Toward the end of a business's fiscal (financial) year, auditors and accountants start to talk about "taking inventory" and "LIFO vs. FIFO." But what's the difference between these terms, and which one is better for your business?
Keeping Track of Inventory
Businesses with products to sell have inventory, the products your business sells, and the parts, materials, and supplies that go into the products.
Inventory and Cost of Goods Sold
You must keep inventory so you can calculate the cost of the products you sell during the year. This calculation is called cost of goods sold (COGS).
COGS is calculated as:
- Inventory at the beginning of the year
- Plus the cost of purchases to increase inventory
- Plus the cost of labor, materials, and supplies, and other costs
- Less inventory at the end of the year.
The cost of beginning and ending inventory is an important factor in COGS. To determine this cost, the value (cost) of inventory that is sold during the year must be calculated by some reasonable method that is common to all businesses.
COGS is important in figuring your business taxes. The greater the COGS, the lower the company's profits—and its taxes.
Inventory Valuation Methods
You must value your inventory at the beginning and end of the year. The valuation method you use must:
- Conform to generally accepted accounting standards for similar
- Clearly reflect income
- Be consistent from year to year
Since inventory is constantly coming into and going out of a company, it's difficult to keep track of the cost of individual items inventory, so accounting standards allow businesses to use some general guidelines in valuing the cost of inventory.
The IRS allows several inventory valuation methods:
Some types of products can be valued individually and have a specific value assigned. For example, antiques, collectibles, artwork, jewelry, and furs can be appraised and assigned a value. The cost of these items is typically the cost to purchase, so the profit can easily be determined.
First-In, First-Out (FIFO)
Under FIFO, it's assumed that the inventory that is the oldest is being sold first. The FIFO method is the standard inventory method for most companies. FIFO gives a lower-cost inventory because of inflation; lower-cost items are usually older.
Last-In, First-Out (LIFO)
LIFO is a newer inventory cost valuation technique (accepted in the 1930s), which assumes that the newest inventory is sold first. LIFO gives a higher cost to inventory.
|FIFO vs. LIFO - A Comparison|
|Assumes first items in inventory sold first||Assumes last items in inventory sold first|
|Better if costs going down||Better if costs going up|
|More accurate||Less accurate|
|Results in higher profits, higher taxes||Results in lower profits, lower taxes|
|Allowed if selling globally||Not allowed for sales outside the U.S.|
|Usual recordkeeping||Increases recordkeeping|
FIFO or LIFO: Which is Better?
Here are details on the comparisons in the table to help you make the decision on which one is best for your business.
Rising vs. Falling Costs
To assess the relative value of LIFO and FIFO inventory cost, you need to look at the way your inventory costs are changing:
- If your inventory costs are going up, or are likely to increase, LIFO costing may be better because the higher cost items (the ones purchased or made last) are considered to be sold. This results in higher costs and lower profits.
- If the opposite is true, and your inventory costs are going down, FIFO costing might be better. Since prices usually increase, most businesses prefer to use LIFO costing.
Accuracy of Counting
If you want a more accurate cost, FIFO is better because it assumes that older less-costly items are most usually sold first.
Profits and Taxes
Higher costs to a business mean a lower net income, which results in lower taxes. Following this guideline, higher-cost inventory means lower taxes. Lower-cost inventory, on the other hand, means higher taxes.
The international accounting standards organization IFRS doesn't allow LIFO inventory, so you will have to use FIFO if you are doing business internationally.
LIFO inventory accounting increases record-keeping, because older inventory items may be kept on hand for several years, while under FIFO, those older items are sold first, so recordkeeping requirements are less.
Tax and Accounting Rules for FIFO vs. LIFO
The U.S. accounting standards organization, the Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting.
Under the most recent tax law, the Tax Cuts and Jobs Act, effective in 2018, a small business with $25 million or less in gross receipts can treat inventory as "non-incidental materials and supplies" (meaning that they are items bought for resale). You must also use an accounting method that clearly reflects income. In this case, you can use the cash method of accounting instead of accrual accounting.
If you do keep inventory, the IRS requires you to use the accrual method of accounting.
Restrictions on Changing Inventory Methods
FIFO inventory valuation is the default method; if you do nothing to change your inventory valuation method, you must use FIFO to cost your inventory each year. As you might guess, the IRS doesn't like LIFO valuation, because it usually results in lower profits (less taxable income). But the IRS does allow businesses to use LIFO accounting, requiring an application, on Form 970.
If your business decides to change from FIFO to LIFO, you must file an application to use LIFO by sending Form 970 to the IRS. If you filed your business tax return for the year when you want to use LIFO, you can make the election by filing an amended tax return within 12 months of the date you filed the original return.
Once you change to the LIFO method, you can't go back to FIFO unless the IRS gives you specific permission. You can apply for this change using Form 3115 Application for Change in Accounting Method.
Consult a Professional
The decision to use LIFO vs. FIFO is complicated, and each business situation is different. You must conform to IRS regulations and U.S. and international accounting standards. Get help from a tax professional before you decide on an inventory valuation method.