Inventory Methods: LIFO versus FIFO 1
Inventory Methods: LIFO versus FIFO
Leslie Lake
Liberty University
ACCT 301-B01
Professor William Sullivan, Jr.
Inventory Methods: LIFO versus FIFO 2
Abstract
LIFO (Last in, First out) and FIFO (First in, First out) are two common methods of inventory
management within a business. Each method is important to any organization in which it tracks
items sold, and also the cost of items for resale. For an organization to choose wither LIFO or
FIFO it affects “everything from balance sheets to income statements, influencing the tax
liability and profitability[Goo13]” of an organization.
Inventory Methods: LIFO versus FIFO 3
Inventory Methods: LIFO versus FIFO
LIFO (Last in, First out) and FIFO (First in, First out) are two common methods of
inventory management within a business. Each method is important to any organization in which
it tracks items sold, and also the cost of items for resale. For an organization to choose wither
LIFO or FIFO it affects “everything from balance sheets to income statements, influencing the
tax liability and profitability[Goo13]” of an organization.
FIFO
The more commonly used of the two inventory methods, FIFO (first-in, first-out)
“method assumes that units sold are the first units acquired[Spi133].” Which follows that the
inventory purchased first, chronologically is the first items that are sold. Businesses or
organizations that deal with food are the best example of FIFO inventory method. For example a
café that sells baked goods, will place the oldest baked good in the front for customers to
purchases, and as they sell down the barista will replace the sold baked good with a newer item.
As an organization purchases new product all new product will be placed in back stock
and used as the stock levels go down. This would mean that as purchase prices of product goes
up, “FIFO provides a higher profit because, older cheaper goods are sold first [Goo13].” The
FIFO does have a disadvantage when it comes to tax liability, because it “results in a lower
recorded cost per unit, it also records a higher level of pre-tax earnings [Goo13].” This in turns
gives the results of a higher profit, and with higher profits there are higher taxes.
LIFO
Inventory Methods: LIFO versus FIFO 4
LIFO (Last-in, First-out) is the most appealing of the two inventory methods, due
to the break in tax liability. The LIFO inventory method “assumes that the units sold are the most
recent units purchased [Spi133].” What this means is that as the price of goods increase, which
means the “cost of goods sold will equate to a higher amount and reduce profits and tax burdens
[Goo13].”
For example, 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, they 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. [Goo13]
Though having the ability to report less taxes does come at a disadvantage
for organizations. What it means for an organization is, though they receive the
tax break due to the reporting lower earnings, this could break an organization,
since reporting lower earnings could affect “meeting various debt covenants as
well as in the valuation of the company's common stock [Jes10].”
FIFO AND LIFO SIMILARITIES AND DIFFERENCES
FIFO and LIFO are two very different inventory methods, but the only
thing that the two have in common is “they both depend on the product remaining
the same, with price being the only fluctuating element [Goo13].” The main
Inventory Methods: LIFO versus FIFO 5
differences for FIFO and LIFO are the inventory processes itself and the tax
liability. FIFO follows that the first product purchased is the first product that
goes out, and the due to a higher profit with FIFO, taxes are higher with this
inventory method. As for LIFO, it follows that the last product purchased is the
first product that goes out, and this will allow the organization to report lower
earnings, and in turn allow for less taxes.
DEATH OF LIFO
In the past organizations have been able to choose from the two inventory
methods, but that may be coming to an end. In August of 2008 the Securities of
Exchange (SEC) proposed that all publicly traded U.S. companies adopt the
International Financial Reporting Standards (IFRS). “The proposal stated its
support for a single set of high quality accounting standards [Car12].” Not only is
LIFO not a recognized inventory method by the SEC, it is also not recognized by
the IFRS and the U.S. GAAP. This is due to the “Obama Budget LIFO Repeal”,
which started in 2010. The budget repeal “calls for the elimination of the LIFO
methodology for Federal tax purposes [Car12].” Currently LIFO cannot be used
by either IFRS or U.S. GAAP, but “under current federal tax law, companies may
only use LIFO for tax purposes if they also use it for financial reporting purposes
[Plu11].”
So what does this mean for businesses if LIFO is eliminated? First,
“companies could no longer use LIFO for tax reporting [Ree13].” If the repeal
Inventory Methods: LIFO versus FIFO 6
that the Obama Administration is suggesting goes through it would cause an
increase in corporate taxes for U.S. businesses.
Next, it “would cause companies to recapture LIFO reserves and the
deferred tax benefits caused by them [Ree13].” What this would mean for
businesses is with the elimination is would cause a huge tax liability. This would
all depend on the businesses reserves and how long they have been using LIFO.
“This effect would cause companies to pay taxes on decisions made by company
management many years ago. Many companies might not be able to finance this
huge cash flow drain and would not survive [Ree13].”
Also affected the elimination of LIFO, would be state and local taxes on a
corporation. “Since state and local taxes piggyback off of federal tax
law[Ree13],” with the elimination of LIFO corporations will see an increase in
taxes.
Though most of the things that are affected by the elimination of LIFO
there is also an issue of accounting quality with adopting IFRS. Since Europe
adopted IFRS in 2005, it “has caused a decline in accounting quality [Ree13].
They maintain this effect makes it harder for investors base their decisions on
IFRS financial reporting [Ree13].”
Conclusion
Both FIFO and LIFO has advantages and disadvantages, it is solely up to
the organization with inventory method they choose to use. FIFO is the more
common of the two inventory methods used among organizations. Though LIFO
Inventory Methods: LIFO versus FIFO 7
does has the advantage of a tax benefit, with the current state in which it could be
eliminated it may be best for an organization to switch to FIFO.
Inventory Methods: LIFO versus FIFO 8
References
Carpenter, B. W., Boyle, D. M., & Ren, Y. P. (2012). The Impending Demise fo LIFO: History, Threats,
Implications, and Potential Remedies. Journal of Applied Business Research, 645-650.
Goodrich, R. (2013, November 22). FIFO Vs.LIFO: What is the Difference? Retrieved Feburary 12, 2014,
from Business News Daily: http://www.businessnewsdaily.com/5514-fifo-lifo-differences.html
Jesswein, K. R. (2010). The Changing Lifo-Fifo Dilemma and its Importance to the Analysis of Financial
Statements. Academy of Accounting and Financial Studies Journal, 53-62.
Plummer, E., & Vigeland, R. L. (2011). Considering Life After LIFO. The CPA Journal, 26-33.
Reed, R. M., & Pence, D. K. (2013). Throwing a Life Saver to LIFO: IFRS Adoption of Incorporation?
Journal of Accounting and Finance, 132-136.
Spiceland, D. J., Sepe, J. F., & Nelson, M. W. (2013). Intermediate Accounting. New York: McGraw-Hill
Irwin.
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