What is LIFO and FIFO and how they cost?

Key Takeaways

• FIFO (First-In, First-Out) assumes the oldest inventory is sold first, while LIFO (Last-In, First-Out) assumes the newest inventory is sold first.
• The choice between FIFO and LIFO impacts a company’s balance sheet, income statement, and tax liability.
• FIFO often results in higher net income and higher inventory values, while LIFO can reduce tax liability in times of rising prices.
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Introduction to FIFO and LIFO Methods

Inventory valuation could positively contribute a  fine decision-making in inventory management which conspires to be beneficial for a company's net income, tax liability, and overall financial health. Two common methods for inventory valuation are FIFO (First-In, First-Out) and LIFO (Last-In, First-Out). Understanding these methods and their implications is essential for accurate financial analysis and strategic decision-making.

Inventory management is a fundamental part of any business dealing with physical goods. The method a company chooses to value its inventory can have profound effects on its financial statements or even tax obligations. FIFO and LIFO are the two primary methods of inventory valuation used by companies. Each has its own set of advantages and disadvantages, impacting the return of investment differently. This article will help you analyze the features of each method, compare their impacts, and discuss their pros and cons.

What Is Inventory?

Inventory represents a company's goods in various stages of production, including raw materials, work-in-progress, and finished goods ready for sale. Accurate inventory valuation is vital because it influences the company's balance sheet, cost of goods sold (COGS), and net income. Inventory is considered an asset, and its valuation must reflect its true worth to ensure the company’s financial statements are accurate.

Stages of Inventory:

1.   Raw Materials: Basic goods used in the production process to generate finished products.

2.   Work-in-Progress: Items that are in the process of being manufactured but are not yet complete.

3.   Finished Goods: Products that are ready for sale and delivery to consumers.

Inventory accounting assigns values to the goods in each stage and classifies them as company assets. Proper valuation ensures that the company’s financial health is accurately represented. The basic formula for calculating inventory is: Beginning Inventory (BI)+Net Purchases−Cost of Goods Sold (COGS)=Ending Inventory (EI)\text{Beginning Inventory (BI)} + \text{Net Purchases} - \text{Cost of Goods Sold (COGS)} = \text{Ending Inventory (EI)}Beginning Inventory (BI)+Net Purchases−Cost of Goods Sold (COGS)=Ending Inventory (EI)

Understanding FIFO (First-In, First-Out)

The FIFO method assumes that the oldest inventory items are sold first. This approach aligns well with the natural flow of inventory, as companies typically use their oldest stock first to prevent obsolescence. For example, in a bakery, the bread baked first is sold first, ensuring that the freshest inventory remains. FIFO is logical and often results in higher net income and higher inventory values on the balance sheet during periods of rising prices.

Example: Consider a bakery that produces 200 loaves of bread on Monday at a cost of $1 each and another 200 loaves on Tuesday at $1.25 each. If the bakery sells 200 loaves on Wednesday, under FIFO, the COGS would be $1 per loaf because the first produced loaves are sold first. The $1.25 loaves remain in ending inventory.

Advantages of FIFO:

• Logical Flow: Aligns with the natural flow of goods, especially for perishable items.

• Higher Net Income: During inflation, older, cheaper goods are sold first, resulting in lower COGS and higher net income.
• Higher Inventory Value: Ending inventory reflects more recent, higher costs, which is beneficial for the balance sheet.

Disadvantages of FIFO:

• Higher Tax Liability: Higher net income leads to higher taxes.

• Potential Obsolescence: If not managed properly, the remaining inventory could become obsolete.

Understanding LIFO (Last-In, First-Out)

Conversely, the LIFO method assumes that the newest inventory items are sold first. This method can be advantageous in times of inflation, as it matches the most recent, higher costs with current revenues, thereby reducing taxable income. However, LIFO can lead to outdated inventory values on the balance sheet, as older, potentially obsolete stock remains recorded at lower historical costs.

Example: Using the same bakery example, if the bakery sells 200 loaves on Wednesday, under LIFO, the COGS would be $1.25 per loaf because the most recently produced loaves are sold first. The $1 loaves remain in ending inventory.

