The LIFO and FIFO methods are valuation methods used in accounting for inventory management and in financial matters related to the amount of money that a company must have tied to the inventories of finished products, raw materials, parts or components.
How a business chooses to account for its inventory can have a direct impact on its balance sheet, the profit shown on its income statement, and its cash flow statement.
Companies not only have to look at the number of items sold, but they also have to keep track of the cost of each item. Using different methods for calculating inventory costs affects the company's profits. It also affects the amount of taxes you must pay each year.
These methods are used to manage cost projections related to inventory, restocking (if purchased at different prices), and for various other accounting purposes.
Characteristics
LIFO and FIFO are cost stratification methods. They are used to value the cost of merchandise sold and the ending inventory. The equation to calculate the ending inventory is as follows:
Ending Inventory = Beginning Inventory + Net Purchases - Cost of Merchandise Sold
The two common methods for valuing this inventory, LIFO and FIFO, can give significantly different results.
FIFO method
The acronym FIFO stands for “First In, First Out,” which means that the items that were added to inventory first, the oldest, are the first items to be removed from inventory for sale.
This does not necessarily mean that the oldest physical item is the one to be tracked and sold first. The cost associated with the inventory that was purchased first is the cost that will first be posted for sale.
Thus, with the FIFO method, the cost of inventory reported on the balance sheet represents the cost of inventory for the items that were most recently purchased.
Because FIFO represents the cost of recent purchases, it generally more accurately reflects inventory replacement costs.
Inflation and deflation
If costs are increasing, when the first items that entered the inventory are sold first, which are the least expensive, the cost of the merchandise sold is reduced, thus reporting more benefits and, therefore, paying a higher amount of income tax short term.
If costs are decreasing, by selling the first items that entered the inventory first, which are the most expensive, the cost of the merchandise sold increases, thus reporting less profit and, therefore, paying a lower amount of income tax in the short term.
Inventory layers
There are generally fewer layers of inventory to track in the FIFO method, as older layers are continually depleted. This reduces the maintenance of historical records.
Since there are few layers of inventory, and those layers more reflect the new prices, unusual crashes or spikes in the cost of merchandise sold rarely occur that are caused by accessing the old layers of inventory.
LIFO method
The LIFO acronym stands for “Last In, First Out,” which means that the items most recently added to inventory are considered the first items to be removed from inventory for sale.
If costs are increasing, the last items to enter inventory, which are the most expensive, are sold first, increasing the cost of merchandise sold, thus reporting less profit. Therefore, a lower amount of income tax is paid in the short term.
If costs are decreasing, selling the last items in inventory first, which are the least expensive, reduces the cost of merchandise sold. In this way, more earnings are reported and, therefore, a greater amount of income tax is paid in the short term.
In essence, the main reason to use the LIFO method is to defer the payment of income tax in an inflationary environment.
Not recommended
Generally speaking, the LIFO method is not recommended primarily for the following reasons:
- It is not allowed according to IFRS. Much of the world is governed by the established framework of IFRS.
- There are generally more layers of inventory to track. Older layers can potentially remain in the system for years. This increases the maintenance of historical records.
- Because there are many layers of inventory, some with costs from several years ago that vary substantially from current costs, accessing one of these old layers can cause a drastic increase or decrease in the amount of the cost of merchandise sold.
This inventory method of accounting rarely provides a good representation of the replacement cost of inventory units. This is one of its drawbacks. Also, it may not correspond to the actual physical flow of the items.
see also finance and business knowledge
