Basics of LIFO and FIFO Inventory Accounting Methods
LIFO ("last-in-first-out") and FIFO ("first-in-first-out") are the two most common inventory methods that companies use to account for the costs of purchased inventory on the balance sheet. The way a business chooses to account for its inventory can directly impact its balance sheet, the profit shown on its income statement, and its statement of cash flows.
Not only do companies have to track the number of items sold, but they must also track the cost of each item. Using different inventory costing methods affects the company's profits and the amount of taxes it must pay each year.
Importance of Inventory and Cost Methods
Business analysts need to understand the important role that inventory plays in the whole financial picture. Of all the assets on a firm's balance sheet, from cash to office supplies to real estate, if the company sells any type of tangible products, it's likely that inventory is the largest asset category in terms of dollars.
Inventory is where many companies have the majority of their funds invested. Inventory typically consists of finished products for sale, raw materials in the process of being made into goods for sale, and raw materials that are used up during the process of producing items for sale.
To calculate the profit a company produces, it must track sales revenue as well as all of the costs involved in producing its widgets. Accordingly, the firm's profits consist of the money remaining from sales after the company has covered all of its costs, including the cost of buying its inventory.
When considering LIFO, FIFO, average cost, or some other inventory pricing method such as the lower of cost or market, the cost a company chooses to record for the inventory it sells affects how much profit it can report for the month, quarter, or year. As such, companies must choose one method and stick with it for at least a year, then get permission from the IRS to switch to a different method the following year.
LIFO and FIFO each have a different effect on a company's financial statements. To understand this, consider how inventory is determined.
Determining Ending Inventory
The Ending Inventory calculation is important because it determines the inventory value that's shown on a company's monthly, quarterly, and annual financial statements. This number changes with each unit the company sells and affects the company's reported profit, asset balance, and tax liability.
The equation to calculate ending inventory is as follows:
Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory
The two common ways of valuing this inventory, LIFO and FIFO, can give significantly different results.
Last-In, First-Out (LIFO)
LIFO assumes that the last items put on the shelf are the first items sold. Last-in, first-out is a good system to use when your products are not perishable or at risk of quickly becoming obsolete. Under LIFO, if the last units of inventory bought were purchased at higher prices, the higher-priced units are sold first, with the lower-priced, older units remaining in inventory. This increases a company's cost of goods sold and lowers its net income, both of which reduce the company's tax liability.
This makes LIFO more desirable when corporate tax rates are higher.
This inventory accounting method seldom gives a good representation of the replacement cost for the inventory units, which is one of its drawbacks. In addition, it may not correspond to the actual physical flow of the goods.
Using the gasoline industry as an example, say that a tanker truck delivers 2,000 gallons of gasoline to Henry's Service Station on Monday and the price at that time is $2.35 per gallon. On Tuesday, the price of gasoline has gone up, and the tanker truck delivers 2,000 more gallons at a price of $2.50 per gallon.
Under LIFO, the gasoline station would assign the $2.50-per-gallon cost of gas to its Cost of Goods Sold account for the gallons actually sold, and the remaining amount of $2.35-per-gallon gasoline would be used to calculate the value of the company's ending inventory at the end of the accounting period.
First-In, First-Out (FIFO)
FIFO, on the other hand, assumes that the first items put on the shelf are the first items sold, so your oldest goods are sold first. This system is generally used by companies whose inventory is perishable or subject to quick obsolescence.
FIFO is the preferred accounting method in an environment of rising prices. If the inventory market prices go up, FIFO will give you a lower cost of goods sold because you are recording the cost of your older, cheaper goods first. Your bottom line will look better to your banker and investors, but your tax liability will be higher because, due to the lower costs, your company has a higher profit. Because FIFO represents the cost of recent purchases, it usually more accurately reflects inventory replacement costs.
Going back to the gasoline industry example, under FIFO, the gasoline station would assign the $2.35-per-gallon gasoline to cost of goods sold and the remaining $2.50-per-gallon gasoline would be used to calculate the value of ending inventory at the end of the accounting period. The result would be significantly different, affecting profits shown on the income statement and the inventory value shown on the balance sheet.
Financial Statement Issues with LIFO
Inventory accounting is only one part of a company's management of its inventory investment, but an important one. For example, if your company begins selling inventory faster than it replaces it, LIFO accounting can produce a mathematical outcome that no longer accurately represents what's going on in the real world.
When you're using LIFO accounting methods in the context of a decline in inventory purchase prices, your balance sheet will soon bear little relation to your actual financial position because your latest costs become the supposed real costs of the goods sold. But as you sell through your inventory, you begin selling goods that were actually acquired for a higher price at some earlier time.
These earlier costs are still there in the Inventory account. The result is that the reported Inventory asset balance has no relation to the cost of goods at current prices. For this reason, many companies choose to use a weighted-average cost method or use the current market price, also known as replacement cost, to prevent these types of issues.