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 cost methods that companies use to account for the costs of purchased inventory on the balance sheet. The method a business chooses to account for its inventory can directly impact its financial statements.
LIFO is the concept of selling the inventory that comes in last, first. Using FIFO, you would sell the inventory in the order it comes in. Each of the two methods affects taxes and costs differently.
Switching between inventory costing methods affects the company's profits and the amount of taxes it must pay each year, which is why the practice is discouraged by the Internal Revenue Service (IRS).
Importance of Inventory and Cost Methods
Understanding the important role that inventory plays in finances is critical. Of all the assets on a firm's balance sheet, it is likely that inventory is the largest asset category in terms of value.
Inventory is where many companies have the majority of their funds invested. Inventory typically consists of finished products and raw materials in the process of being made into goods for sale.
To calculate the profit a company produces, it must track sales revenue as well as the costs involved in producing its products.
When considering LIFO or FIFO, the cost a company chooses to record for the inventory it sells affects how much profit it can report for a period, based on it's ending inventory.
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. This IRS regulation is in place to keep companies from switching in the middle of a period to reduce taxes.
Determining Ending Inventory
Calculating ending inventory is important because it determines the inventory value that's shown on a company's financial reports and 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.
Using 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.
LIFO 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.
For example, if a tanker delivers 2,000 gallons of gasoline to Henry's Service Station on Monday. The price at that time is $2.35 per gallon. On Tuesday, the price of gasoline has gone up, and the tanker 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 due to higher profit from lower costs. 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. 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 lower costs reflect on your cost of 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.
The earlier costs are still 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.