FIFO vs LIFO: A Guide to Inventory Valuation Methods
Inventory valuation is a critical aspect of business accounting and financial reporting. There are two predominant techniques for valuing inventory – FIFO and LIFO. Understanding the key differences between these first in, first out and last in, first out inventory valuation methods is crucial for any business that carries inventory.
In this guide, we’ll examine FIFO and LIFO in depth, including:
- Defining FIFO and LIFO Inventory Valuation
- How FIFO and LIFO Work
- Key Differences Between the Methods
- Examples and Impact on Financial Statements
- Pros and Cons of FIFO vs LIFO
- Determining the Best Method
- Accounting Standards for FIFO and LIFO
- Tax and Cash Flow Implications
- Which Method Aligns with Physical Inventory Flow?
- Potential Inventory Management Challenges
- International Use of FIFO vs LIFO
- Implementing and Switching Methods
Let’s start with the basics of defining FIFO and LIFO inventory valuation.
Defining FIFO and LIFO Inventory Valuation
FIFO and LIFO stand for first in, first out and last in, first out. These terms refer to accounting assumptions and methods used to value the cost of inventory.
FIFO (first in, first out) assumes the first inventory purchased is also the first inventory sold. The earliest acquired inventory items are assumed to leave the company first.
LIFO (last in, first out) makes the opposite assumption – the most recent inventory purchased is sold first. LIFO assumes the newest inventory items are the first to be sold.
Both FIFO and LIFO are techniques for applying the matching principle in accounting. They match current revenues with current costs of inventory sold. But the different assumptions significantly impact inventory valuation and the calculation of cost of goods sold.
How FIFO and LIFO Work
FIFO and LIFO may seem confusing at first, but the underlying logic is straightforward. Here’s a simple example to demonstrate how they work:
- Beginning inventory is 100 units at £10 per unit, so beginning inventory value is £1,000
- Purchase 200 units at £12 per unit, so total inventory is now 300 units at £10 and £12
- Sell 150 units during the period
Using the FIFO method:
- The first 100 units sold came from the original inventory at £10 per unit, so cost of goods sold is £1,000
- The remaining 50 units sold came from the new purchase at £12 per unit, so cost of goods sold is now £1,000 + £600 = £1,600
- Ending inventory is the remaining 150 newer units valued at £12 each, so ending inventory value is £1,800
Using the LIFO method:
- The first 50 units sold came from the newest inventory at £12 per unit, so cost of goods sold is £600
- The next 100 units sold came from the original inventory at £10, so total cost of goods sold is £600 + £1,000 = £1,600
- Ending inventory is the remaining 200 older units at the original £10 valuation, so ending inventory value is £2,000
While cost of goods sold is the same under both methods, the valuation of ending inventory differs significantly.
Key Differences Between the Methods
The major differences between FIFO and LIFO include:
- Inventory value – Ending inventory balance is higher under FIFO than LIFO during periods of rising costs. FIFO leaves the oldest, lower costs in ending inventory.
- Cost of goods sold – LIFO results in higher cost of goods sold relative to FIFO when inventory costs are increasing, since LIFO expenses the newest costs first.
- Gross margin – Due to higher COGS, gross margin is lower under LIFO compared to FIFO when inventory costs rise over time.
- Net income – Similarly, LIFO leads to lower net income versus FIFO in times of inflation or rising inventory expenses.
- Cash flow – Lower net income under LIFO reduces income tax obligations, leaving more operating cash flow for the business.
- Physical flow – FIFO matches the physical flow of inventory while LIFO does not.
Examples and Impact on Financial Statements
Here are two examples that demonstrate the impact of FIFO and LIFO on ending inventory balances and cost of goods sold:
Beginning inventory: 100 units at £5 per unit = £500
- March: Bought 100 units at £6 per unit = £600
- June: Bought 100 units at £7 per unit = £700
Units sold: 200 units
- COGS = Original 100 units at £5 = £500 + Next 100 units at £6 = £600
- Total COGS = £500 + £600 = £1,100
- Ending inventory = 100 units remaining at £7 each = £700
- COGS = Most recent 100 units at £7 = £700 + Earlier 100 units at £6 = £600
- Total COGS = £700 + £600 = £1,300
- Ending inventory = Original 100 units remaining at £5 each = £500
Beginning inventory: 300 units at £10 each = £3,000
- May: 200 units at £12 each = £2,400
- August: 100 units at £15 each = £1,500
Units sold during period: 400 units
- COGS = First 300 sold at original £10 price = £3,000 + Next 100 sold from May purchase at £12 = £1,200
- Total COGS = £3,000 + £1,200 = £4,200
- Ending inventory = Remaining 200 units from August purchase at £15 each = £3,000
- COGS = First 100 sold from August purchase at £15 = £1,500 + Next 300 sold from May purchase at £12 = £3,600
- Total COGS = £1,500 + £3,600 = £5,100
- Ending inventory = Remaining original 300 units at £10 each = £3,000
As demonstrated, the different cost flow assumptions substantially impact COGS and ending inventory valuations.
Pros and Cons of FIFO vs LIFO
FIFO and LIFO offer different advantages and disadvantages:
- Aligns with physical flow of inventory units
- Provides most accurate valuation of ending inventory
- Results in higher reported profits and net income
- Follows GAAP accounting standards
- Can result in higher tax expenses due to higher income
- Leaves oldest inventory costs on balance sheet
- Expenses newest costs first
- Reduces taxable income and tax obligations
- Performs better in inflationary environments
- Does not match physical flow of inventory
- Results in outdated valuation of ending inventory
- Reduces reported profits and net income
- Prohibited under international accounting standards
Determining the Best Method
There are several factors to consider when determining the optimal inventory valuation method:
- Accounting accuracy – FIFO provides the most accurate representation of ending inventory balances.
