The FIFO and LIFO accounting concepts are the best way for companies and business owners to distinguish the ways they historically process their inventory. From a professional standpoint, the rapid growth and adoption of technology has significantly changed the way everyone, even businesses, manage all the information they need to process.
Before we take a deeper dive into this topic, let’s first define FIFO and LIFO. They are terms used to account for inventory items financially as they enter and leave a business. LIFO accounting stands for Last In First Out. LIFO is based on the idea that the cost of the last item put on the shelf (newest item) is used when determining value. On the other hand, FIFO stands for First In First Out and it states that the cost of the item put first on the shelf (oldest item) should be used.
Use of LIFO and FIFO Beyond Accounting
There are many reasons for these distinctions which will be discussed later on. But first let’s focus on when a particular item is addressed—is the oldest or newest item of considered more important? Apparently, we’ve moved on from the old-school method of managing inventories in a FIFO manner to a LIFO manner. This means that, for the most part, we used to take the oldest on our to-do list and get it done before we move on to newer tasks. As a consequence, things never got too dusty on our to-do list and we stay reasonably updated on our workload and deadlines.
And yet, as the inputs start pouring in faster and faster due to technological advances and the internet, we started shifting to LIFO behaviors –or addressing things as they come at us, leaving those that were older to decompose or rot a little longer on the to-do list. This kind of behavior has become so strongly embedded in our work cultures the moment smartphone started producing multiple inputs to us wherever and whenever.
This has gotten so bad to that point that people regularly send a second email or text a few minutes after they have sent the first one if they haven’t received a response immediately. Instead of focusing on the to-dos that are currently at hand, we have to deal with newer to-dos. What about improving client/customer service? How is it considered an advancement if you are yanked from input to input without having time to actually think of the right solution?
Reasons for Using FIFO instead of LIFO
If a US-based company’s cost of inventory items is steadily increasing and the corporation has been experiencing operating losses and a negative taxable income, using the FIFO accounting method means they’d match their oldest/lower costs with their current sales. This results to a larger gross profit and a good or positive operating income.
Reasons for Using LIFO instead of FIFO
If a US-based company’s cost of inventory items is steadily on the rise, or increasing, they will have lower income tax payments with LIFO accounting. This results to matching the most recent higher cost of items to the newest or most recent sales. (The higher cost of items sold translates to lower net income and lower taxable income compared to FIFO).
Another reason for companies to use the LIFO method is so they can improve the matching of costs with sales. If the company has matched the old low costs using FIFO, they would have better profit that was caused mostly by holding some old inventory items.
LIFO vs. FIFO: Which is Better?
Below are some details on the comparisons in the table to help you decide which accounting method is appropriate for your business.
Rising vs. Falling Costs
To evaluate the relative value of LIFO and FIFO inventory cost, you must look into the way your inventory costs are changing. For example:
• Your inventory costs are increasing or has the potential to increase, you might be better of using the LIFO method because the higher cost items (those purchased or made last) are considered sold. This leads to higher costs and lower profits.
• If, however, the opposite is happening, meaning your inventory costs are going down, then FIFO method might be better. Because prices usually go up, many businesses prefer to use the LIFO accounting method.
Accuracy of Counting
If you prefer a more accurate way to account costs, FIFO is better because it assumes that older, less-expensive items are most usually sold first.
Profits and Taxes
Higher business costs translate to a lower net income, resulting to lower taxes. Higher-cost inventory means lower taxes. Lower-cost inventory, however, means higher taxes.
The LIFO method is prohibited by the international accounting standards body IFRS, therefore if you are doing or want to do business internationally, you will have to use FIFO.
The LIFO accounting method increases record-keeping opportunities, because older inventory items may be recorded and stored for several years, whereas under FIFO, the older items are sold first, so there are less record-keeping requirements.
FIFO vs. LIFO Tax and Accounting Rules
The Financial Accounting Standards Board (FASB), a US-based accounting standards organization, in its Generally Accepted Accounting Procedures, has stated that it allows both FIFO and LIFO accounting methods.
Under its current tax laws, the Tax Cuts and Jobs Act, which took effect in 2018, small businesses with $25million or les in gross receipts can label inventory as “non-incidental materials and supplies.” This means that these are items bought for resale. They are also required to use an accounting method that properly reflects their income. In this case, they can use the cash method of accounting rather than the accrual method of accounting.
If your business does keep inventory, the IRS requires you to use the accrual method instead.
Restrictions on Changing Inventory Methods
The FIFO inventory valuation is generally the default method used. If you make no attempts to change your inventory valuation method, you must use FIFO to cost your inventory every year. The IRS obviously does not like the LIFO method, because it usually leads to lower profits (lower taxable income). However, the IRS does allow businesses to use LIFO accounting, albeit they require businesses to apply for it, on Form 970.