Inventory management is a crucial function for any product-oriented business. "First in, First Out," or FIFO, and "Last in, First Out," or LIFO, are two common methods of inventory valuation among businesses. The system you choose can have profound effects on your taxes, income, logistics and profitability. Here are the major differences between the two.
Companies operating on the principle of "First in, First Out" value inventory on the assumption that the first goods purchased for resale became the first goods sold. In some cases, this may not be true, as some companies stock both new and old items.
Due to the fluctuations of the economy and the risk that the cost of producing goods will rise over time, businesses using FIFO are considered to be more profitable — at least, on paper. For example, a grocery store purchases milk at regular intervals to stock its shelves. As customers purchase milk, the stockers push the oldest product to the front of the fridge and replace newer milk behind those cartons. The cartons of milk with the nearest expiration dates are thus the ones first sold, whereas the later expiration dates are sold after the older product. This ensures that older products are sold before they perish or become obsolete, and then become profit lost.
Companies that sell perishable products or units subject to obsolescence, such as food products or designer fashions, commonly follow the FIFO method of inventory valuation.
Anil Melwania, CPA with New York accounting firm 212 Tax & Accounting Services, said that because prices rise in the long term, the choice of accounting method can significantly affect valuations.
"FIFO gives us a better indication of the value of ending inventory on the balance sheet, but it also increases net income, because inventory that might be several years old is used to value the cost of goods sold," Melwania told Business News Daily. "Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay."
For businesses needing to impress investors, this becomes an ideal method of valuation, until the higher tax liability is considered. Because FIFO results in a lower recorded cost per unit, it also records a higher level of pre-tax earnings. And, with higher profits, companies can likewise experience higher taxes.
The "Last In, First Out" method of inventory entails using current prices to count a measure called "the cost of goods sold," as opposed to using what was paid for the inventory already in stock. If the price of such goods has increased since the initial purchase, the "cost of goods sold" measure will be higher and thereby reduce profits and tax burdens. Nonperishable commodities like petroleum, metals and chemicals are frequently subject to LIFO accounting.
"LIFO isn't a good indicator of ending inventory value, because the leftover inventory might be extremely old and, perhaps, obsolete," Melwani said. "This results in a valuation much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher. So [there is a] lower taxable income. By using more recent inventory in valuation, your cost basis is higher on current income statements. This reduces gross profit and ultimately net income. This is the implication of LIFO, and many companies prefer LIFO because lower profit reporting means a reduced tax burden."
As an example of how LIFO works, a website development company might purchase a plugin for $30 and then sell the finished product at $50. However, several months later, that asset is increased in price to $35. When the company then writes off profits, it would use the most recent price of $35 as part of LIFO. In tax statements, it would then appear as if the company made a profit of only $15. By using LIFO, a company would appear to be making less money than it actually did, and therefore have to report less in taxes.
The principle of LIFO is highly dependent on how the price of goods fluctuates based on the economy. If a company holds inventory for a long period of time, holding on to product may prove quite advantageous in hedging profits for taxes. LIFO allows for higher after-tax earnings due to the higher cost of goods. At the same time, these companies risk the cost of goods going down in the event of an economic downturn and causing the opposite effect for all previously purchased inventory.
FIFO and LIFO similarities
FIFO and LIFO are quite different inventory management techniques. However, they are similar in one regard: They both depend on the product remaining the same, with price being the only fluctuating element.
FIFO and LIFO influence a company's earnings on paper. FIFO is most successful when used in an industry when the price of a product remains steady and the company sells its oldest products first. That's because FIFO is based on the cost of the first goods purchased, ignoring any increases or reductions in price for newer units. LIFO, in comparison, works well in an industry when prices fluctuate and the newest units are sold first.
Restrictions on the use of LIFO
Though the Obama administration has lobbied since 2011 for the repeal of the LIFO standard, talks are still ongoing in 2015. Regardless, the accounting method is still subject to increased restrictions both in the United States and internationally. Basically, once you use LIFO, you can't use any other method that year.
"If LIFO is used on a taxpayer's tax return, then no other method can be used to value inventory to calculate income, profit or loss in any report or statement covering the same tax year that is provided to shareholders and other owners or to creditors," Melwani said.
In the United States, the IRS strictly enforces this rule. Meanwhile, LIFO is banned by International Financial Reporting Standards (IFRS), a set of common rules for accountants who work across international borders. While many nations have adopted IFRS, the United States still operates under the guidelines of Generally Accepted Accounting Principles (GAAP). If this country were to ban LIFO, the United States would clear an obstacle to adopting IFRS, thus streamlining accounting for global corporations.
Because of the current discrepancy, however, U.S.-based companies that use LIFO must convert their statements to FIFO in the footnotes of their financial statements. This difference is known as the LIFO reserve, and is calculated between the cost of goods sold (COGS) under LIFO and FIFO, Melwani said. This increases the comparability of LIFO and FIFO firms.
In general, standards both in the United States and internationally are moving away from LIFO and FIFO. Many U.S.-based companies have switched to FIFO; some companies still use LIFO within the United States as a form of inventory management, but translate it to FIFO for tax reporting. Only a select few large companies within the United States are still able to use LIFO for the purpose of tax reporting.
Many companies believe the repeal of LIFO would result in a tax increase for both large and small businesses, though many other companies use FIFO with little financial repercussion.
More information on accounting standards is available at the following links:
Additional reporting by Ryan Goodrich, Business News Daily contributor.
Originally published on Nov. 22, 2013. Updated Feb. 20, 2015.