LIFO vs. FIFO: a return to the basics

RMA Journal, The, Oct, 2002 by Scott C. Gibson

Whether a company presents its financial statements using the last in, first out (LIFO) valuation technique or the first in, first out (FIFO) method, lenders should understand them both. This article presents an overview of both systems and explains their inherent advantages and disadvantages.

Since the early 1970s, a trend toward the increased use of the last in, first out (LIFO) method of inventory valuation has been apparent. The question as to why this trend exists is perhaps answered by the managerial responses from businesses, both large and small, to inflation, higher taxes, and the desire to maximize after tax cash flow from operations. In times of increasing prices and costs, illusory inventory profits may result from using an inventory valuation method other than LIFO. These "inventory profits" result in improved reported earnings, but because the inventory profits are taxed, they reduce a company's net cash flow.

Distinction Between LIFO and FIFO

LIFO. The LIFO method of inventory costing uses both unit-base and cost-base methods of inventory valuation, in which the latest unit acquisition cost is matched with current sales revenue. Therefore, under LIFO, the order of cost outflow recognized is the inverse of the order of cost inflow. The units remaining in ending inventory are costed at the oldest unit costs available; the units in cost of sales are costed at the most recent unit costs available.

Company administrators who have elected to use the LIFO approach generally believe that costs will either remain stable or increase. Companies that commonly use the LIFO valuation approach are those whose costs predominantly increase each year and whose inventory is generally quite large.

It is often desirable for a company to use LIFO for tax purposes to obtain a cash flow advantage (resulting from decreased tax payments) when inventory costs are rising. However, owing to a congressional income tax rule, a company that adopts the LIFO valuation method for income tax purposes also automatically adopts LIFO for financial reporting purposes.

Therefore, accounting for inventory under LIFO includes complexities relating to federal tax regulations. And it may reflect less favorable financial results owing to earnings reductions and negative effects on the balance sheet as a company reports its financial position.

FIFO. The LIFO costing method contrasts with the first in, first out (FIFO) inventory method, which assumes that the cost of items sold in a period reflects the oldest cost in inventory just before sale. As a consequence, remaining inventory valued at FIFO more closely represents current or replacement cost.

As a practical matter, FIFO more closely depicts the physical movement of goods. Companies generally use the oldest items in inventory first so they can continually roll the stock and prevent deterioration or obsolescence. In times of stable prices, FIFO has been widely used and accepted.

However, in an inflationary environment, FIFO results in "inventory profits"--profits that arise merely from holding inventory--and fails to provide the best matching of costs and revenues.

Comparability

The financial statements of a company using the LIFO approach as opposed to FIFO generally reflect:

* Conservative profits, because LIFO buffers the effects of inflation.

* Better matching of current costs with current revenues.

* Lower liquidity, that is, a lower current ratio.

* Lower equity position, that is, a higher debt-to-worth ratio.

The ABC Company. To clarify the primary differences between LIFO and FIFO, consider the hypothetical example of the ABC Company:

* ABC produces gadgets that sell for $1,000 each.

* At start-up, ABC's cost to produce each gadget was $500.

* During the year, ABC sold 10 gadgets for a total of $10,000 (10 at $1,000 per gadget).

* As ABC replenished its inventory, inflation increased the production cost to $600 per gadget.

* Total cost to ABC to replenish the inventory was $6,000 (10 at $600 per gadget).

ABC uses the FIFO evaluation method, and it is assumed that the cost of each gadget produced will be $500 (oldest cost). Conversely, if ABC were to use the LIFO valuation method, each gadget's production cost would be $600 (most recent cost). The effect of each valuation method is shown as follows:

                       LIFO     FIFO

Sales                $10,000   $10,000
Cost of sales         (6,000)   (5,000)
Gross profit           4,000     5,000
Operating expenses    (1,500)   (1,500)
Income before taxes    2,500     3,500
Taxes *                 (875)   (1,225)
Net income             1,625     2,275

* An assumed 35% income tax rate.

The gross profit differential between the LIFO and FIFO approaches is $1,000. The difference can be attributed to the increased cost of sales (10 at $100 per gadget), resulting in illusory inventory profits when FIFO is used to value ending inventory.

As a result of ABC's replenishing its inventory at the higher cost, the $1000 of "inventory profits" under FIFO would not be available for stockholder distribution. Under LIFO, current costs are matched against sales, and therefore inventory profits are not recorded.