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Understanding FIFO and LIFO:
Now that we've briefly introduced you to what the FIFO and LIFO methods are, we'll look at them each in a little more detail:
- FIFO (First-In, First-Out): FIFO is an inventory valuation method where the oldest items (first-in) are sold or used first. It ensures that inventory is rotated effectively, using up older stock before newer items. This approach is common in industries dealing with perishable goods, such as food or pharmaceuticals, where freshness or expiration dates need to be managed. For example, a grocery store stocking milk would use FIFO to sell the oldest cartons first to prevent spoilage. By doing so, FIFO often produces a more accurate reflection of costs during times of rising prices, as the cost of older, lower-priced inventory is recognized first, potentially resulting in higher profits in such periods.
- LIFO (Last-In, First-Out): LIFO is an inventory valuation method where the most recent items added to inventory (last-in) are sold or used first. This method assumes that newer inventory is consumed first, which can be beneficial for accounting in certain financial environments. For instance, a retailer managing non-perishable items might use LIFO to match the most recent, often higher, inventory costs against revenue during periods of inflation. This higher cost of goods sold can decrease taxable income, providing a potential tax advantage. However, LIFO is not allowed under International Financial Reporting Standards (IFRS), limiting its use to jurisdictions that follow GAAP, such as the United States.
Key Differences Between FIFO and LIFO:
Here, we'll look at some of the biggest differences of FIFO and LIFO.
- Comparison of Cost-Flow Assumptions: FIFO (First-In, First-Out) assumes that the oldest inventory items are sold first, meaning the cost of goods sold (COGS) is based on the cost of the earliest purchased inventory. This method aligns closely with the physical movement of many goods. On the other hand, LIFO (Last-In, First-Out) assumes that the newest inventory items are sold first, so the COGS reflects the most recent inventory costs.
- Impact on Financial Statements: Under FIFO, during periods of rising prices, COGS tends to be lower since older, cheaper inventory is used to calculate it. This results in higher gross profits and net income, as well as higher ending inventory values on the balance sheet. Conversely, LIFO results in higher COGS due to the use of more recent, expensive inventory, which reduces gross profits and net income. LIFO can also lead to lower inventory valuations on the balance sheet in inflationary periods.
- Influence on Decision-Making Related to Taxes and Profits: The choice between FIFO and LIFO can significantly impact tax liability. LIFO generally lowers taxable income during times of inflation, as higher COGS reduce reported profits, thereby decreasing taxes owed. FIFO, while leading to higher profits, results in a higher tax burden. Companies must carefully consider their priorities—whether they aim to present stronger financial performance for stakeholders or reduce their tax obligations—when deciding which method to implement.
Advantages and Disadvantages of FIFO vs LIFO:
Above we looked at the difference between FIFO and LIFO methods. Here, we'll look at some of the advantages and disadvantages of using each method:
- Advantages of FIFO: The First-In, First-Out (FIFO) method simplifies inventory valuation by assigning the cost of older inventory to the cost of goods sold (COGS) first, leaving newer inventory on the balance sheet. This approach is particularly advantageous during periods of inflation as it results in lower COGS and higher reported profits, which can improve a company’s financial statements. Additionally, FIFO's straightforward calculations and global acceptance under both International Financial Reporting Standards (IFRS) and US GAAP make it a preferred choice for companies operating internationally.
- Disadvantages of FIFO: While the FIFO method is straightforward and easy to implement, it has potential disadvantages under certain circumstances. During periods of rising prices, FIFO often results in higher taxable income because the older, often cheaper inventory is sold first, leading to a higher cost of goods sold (COGS) on financial statements. This can increase a company’s tax burden. Additionally, FIFO does not accurately reflect the current market value of inventory, as the remaining stock may be valued at outdated purchase prices, which could potentially misrepresent financial health.
- Advantages of LIFO: The Last-In, First-Out (LIFO) method is often valued for its tax-saving benefits during inflationary periods. By assigning the most recent inventory costs to COGS first, LIFO typically results in higher COGS and lower taxable income, reducing tax liabilities. Furthermore, LIFO provides a realistic matching of current costs to current revenues, offering better profitability insights for industries dealing with fluctuating inventory costs, such as manufacturing and retail. However, it is worth noting that LIFO is not permitted under IFRS, limiting its applicability globally.
- Disadvantages of LIFO: The LIFO method comes with its own limitations, especially since it is not permitted under International Financial Reporting Standards (IFRS), restricting its global applicability. Companies using LIFO may also face the challenge of older inventory lingering unsold for long periods, which could lead to potential obsolescence or spoilage, particularly in industries dealing with perishable goods. Furthermore, LIFO can be complex to implement and maintain, requiring meticulous record-keeping and inventory tracking, which can strain internal resources and lead to higher administrative costs.
