FIFO and LIFO accounting

From Wikipedia, the free encyclopedia
FIFO and LIFO accounting Methods are means of managing inventory and financial matters involving the money a company ties up within inventory of produced goods, raw materials, parts, components, or feed stocks. FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first. LIFO stands for last-in, first-out, meaning that the most recently purchased items are recorded as sold first. Since the 1970s, U.S. companies have tended to use LIFO, which reduces their income taxes in times of inflation.

LIFO accounting
LIFO is an acronym for "last in, first out." (Sometimes the term FILO ("first in, last out") is used synonymously.) In LIFO accounting, a historical method of recording the value of inventory, a firm records the last units purchased as the first units sold. LIFO accounting is in contrast to the method FIFO accounting covered below.
Since prices generally rise over time because of inflation, this method records the sale of the most expensive inventory first and thereby decreases profit and reduces taxes. However, this method rarely reflects the physical flow of indistinguishable items.
LIFO valuation is permitted in the belief that an ongoing business does not realize an economic profit solely from inflation. When prices are increasing, they must replace inventory currently being sold with higher priced goods. LIFO better matches current cost against current revenue. It also defers paying taxes on phantom income arising solely from inflation. LIFO is attractive to business in that it delays a major detrimental effect of inflation, namely higher taxes. However, in a very long run, both methods converge.
“Last in first out” (LIFO) is not acceptable in the IFRS.
FIFO accounting
FIFO accounting is a common method for recording the value of inventory. It is appropriate where there are many different batches of similar products. The method presumes that the next item to be shipped will be the oldest of that type in the warehouse. In practice, this usually reflects the underlying commercial substance of the transaction, since many companies rotate their inventory (especially of perishable goods). This is still not in contrast to LIFO because FIFO and LIFO are cost flow assumptions not product flow assumptions.
LIFO is based on an irrational assumption that inventories entering last in stores are issued/consumed first.
In an economy of rising prices (during inflation), it is common for beginning companies to use FIFO for reporting the value of merchandise to bolster their balance sheet. As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company's books. Having the higher valued inventory and the lower cost of goods sold on the company's financial statements may increase the chances of getting a loan. However, as it prospers the company may switch to LIFO to reduce the amount of taxes it pays to the government.
LIFO liquidation
Notwithstanding its deferred tax advantage, a LIFO inventory system can lead to LIFO liquidation, a situation where in the absence of new replacement inventory or a search for increased profits, older inventory is increasingly liquidated (or sold). If prices have been rising, for example through inflation, this older inventory will have a lower cost, and its liquidation will lead to the recognition of higher net income and the payment of higher taxes, thus reversing the deferred tax advantage that initially encouraged the adoption of a LIFO system. Some companies who use LIFO have decades-old inventory recorded on their books at a very low cost. For these companies a LIFO liquidation would result in an inflated net income and higher tax payments. This situation is usually undesirable; on rare occasions a company in financial stress could abuse this method to temporarily increase income.
[edit] See also
• Average costing
[edit] Example of FIFO vs LIFO accounting
Suppose we have to value 120 items of our stock today (June 2009), and that they were purchased at 3 different dates and 3 different prices:
Date Quantity Unitary Price (USD)
March 2009 50 10
April 2009 55 11
May 2009 15 12
The FIFO price starts with the oldest one. Since we have to calculate 120 items, we consider that the first 50 have a unitary value of 10 USD, (the oldest price); the next 55 will have a unitary value of 11 USD, and the remaining 15 (120-50-55) will have a unitary value of 12 USD.

Therefore, the FIFO price is 10.71 USD:


The LIFO price starts with the most recent one. Since we have to calculate 120 items, we consider that the first 52 have a unitary value of 12 USD, (the most recent price); the next 55 will have a unitary value of 11 USD, and the remaining 13 (120-52-55) will have a unitary value of 10 USD.

Therefore, the LIFO price is 11.33 USD:


As we can see, in normal economic conditions (i.e. in presence of inflation) the LIFO price is bigger than the FIFO. Indeed, the FIFO price undervalues the price of the liabilities (the 120 items in the example), and since these are smaller the FIFO price overvalues the remaining stock. On the contrary, the LIFO price undervalues the current stock because it overprices the liabilities.