Lifo and fifo

LIFO and FIFO: Definition, Example, and FAQs

LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) are distinct inventory costing methods used by businesses to manage their inventory and calculate the cost of goods sold (COGS). These methods fall under the broader category of inventory accounting, which is a critical component of a company's financial reporting and tax obligations. The choice between LIFO and FIFO can significantly impact a company's reported net income, tax liability, and overall financial presentation, particularly during periods of changing costs.

History and Origin

The evolution of inventory accounting methods like LIFO and FIFO is closely tied to the development of modern accounting practices and the need for businesses to accurately represent their financial position. As commerce grew in complexity, so did the necessity for standardized ways to value goods. The conceptual underpinnings of FIFO, which assumes that the first goods purchased are the first ones sold, align with the natural flow of many businesses, especially those dealing with perishable goods or products with limited shelf lives. This method became widely adopted early on due to its intuitive nature.

LIFO, on the other hand, gained prominence in the United States primarily due to its potential tax benefits during periods of rising costs. In an inflationary environment, LIFO tends to result in a higher cost of goods sold, which in turn leads to lower reported taxable income and, consequently, lower tax payments. The Internal Revenue Service (IRS) outlines various accounting methods that businesses can use, including LIFO and FIFO, in publications like IRS Publication 538.⁴ The use of LIFO for tax purposes in the U.S. is subject to the "LIFO conformity rule," which generally mandates that if a company uses LIFO for tax reporting, it must also use it for financial reporting to shareholders and creditors. This rule, stipulated under Section 472(c) of the Internal Revenue Code, was introduced to prevent companies from presenting a higher profit to investors (by using FIFO) while simultaneously reporting a lower profit for tax purposes (by using LIFO).³

Key Takeaways

• FIFO (First-In, First-Out): Assumes the oldest inventory items are sold first, generally resulting in a lower COGS and higher reported net income during periods of inflation.
• LIFO (Last-In, First-Out): Assumes the newest inventory items are sold first, typically leading to a higher COGS and lower reported net income during periods of inflation.
• Impact on Financial Statements: The choice between LIFO and FIFO affects the income statement (through COGS and net income) and the balance sheet (through inventory valuation).
• Tax Implications: In inflationary environments, LIFO can result in lower taxable income compared to FIFO due to higher COGS.
• Global Differences: LIFO is generally permitted only in the United States under generally accepted accounting principles (GAAP); International Financial Reporting Standards (IFRS) prohibit its use.

Formula and Calculation

Neither LIFO nor FIFO uses a singular formula in the traditional sense, but rather a methodology for assigning costs to goods sold and remaining inventory. The calculation involves tracking the cost of each inventory purchase and applying the chosen assumption (LIFO or FIFO) when items are sold.

To calculate the Cost of Goods Sold (COGS) and Ending Inventory using LIFO or FIFO, you essentially apply the respective assumption to the units sold.

For FIFO:

• Cost of Goods Sold (COGS): The cost of units sold is calculated using the cost of the oldest units available in inventory.
• Ending Inventory: The cost of units remaining in inventory is calculated using the cost of the most recent units purchased.

For LIFO:

• Cost of Goods Sold (COGS): The cost of units sold is calculated using the cost of the most recent units purchased (the "last in").
• Ending Inventory: The cost of units remaining in inventory is calculated using the cost of the oldest units available in inventory (the "first in").

The total value of inventory and COGS is then summarized in the company's financial statements.

Interpreting LIFO and FIFO

The interpretation of a company's financial performance is significantly influenced by whether it uses LIFO or FIFO. In an environment where costs are rising (inflationary periods), a company using FIFO will report a lower COGS because it's expensing the older, cheaper inventory first. This results in a higher gross profit and ultimately a higher net income and earnings per share. Conversely, a company using LIFO during inflation will report a higher COGS (expensing the newer, more expensive inventory) and, consequently, a lower gross profit, net income, and earnings per share.

In periods of falling costs (deflation), the opposite effect occurs. LIFO would result in a lower COGS and higher net income, while FIFO would lead to a higher COGS and lower net income. This impact on reported profits means that investors and analysts must consider the inventory costing method when comparing companies, especially those in different industries or with differing inventory characteristics. Understanding these methods is crucial for accurate asset management and financial analysis.

Hypothetical Example

Consider "Gadget Co.," which sells a single type of gadget.

• Beginning Inventory: 0 units
• Purchases:
  • Jan 5: 100 units @ $10/unit
  • Jan 20: 150 units @ $12/unit
  • Feb 10: 80 units @ $15/unit
• Sales:
  • Feb 15: 220 units sold

Let's calculate COGS and ending inventory using both methods.

1. FIFO (First-In, First-Out):
Under FIFO, Gadget Co. assumes the first units acquired are the first ones sold.

• COGS Calculation (220 units sold):

  • First 100 units from Jan 5 purchase: (100 \text{ units} \times $10/\text{unit} = $1,000)
  • Next 120 units from Jan 20 purchase: (120 \text{ units} \times $12/\text{unit} = $1,440)
  • Total COGS = ($1,000 + $1,440 = $2,440)

• Ending Inventory Calculation:

  • Remaining units from Jan 20 purchase: (150 - 120 = 30 \text{ units}) @ $12/unit = ($360)
  • All 80 units from Feb 10 purchase: (80 \text{ units} \times $15/\text{unit} = $1,200)
  • Total Ending Inventory = ($360 + $1,200 = $1,560)

2. LIFO (Last-In, First-Out):
Under LIFO, Gadget Co. assumes the last units acquired are the first ones sold.

• COGS Calculation (220 units sold):

