LIFO and FIFO: Accounting Standards in GAAP and IFRS

Introduction to GAAP and IFRS

Accounting principles are used globally to track income, profits, losses, and transactions. GAAP, or Generally Accepted Accounting Principles, is the accounting system used exclusively in the United States. IFRS, or International Financial Reporting Standard, is used in over 110 countries outside the United States. The fundamental difference between the two can be described concisely: GAAP operates as a rules-based system, whereas IFRS operates as a principle-based system.

Although the United States uses only GAAP, IFRS is becoming increasingly relevant to U.S. companies—both large and small. All accounting systems follow double-entry practices that categorize transactions as revenue or expenses, and as assets or liabilities. While the United States and foreign countries use these two different systems, both have similarities and differences. One major distinction is how they employ inventory valuation methods. Specifically, GAAP permits both LIFO (Last In First Out) and FIFO (First In First Out), whereas IFRS uses only FIFO. Both methods refer to how the influx of goods purchased and sold is distributed in financial records.

Historically, the U.S. Securities and Exchange Commission has indicated interest in transitioning to IFRS, which would align the United States with international standards. If adopted, this change would provide the U.S. with greater benefits toward international investing and trading, and would enhance comparability for investors across borders.

Understanding GAAP: Structure and Principles

GAAP is a collection of rules, procedures, and conventions that define accepted accounting practice in the United States. It includes broad guidelines as well as detailed procedures that companies must follow when preparing financial statements. GAAP deals with two main principles. The first is the cost principle, which sets all of a company's costs and dictates the company's records. The second is the fair value principle, which states that all assets and liabilities of a company should be reported at fair value price.

The objectives of GAAP are to assist in making financial decisions and long-term strategic choices. It improves business performance and makes record-keeping easier. GAAP serves as the definitive source of accounting guidelines for companies preparing financial statements. The framework is updated regularly to reflect modern accounting methods.

GAAP also provides a reliable means of comparing financial results from industry to industry and year to year. The system is developed by the Financial Accounting Standards Board, and companies that distribute financial statements outside their organization must adhere to GAAP. If a corporation's stock is traded publicly, its financial statements must also comply with the Securities and Exchange Commission standards. GAAP covers revenue recognition, balance sheet item classification, and outstanding share measurements. Under GAAP, both LIFO and FIFO cash flow assumptions are accessible, meaning companies can choose which inventory method best suits their financial strategy.

International Financial Reporting Standards Explained

The International Financial Reporting Standards (IFRS) is the accounting system used in over 110 countries outside the United States. It is designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. The IFRS was established around the world in 2001 and adopted by the European Union in 2005.

A key difference between IFRS and GAAP is that IFRS requires inventory to be written down, but inventory cannot be written up above its original cost. Additionally, unlike GAAP, IFRS does not include a statement of comprehensive income. A fundamental difference is that IFRS declares an asset as being a resource with future economic benefit that will flow into a company.

The main goal IFRS sets is to make international comparisons as easy as possible. However, this goal faces challenges because each country has its own set of rules governing accounting practices. IFRS uses FIFO as its sole cash flow assumption because it is easier and more efficient for countries to conduct business together while maximizing profit opportunities. Investors and companies seek maximum profit in the shortest amount of time. If IFRS adopted LIFO, the opportunity for profit could take longer and many opportunities might not occur at all, because the original inventory would not be sold promptly. Companies and investors are unwilling to risk their capital in such an accounting system.

Companies based in the U.S. but conducting substantial business overseas—such as General Motors, which generates over 70 percent of revenue internationally—would benefit significantly from IFRS. These multinational firms require a consistent framework across all markets rather than managing separate GAAP and IFRS reports.

LIFO and FIFO: Benefits and Disadvantages

The benefits of the FIFO cash flow assumption include accounting for inventory received first when sales are made. Companies choose FIFO because it is a straightforward approach: you account for your first inventory as the first items sold, making it especially useful for tracking inventory items. However, when a company purchases inventory in multiple batches at different times, tracking becomes complicated. If a company's cost of inventory inflates over time, its taxable income becomes higher under FIFO. Despite this, FIFO remains logical for most businesses because selling the oldest inventory reduces the risk of stock spoilage or obsolescence.

LIFO, by contrast, accounts for the most recently received inventory as the first items sold. A major reason companies choose LIFO is because it keeps business taxable income low. However, a significant disadvantage is that companies cannot switch to FIFO for several years without permission from the Internal Revenue Service. Additionally, LIFO creates a larger discrepancy between the cost basis of initial inventory and current market prices. The LIFO approach is only used in GAAP because foreign countries do not consider it sufficiently beneficial. Since nearly all foreign business operates under FIFO, the United States has been pursuing a transition to FIFO by adopting IFRS.

The Securities and Exchange Commission has proposed changing U.S. accounting standards from GAAP to IFRS. According to the agency's proposal, the shift could eventually reduce costs for companies and smooth cross-border investing. However, investors worry it will create confusion, especially during the transition. Other critics argue that the international system offers too much flexibility for companies compared with the more precise rules in U.S. standards.

The SEC Transition Proposal and Global Competition

Through the SEC's proposal, some large multinational companies were allowed to report earnings according to IFRS beginning in 2010. The agency laid out a roadmap by which all U.S. companies would switch to International Financial Reporting Standards beginning in 2014, at the expense of U.S. GAAP. The SEC maintains that this change will help the U.S. compete globally because many other nations use international standards or plan to do so.

The SEC argues that the increasing worldwide acceptance of IFRS and U.S. investors' growing ownership of foreign companies demonstrate that maintaining separate systems will decrease comparability and transparency. If the United States adopts IFRS with its dominant cash flow assumption (FIFO), it will give investors and business owners of large and small companies greater opportunities for profit both domestically and in international markets.

The United States' GAAP operates as a rules-based system with detailed, specific guidance for virtually every accounting scenario. Critics have argued that rules-based GAAP is partly responsible for accounting scandals that the United States has experienced. They contend that when companies can find loopholes within explicit rules, financial statements may not reflect economic reality.

Conclusion and Future Implications

GAAP, used in the United States, and IFRS, used globally in foreign countries, are both reliable accounting principle guidelines with significant similarities and differences. A major distinction is how they handle cash flow assumptions: GAAP uses both FIFO and LIFO approaches, whereas IFRS uses only FIFO. Although the United States has pursued a switch from GAAP to IFRS, the GAAP system does have inherent benefits, particularly in the specificity and precision of its rules.

Both accounting principles serve as guidelines in the language of accounting. GAAP functions as a rules-based system, while IFRS operates as a principles-based system. If the United States adopts IFRS and its dominant cash flow assumption (FIFO), it will provide investors and business owners of large and small companies greater opportunities for profit in both domestic and overseas markets. Such a transition would enhance financial reporting transparency and enable easier comparison of U.S. financial statements with those of international competitors, ultimately strengthening the position of American companies in the global marketplace.