Lifo vs fifo

LIFO vs. FIFO: Understanding Inventory Valuation Methods

LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) are two fundamental inventory valuation methods used by businesses to manage their inventory and determine the cost of goods sold (COGS). These methods are crucial components of a company's accounting methods, directly impacting its financial statements, particularly the balance sheet and income statement. The choice between LIFO vs. FIFO can significantly affect reported gross profit, net income, and ultimately, a company's taxable income.

History and Origin

The development of inventory costing methods like LIFO and FIFO arose from the need for businesses to systematically account for the flow of goods and their associated costs. Historically, physical flow rarely dictated accounting flow, especially for interchangeable goods. Early accounting practices often relied on specific identification, which became impractical for large volumes of similar items.

In the United States, the Last-In, First-Out (LIFO) method gained traction, particularly after the Internal Revenue Code permitted its use for tax purposes in the 1930s. Its primary appeal was the ability to reduce taxable income during periods of rising prices by matching the most recent, higher costs against current revenues. The Internal Revenue Service (IRS) outlines acceptable accounting periods and methods, including those for inventory, in publications like IRS Publication 538.⁶

Conversely, the First-In, First-Out (FIFO) method is often seen as more intuitive, reflecting the common physical flow of goods where the oldest items are sold first to prevent obsolescence. Internationally, the International Financial Reporting Standards (IFRS) actively prohibit the use of LIFO, mandating either FIFO or the weighted-average cost method for inventory valuation. This divergence between U.S. Generally Accepted Accounting Principles (GAAP), which allows LIFO, and IFRS, which does not, has been a significant point of discussion in global financial reporting.⁵ The International Accounting Standards Board (IASB), through International Accounting Standard (IAS) 2 Inventories, provides guidance on determining the cost of inventories and their subsequent recognition as an expense, specifically allowing FIFO or weighted-average cost formulas.⁴

Key Takeaways

• LIFO and FIFO are methods to determine the cost of goods sold and the value of ending inventory.
• LIFO assumes the most recently purchased inventory items are sold first.
• FIFO assumes the oldest inventory items are sold first.
• The choice between LIFO vs. FIFO impacts reported profit margins and tax liabilities, especially during periods of inflation.
• LIFO is permitted under U.S. GAAP but prohibited under IFRS.

Interpreting the LIFO vs. FIFO Impact

The choice between LIFO and FIFO significantly influences a company's reported financial performance and position. In an inflationary environment, where the cost of acquiring inventory is steadily increasing, LIFO generally results in a higher cost of goods sold and a lower reported net income. This is because the most expensive, recently acquired items are assumed to be sold first. Conversely, FIFO results in a lower cost of goods sold and a higher reported net income during inflationary periods, as the older, cheaper items are assumed to be sold.

The inverse effect occurs during periods of deflation. When prices are falling, LIFO would result in a lower COGS and higher net income, while FIFO would lead to a higher COGS and lower net income. Investors and analysts must understand which method a company uses to accurately interpret its profitability and compare it with competitors. The method impacts the valuation of assets on the balance sheet and the expense recognition on the income statement.

Hypothetical Example

Consider a small electronics retailer, "TechMart," selling a popular brand of headphones.

Scenario:

• January 1: TechMart buys 100 headphones at $50 each.
• February 1: TechMart buys 100 headphones at $55 each.
• March 1: TechMart sells 150 headphones.

Under FIFO (First-In, First-Out):
TechMart assumes it sold the first 100 headphones bought in January and 50 of the headphones bought in February.

• Cost of first 100: 100 units * $50/unit = $5,000
• Cost of next 50: 50 units * $55/unit = $2,750
• Total Cost of Goods Sold (FIFO): $5,000 + $2,750 = $7,750
• Ending Inventory (FIFO): 50 units (from February purchase) * $55/unit = $2,750

Under LIFO (Last-In, First-Out):
TechMart assumes it sold the 100 headphones bought in February and 50 of the headphones bought in January.

• Cost of last 100: 100 units * $55/unit = $5,500
• Cost of next 50: 50 units * $50/unit = $2,500
• Total Cost of Goods Sold (LIFO): $5,500 + $2,500 = $8,000
• Ending Inventory (LIFO): 50 units (from January purchase) * $50/unit = $2,500

In this example, with rising costs, LIFO results in a higher cost of goods sold ($8,000) and a lower ending inventory value ($2,500) compared to FIFO (COGS of $7,750, ending inventory of $2,750). This difference directly affects the reported profitability and the carrying value of current assets.

