FIFO And LIFO Accounting

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 feedstocks.

LIFO Accounting

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 is an acronym for “last in, first out.” Sometimes the term FILO (“first-in, last out”) is used synonymously. LIFO accounting is in contrast to the method FIFO accounting covered below.

Since prices generally rise over time, this method records the sale of the most expensive inventory first and thereby can reduce 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.

“Last in first out” (LIFO) is not acceptable in the IFRS (IAS2.25).

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 in contrast to LIFO.

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 a 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 wherein 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 may abuse this method to temporarily increase income.

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