- Tax considerations – LIFO reduces taxable income and tax payments owed.
- Financial reporting – FIFO presents inventory costs and profits more accurately.
- Industry standards – Adopting the predominant method used in your industry.
- Inflation conditions – LIFO performs better in inflationary environments.
For most companies, FIFO is preferable because it aligns with the physical inventory flow and produces the most accurate financial statements. Public companies almost always use FIFO.
However, LIFO can provide tax advantages that improve cash flow. Some organisations use LIFO domestically for tax purposes while applying FIFO for international operations.
Accounting Standards for FIFO and LIFO in the UK
In the UK, accounting standards follow the regulations set out by the Financial Reporting Council (FRC). The FRC requires adherence to the International Accounting Standards Board (IASB) guidelines.
The IASB standards prohibit the use of LIFO as an inventory valuation method. UK companies must use FIFO inventory accounting in alignment with International Financial Reporting Standards (IFRS).
Therefore, publicly traded corporations and most large private companies in the UK report financials using the FIFO method for inventory costing. LIFO is generally not permitted or accepted under British accounting rules.
FIFO provides the most accurate representation of ending inventory balances and cost of goods sold. It reflects the actual physical flow of inventory units sold. For these reasons, FIFO is the approved technique under international standards applied in the UK.
Inventory Valuation Methods in Europe
European companies follow the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
The IFRS guidelines mandate the use of FIFO for inventory valuation for any entities adhering to these international standards. The use of LIFO is prohibited under IFRS rules.
Therefore, corporations across Europe adopt FIFO for financial reporting purposes in alignment with accepted international accounting principles.
Within the Eurozone, adherence to IFRS standards is required for consolidated financial statements of publicly listed companies. Private companies may use local Generally Accepted Accounting Principles (GAAP) which also typically require FIFO.
The predominance of FIFO for inventory costing across Europe promotes harmonisation, transparency, and accounting integrity per international standards. LIFO remains primarily a U.S. approach.
Accounting Standards for FIFO and LIFO in the US
LIFO is allowed under GAAP in the U.S. but prohibited under IFRS followed outside the U.S.
FIFO is considered the better method for accurately presenting inventory costs and profits. But U.S. firms can elect to use LIFO for tax benefits provided they meet GAAP reporting requirements.
Tax and Cash Flow Implications
A major implication of choosing FIFO or LIFO involves taxes paid and operating cash flow:
- FIFO results in higher ending inventory values and higher net income. This increases taxable income and taxes owed.
- LIFO results in lower ending inventory on the books and lower net income. This reduces taxable income and income tax expenses.
- So LIFO provides cash flow advantages by reducing taxes paid. But the cash flow benefits could disappear if tax rates decline.
Which Method Aligns with Physical Inventory Flow?
FIFO matches the actual physical flow of inventory units. The first units acquired are the first units sold in reality.
LIFO does not match the physical movement of inventory. In most cases, the newest units purchased are not the first units actually sold.
So FIFO aligns with the real inventory flow while LIFO follows an accounting construct that does not reflect operational reality.
Potential Inventory Management Challenges
The biggest potential problem with LIFO is that the balance sheet can significantly understate the value of inventory. This occurs when very old inventory costs remain on the books despite rising prices over time.
For example, a business that uses LIFO may have inventory costs from 10 or 20 years ago still on the books. This means the true market value of the current physical inventory could far exceed the carrying value reported.
This discrepancy gets larger over time and can amount to a multi-million dollar difference in some cases. The sizable LIFO reserve requires added reconciliation work.
FIFO does not present the same inventory valuation challenges. The inventory carrying value tends to track closer to actual market prices under FIFO.
International Use of FIFO vs LIFO
Outside the U.S., LIFO is prohibited under IFRS accounting rules followed in most countries. FIFO is the standard technique used internationally.
Some multinational firms report financials using LIFO for U.S. operations to obtain tax deductions. But their international divisions report under FIFO to comply with IFRS.
So LIFO adoption is largely restricted to U.S. domestic companies and entities. FIFO is the commonly used global standard.
Implementing and Switching Methods
In most cases, businesses choose a method and stick with it over time. But they can change methods with proper accounting adjustments.
Implementing LIFO typically requires maintaining a LIFO reserve to track the growing difference versus FIFO value. Companies can liquidate LIFO layers to realise taxable income benefits.
But the costs and complexities mean most organisations implement FIFO initially. Public companies almost exclusively use FIFO to comply with accounting standards and provide consistent financial reporting.
While LIFO and FIFO represent very different inventory cost assumptions, both aim to properly match revenues and expenses per accounting guidelines. For most businesses, FIFO is the best approach unless LIFO tax benefits are substantial and enduring.
Carefully evaluating inventory valuation methods and deploying the right techniques is vital for accurate accounting, financial reporting, operational efficiency, and strategic performance management.
The Bottom Line on FIFO vs LIFO
Having sharp inventory management skills is critical for warehouse and operations personnel. While FIFO and LIFO may seem confusing at first, the underlying logic makes sense when you break it down.
FIFO matches the actual flow of inventory. LIFO does not but can lower taxes. Most businesses use FIFO since it provides the most accurate accounting.
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