What is LIFO vs. FIFO?
Amid the ongoing LIFO vs. FIFO debate in accounting, deciding which method to use is not always easy. LIFO and FIFO are the two most common techniques used in valuing the cost of goods sold and inventory. More specifically, LIFO is the abbreviation for last-in, first-out, while FIFO means first-in, first-out.
The International Financial Reporting Standards – IFRS – only allow FIFO accounting, while the Generally Accepted Accounting Principles – GAAP – in the U.S. allow companies to choose between LIFO or FIFO accounting.
There are other methods used to value stock such as specific identification and average or weighted cost. The method that a business uses to compute its inventory results in a significant impact on its financial statements.
Last In, First Out (LIFO)
The LIFO system is founded on the assumption that the last items on the shelf are the first items to be sold. It is the most recommended technique for businesses dealing in products that are not perishable or ones that don’t face the risk of obsolescence.
Whenever there’s a price increase, the LIFO method recommends the selling of higher-priced items first while the cheaper products are maintained as stock. Doing so causes a firm’s cost of goods sold to increase and the net income to decrease. Both aspects help to minimize the company’s tax liability.
The best way to explain the concept is through an illustration. Consider a dealership that pays $20,000 for a 2015 model car during spring and $23,000 for the same during fall. In December, the dealership sells one of these automobiles for $26,000.
From the perspective of income tax, the dealership can consider either one of the cars as a sold asset. If it accounts for the car purchased in the fall using LIFO technique, the taxable profit on this sale would be $3,000. However, if it considers the car bought in spring, the taxable profit for the same would be $6,000.
Apart from reducing the tax liability, using LIFO technique offers other benefits such as:
- Eliminating the challenges that come with matching inventory expenses to their revenues
- Reducing the write-downs of products to their fair market value because of the reduction in inventory costs
- Improving cash flow
However, last-In, first-out is not without a few disadvantages. One of its drawbacks is that it does not incorporate the cost of replacing stock. Also, the LIFO approach tends to understate the value of the closing stock, leaving little room for adjustment, especially for companies that are struggling. Many businesses are not able to balance out the effect of rising expenses brought about by inflation.
Since LIFO understates the closing inventory and exaggerates the cost of sales, it’s not accepted by most taxation authorities. If a company uses such a technique, it will need to conduct the tax liability calculations separately, which calls for additional resources.
First In, First Out (FIFO)
With FIFO, the assumption is that the first items to be produced are also the first items to be disposed of. For example, let’s say a grocery receives 30 units of milk on Mondays, Thursdays, and Saturdays. If an individual was to purchase a gallon of milk on Friday, high chances are that he will pick from the Monday batch since it is what was put on the shelves first.
Under the first-in, first-out technique, the store owner will assume that all the milk sold first is from the Monday shipment until all 30 units are sold out, even if a customer picks from a more recent batch.
FIFO is mostly recommended for businesses that deal in perishable products. The approach provides such ventures with a more accurate value of their profits and inventory. FIFO is not only suited for companies that deal with perishable items but also those that don’t fall under the category.
With the FIFO method, the stock that remains on the shelves at the end of the accounting cycle will be valued at a price closer to the actual market price for the items. It means that the business assets will be of higher value.
Why Use FIFO?
The biggest advantage of FIFO lies in its simplicity. Many business owners are pleased by the fact that it’s easy to compute.
Another advantage is that there’s less wastage when it comes to the deterioration of materials. Since the first items acquired are also the first ones to be sold, there is effective utilization and management of inventory.
The LIFO vs. FIFO methods represent entirely different accounting treatments that produce different results. Although LIFO is an attractive choice for those looking to keep their taxable incomes low, the FIFO method offers more benefits.
LIFO helps in boosting customer satisfaction. Since the business is constantly moving newer inventory, customers are less likely to end up with obsolete or outdated products.
FIFO, in turn, allows companies to cut back on waste as it ensures the items produced first are the first ones out of the shelves. It also enables company owners to improve their quality control.
Thank you for reading our guide on LIFO vs. FIFO accounting methods. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more, the following resources will be helpful: