Financial and tax implications of FIFO and LIFO inventory methods

LIFO and FIFO Inventory Valuation Methods

FIFO or LIFO

A Comparison of LIFO and FIFO Inventory Valuation Methods

There are a number of considerations when choosing between the inventory tracking and valuation methods of 'first in, first out' (FIFO) and 'last in, last out' (LIFO). These include the company's balance sheet, income statement, cash flow statement, and tax considerations (Drive Your Success, 2010).

Balance Sheet, Income Statement, Cash Flow Statement, and Tax Implications

When FIFO is used the value of the year-end inventory is higher because the lowest cost goods are sold first. Since the goods sold have a lower cost, gross profit and net income are increased. This will increase tax liability in terms of the company's profit (Fried, n.d.). When LIFO is used the cost of goods sold is higher, which reduces profit and net income and lowers tax liability. It should be noted that the U.S. tax code requires that the same inventory valuation method be used for both tax and financial reporting purposes (Fried, n.d.) and LIFO is banned in the United Kingdom (Drive Your Success, 2010).

The ability of a balance sheet or income statement to accurately reflect cost of goods also differs. When using LIFO the cost of goods is more accurately reflected in the income sheet than on the balance sheet, whereas FIFO produces the opposite effect. This phenomenon is related to the difference in how these two statements evaluate a company, with a balance sheet giving a 'point in time' view and an income statement providing a long-term view.

If the economy is under considerable inflationary pressure and the cost of goods increases during the year, then significant benefits can be obtained using LIFO if the inventory is of considerable size and value. The benefits in terms of a lower tax liability can be so significant that this alone dictates the use of LIFO, primarily because the tax savings increase cash flow. Should inflationary pressures be minimum or nonexistent, then FIFO would probably be the preferred choice. LIFO is typically more expensive to implement and FIFO tends to provide better leverage ratios (Fried, n.d.).

Sources

Drive Your Success. (2010). Small Business Inventory Management: LIFO vs. FIFO vs. Average Cost. Retrieved June, 2011 from http://www.driveyoursuccess.com/2010/11/small-business-inventory-management-lifo-vs.-fifo-vs.-average-cost.html

Fried, Haim D. (n.d.) Inventory. Retrieved June, 2011 from http://pages.stern.nyu.edu/~hfried/download/Inventory.pdf