FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old—which was acquired for a lower cost—is used to value COGS. However, the higher net income means the company would have a higher tax liability. The first in, first out (FIFO) method assumes that the first unit making its way into inventory–the oldest inventory–is sold first.
What’s the Difference Between Cost of Goods Sold (COGS) and Inventory?
Depending on the actual shelf life, this may not reflect the real value of the company’s inventory. Companies outside of the United States that must adhere to International Financial Reporting Standards (IFRS) are not permitted to use the LIFO method. Public companies in the U.S. are required to adhere to the generally accepted accounting principles (GAAP)—accounting standards set forth by the Financial Accounting Standards Board (FASB).
Impact on Financial Statements
LIFO supporters contend that the increased usefulness of the income statement more than offsets the negative effect of this undervaluation of inventory on the balance sheet. It illustrates how using LIFO not only results in the most equitable outcome to all stakeholders, it also contributes to the ongoing sustainability of the business. Furthermore, it demonstrates how, while companies using FIFO may present higher earnings numbers, once adjusted for inventory replacement cost, economic earnings are lower than they would be under LIFO.
In addition to writing, she is the co-owner of a small dog bakery in rural Ohio. LIFO assigns the most recent purchase costs to COGS and leaves older costs in ending inventory. In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. For example, a chip manufacturer may want to ensure older units of a specific model are moved out of inventory; more recently manufactured units of the same model may be able to better withhold storage conditions. However, if inventory has been stagnant for some time, this method may not reflect the actual cost of materials, especially in an inflationary environment.
LIFO and FIFO: Advantages and Disadvantages
Conversely, FIFO uses older costs in income, and LIFO does so for the balance sheet. The first unit was purchased earlier for $100; the second was purchased more recently at the current cost of $110. If both units remain unsold, the balance reported in Inventory (INV) would be $210 (100 + 110). Now assume that one unit is sold at a price of $132, consistent with a 20% markup of the current $110 cost.
It assumes the first inventory to come into a business is the first inventory to be sold. If you sell 500 ears of corn, the cost of that corn is $2 each or $1,000. The cost of the corn still held in inventory — and recorded on the balance sheet — is $1 each, or $500.
It is also a major success factor for any business that holds inventory because it helps a company control and forecast its earnings. For investors, inventory is an important item to analyze because it can provide insight into what’s happening with a company’s core business. However, the LIFO method may not represent the actual movement of inventory.
Unit 7: Inventory Valuation Methods
- If, however, an entity was forced to use FIFO, COGS would be $100, and pre-tax income would be $32.
- Each method reflects a different assumption about the flow of inventory and can significantly impact financial reporting outcomes.
- The ending inventory value of one period should always be equal to the beginning inventory value of the next period.
- FIFO often results in higher net income and higher inventory balances on the balance sheet.
- 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.
Inventory is one of the largest costs for non-service-oriented businesses. It is defined as those assets on the balance sheet that are intended to be sold or used in the current year. While the calculation of inventory is rather straightforward, several methods are used to value inventory, which can greatly affect the income statement and subsequently the amount a business pays in income taxes.
Below are the Ending Inventory Valuations:
- One would charge a friend the cost one would incur to replace the unit.
- Edited by CPAs for CPAs, it aims to provide accounting and other financial professionals with the information and analysis they need to succeed in today’s business environment.
- For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products.
- Inventory accounting methods are used to track the movement of inventory and record appropriate and relevant costs.
Generally, companies use the inventory method that best fits their individual circumstances. However, this freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report higher income. Continuous switching of methods violates the accounting principle of consistency, which requires using the same accounting methods from period to period in preparing financial statements. Consistency of methods in preparing financial statements enables financial statement users to compare statements of a company from period to period and determine trends.
They argue that repealing LIFO would disincentivize inventory investment, hampering efforts to make U.S. supply chains more resilient. It would also reduce economic growth and penalize industries that typically keep more inventory on hand, such as retailers of durable goods (Muresianu and Durante 2022). The company made inventory purchases every month during Q1, resulting in a total of 3,000 units. However, the company already had 1,000 units of older inventory; these units were purchased at $8 each for an $8,000 valuation. In addition to being allowable by both IFRS and GAAP users, the FIFO inventory method may require greater consideration when selecting an inventory method. Companies that undergo long periods of inactivity or accumulation of inventory will find themselves needing to pull historical records to determine the cost of goods sold.
But there are also several reasons why a switch to LIFO is not as attractive a proposition as it might have been years ago. First, since the Tax Cuts and Jobs Act of 2017 lowered the corporate tax rate from 35% to 21%, the tax benefit of switching to LIFO has substantially decreased. Third, while inflation has been high since 2021, many believe this is a temporary phenomenon (D.P. Tinkelman, and Q. Ling, “The Rise and Decline of LIFO,” Accounting Historians Journal, vol. 49, no. 2, p.103–120, 2022). Fourth, as mentioned earlier, IFRS’s disallowance of LIFO has caused many large companies to disregard it.
Each method reflects a different assumption about the flow of inventory and can significantly impact financial reporting outcomes. In periods of rising prices, older inventory (first in) is expensed first, thus contributing to a lower cost of goods sold (COGS) and, in turn, a higher pretax income. LIFO, on the other hand, delivers higher COGS numbers, due to charging the highest-priced inventory to cost of goods sold, thereby lowering pre-tax income, and lowering the tax liability. And that benefit grows as inventory pricing rises due to inflation or other factors, and as tax rates increase. Therefore, all else being equal, management at times must choose between reporting higher earnings–and paying the taxes on them—or reporting less attractive earnings numbers while achieving a tax benefit.
This also means that the earliest goods (often the least expensive) are reported under the COGS. Because the expenses are usually the inventory costing method that results in the lowest taxable income in a period of rising costs is: lower under the FIFO method, net income is higher—resulting in a potentially higher tax liability. During a period of rising prices, the most expensive items are sold with the LIFO method. This means the value of inventory is minimized, and the value of COGS is increased. So taxable net income is lower under the LIFO method, as is the resulting tax liability. When sales are recorded using the FIFO method, the oldest inventory—that was acquired first—is used up first.
In the tables below, we use the inventory of a fictitious beverage producer, ABC Bottling Company, to see how the valuation methods can affect the outcome of a company’s financial analysis. While U.S. generally accepted accounting principles allow both the LIFO and FIFO inventory method, the LIFO method is not permitted in countries that use the International Financial Reporting Standards (IFRS). Although the ABC Company example above is fairly straightforward, the subject of inventory—and whether to use LIFO or FIFO—can be complex. Knowing how to manage inventory is critical for all companies, no matter their size.
Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying. While LIFO helps manage tax liabilities when inflation occurs, it may not present the most accurate inventory valuation and is prohibited under IFRS globally. Each method has distinct implications on financial statements, so businesses must consider their specific economic context and objectives when choosing between LIFO and FIFO.