Practical Applications

The application of LIFO vs. FIFO is prevalent in industries with high inventory turnover and varying input costs, such as retail, manufacturing, and distribution. Companies often choose between LIFO and FIFO based on strategic financial objectives and prevailing economic conditions.

For U.S. companies operating in an inflationary environment, LIFO can be advantageous for tax purposes, as it typically leads to a higher COGS and thus lower taxable income. This can result in lower immediate tax liabilities. However, this tax benefit comes at the expense of reporting lower net income on the financial statements, which some stakeholders may view less favorably. Conversely, FIFO generally presents a higher net income in inflationary periods, which can be appealing to investors seeking stronger profitability metrics.

The impact of supply chain disruptions, such as those experienced during the COVID-19 pandemic, can highlight the complexities of LIFO accounting. When companies struggle to replenish inventory, they may experience a "LIFO liquidation," where older, lower-cost inventory layers are sold, potentially leading to a significant increase in taxable income. The U.S. government has, at times, provided relief measures, such as those under Section 473, to address unexpected LIFO liquidations caused by major trade interruptions.³

Limitations and Criticisms

Both LIFO and FIFO have inherent limitations and have faced criticisms. A primary criticism of LIFO is its potential to distort the balance sheet by valuing inventory assets at outdated, often significantly lower, historical costs, especially after prolonged periods of inflation. This can misrepresent a company's true economic resources. Furthermore, the LIFO conformity rule in the U.S. mandates that if LIFO is used for tax purposes, it must also be used for financial reporting, preventing companies from showing higher profits to shareholders while benefiting from tax savings.²

FIFO, while often reflecting the actual physical flow of goods and presenting a more current inventory value on the balance sheet, can be criticized for mismatching older costs with current revenues during periods of rapid price changes. This can lead to an artificially inflated profit margin, particularly in inflationary environments, which may not accurately reflect the economic reality of replacing sold goods at current, higher prices.

The global split in accounting standards, with IFRS prohibiting LIFO, creates challenges for multinational corporations and makes cross-border financial analysis more complex. The ongoing debate about converging U.S. GAAP with IFRS has often centered on the elimination of LIFO, which would have significant implications for many U.S. companies currently using the method.¹

LIFO vs. Weighted-Average Cost

While LIFO and FIFO are the most commonly discussed inventory methods, the weighted-average cost method offers an alternative approach. Unlike LIFO, which focuses on the latest costs, or FIFO, which focuses on the earliest costs, the weighted-average cost method calculates an average cost for all inventory available for sale during a period. This average cost is then applied to both the cost of goods sold and the ending inventory.

The weighted-average method tends to smooth out price fluctuations, resulting in COGS and inventory values that fall between those calculated under LIFO and FIFO, particularly in volatile price environments. It is often considered simpler to apply than LIFO, especially for businesses with a large volume of undifferentiated inventory.

FAQs

What is the main difference between LIFO and FIFO?

The main difference lies in the assumption of which inventory units are sold first. LIFO assumes the last units purchased are sold first, while FIFO assumes the first units purchased are sold first.

Why do companies choose LIFO or FIFO?

Companies choose between LIFO and FIFO based on several factors, including the impact on their reported profits, cash flow, and tax obligations. In the U.S., LIFO can be appealing during inflationary periods for its tax benefits (lower taxable income), while FIFO often results in higher reported profits, which can be favorable for investor perception.

Does LIFO reflect the actual physical flow of goods?

Typically, LIFO does not reflect the actual physical flow of goods for most businesses, as companies usually sell their oldest inventory first to prevent obsolescence or spoilage. It is an accounting convention rather than a reflection of physical movement.

Is LIFO allowed everywhere?

No, LIFO is primarily allowed under U.S. Generally Accepted Accounting Principles (GAAP). It is prohibited under International Financial Reporting Standards (IFRS), which are used in many countries worldwide.

How does the choice of inventory method affect a company's taxes?

In an inflationary environment, LIFO generally leads to a higher cost of goods sold, resulting in lower reported profits and thus lower taxable income and tax payments. FIFO, conversely, leads to a lower cost of goods sold, higher reported profits, and higher tax payments in such an environment. The Internal Revenue Service (IRS) requires consistency in the use of inventory methods for tax purposes.