FIFO and LIFO are two methods of accounting for inventory purchases, or more specifically, for estimating the value of inventory sold in a given period. Show
 Table of Contents
FIFO vs. LIFO Accounting – Inventory Valuation MethodsWhat is FIFO?FIFO is an abbreviation for “First In, First Out.” Under the FIFO approach of accounting, the inventory purchased earlier is the first to be recognized and expensed on the income statement, within the cost of goods sold (COGS) line item. Outside of the U.S., only FIFO is permitted under IFRS, so FIFO tends to be the prevalent inventory valuation method for international companies. What is LIFO?Alternatively, LIFO is an abbreviation for “Last In, First Out.” LIFO, unlike FIFO, recognizes the more recently purchased inventories ahead of those purchased earlier – i.e. the most recent inventory purchases are the first to be sold. Under U.S. GAAP, LIFO is permitted, making the FIFO vs LIFO decision a discretionary decision for U.S. companies. Hence, many U.S. companies will present their financials abiding by the LIFO method on their filings and financial statements with the SEC but switch to FIFO for their international operations (e.g. subsidiaries). FIFO vs. LIFO: Advantages and Disadvantages ChartThe importance of FIFO vs. LIFO is due to the fact that inventory cost recognition directly impacts a company’s current period net profits (and taxes). LIFO vs. FIFO: Net Income Impact ExamplesIncreasing Inventory CostsTo further expand upon the summary chart, the rules are as follows:
In this situation, the inventory purchased earlier is less expensive compared to recent purchases. Since the inventory purchased first was recognized, net income will thus be higher in the current period. With that said, if inventory costs have increased, the COGS for the current period are higher under LIFO. Decreasing Inventory CostsAs for declining inventory costs, the impacts of FIFO vs LIFO are:
By contrast, the inventory purchased in more recent periods is cheaper than those purchased earlier (i.e. older inventory costs are more expensive). Therefore, considering the older, more expensive inventory was recognized, net income is lower under FIFO for the given period. Conversely, COGS would be lower under LIFO – i.e. the cheaper inventory costs were recognized – leading to higher net income. FIFO vs. LIFO Calculation ExampleLet’s assume that a company has sold 100 units of t-shirts in the current period at the prices listed below:
The trend above shows that the more recent inventory costs have increased versus earlier costs. Under the two methods, FIFO and LIFO, the following could be recognized as COGS in our example:
Since inventory costs have increased in recent times, LIFO shows higher COGS and lower net income – whereas COGS is lower under FIFO, so net income is higher. Accountants have two main options for inventory valuation: FIFO (First In First Out) and LIFO (Last In First Out). LIFO is only allowed under US GAAP and is a choice that US companies need to make. For this reason, FIFO is the more dominant valuation method internationally as it is permitted under IFRS. FIFO assumes that the first goods in are the first to be sold. This means that ending inventory comprises the most recent purchases and therefore will reflect the most up to date costs. LIFO assumes that the last goods in are the first to be sold, meaning stock turnover is the opposite to that of FIFO. Closing inventory is therefore valued at older costs. Sometimes it is not always possible to know with accuracy the flow of stock in and out of the business; this is when a third approach to valuation, “weighted average”, might be used. This method will take the total cost of the goods and divide it by the total number of units within that accounting period. It gives a middle value between FIFO and LIFO value. Key Learning Points
Analytical ImpactInventory is a key line item in the balance sheet and affects the financial statements in several different ways. It matters which inventory cost is allocated into COGS as this directly affects reported profits. If reported profits are impacted by the expense incurred, then so is retained earnings and hence shareholders’ equity. Inventory will also affect working capital, therefore, valuing inventory correctly is crucial. FIFO charges old units of stock to COGS and so this approach results in stock valuation at more recent prices. Therefore, FIFO produces a more accurate or relevant balance sheet. LIFO charges new units to COGS, which means this approach produces a more realistic income statement. In an inflationary environment where we assume prices are rising and inventory is consistent or growing, then we expect to see the following impacts on each item: MeasureLIFOFIFONet incomeLowerHigherInventory balanceLowerHigherTaxesLowerHigherHow to Adjust a Company Reporting Under LIFO (US GAAP Only) to Make it Comparable with Companies Using FIFO?In the US, companies using LIFO inventory accounting will always give you the value of their inventory using FIFO as well, so you can adjust to make their EBIT earnings number comparable. Take Reliance Steel and Aluminium Inc. NYSE:RS. RS operates in an industry with highly variable prices of raw materials, so its choice of inventory accounting method will impact its profitability. RS’s inventory accounting policy is to use LIFO. They disclose the following in their accounts. Inventory accounting note: Income statement: Balance sheet: In 2018, RS reported EBIT of 974.5 (937.5 + 37 adding back the non-recurring impairment charge), using COGS of 8,253 and LIFO accounting. We can restate the EBIT level by doing a B-A-S-E analysis of the inventory accounting using the LIFO numbers to solve for purchase of inventory: Current Inventories (mostly LIFO)Beginning inventory1726.0From the balance sheetPurchases8344.1Reversed engineered from the other itemsCOGS(8,253.0)From the income statementEnding inventory1,817.0From the balance sheetRS uses a combination of LIFO and FIFO inventory methods but mostly LIFO, however, we can still make the adjustment. Using the information in the note above, we can restate the B-A-S-E analysis using the FIFO ending balances, the inventory purchases, and solve for FIFO COGS: FIFO InventoriesBeginning inventory1747.8From the balance sheetPurchases8344.1From the LIFO BASE analysisCOGS(7,981.2)From the income statementEnding inventory2,110.7From the balance sheetNote the beginning and ending balances add both FIFO inventory lines (21.8m in 2017 and 293.6m in 2018). So, if the company used FIFO inventory accounting its COGS would be 7,981.20 rather than 8,253 – a difference of US$271.80MM, and its EBIT number would be US$1,246.3MM a material difference. In trading comparables, analysts would use the FIFO number as it’s comparable to the international peer group. You might have noticed a faster, but less intuitive way of making the adjustment, is just to take the change in the LIFO reserve – also noted in the inventory note. The LIFO reserve is the accumulated difference between LIFO and FIFO inventory accounting. LIFO LiquidationA final issue is where companies who use LIFO inventory accounting start to sell down their inventory and stop replacing sold products. LIFO accounting always takes the most recent purchases as COGS, but if you stop purchasing new inventory you will begin to account for COGS using older and older ‘layers’ of inventory. In some situations, the ‘liquidation’ of inventory can result in extremely old inventory prices, which due to inflation can dramatically understate the current cost of inventory in COGS, and suddenly higher profits. In the inventory note above, the company states any liquidation of LIFO inventory layers is insignificant. A good example of a LIFO liquidation is RYI in 2007. In RYI’s 10-K they noted:
|