  • First 80 units from Feb 10 purchase: (80 \text{ units} \times $15/\text{unit} = $1,200)
  • Next 140 units from Jan 20 purchase: (140 \text{ units} \times $12/\text{unit} = $1,680)
  • Total COGS = ($1,200 + $1,680 = $2,880)

• Ending Inventory Calculation:

  • Remaining units from Jan 20 purchase: (150 - 140 = 10 \text{ units}) @ $12/unit = ($120)
  • All 100 units from Jan 5 purchase: (100 \text{ units} \times $10/\text{unit} = $1,000)
  • Total Ending Inventory = ($120 + $1,000 = $1,120)

In this example, with rising costs, FIFO results in a lower COGS ($2,440) and higher ending inventory ($1,560), while LIFO yields a higher COGS ($2,880) and lower ending inventory ($1,120). This difference directly impacts reported profitability and the valuation of inventory on the balance sheet.

Practical Applications

LIFO and FIFO are foundational concepts in accounting and have several real-world applications across various business functions:

• Financial Reporting: Companies choose one of these methods to present their financial statements to investors, creditors, and other stakeholders. The chosen method impacts reported profitability and asset values, influencing perceptions of financial health.
• Tax Planning: As demonstrated, LIFO can offer significant tax advantages in inflationary environments by reducing taxable income. This makes it a strategic choice for many U.S. companies. However, this benefit comes with the caveat of reporting lower profits to external parties due to the LIFO conformity rule.
• Inventory Management: While primarily accounting methods, the underlying assumptions of LIFO and FIFO can sometimes influence operational inventory management decisions, particularly in industries where obsolescence or spoilage is a concern. Companies handling perishable goods often find FIFO aligns more with their physical cash flow.
• Economic Analysis: Economists and financial analysts consider the prevailing inflation rate when evaluating companies that use LIFO or FIFO. During periods of high inflation, such as those reflected in the Consumer Price Index for All Urban Consumers (CPIAUCSL) data from the Federal Reserve Bank of St. Louis, the divergence in reported profitability between LIFO and FIFO companies becomes more pronounced.²

Limitations and Criticisms

Despite their widespread use, LIFO and FIFO have limitations and have faced criticism:

• Real-World Flow vs. Accounting Assumption: A primary criticism is that LIFO often does not reflect the actual physical flow of inventory. Most businesses, especially those with perishable goods, aim to sell their oldest stock first (a FIFO flow) to prevent spoilage or obsolescence. Using LIFO in such a scenario creates a disconnect between the accounting records and operational reality.
• Distortion of Inventory Value: In an inflationary environment, LIFO can result in significantly understated inventory values on the balance sheet because the remaining inventory is valued at older, lower costs. This can make a company's assets appear less valuable than their current replacement cost, potentially affecting financial ratios and the perception of the company's financial strength.
• Comparability Issues: The co-existence of LIFO and FIFO (and other inventory costing methods like weighted-average cost) can hinder direct financial comparisons between companies. A company using FIFO might appear more profitable than an identical company using LIFO simply due to accounting choice during inflation. Analysts often need to adjust financial statements to a common basis for meaningful comparisons.
• Complexity and Maintenance: Maintaining LIFO records, especially with numerous inventory layers and frequent purchases, can be complex. Companies must meticulously track the costs of specific purchase batches to apply the LIFO assumption correctly, adding to accounting overhead.
• International Prohibition: LIFO is not permitted under International Financial Reporting Standards (IFRS), which are used by most countries worldwide. This creates a barrier for comparability and can complicate financial reporting for multinational corporations that operate in both GAAP and IFRS jurisdictions. The Securities and Exchange Commission (SEC) provides guidance on financial reporting for companies, including those that might navigate these differences.¹

LIFO vs. Weighted-Average Cost

While LIFO and FIFO represent two ends of the inventory costing spectrum, another common method is the weighted-average cost method. The key difference lies in their approach to assigning costs.

The weighted-average cost method computes an average cost for all available inventory items and applies that average to both the cost of goods sold and the ending inventory. This approach provides a smoother, less volatile representation of costs and inventory values compared to LIFO or FIFO, as it dampens the effects of individual price fluctuations. While LIFO and FIFO represent distinct assumptions about inventory flow, the weighted-average method seeks to provide a more consistent cost assignment over time.

FAQs

What is the primary difference between LIFO and FIFO?

The primary difference lies in the assumption about which inventory units are sold first. FIFO assumes the first units purchased are sold first, while LIFO assumes the last units purchased are sold first. This impacts the calculation of cost of goods sold and ending inventory.

Why would a company choose LIFO over FIFO?

In the United States, companies primarily choose LIFO during periods of inflation to benefit from lower taxable income. By expensing the higher, more recent costs, LIFO results in a higher COGS and thus a lower reported net income, leading to reduced tax payments.

Is LIFO allowed everywhere?

No, LIFO is generally permitted only in the United States under generally accepted accounting principles (GAAP). International Financial Reporting Standards (IFRS), used by many other countries, prohibit the use of LIFO, requiring companies to use FIFO or weighted-average cost instead.

How does the choice of LIFO or FIFO affect a company's balance sheet?

The choice directly impacts the value of inventory reported on the balance sheet. In an inflationary environment, FIFO will result in a higher ending inventory value (as older, cheaper units are expensed), while LIFO will result in a lower ending inventory value (as newer, more expensive units are expensed). This can influence a company's asset base and financial ratios.

Can a company switch between LIFO and FIFO easily?

Switching between inventory accounting methods typically requires approval from tax authorities, such as the IRS in the U.S., and may have significant implications for prior period financial statements and comparability. Once a method is chosen, consistency is generally required for accurate financial reporting.