Advantages of LIFO:

• Tax Savings: During inflation, higher COGS leads to lower net income, reducing tax liability.
• Current Cost Matching: Matches recent costs with current revenues, providing a more accurate picture of profit margins during inflation.

Disadvantages of LIFO:

• Lower Net Income: Higher COGS results in lower net income.
• Outdated Inventory Values: Ending inventory reflects older, lower costs, which may not be realistic.
• Not Allowed Under IFRS: LIFO is not permitted under International Financial Reporting Standards, limiting its use to countries that follow GAAP, such as the United States.

Comparing FIFO and LIFO: Impact During Inflation

In an inflationary environment, FIFO and LIFO have distinct impacts on a company’s financial statements. FIFO results in lower COGS because older, cheaper inventory is used first, leading to higher net income and higher taxes. In contrast, LIFO results in higher COGS as newer, more expensive inventory is sold first, leading to lower net income and reduced tax liability. This difference can significantly affect a company’s financial health and tax strategy.

Impact on Financial Statements:

·         FIFO:

• Income Statement: Lower COGS, higher net income.
• Balance Sheet: Higher inventory values.
• Tax Liability: Higher due to increased net income.

·         LIFO:

• Income Statement: Higher COGS, lower net income.
• Balance Sheet: Lower inventory values.
• Tax Liability: Lower due to decreased net income.

Pros and Cons of FIFO and LIFO Methods

FIFO Pros:

• Higher net income and inventory values.
• Logical and aligns with the natural flow of inventory.
• Better reflects current market prices.

FIFO Cons:

• Higher tax liability due to increased net income.
• Potential for higher future write-offs if inventory becomes obsolete.

LIFO Pros:

• Lower tax liability in times of rising prices.
• Matches current costs with current revenues.

LIFO Cons:

• Lower net income.
• Outdated inventory values on the balance sheet.
• Not permitted under IFRS.

Example of Impact During Inflation: Assume a company purchases 1,000 units of inventory at $10 each in January and another 1,000 units at $15 each in June. By December, the company sells 1,000 units at $20 each.

·         FIFO:

• COGS: 1,000 units x $10 = $10,000.
• Ending Inventory: 1,000 units x $15 = $15,000.
• Net Income: Sales - COGS = (1,000 units x $20) - $10,000 = $10,000.

·         LIFO:

• COGS: 1,000 units x $15 = $15,000.
• Ending Inventory: 1,000 units x $10 = $10,000.
• Net Income: Sales - COGS = (1,000 units x $20) - $15,000 = $5,000.

In this example, FIFO results in higher net income and ending inventory values, while LIFO results in lower net income and ending inventory values, illustrating the tax benefits of LIFO during inflation.

FAQs

1. Is FIFO better than LIFO?

FIFO is often better for companies seeking higher net income and inventory values, but it can result in higher taxes. LIFO can reduce tax liability but may not reflect current inventory values accurately.

2. Can companies switch between FIFO and LIFO?

Companies can switch inventory methods, but they must follow regulatory guidelines and disclose the change in their financial statements. Changing methods can have significant tax and financial reporting implications, so it is typically done under strategic circumstances.

3. Why is LIFO not allowed under IFRS?

LIFO is not allowed under IFRS because it can distort inventory values and does not align with the fair value principle. IFRS emphasizes transparency and comparability in financial reporting, and LIFO’s potential for outdated inventory valuations conflicts with these goals.

4. Which industries typically use FIFO?

Industries dealing with perishable goods, such as food and pharmaceuticals, typically use FIFO to ensure the oldest inventory is sold first. This method helps prevent spoilage and ensures that inventory values reflect more current costs.

5. How does inventory valuation affect net income?

 Inventory valuation directly impacts COGS, which in turn affects net income. FIFO usually results in higher net income, while LIFO results in lower net income during inflationary periods. Accurate inventory valuation is crucial for understanding a company’s profitability and financial health.

Final Words

Both methods have their advantages and disadvantages, and the choice largely depends on the company’s specific circumstances, such as the nature of their inventory and economic conditions. Whether using FIFO or LIFO, companies must carefully consider their inventory valuation method and its implications for their business operations.

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