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    Home >> Inventory Accounting Topics

     

    FIFO vs. LIFO Accounting


    FIFO is a contraction of the term "first in, first out," and means that the goods first added to inventory are assumed to be the first goods removed from inventory for sale. LIFO is a contraction of the term "last in, first out," and means that the goods last added to inventory are assumed to be the first goods removed from inventory for sale. Both terms are accounting concepts used to value the cost of goods sold and ending inventory.

    Why use one method over the other? Here are some considerations that take into account the fields of accounting, materials flow, and financial analysis:

    Issue

     FIFO Method

    LIFO Method

    Materials flow

     In most businesses, the actual flow of materials follows FIFO, which makes this a logical choice.

    There are few businesses where the oldest items are kept in stock whiler newer items are sold first.

    Inflation

    If costs are increasing, the first items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.

    If costs are increasing, the last items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.

    Deflation

    If costs are decreasing, the first items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.

    If costs are decreasing, the last items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.

    Financial reporting

    There are no GAAP or IFRS restrictions on the use of FIFO in reporting financial results.

    IFRS does not all the use of the LIFO method at all. The IRS allows the use of LIFO, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity.

    Record keeping

    There are usually fewer inventory layers to track in a FIFO system, since the oldest layers are continually used up. This reduces record keeping.

    There are usually more inventory layers to track in a LIFO system, since the oldest layers can potentially remain in the system for years. This increases record keeping.

    Reporting fluctuations

    Since there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers.

    There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold.


    In general, LIFO accounting is not recommended, for the following reasons:

    • It is not allowed under IFRS, and a large part of the world uses the IFRS framework.
    • The number of layers to track can be substantially larger than would be the case under FIFO.
    • If old layers are accessed, costs may be charged to expense that vary substantially from current costs. 

    In essence, the primary reason for using LIFO is to defer the payment of income taxes in an inflationary environment.

    Related Topics

    First-in first-out method
    Last-in first-out method
    Specific identification method
    Weighted average method
    What are perpetual LIFO and periodic LIFO?