs against current revenues, potentially giving a misleading impression of operational efficiency without considering the higher replacement costs of inventory.

FIFO vs. Weighted Average Cost

FIFO and LIFO are two prominent methods for inventory valuation, but another widely used approach is the Weighted Average Cost method. While FIFO and LIFO make assumptions about the order in which inventory is sold (first-in, first-out or last-in, first-out), the Weighted Average Cost method takes a different approach by averaging the cost of all available inventory.

The primary difference lies in how each method assigns costs. FIFO assumes specific cost layers are sold, starting with the oldest. LIFO assumes specific cost layers are sold, starting with the newest. In contrast, the Weighted Average Cost method calculates an average cost for all units available for sale during the period and applies that average cost to both the units sold (Cost of Goods Sold) and the units remaining in Inventory (Ending Inventory).

This means that under the Weighted Average Cost method, every unit is assigned the same average cost, smoothing out the impact of price fluctuations. During periods of rising prices, the Weighted Average Cost method will generally produce a Cost of Goods Sold that falls between that of FIFO and LIFO, and an Ending Inventory value that also falls between the two. This method can be particularly suitable for businesses that deal with large volumes of identical, commingled goods where it is impractical to track individual unit costs, such as in grain storage or bulk liquid handling. The Weighted Average Cost method is often praised for its simplicity and for presenting a more moderate view of profitability compared to the more volatile impacts of FIFO and LIFO during fluctuating price environments.

FAQs

Q1: Does the choice between FIFO and LIFO affect a company's actual physical inventory?

No, the choice between FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) is purely an Accounting Policies decision regarding how inventory costs are flowed through the Financial Statements. It does not dictate or necessarily reflect the physical movement of goods within a warehouse or store. For example, a grocery store might use FIFO in practice to sell perishable items before they expire, but if allowed, could still use LIFO for accounting purposes to value its Cost of Goods Sold.

Q2: Why would a company choose LIFO over FIFO if LIFO results in lower reported net income?

A company might choose LIFO, especially in the United States, primarily for tax advantages during periods of [Inflation]. By expensing the most recent, and typically higher, inventory costs as Cost of Goods Sold, LIFO results in a lower reported Net Income and, consequently, lower Taxable Income. This leads to reduced tax payments, which can improve a company's immediate [Cash Flow].

Q3: Are FIFO and LIFO allowed under all accounting standards?

No. While both FIFO and LIFO are permitted under U.S. Generally Accepted Accounting Principles (GAAP), LIFO is explicitly prohibited under International Financial Reporting Standards (IFRS), which are used in most other countries worldwide. This difference creates challenges for multinational companies and requires careful consideration of reporting requirements.

Q4: How does the choice of FIFO or LIFO impact financial analysis?

The choice of inventory method significantly impacts key financial metrics like Gross Profit, Net Income, and the value of Inventory on the balance sheet. During inflationary periods, LIFO typically shows lower profits and lower inventory values, while FIFO shows higher profits and higher inventory values. Analysts need to be aware of the method used by a company to accurately compare its performance against competitors or industry benchmarks, often requiring adjustments for consistent analysis.