FIFO vs. LIFO method: Definitions, Differences, Examples, Advantages and Disadvantages
FIFO and LIFO are two accounting methods for valuing inventory. FIFO is considered to be superior, but LIFO also has its merits. This post discusses both methods and provides an example that illustrates their difference.
FIFO and LIFO are acronyms for two inventory accounting methods. FIFO or First In, First Out, works on the assumption that goods in a company’s inventory are consumed in the order they are purchased.
The other inventory accounting method, LIFO or Last In, First Out, takes the opposite view. Instead of accounting for the oldest goods first, it assumes that the most recently acquired goods are the first to be consumed.
How are these two methods different? And does it matter which of them a company adopts?
We’ll address these questions in the following sections of this post. We’ll also provide an example to illustrate the impact that the two inventory valuation methods can have on a company’s profits and taxes.
FIFO and LIFO: definitions and a brief explanation of the terms
First off, let’s start with the definitions of the two terms. Here’s how the New York State Society of CPAs explains FIFO and LIFO:
FIFO: Accounting method of valuing inventory under which the costs of the first goods acquired are the first costs charged to expense. Commonly known as FIFO.
LIFO: Accounting method of valuing inventory under which the costs of the last goods acquired are the first costs charged to expense. Commonly known as LIFO.
There’s a crucial point that needs to be addressed here. FIFO and LIFO don’t require individual items in a company’s inventory to be tracked. They are accounting methods used for the valuation of inventory. So, when a company adopts, say, FIFO, it assumes that the oldest goods are sold first. The sale doesn’t need to be of a product that was acquired earlier than the other items in stock.
Of course, in some firms, it would be essential to keep a record of the date on which a specific item was purchased. For example, if you were dealing in perishable goods, you would need to ensure that you consume the oldest inventory first. In this situation, it would be imperative to track each item in physical inventory. However, you should remember that individual monitoring isn’t a prerequisite for implementing the FIFO and LIFO methods.
Understanding the difference between FIFO and LIFO
If the price at which you purchase inventory remains constant, it doesn’t matter whether a company adopts LIFO or FIFO. But if unit costs are changing over time, the impact can be significant.
Bear in mind that in the real world, prices don’t stay at the same level. Let’s consider an environment in which prices are rising. In this scenario, adopting LIFO could help a company keep its profits down and pay less tax.
Here’s a quick explanation about how this could happen:
FIFO vs. LIFO--An example
Say a company purchases 100 units of inventory at $10 each. Subsequently, it buys another 100 units at $15 per item. If it uses the LIFO method of inventory valuation, it will consume the $15 items first. Consequently, its cost of goods sold or COGS would be higher than if it had consumed the $10 items. Remember that the FIFO method would have required the $10 items to be consumed first.
Let’s see the financial impact of consuming 100 units under the two methods:
COGS with the LIFO method: 100 units X $15 = $15,000
COGS with the FIFO method: 100 units X $10 = $10,000
A higher COGS figure would result in a lower gross profit figure and lower taxes. Most companies that use the last in, first out method of inventory accounting do so because it enables them to report lower profits and pay less tax.
Advantages and disadvantages
As we explained in the previous section, the LIFO method’s primary advantage is that it allows firms to lower their profits in an inflationary situation.
There’s another advantage, as well. The LIFO method allows companies operating in an inflationary situation to reflect costs more accurately.
However, this accounting method carries a distinct disadvantage. When a company follows the LIFO method, the ending inventory is valued at old prices. These don’t reflect the current situation. Consequently, the financial statements could present a distorted picture of the value of a company’s inventory.
The first in, first out method, on the other hand, is considered to be superior to LIFO in several ways. That’s because it assumes that goods are consumed or sold in the same sequence in which they are acquired.
In fact, for most companies, the actual consumption of inventory follows FIFO. This is especially true for those firms that sell perishable commodities with a limited shelf life. So, the first in, first out method makes for a more rational choice.
The FIFO method of inventory accounting has two other advantages:
- As inventory is consumed in the same order as it is purchased, it’s easy to follow this method.
- The value of the company’s inventory in its books at the end of the year reflects a more accurate picture. As it has been acquired recently, the amount is closer to the market value. Under the LIFO method, inventory valuation is out-of-date.
It’s generally accepted that FIFO is a better method. As a matter of fact, the International Financial Reporting Standards (IFRS) bans LIFO’s use. The IFRS is a set of accounting standards issued by the International Accounting Standards Board (IASB). These rules are followed by the United Kingdom, Canada, Australia, and China, among other countries.
The main reason that the LIFO method is prohibited in these countries is that it enables companies to understate their net income. However, in America, companies are permitted to use LIFO.
The bottom line
So, which inventory accounting method should you use? LIFO or FIFO? For most firms, it makes sense to adopt FIFO. However, if you can get a tax benefit, the last in, first out method can be a better option.
