LIFO supporters contend that it makes more sense to match current costs against current revenues than to worry about matching costs for the physical flow of goods. Supporters of FIFO argue that LIFO (1) matches the cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income manipulation. In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. No, the LIFO inventory method is not permitted under International Financial Reporting Standards (IFRS). Both the LIFO and FIFO methods are permitted under Generally Accepted Accounting Principles (GAAP).
LIFO and FIFO: Financial Reporting
It is up to the company to decide, though there are parameters based on the accounting method the company uses. In addition, companies often try to match the physical movement of inventory to the inventory method they use. The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows. Changes should be made at the end of an accounting period and cannot be changed each accounting period.
LIFO and FIFO: Advantages and Disadvantages
Companies have their choice between several different accounting inventory methods, though there are restrictions regarding IFRS. A company’s taxable income, net income, and balance sheet balances will all vary based on the inventory method selected. If inflation were nonexistent, then all three of the inventory valuation methods would produce the same exact results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, our bakery example from earlier would be able to produce all of its bread loaves at $1, and LIFO, FIFO, and average cost would give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period.
Understanding LIFO and FIFO
The method allows them to take advantage of lower taxable income and higher cash flow when their expenses are rising. Although the ABC Company example above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO, or average cost can be complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage, can prevent a company from operating efficiently.
- However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation.
- Although the ABC Company example above is fairly straightforward, the subject of inventory and whether to use LIFO, FIFO, or average cost can be complex.
- The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve assumptions about how costs flow through a business.
- So, why do so many businesses neglect inventory and fail to establish a method for valuing one of their biggest assets & expenses?
- The average cost method produces results that fall somewhere between FIFO and LIFO.
Example of LIFO
Businesses that use FIFO record the oldest inventory items to be sold first. When inventory is sold, the oldest cost of an item in inventory will be recovered and then reported on the income statement as part of the cost of goods sold. We track how many items were bought at the oldest price tier and then use them all up before moving onto the next price tier. It’s simple – you divide the total cost of purchased items by the number of items in stock. The FIFO and specific identification methods result in a more precise matching of historical cost with revenue. However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation.
Average Cost
The larger the cost of goods sold, the smaller the net income. Most companies use the first in, first out (FIFO) method of accounting to record their sales. The last in, first out (LIFO) method is suited to particular businesses in particular times. That is, it is used primarily by businesses that must maintain large and costly inventories, and it is useful only when inflation is rapidly pushing up their costs.
FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this results in higher tax liabilities and potentially higher future write-offs if that inventory becomes the inventory costing method that results in the lowest taxable income in a period of rising costs is: obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory. One disadvantage of the specific identification method is that it permits the manipulation of income.
In the video, we saw how the cost of goods sold, inventory cost, and gross margin for each of the four basic costing methods using perpetual and periodic inventory procedures was different. The differences for the four methods occur because the company paid different prices for goods purchased. Since a company’s purchase prices are seldom constant, inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore, companies must disclose on their financial statements which inventory costing methods were used. The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with the actual physical flow of goods.
