The profitability and financial standing of a business are directly impacted by inventory value, which is a crucial component of financial accounting. The cost of goods sold (COGS), net income, and tax obligations can all be greatly impacted by the method of inventory valuation. GAAP permits companies to adopt first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost inventory accounting techniques. These techniques are employed to monitor inventory movement and document pertinent and appropriate expenditures. This blog provides a detailed comparison of the two most common methods– FIFO vs LIFO on various bases, including when to choose each method and their pros and cons.
What is the First-in-First-Out (FIFO) Inventory Method?
The acronym FIFO denotes “First-In, First-Out.” According to this strategy, inventory goods that are the oldest are sold first. As a result, the cost of goods sold (COGS) reflects the cost of the earliest purchased inventory, while the remaining inventory is valued at the cost of the more recent purchases. This method is particularly useful for businesses that deal with perishable goods or products with a short shelf life, as it ensures that older inventory is sold first.
What is the Last-in-First-Out (LIFO) Inventory Method?
LIFO, or “Last-In, First-Out,” assumes that the most recently acquired inventory items are sold first. This means that the COGS reflects the cost of the latest inventory while the older inventory remains on the balance sheet. LIFO is often used by businesses that deal with non-perishable goods or products with stable prices, as it reduces taxable income during periods of rising prices.
FIFO vs LIFO: The Difference between Inventory Valuation Methods
1: Formula for COGS
- FIFO: This formula emphasizes the use of the earliest inventory costs, providing a clear picture of expenses as they relate to the revenue generated from the oldest items sold. The formula for calculating COGS using FIFO is as follows: COGS = Cost of Oldest Inventory + Cost of Remaining Old Inventory
- LIFO: This formula highlights that the most recent inventory costs are applied first, reflecting the current market conditions and providing a more accurate representation of expenses when prices are rising. For LIFO, the COGS formula is expressed as: COGS = Cost of Newest Inventory + Cost of Remaining New Inventory
- Inventory Cost Flow
- FIFO: Under FIFO, the cost of the oldest inventory items is used to calculate the Cost of Goods Sold (COGS). This means that the expenses associated with the earliest purchases will be reflected in the income statement, leading to potentially lower COGS during periods of inflation. The remaining inventory is valued at the cost of more recently purchased items, which can lead to an inflated inventory value on the balance sheet.
- LIFO: In contrast, LIFO uses the cost of the most recently acquired items to calculate COGS. This can lead to higher COGS during inflationary periods, as the latest, more expensive inventory costs are recognized first. Consequently, this method results in lower profits on the income statement during such times, as the expenses are higher, thus impacting the perception of financial health.
- Impact on COGS
- FIFO: During periods of inflation, FIFO generally results in a lower COGS compared to LIFO. This is because the costs associated with older inventory, which were likely acquired at lower prices, are recognized first. Consequently, this can lead to higher reported profits, enhanced overall financial performance of the business in the short term.
- LIFO: Conversely, LIFO results in higher COGS during inflationary times. By using the most recent inventory costs first, companies report lower profits, which can be unfavourable for attracting investors. However, this method can provide advantages by better matching the costs of current inventory with current revenue.
- Net Income:
- FIFO: As FIFO leads to lower COGS during inflation, it typically results in higher net income. This can create a favourable impression among investors, making the company appear more profitable and financially healthy. The enhanced net income can also improve earnings per share (EPS), further attracting potential investors.
- LIFO: LIFO, with its higher COGS during inflation, leads to lower net income. While this might deter some investors due to perceived lower profitability, it can be advantageous for companies looking to reinvest in their operations or minimize tax obligations due to reduced taxable income.
- Tax Implications
- FIFO: Higher net income associated with FIFO translates into increased tax liability. Businesses using this method may face higher tax payments, which can impact cash flow and limit available resources for reinvestment or operational expansion. This increased tax burden can be particularly challenging for companies operating with thin profit margins.
- LIFO: LIFO typically results in lower taxable income due to its higher COGS, which can significantly reduce tax obligations. This immediate tax benefit can improve cash flow, allowing businesses to allocate funds toward growth initiatives or debt repayment. This strategy can be particularly beneficial for companies that operate in volatile markets with rapidly rising costs.
- Inventory Valuation
- FIFO: The inventory remaining on the balance sheet under FIFO is valued at more recent purchase costs. This can lead to inflated asset values during inflation, which might misrepresent the true financial condition of the business. Investors and analysts might view this higher inventory valuation as a positive sign; however, it may not accurately reflect the current market value of the inventory.
- LIFO: In LIFO, the older costs remain on the balance sheet, potentially leading to an undervalued inventory. This situation can skew financial ratios, such as the current ratio and quick ratio, making a company appear less liquid than it truly is. Additionally, if inventory becomes obsolete, the impact of carrying older, lower-cost inventory can lead to significant write-offs.
- Global Acceptance
- FIFO: FIFO is accepted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it a versatile choice for businesses operating in multiple jurisdictions. Its acceptance worldwide allows for easier comparisons between companies and enhances transparency in financial reporting.
- LIFO: LIFO is allowed under GAAP but is not permitted under IFRS, limiting its applicability to companies operating internationally. Businesses that choose LIFO may face challenges if they plan to expand into global markets or engage in financial reporting that adheres to IFRS standards, as they would need to adopt FIFO or another acceptable method.
When to Choose FIFO or LIFO
When to Choose FIFO
- Perishable Goods: Businesses dealing with perishable items (e.g., food, pharmaceuticals) should consider FIFO to minimize spoilage.
- Stable Pricing Environment: In a market with stable or declining prices, FIFO can accurately reflect inventory costs.
- Investor Expectations: Companies looking to attract investors may benefit from FIFO’s higher reported income.
When to Choose LIFO
- Inflationary Periods: Businesses operating in an inflationary environment can benefit from LIFO’s tax advantages.
- Cost Matching: Companies that want to match their latest costs against current revenues for a more accurate profit margin should consider LIFO.
- Lower Tax Liability Goals: If minimizing tax obligations is a priority, LIFO can provide immediate benefits.
Conclusion
The choice between FIFO and LIFO requires careful consideration of the specific circumstances of a business. When deciding between FIFO and LIFO inventory methods, businesses must carefully consider their operational characteristics, market conditions, and financial goals. FIFO typically offers advantages in terms of higher net income and easier implementation, particularly for companies dealing with perishable goods or in stable pricing environments. Conversely, LIFO can provide significant tax benefits and better cash flow in inflationary periods, making it an appealing choice for businesses in certain industries. Ultimately, the choice between FIFO and LIFO can have far-reaching effects on a company’s financial health, cash flow, and long-term growth potential.
